Financial Accounting Theory, 5e Craig Deegan(2023-[9780170460491])
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Craig Deegan Financial Accounting Theory 5e Craig Deegan Financial Accounting Theory 5e Financial Accounting Theory © 2023 Cengage Learning Australia Pty Limited 5th Edition Craig Deegan Copyright Notice This Work is copyright. No part of this Work may be reproduced, stored in a retrieval system, or transmitted in any form or by any means without prior Portfolio manager: Fiona Hammond written permission of the Publisher. Except as permitted under the Product manager: Rachael Pictor / Geoff Howard Copyright Act 1968, for example any fair dealing for the purposes of private study, Content developer: Eleanor Yeoell / Sarah Payne / Kylie Scott research, criticism or review, subject to certain limitations. 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National Library of Australia Cataloguing-in-Publication Data ISBN: 9780170460491 This publication contains copyright material of the IFRS® Foundation in respect A catalogue record for this book is available from the National Library of of which all rights are reserved. Reproduced by Cengage Learning Australia Pty Australia. Limited with the permission of the IFRS Foundation. No permission granted to third parties to reproduce or distribute. For full access to IFRS Standards and the Cengage Learning Australia work of the IFRS Foundation please visit http://ifrs.org. Level 5, 80 Dorcas Street Southbank VIC 3006 Australia The International Accounting Standards Board® , the IFRS Foundation, the authors and the publishers do not accept responsibility for any loss caused by Cengage Learning New Zealand acting or refraining from acting in reliance on the material in this publication, Unit 4B Rosedale Office Park whether such loss is caused by negligence or otherwise. 331 Rosedale Road, Albany, North Shore 0632, NZ For learning solutions, visit cengage.com.au Printed in Singapore by 1010 Printing International Limited. 1 2 3 4 5 6 7 26 25 24 23 22 Brief contents CHAPTER 1 Introduction to financial accounting theory 1 CHAPTER 2 Accountability and its link to responsibility and accounting 43 CHAPTER 3 The financial reporting environment 74 CHAPTER 4 The regulation of financial accounting 111 CHAPTER 5 International accounting 159 CHAPTER 6 Measurement issues: accounting for the effects of changing prices and markets 219 CHAPTER 7 Normative theories of accounting: the case of conceptual framework projects 273 CHAPTER 8 Positive Accounting Theory 343 CHAPTER 9 Unregulated corporate reporting decisions: considerations of systems-oriented theories 422 CHAPTER 10 Extending corporate accountability: the practice of social and environmental reporting 498 CHAPTER 11 Reactions of capital markets to financial reporting 593 CHAPTER 12 Reactions of individuals to financial reporting: an examination of behavioural research in accounting 638 CHAPTER 13 Critical perspectives of accounting 669 iii Contents Guide to the text xiii Guide to the online resources xvi Preface xvii About the author xx Acknowledgements xxi CHAPTER 1 1 2 Introduction to financial accounting theory What is a theory? Why is it important for accounting students to study accounting theory? 4 A brief overview of theories of accounting Inductive accounting theories 8 Explanatory and predictive (positive) accounting theories 10 Prescriptive (normative) accounting theories 12 Critical theories of accounting 14 Evaluating theories of accounting 18 Is the theory parsimonious? Can we prove a theory? Is the theory falsifiable? Evaluating theories – considerations of logic and evidence Evaluation through logical deduction CHAPTER 2 21 22 23 24 24 Evaluating the underlying assumptions 26 Universal applicability of theories 28 Generalising theories from the testing of samples 29 Can (or should ) more than one theory be used at a time? 30 Key factors that influence the research process 31 Study Tools 35 Accountability and its link to responsibility and accounting Introduction 43 44 The relationship between ‘accounting’ and ‘accountability’ 46 What do we mean by accountability? 48 So, what are the responsibilities of organisations? 51 Who are the ‘stakeholders’ of an organisation? 52 Why might we all have different perceptions of organisational responsibilities, and therefore of organisational accountability? 54 Perceptions of organisational accountability will change over time iv 7 56 The influence of stakeholder power on corporate accountability 57 An accountability model 58 Why is an organisation collecting and disclosing particular information? 59 To whom is the account information being directed? 61 Contents What information needs to be reported? 62 How should the information be disclosed? 63 The normative nature of the four-step accountability model 63 The materiality determination process 65 The influence of organisational objectives upon accounting CHAPTER 3 Identifying the problem for Walt Disney 68 Identifying the problem for Greenpeace 68 Identifying the problem for Harvard 68 Corporate governance 69 Study Tools 71 The financial reporting environment Introduction 74 75 The objective, use and regulation of general purpose financial reports 76 Alternative measures of financial performance disclosed within financial reports 79 Financial accounting versus management accounting 80 Application of our ‘accountability model’ to the practice of financial reporting 80 An overview of the development and regulation of accounting practice 83 Reliance on double-entry accounting 83 Early development of professional accounting bodies 84 Early codification of accounting rules 85 Development of disclosure regulations 86 Twenty-first-century political pressure on financial accounting regulation 88 The rationale for regulating financial accounting practice 91 The costs and benefits of accounting regulation 94 Regulation and enforcement 95 The role of professional judgement in financial accounting CHAPTER 4 66 96 How powerful is the accountant? 99 Study Tools 106 The regulation of financial accounting Introduction 111 112 What is regulation? 114 The ‘free-market’ perspective 114 Market-related incentives 117 The ‘pro-regulation’ perspective 119 The ‘invisible hand’ 122 Enlightened self-interest 126 Public interest theory 130 Capture Theory 132 Economic and social impacts of accounting regulation 141 v Contents CHAPTER 5 Lobbying and the economic interest group theory of regulation 142 Accounting regulation as an output of a political process 146 Study Tools 150 International accounting Introduction 159 160 Evidence of international differences in accounting prior to recent standardisation initiatives 161 Does it really matter if different countries use different financial accounting methods? 163 A brief overview of the IASB and its globalisation activities 165 Role of the European Union 170 Australia adopts IFRS 173 The United States’ role in the international standardisation of financial accounting 175 Does the international standardisation of accounting standards necessarily lead to the international standardisation of accounting practice? 179 Differences in taxation systems Differences in economic and political influences on financial reporting 181 Modifications made to IFRS at a national level 182 Issues of translation 182 Differences in implementation, monitoring and enforcement 182 Explanations of differences in accounting CHAPTER 6 vi 181 187 Culture 189 Religion 200 Legal systems 201 Business ownership and financing systems 202 Taxation systems 204 Strength of the accounting profession 205 Accidents of history 206 Impacts of culture on issues beyond financial reporting 208 Concluding comments about obstacles to the ongoing standardisation of financial accounting 209 Study Tools 210 Measurement issues: accounting for the effects of changing prices and markets Introduction 219 220 The process of measurement 221 Measurement bases utilised within financial reporting standards 227 Factors to consider when choosing between alternative measurement bases 229 Limitations of historical cost accounting in times of rising prices 230 Contents Current purchasing power accounting (CPPA) CHAPTER 7 236 Calculating indices 237 Performing current purchasing power adjustments 238 Current cost accounting 241 Exit price accounting: the case of Chambers’ Continuously Contemporary Accounting 243 The demand for price-adjusted and value-adjusted accounting information 249 Fair value accounting 252 Fair value and its relationship to volatility and procyclicality in accounting measures 257 Fair value and the decision usefulness versus stewardship role of financial reporting 262 Study Tools 266 Normative theories of accounting: the case of conceptual framework projects Introduction 273 274 So, what is a conceptual framework of accounting? 275 A brief overview of the history of the development of conceptual frameworks 279 The Trueblood Report 280 The FASB conceptual framework project 281 The (UK) Corporate Report 282 Development of conceptual frameworks in Australia and elsewhere 282 Recent efforts of the IASB and the FASB 283 Building blocks of a conceptual framework 285 Definition of the reporting entity 285 Users of financial reports 288 Objectives of general purpose financial reporting 290 Qualitative characteristics of financial reports 294 Can financial statements provide neutral and unbiased accounts of an entity’s performance and position? 302 Definition and recognition of the elements of financial statements 305 Definition and recognition of assets 308 Definition and recognition of liabilities 316 Definition and recognition of expenses 321 Definition and recognition of income 321 Definition of equity 323 Measurement principles 324 Pros and cons associated with having a conceptual framework 327 A restricted view of accountability 328 Stifle future reporting innovation 329 A potentially distorted view of an organisation’s ‘performance’ 329 vii Contents CHAPTER 8 Simply a reflection of existing accounting practice 334 A device to legitimise accounting standard setters and the accounting profession 335 Study Tools 337 Positive Accounting Theory Introduction 343 344 Positive Accounting Theory defined 345 The origins and development of Positive Accounting Theory 347 Role of the Efficient Markets Hypothesis 351 Share price reactions to unexpected earnings announcements 352 Use of Agency Theory to help explain and predict managerial choice of accounting policies 354 The perspective of the organisation as a ‘nexus of contracts’ 358 The emergence of Positive Accounting Theory 362 Opportunistic and efficiency perspectives 366 Owner-manager contracting 369 Bonus schemes generally 370 Accounting-based bonus plans 370 Incentives to manipulate accounting numbers 372 Accounting-based bonus schemes that rely upon conservative accounting practices 374 Market-based bonus schemes 375 Debt contracting CHAPTER 9 viii 381 The use of conservative accounting methods to reduce agency costs of debt 382 Evidence of the use of accounting-based debt covenants 383 Incentives to manipulate accounting numbers in the presence of debt contracts 386 Political costs 389 Relevance of PAT-based research to efforts by the IASB and FASB to promote fair value accounting 394 Earnings management 399 Accounting policy choice and ‘creative accounting’ 404 Some criticisms of Positive Accounting Theory 406 Study Tools 412 Unregulated corporate reporting decisions: considerations of systems-oriented theories Introduction 422 423 Political Economy Theory 425 Legitimacy Theory 427 Legitimacy, public expectations and the social contract 428 Legitimacy and changing social expectations 431 Phases of legitimation 434 Contents Use of accounting reports in legitimation strategies 437 Corporate views on the importance of the social contract 439 Empirical tests of Legitimacy Theory 440 Legitimacy Theory favoured by some researchers as it provides a parsimonious explanation of an underlying phenomenon 449 Some issues that are not currently addressed by Legitimacy Theory 451 Stakeholder Theory 458 The ethical branch of Stakeholder Theory 461 The managerial branch of Stakeholder Theory 465 Empirical tests of Stakeholder Theory 467 Institutional Theory 471 Isomorphism and decoupling as important components of Institutional Theory 478 Further empirical tests of Institutional Theory 485 Study Tools CHAPTER 10 Extending corporate accountability: the practice of social and environmental reporting Introduction The meanings of social, environmental and sustainability reporting 488 498 499 501 Social reporting 501 Environmental reporting 502 Sustainability reporting 502 The incidence of CSR reporting 503 Developing notions of sustainability 507 Steps within the sustainability reporting process 509 Objectives of the social and environmental reporting process – the ‘why report?’ stage 510 An acceptance of accountability to provide information 511 To comply with legal requirements 512 To forestall efforts to introduce more onerous disclosure regulations 514 To influence the perceived legitimacy of the organisation 515 To align the organisation with its institutional environment 516 To manage particular stakeholder groups 517 To increase the wealth of the shareholders and the managers of the organisation 518 Identifying stakeholders – the who stage 520 Identifying stakeholder information needs and expectations – the ‘what do we report?’ stage 522 Theoretical perspectives on some social and environmental reporting procedures – the how stage 525 Limitations of traditional financial accounting in respect of its ability to reflect social and environmental performance 526 Triple bottom line reporting 534 ix Contents The Global Reporting Initiative – a conceptual framework for social and environmental reporting? Integrated reporting Value creation versus accountability CHAPTER 11 x 535 545 547 Materiality 547 The capitals 549 Some shortfalls and some strengths of the International <IR> Framework 551 The International Sustainability Standards Board 552 The Sustainability Accounting Standards Board 554 The Task Force on Climate-related Financial Disclosures 556 The United Nations Sustainable Development Goals 557 The United Nations Global Compact 560 Other frameworks 561 Sustainability ratings 561 Accounting for externalities 563 Climate change 569 The Greenhouse Gas Protocol 574 The Carbon Disclosure Project 575 Accountability for modern slavery 576 Counter and dialogic accounts 578 Personal social responsibility 581 Study Tools 582 Reactions of capital markets to financial reporting Introduction 593 594 An overview of capital markets research 595 The information content of earnings 605 Results of capital markets research into financial reporting 610 Historical cost income is used by investors 611 Prior to an earnings release, investors obtain much of the information they need from other sources 612 The information content of earnings announcements depends on the extent of alternative sources of information 614 The capital market impact of unexpected changes in earnings depends on whether the change is expected to be permanent or temporary 615 Earnings persistence depends on the relative magnitudes of cash and accruals components of current earnings 615 The earnings announcements of other organisations in the same industry have information content 616 Earnings forecasts have information content 617 There are benefits associated with the voluntary disclosure of information 618 Contents CHAPTER 12 CHAPTER 13 Recognition is perceived differently to mere footnote disclosure 618 Size of a company affects whether the capital market will react to a company’s release of information 618 Unexpected changes in accounting earnings created by unexpected increases in revenues 619 Do current share prices anticipate future accounting earnings announcements? 620 Relaxing assumptions about market efficiency 630 Study Tools 633 Reactions of individuals to financial reporting: an examination of behavioural research in accounting Introduction 638 639 An overview of behavioural research 641 The Brunswik Lens Model 646 The use of particular information items and the implications of different forms of presentation 650 Decision-making processes and the use of heuristics 654 Environmental factors that influence decisions 660 Issues of decision accuracy 660 Protocol analysis 661 The relevance of differences in culture 663 Limitations of behavioural research 663 Study Tools 665 Critical perspectives of accounting Introduction 669 670 The critical perspective defined 672 Insights into the partisan nature of accounting 676 A Marxist critique of accounting 679 Critical accounting research versus social and environmental accounting research 681 Possible impact of critical accounting research on social practice 686 The role of the state in supporting existing social structures 691 The role of accounting research in supporting existing social structures 693 Accounting research and support for deregulation of accounting 693 A critical accounting interpretation of increased accounting regulation post-Enron 695 A critical accounting view on the active role of academic and non-academic discourse in protecting capitalism 696 The role of accounting practice in supporting existing social structures The role of accounting reports in creating a selective ‘reality’ 697 698 xi Contents The power of accountants through a false image of neutrality xii 699 A critical accounting perspective of accounting and legitimation 701 The role of accounting in legitimising the capitalist system 702 Counter accounts and dialogic accounts 703 A critical reflection on the role of critical accounting researchers in creating change 712 Study Tools 715 Glossary 722 Index 730 CHAPTER 1 Guide to the text As you read this text you will find a number of features in every chapter to enhance your study of financial accounting theory and help you understand how the theory is applied in the real world. INTRODUCTION TO FINANCIAL ACCOUNTING THEORY CHAPTER-OPENING FEATURES Identify the key concepts you will engage with through the Learning objectives at the start of each chapter. LEARNING OBJECTIVES On completing this chapter, readers should: LO1.1 understand that there are many theories of accounting LO1.2 understand how knowledge of different accounting theories increases our ability to understand and evaluate various alternative accounting practices LO1.3 understand that the different theories of accounting are often developed to perform different functions, such as to describe accounting practice, or to prescribe particular accounting practices LO1.4 understand that theories, including theories of accounting, are developed as a result of applying various value judgements and also appreciate that acceptance of one theory in preference to others will in part be tied to one’s own value judgements LO1.5 be aware that we should critically evaluate theories (in terms of such things as the underlying logic, assumptions made and evidence produced) before accepting them LO1.6 understand some alternative perspectives about how knowledge develops across time LO1.7 understand why students of accounting should study accounting theories as part of their broader accounting education. Check your understanding of accounting concepts with the Opening questions. Answers to these opening questions can be found at the end of the chapter so you can check how your understanding has changed. 1 BK-CLA-DEEGAN_FAT_5E-220197-Chp01.indd 1 21/09/22 7:33 AM xiii Guide to the text FEATURES WITHIN CHAPTERS Reflection questions encourage you to pause and reflect on concepts that have you learned in the chapter. Introduction to financial accounting theory CHAPTER 1 normative theories can be further subdivided. For example, some normative theories can be classified as ‘true income theories’, and other theories as ‘decision usefulness theories’. The true income theories make certain assumptions about the role of accounting and then seek to provide a single ‘best measure’ of profits (for example, see Lee, 1974).6 Why do I need to know …? boxes provide context to complex subject matter to show how the topic relates to the real world. REFLECTION QUESTION 1.1 Contrasting positive and normative research Would the above research be considered positive or Question normative research? There are two researchers: • Researcher 1 is undertaking research to determine Solution whether organisations with greater levels of negative • Positive research: Positive research seeks to explain or media attention directed at their activities are likely predict particular phenomena. Researcher 1 would be to provide greater levels of socially oriented undertaking positive research. disclosures. • Normative research: Normative research seeks to provide • Researcher 2 evaluates the disclosures being made by prescriptions about what should be done. Researcher 2 different organisations with the intention of developing would be undertaking normative researchers. reporting guidance that will assist organisations to Important Key terms marked bold inabout thetheir text and defined in the margin when they are used for the provide are relevant and reliablein information contributions to climate change. first time. Decision usefulness theories ascribe a particular type of information for particular classes of users on the basis of assumed decision-making needs. According to Bebbington, Gray and Laughlin (2001, p. 418), the decision usefulness approach can be considered to have two branches – the decision-makers emphasis and the decision-models emphasis. The decision-makers emphasis relies on undertaking research that seeks to ask the users of the information what information they want.7 Once that is determined, this knowledge is used to prescribe what information should be supplied to the users of financial statements. Much of this research is questionnaire-based. This branch of research tends to be fairly disjointed, as different studies typically address different types of information, with limited linkages between them. Another variant of the decision-makers emphasis, which is explored in Chapter 11, is capital markets research. Briefly, capital markets research works on the assumption that if the capital market responds to information (as evidenced through share price changes that occur around the time of the release of particular information), then the information must be useful.8 This forms the basis for subsequent prescriptions about the types of information that should be provided to users of financial statements. It also has been used to determine whether particular mandatory reporting requirements (such as the introduction of new accounting standards) were necessary or effective, the rationale being that, if a new accounting standard does not evoke a market reaction, it is questionable whether the new requirement is useful or necessary in providing information to the capital market or investors. Research that evaluates information on the basis of whether it evokes a market reaction, or whether stakeholders indicate that it is useful to them, ignores the possibility that there could be information that is ‘better’ than that provided or sought. There is also the 6 7 xiv 8 Decision usefulness theories Theories that ascribe a particular type of information for particular classes of users on the basis of assumed decisionmaking needs. Much of the work undertaken in developing ‘true income theories’ relies on the work of Hicks (1946). Hicks defined ‘income’ as the maximum amount that can be consumed by a person or an organisation in a particular period without depleting the wealth that existed for that person or organisation at the start of the period. For example, in recent years a number of research studies have asked a number of different stakeholder groups what types of social and environmental performance information the stakeholders considered to be useful for their various decision-making processes. Based on the Efficient Markets Hypothesis, which predicts that the stock market instantaneously reacts, through price adjustments (changes), to all relevant publicly available information. 13 Guide to the text END-OF-CHAPTER FEATURES Accountability and its link to responsibility and accounting CHAPTER 2 At the end of each chapter you will find several tools to help you to review, practise and extend your knowledge Accountability and its link to responsibility and accounting CHAPTER 2 of the key learning objectives. STUDY TOOLS STUDY TOOLS Review your understanding of the key chapter topics with the Chapter summary. CHAPTER SUMMARY This chapter has addressed a number of issues that are fundamental to the understanding and practice CHAPTER SUMMARY of accounting. We have provided definitions of ‘accounting’ and ‘accountability’, and we have explored This chapter has between addressed a number ofresponsibilities, issues that are fundamental the understanding and practice the relationship organisations’ accountability,toand accounting practices. We of accounting. We have providedmanagers definitionswill of ‘accounting’ and ‘accountability’, we and havefor explored have emphasised that different interpret their responsibilities (to and whom, what) the relationship between organisations’ accountability, andthey accounting differently, and this will have implicationsresponsibilities, for the accounting practices that will havepractices. in place. We have that different managers will interpret their responsibilities (to whom, and for and what) have emphasised also emphasised that perceptions of organisational responsibility will change over time, this differently, and this implications for thepractice. accounting practices that they will have in place. We has implications forwill thehave evolution of accounting haveWe also emphasised that perceptions of organisational responsibility willvarious changejudgements over time, and thisas introduced a four-step accountability model that emphasises how made has for the evolution of accounting partimplications of an ‘accountability relationship’ between practice. organisations, and their stakeholders, have sequential We introduced a four-stepjudgements. accountability thatthe emphasises howmanagers various judgements made as implications for subsequent Formodel example, reasons why are reporting part of an ‘accountability relationship’ their stakeholders, have sequential information has implications for who isbetween intendedorganisations, to receive theand information, which in turn has implications implications for subsequent judgements. For example, the reasons why managers are reporting for what is reported, and how it is reported. information has concluded implicationswith for awho is discussion intended toofreceive the information, in turn has implications The chapter brief corporate governance which emphasised that for how it is reported. thewhat form isofreported, corporateand governance employed within an organisation ultimately is influenced by the Refer to the Answers the opening questions to assess how your understanding has that developed, as a result of Theto chapter concludedbywith a brief discussion of corporate governance which emphasised responsibilities accepted corporate managers. the form of corporate governance employed within an organisation ultimately is influenced by the reading the material provided within the chapter. responsibilities accepted by corporate managers. ANSWERS TO THE OPENING QUESTIONS Financial Accounting Theory At the beginning of the chapter, we asked the following five questions. As a result of reading this ANSWERS TO THE OPENING QUESTIONS chapter, you should be able to provide informed answers to these questions – ours are shown below. At beginning of the chapter,mean? we asked the following five questions. As a result of reading this 1 the What does ‘accountability’ chapter, you shouldwe behave able provided to provideainformed answers to these questions – ours are shown below. In this chapter number of definitions of accountability. useful definition 5 Is there a relationship between an organisation’s corporate governanceOne policies and the 1 What does ‘accountability’ mean?and Owen (2014, p. 50) which is ‘the duty to provide an account is that provided by Gray, Adams managers’ perceptions about organisational responsibility and accountability? In chapterofwe haveactions provided a number of accountability. One useful orthis reckoning those for which one of is definitions held responsible’. The ‘accountability’ of definition an Yes, there is a relationship. Managers’ assessments of their responsibilities and accountabilities is that provided by Gray, Adams Owen (2014,made p. 50)about whichan is organisation’s ‘the duty to provide an account organisation is very much linkedand to judgements responsibilities. will have direct implications for the corporate governance policies in place. For example, if reckoning of thoseof actions for which one is held responsible’. The ‘accountability’ of an 2 or How do perceptions organisational perceptions of organisational managers believe that they have a responsibility responsibility influence and an associated accountability to minimise organisation is very much linked to judgements made about an organisation’s responsibilities. accountability? their contribution to climate change, then they would put in place policies and procedures 2 How dochapter perceptions of organisational responsibility influence perceptions of Figure 2.1.they Asorganisational we discuss, In this we provided simple, but useful, – see (governance policies) thata aim to reduce their diagram emissions (for example, might have capital accountability? perceptions of policies organisational responsibilities perceptions to whomor anthey investment that stipulate that only directly energy influence efficient equipment is about to be acquired 2.1. As we discuss, In this chapter provided aand simple, but useful, diagram – seetoFigure organisation iswe responsible for what aspects of are performance it is responsible. Where there might have in place management bonuses that linked achieving emission reduction perceptions of organisational responsibilities directly influence perceptions about to in whom an to aretargets). responsibilities, managers need to provide anreporting account (that is, beinaccountable) relation They would also be expected to have practices place which measure organisation isthe responsible for undertaken what performance it is responsible. Wheretothere whether those responsibilities have beenaspects properly demonstrated. and report results ofand efforts to of reduce the organisation’s contribution are responsibilities, managers need to provide an account (that is,ofbeaccountability? accountable) in relation to climate change. 3 and How, if at all, is the practice ‘accounting’ related tothe perceptions Test your knowledge consolidate your of learning through end-of-chapter Questions. whether those about responsibilities haveofbeen properly demonstrated. The decisions what aspects an organisation’s performance are ‘accounted for’ areand accounting CHAPTER 2 Accountability and its link to responsibility 3 How, if at all, is the practice of ‘accounting’ related to perceptions of accountability? directly related to the types and extent of accountability accepted by managers. The broader the The decisions about whatbyaspects of an performance are ‘accounted for’ accountability accepted managers in organisation’s terms of to whom they are accountable, and forare what QUESTIONS directly to the types and of accountability by practice managers. The broader the aspectsrelated of performance they areextent accountable, then the accepted broader the of accounting that LO2.1 2.1 expectations Define ‘accountability’. regarding the of ‘accounts’ thatofparticular should prepare, and therefore, accountability accepted by types managers terms to whom they are accountable, and what will be adopted. If managers accept ainresponsibility and entities associated accountability to for a broad 2.2 in the Would different managers necessarily have similar views about organisational accountability? types or forms of ‘accounting’ that they should undertake. aspects ofstakeholders, performance theyfor are accountable, then the broaderthen the practice of accounting thatto range of and a broad range of performance, such managers will tend Why? LO2.2 will adopted. If managers accept responsibility andLO2.6 associated accountability to a broad Explain clearly the logic above quote. usebe accounting practices thatbehind provideathe information about various aspects of the organisation’s 2.3 Why might different managers have different perceptions of their organisation’s responsibilities? LO2.4 range of stakeholders, and for a broad rangeinofFigure performance, such managers will tend to financial, social and performance. 2.20 logic of environmental the relationship shown 2.1. LO2.2 then 2.4 Explain Doesthe it make sense to study accounting without considering, in some depth, the issue of accounting practices that provide information about various aspects of the 2.21 the managers of an organisation are primarily focused on satisfying the information 4 use If Ifwe were to develop a model of ‘organisational accountability’, and if it was toorganisation’s have fourneeds of LO2.2 ‘organisational accountability’? Why? financial, social and environmental performance. powerful then how would the managers determine what to disclose? Further, would steps, what might steps be? LO2.3 2.5sequential What isstakeholders, a ‘stakeholder’ of these an organisation? LO2.5 42.6IfThere we were tostakeholder develop a be model ‘organisational accountability’, and if it was to have has four opted such an aorganisation likely be to be high levels of accountability? could potentially a variety ofperson steps that could bepeople? identified, but this chapter LO2.3 Does have toofdeemed be a ordemonstrating group of LO2.7 sequential steps, these being ‘why steps, what might these steps be? 2.22 will accounting practices evolve over time? toWhy use a four-step accountability model which identifies four LO2.3 LO2.4 2.7sequential What is stakeholder engagement, and what isLO2.2 its purpose? could potentially be asked a between variety oftostakeholder steps thatand could beproduce identified, but chapter has step optedhas 2.23 If you were a consultant to help an organisation itsorganisational firstthis publicly report?’, ‘tois whom to report?’, ‘what report?’ ‘how to report?’ The answer toavailable each 2.8There What the connection engagement and to use a four-step accountability identifies sequential these are being ‘why to ‘sustainability thenLO2.3 it bewhich relevant to you four to know why thesteps, managers wanting implications for report’, the answer towould themodel following step. LO2.2 accountability? LO2.1 ‘tothe whom to report?’, ‘what LO2.6 to report?’ and ‘howshould to report?’ Theofanswer to eachgovernance step has produce report? Why? 2.9report?’, Would you consider that stakeholder engagement be part the corporate theorganisation? answer to the LO2.3 following 2.24 implications Would you for expect similar accounting practices LO2.8 step. to be used in different countries? policies of an LO2.2 the LO2.4 list LO2.6of References relevant to each chapter. Extend your understanding 2.10 Why? Arewith the views or expectations of all stakeholders likely to be considered/acted upon by an 71 organisation? LO2.5 2.11 What is ‘corporate governance’, and would you expect systems of corporate governance to be 71 REFERENCES influenced by managers’ perceptions of their organisational responsibilities? Why? LO2.8 AccountAbility (2018), AA1000 AccountAbility Principles 2018 , Gray, A. & Jenkins, B. (1993), ‘Codes of accountability in the 2.12 Are systems of corporate governance and accounting practices likely to be related? viewed 1 June 2022, http://www.accountability.org/ new public sector’, Accounting, Auditing & Accountability LO2.8 Why? LO2.7 BK-CLA-DEEGAN_FAT_5E-220197-Chp02.indd 71 15/09/22 8:10 PM standards Journal, 6(3). Some ‘accounting educators’ incorporate issues toR.,doAdams, with measuring and reporting information ASX2.13 Corporate Governance Council (2019), Corporate Gray, C. & Owen, D. (2014), Accountability, Social BK-CLA-DEEGAN_FAT_5E-220197-Chp02.indd 71 15/09/22 8:10 PM about organisational social and, environmental performance across their various accounting Governance Principles and Recommendations 4th edn, Responsibility and Sustainability: Accounting for Society Sydney: ASX. and the Harlow, UK: Pearson Education. subjects/units, whereas other accounting educators doEnvironment not. Why ,do you think that such differences Australian Corporations and Marketseducators Advisory Committee Colin, D., Dave, O., Richard, E. & Simon, Z. LO2.4 R.,LO2.6 between accounting exist? LO2.2 Gray, (2006), The Social Responsibility of Corporations, (1997), ‘Struggling with the praxis of social accounting: 2.14 What is a ‘surrogate stakeholder’, and what is their role? LO2.3 Canberra: Australian Government. stakeholders, accountability, audits and procedures’, 2.15A. D.What is ‘Public the ‘materiality determination process’?Accounting, Why would it be useful for readers of , 10(3), Barton, (2006), sector accountability and Auditing & Accountability Journal organisational accounts be provided with information commercial-in-confidence outsourcingtocontracts’, pp. 325–64.about the materiality determination Accounting, Auditing & Accountability , 19(2), of an organisation? Gray, R., Owen,LO2.6 D. & Adams, C. (1996), Accounting process instigated by theJournal managers pp. 256–71. and Accountability: Changes and Challenges in to make 2.16 Is it important for accounting researchers to explore the factors that motivate managers Benston, G. J. (1982), ‘Accounting and corporate Corporate Social and Environmental Reporting, particular accounting disclosures? Why? LO2.6 accountability’, Accounting, Organizations and Society, London: Prentice Hall. 2.17pp. 87–105. Explain why each step in the four-step accountability model discussed in https://www.greenpeace. this chapter influences 6(2), Greenpeace (2022), ‘Our values’, step that follows. For example, why does the answer to the ‘why report?’ step influence the BHP (2022), the ‘Sustainability’, https://www.bhp.com/ org/international/explore/about/values sustainability/approach Haque, C. & Inglis, R.step (2016),influence ‘Demand the for, and issue about ‘to whom?’ to report, and why does the S., ‘toDeegan, whom to report?’ ‘what Black, J. (2008), ‘Constructing contesting legitimacy impediments to, the disclosure of information about to report?’ step?andLO2.6 and accountability in polycentric regulatory regimes’, climate change-related corporate governance practices’, 2.18 Why might it be useful for stakeholders to have insights into ‘why’ managers are reporting Regulation & Governance, 2(2), pp. 137–64. Accounting and Business Research, 46(6), pp. 1–45. xv Guide to the online resources FOR THE INSTRUCTOR Cengage is pleased to provide you with a selection of resources that will help you to prepare your lectures and assessments, when you choose this textbook for your course. Log in or request an account to access instructor resources at au.cengage.com/instructor/account for Australia or nz.cengage.com/instructor/account for New Zealand. SOLUTIONS MANUAL The Solutions Manual provides detailed solutions to every question in the text. COGNERO® TEST BANK A bank of questions has been developed in conjunction with the text for creating quizzes, tests and exams for your students. Create multiple test versions in an instant and deliver tests from your LMS, your classroom, or wherever you want using Cognero. Cognero test generator is a flexible online system that allows you to import, edit, and manipulate content from the text’s test bank or elsewhere, including your own favourite test questions. POWERPOINT™ PRESENTATIONS Use the chapter-by-chapter PowerPoint slides to enhance your lecture presentations and handouts by reinforcing the key principles of your subject. AUTHOR VIDEOS Craig Deegan's signature author videos provide an overview of the contents and act as mini lectures for online units. These videos will be available for both students and instructors via the instructor website. ARTWORK FROM THE TEXT Add the digital files of graphs and flow charts into your learning management system, use them in student handouts, or copy them into your lecture presentations. xvi Preface About this book The underlying motivation for writing this book is a belief that all students of accounting, whether at the undergraduate or postgraduate level, and indeed all practitioners of accounting, should have a rich understanding of the implications that flow from the practice of accounting. Accounting practice can be linked to various economic, social, and environmental impacts that reverberate throughout society, and students and practitioners of accounting need to understand this. In understanding this, they need knowledge of different theories. This book has therefore been written to provide readers with a balanced discussion of different theories of accounting. Chapter 1 provides a discussion of the role and importance of theory and discusses the different types of accounting theories ‘out there’ and the different ways in which theories are developed. Chapter 1 also provides tools for evaluating theories. Chapter 2 then explores the link between organisational responsibilities, accountabilities, and accounting and in doing so, introduces a four-step accountability model. It also discusses corporate governance and the linkage between corporate governance and accounting practice. Chapter 2 emphasises that relevant and reliable accounting information provides power to users of that information that enables them to make informed choices. Chapters 3 and 4 explore the objectives, use and regulation of general purpose financial reports and critically discuss various theories for and against the regulation of financial reporting. Chapter 5 explores the topic of ‘international accounting’ and critically evaluates efforts towards, and the obstacles to, the standardisation of international financial reporting practices – something that has been aggressively pursued by the International Accounting Standards Board (IASB). The book also describes and evaluates the development of various normative theories of accounting, including various approaches developed to account for changing prices (Chapter 6), as well as various issues associated with the development of conceptual frameworks for financial reporting, in particular the Conceptual Framework for Financial Reporting developed by the IASB (Chapter 7). Apart from exploring various normative prescriptions for how the practice of financial reporting should be undertaken, we also explore various positive theories that have been used to explain and/or predict the practice of accounting. Chapter 8 explores Agency Theory and Positive Accounting Theory while Chapter 9 explores Political Economy Theory, Legitimacy Theory, Stakeholder Theory, and Institutional Theory. Reflecting the growing relevance globally of the sustainability agenda – including efforts to address climate change and modern slavery – social and environmental accountability/sustainability and reporting issues are discussed in depth in Chapter 10. Chapter 10 provides one of the most comprehensive coverages of sustainability/ social and environmental accounting and accountability available within any published accounting-related text. Chapters 11 and 12 then focus on how people use and react to accounting information, with Chapter 11 focusing on capital markets research and Chapter 12 focusing on behavioural research. The book then concludes with Chapter 13, which provides a fascinating exploration of the insights provided by critical accounting theorists – insights that tend to challenge many preconceived ideas about the role of accounting, accountants, professions and the state within society. From the outset, the aim has been to present a balanced perspective about alternative and sometimes conflicting theories of accounting. As such, this book also provides an excellent basis for readers contemplating further research in different areas of accounting. This book has proved to be an invaluable and highly cited resource for accounting researchers and accounting research students, including those pursuing a PhD in the area of accounting. xvii Preface In writing this book, a style has been adopted that enables readers at both the undergraduate and the postgraduate level to gain a sound understanding of accounting theory. As each chapter incorporates research from around the world, the book is of relevance to accounting students and researchers internationally. To assist in the learning process, each chapter provides learning objectives and opening questions which readers are encouraged to answer before reading the chapter. Solutions to each opening question are then provided at the end of the chapter and readers are encouraged to consider how their answers changed as a result of reading the chapter material. ‘Why do I need to know ….?’ boxes also appear throughout every chapter with the aim of enhancing the ‘real world relevance’ of the material by pointing out the respective materials’ likely relevance to readers’ lives within, and beyond, university. Reflection questions have also been incorporated throughout each chapter to encourage readers to apply the material to various realworld issues. There are also chapter summaries and end-of-chapter discussion questions. This fifth edition is also supported by videos for each chapter which are both entertaining and informative. Throughout the book readers are encouraged to critically evaluate and challenge the various views presented. To give the different theoretical perspectives a ‘real world’ feel, some chapters use extracts from newspapers, directly related to the issues under consideration. The chapters also draw upon various published research papers to support particular views. As a review of the references list at the end of each chapter will show, the writing of the chapters has drawn upon a great deal of high-quality internationally published research. A glossary of key terms is provided towards the back of the book which brings together in one place all the key terms that were used throughout the book. In the 23 years since the first edition of this book was published, it has proved very popular with students and academics across the world. This new edition retains and builds on the features of the previous four editions that readers have found so appealing and distinctive, such as the use of straightforward explanations, the assessable nature of the language, frequent practical examples, and illustrations using newspaper articles. We have taken the opportunity of updating the text to reflect significant developments in accounting theory over the 23 years. How is this book different to other books? Unlike many other accounting theory texts, this text is written in language that should be accessible to most readers. It also draws on research that is international in orientation and is used in a way that reinforces the real-world relevance of the material that is addressed. That is, we show how the documented research has relevance to our daily lives. The text accepts that there are different, often competing, views about the role of theory and the roles of accounting and the accounting profession and we try to provide a balanced representation of these different beliefs. This is often not the case with other theory texts. What is clearly emphasised is that accounting is both a technical and social practice and that the impacts of accounting reverberate throughout society. The videos that support each chapter are also different to the material that generally accompanies books of this type. The videos are informal but informative and contribute greatly to the readers’ learning experience. The intention in writing this book has been to show that the practice of accounting is far from mundane. Rather, we show that accounting is actually a very interesting and arguably exciting practice that impacts all of our lives. How to use this book? Divided into 13 chapters sequenced in a logical order, this book provides the basis for subjects/units that investigate financial accounting theory. Alternatively, the book can be used as a key text across multiple subjects/units that include coverage of different aspects of accounting practice. The entire book could realistically be used in an eleven- to thirteen-week university term, with chapters being studied in the sequence in which they are presented. Alternatively, some universities xviii Preface have elected to only use between eight and ten chapters from the book and this works, as there is not generally a need that certain chapters must be read in order to be able to understand other chapters. If only some of the chapters are to be used, then it is recommended that Chapter 1 be initially read as it sets the scene for all the chapters that follow. If a unit’s focus allows, then it would also be recommended that consideration be given to concluding the unit/subject with Chapter 13, as the ‘critical content’ of Chapter 13 provides a very useful and thought-provoking way to wrap up a discussion of accounting theory. We hope readers continue to find this book interesting, informative and enjoyable to read. As usual, we welcome constructive feedback. xix About the author Craig Deegan, BCom (University of NSW), MCom (Hons) (University of NSW), PhD (University of Queensland), FCA, is Professor of Accounting in the School of Accounting at the University of Tasmania. Craig has taught at both undergraduate and postgraduate level for many years and has supervised over 30 PhDs to completion as well as many Honours and Masters by Research students. Prior to working in the university sector, Craig worked as a chartered accountant. His research focuses on various social and environmental accountability and financial accounting issues, and he has been published in a number of leading international accounting journals, including: Accounting, Organizations and Society; Accounting and Business Research; Accounting, Accountability and Auditing Journal; Accounting and Finance; British Accounting Review; Critical Perspectives on Accounting; Journal of Business Ethics; Australian Accounting Review; Australian Journal of Management; Meditari Accountancy Research; Accounting Forum; The International Journal of Accounting; Managerial Auditing Journal; and Environmental and Planning Law Journal. According to Google Scholar, Craig’s work has attracted approximately 30 000 citations making him one of the most highly cited researchers internationally within the accounting and/or finance literature. On 28 September 2018, and reflective of the extent to which Craig’s research has been relied upon by many researchers and practitioners, the leading Australian national newspaper, The Australian (within its annual feature on research), identified Craig as being Australia’s Research Field Leader in the Field of Accounting and Taxation. Craig has regularly provided consulting services to corporations, government and industry bodies on issues pertaining to financial accounting, stakeholder engagement and corporate social and environmental accountability. He was former Chairperson of the Triple Bottom Line Issues Group of the Institute of Chartered Accountants in Australia (now Chartered Accountants Australia and New Zealand) and for many years was involved in developing the CPA Program of CPA Australia, as well as being a judge on the Australasian Sustainability Reporting Awards. He is on the editorial board of a number of academic accounting journals and has been the recipient of various teaching and research awards, including teaching prizes sponsored by KPMG and the Institute of Chartered Accountants in Australia. He was the inaugural recipient of the Peter Brownell Manuscript Award, an annual research award presented by the Accounting and Finance Association of Australia and New Zealand. He was also awarded the University of Southern Queensland Individual Award for Research Excellence. Craig is currently a member of the United Nations sponsored organisation, Education for Sustainability (EfS), is a member of the University of Tasmania Sustainability Committee, and is a member of the Australian Accounting Standards Board (AASB) Academic Advisory Panel. Craig is also the author of the leading corporate accounting textbook, Financial Accounting, now in its ninth edition (McGraw Hill), as well as being the author of the leading introductory accounting textbook, An Introduction to Accounting: Accountability in Organisations and Society, a second edition of which was published by Cengage in 2023. All Craig’s books are widely used throughout Australia as well as in many other countries. Above all, Craig has a passion for emphasising that accounting is both a technical and social practice that creates various affects that reverberate throughout society. This passion is very well reflected and encapsulated within the contents of this thought-provoking book. xx Acknowledgments The writing of this fifth edition, as well as the preceding editions, has been influenced by many people with whom I have been blessed to work with throughout my academic career. When the first edition was published back in 1999, various people generously provided invaluable help and insight, including Reg Mathews, Rob Gray, Dave Owen and Michaela Rankin. Reg and Rob have since passed away and are greatly missed, but their intellectual contribution to the accounting literature is still strongly evident today. I was also very fortunate to have some great mentors along my academic journey, including Malcolm Miller, the late Bill Birkett, Don Stokes, Richard Morris, and the late Ian Zimmer. I have supervised many Honours, Masters, and PhD students throughout my academic career, many of whom I have published with and several of whom have become lifelong friends. These people have exposed me to various important and rich insights and have helped maintain my motivation to gain new knowledge – knowledge that often challenged my pre-existing beliefs. Supervising research students is such a rewarding experience and a vital part of being within a university. Relatedly, I have co-authored over 40 papers in leading international accounting journals at the A or A* level [applying the Australian Business Deans Council (ABDC) Journal Quality List rankings] with my former research students. I deeply thank all the past research students that I was lucky enough to supervise. In writing this text I have drawn on much of the knowledge that has come from this supervisory-related work. I would also like to than Jeffrey Unerman who reviewed the third edition of this book and added some content to pre-existing chapters in order to ‘Europeanise’ it for the purpose of two ‘European editions’ of this book, which were published in 2006 (1st edition) and 2011 (2nd edition). Jeffrey is also sadly missed, but his work also continues to contribute widely to academic debate. The writing of the first four editions of this book was undertaken while I was employed at the University of Southern Queensland and RMIT University. I thank these two institutions for supporting my work. I am now at the University of Tasmania, and I would like to thank UTAS for supporting my efforts in writing this 5th edition – an exercise that does take considerable time. I would also like to thank the staff at Cengage for all the work they have done to publish this book. I would particularly like to extend my appreciation to Geoff Howard for his early support in making this 5th edition come to life, to Paul Petrulis VP Cengage Australia for supporting this book, as well as thanking Rachael Pictor, Nathan Katz and Anne Mulvaney for all their work. Lastly, I would like to thank my ‘most excellent’ daughter Cassandra Joy Deegan who was born around the time that the first edition of this book was published (no causality inferred). She provides my life with necessary love and purpose. Cengage Learning Australia would also like to thank the following reviewers for their helpful feedback: Robyn Cameron (Griffith University) Sarah Adams (Australian National University) Joanne Tingey-Holyoak (University of South Australia) Bobae Choi (University of Newcastle), Giulia (RMIT University) Patrick Mauder (Bond University), Tricia Ong (Edith Cowan University) Gerard Ilott (Central Queensland University) Sorin Daniliuc (Australian National University) Meiting Lu (Macquarie University) Dharmendra Naidu (Monash University), and Yeut Hong Tham (Curtin University). Every effort has been made to trace and acknowledge copyright. However, if any infringement has occurred, the publishers tender their apologies and invite the copyright holders to contact them. xxi CHAPTER 1 INTRODUCTION TO FINANCIAL ACCOUNTING THEORY LEARNING OBJECTIVES On completing this chapter, readers should: LO1.1 understand that there are many theories of accounting LO1.2 understand how knowledge of different accounting theories increases our ability to understand and evaluate various alternative accounting practices LO1.3 understand that the different theories of accounting are often developed to perform different functions, such as to describe accounting practice, or to prescribe particular accounting practices LO1.4 understand that theories, including theories of accounting, are developed as a result of applying various value judgements and also appreciate that acceptance of one theory in preference to others will in part be tied to one’s own value judgements LO1.5 be aware that we should critically evaluate theories (in terms of such things as the underlying logic, assumptions made and evidence produced) before accepting them LO1.6 understand some alternative perspectives about how knowledge develops across time LO1.7 understand why students of accounting should study accounting theories as part of their broader accounting education. 1 Financial Accounting Theory OPENING QUESTIONS Before reading this chapter, please consider how you would answer the following three questions. We will return to these questions at the end of the chapter, where we suggest some answers. 1 Why do students of accounting need to bother with the study of ‘theories’? For example, why not just study some more of the numerous accounting standards (and there are certainly plenty of them!) or other pronouncements of the accounting profession? 2 Why would (or perhaps ‘should’) accounting practitioners and accounting regulators have knowledge of various theories of accounting? 3 Do all ‘theories of accounting’ seek to fulfil the same role, and, if there are alternative theories to explain or guide particular practice, how does somebody select one theory in preference to another? LO1.1 Theory A scheme or system of ideas or statements held as an explanation or account of a group of facts or phenomena. LO1.2 What is a theory? In this book, we consider various theories of accounting. Perhaps, therefore, we should start by considering what we mean by a ‘theory’. There are various perspectives of what constitutes a theory. The Oxford English Dictionary provides various definitions, including: A scheme or system of ideas or statements held as an explanation or account of a group of facts or phenomena. The Macquarie Dictionary provides the following definition of a theory: A coherent group of general propositions used as principles of explanation for a class of phenomena. The accounting researcher Hendriksen (1970, p. 1) defines a theory as: A coherent set of hypothetical, conceptual and pragmatic principles forming the general framework of reference for a field of inquiry. The definition provided by Hendriksen is very similar to the US Financial Accounting Standards Board’s definition of its Conceptual Framework for Financial Reporting (which, in itself, is deemed to be a normative theory of accounting), which is defined as: a coherent system of concepts that flow from an objective. (FASB, 2016) The use of the word ‘coherent’ in three of the above four definitions of theory is interesting and reflects a view that the components of a theory (perhaps including assumptions about human behaviour) should logically combine together to provide an explanation or guidance in respect of certain phenomena. The definitions are consistent with a perspective that theories are not ad hoc in nature and should be based on logical (systematic and coherent) reasoning. Therefore, when we talk about a ‘theory’ we are talking about much more than simply an idea or a ‘hunch’, which we acknowledge is different from how the term ‘theory’ is used in some contexts (for instance, we often hear people say they have a ‘theory’ about why something might have occurred when they really mean they have a ‘hunch’). Theories can have various applications, including being used to answer particular research questions. A research question is a question that a particular research project seeks to answer. A well-constructed research question would be clear and specific. The determination of the research question is typically one of the first steps undertaken within a research project. The 2 Introduction to financial accounting theory CHAPTER 1 nature of the research question will be influenced by the theory to be used within the research, and the nature of the research question will influence the research methods to be applied to answer the research question. As will be seen in this book, some accounting theories are developed on the basis of past observations (they are empirically based), some of which are further developed to make predictions about likely occurrences (and sometimes also to provide explanations of why the events occur). That is, particular theories may be generated and subsequently supported by undertaking numerous observations of the actual phenomena in question. Such empirically based theories are said to be based on inductive reasoning and are often labelled ‘scientific’, as, like many theories in the ‘sciences’, they are based on observation. However, empirical research is restricted by the data that is currently available, which in turn means that empirically based studies cannot be undertaken of phenomena that cannot be observed by the researcher – and this has broader philosophical implications. Alternatively, other accounting theories that we also consider do not seek to provide explanations or predictions of particular phenomena but, rather, prescribe what should be done (as opposed to describing or predicting what is done) in particular circumstances. Llewelyn (2003) points out that the term ‘theory’ in accounting not only applies to ‘grand theories’ that seek to tell us about broad generalisable issues (like the theory of gravity in physics) but also applies to any framework that helps us make sense of aspects of the (social) world in which we live, and that helps provide a structure to understand our (social) experiences. We stress that different theories of accounting often have different objectives. Llewelyn provides some interesting views about what constitutes theory. She states (2003, p. 665) that: Empirically based theories A theory developed on the basis of past observations, and developed to make predictions about likely occurrences of particular events. Inductive reasoning A way to explain a set of particular facts, weighing up observational evidence for a general proposition about a set of facts. Empirical research Research that relies upon observing actual phenomena or data. Theories impose cohesion and stability (Czarniawska, 1997, p. 71). So that whenever ‘life’ is ambiguous (which is most of the time!) people will work at confronting this ambiguity through ‘theorizing’. Also, because ‘life’ and situations commonly have multiple meanings and give rise to different assessments of significance, everyone has a need for ‘theory’ to go about their everyday affairs. ‘Theories’ do not just reside in libraries, waiting for academics to ‘dust them down’; they are used whenever people address ambiguity, contradiction or paradox so that they can decide what to do (and think) next. Theories generate expectations about the world. …Theorizing expresses the meaning and significance of social phenomena, it negotiates peoples’ everyday experiences, and it generates expectations about the social world. Llewelyn (2003) suggests that five levels of theorising can be, and have been, utilised within the accounting literature, ranging from ‘level 1 theories’ which rely on ‘metaphors’ and which form foundations for simple insights that can be further developed, through to ‘level five theories’ that are considered as ‘grand theories’ and which are proposed as having universal application across all settings. ‘Grand theories’ are deemed to be those that tend to generate concepts that are highly abstract and which cannot easily be operationalised into, for example, variables which might be used within hypotheses developed to explain particular organisational activities. According to Llewelyn, at the extreme, level five theorisation may aim for universal explanations that are beyond history and society and where ‘meaning’ attributed to local conditions and issues by organisational actors are not seen as particularly significant. Llewelyn argues that ‘level four theorising’, which explains, for example, specific social, organisational or individual phenomena in their respective settings (rather than across all settings as would be the case for grand theories), is the form of theorising most often applied within accounting research. Level four theories explain relationships between various social phenomena in the particular social or environmental context in which they are being researched (but perhaps, not beyond such settings). Some of the theories we explore within this book (Legitimacy Theory, Institutional Theory, Stakeholder Theory) are identified by Llewelyn as being level four theories. 3 Financial Accounting Theory While we do not need to fully understand all the different levels of theorising proposed by Llewelyn, it is nevertheless useful to know that theories can be classified in terms of their sophistication or their perceived level of generalisability to different settings. Other researchers have also applied similar schema to categorise theories. For example, Merton (1968) used the term ‘middle range theories’, which referred to theories that fall somewhere in between theories that are based upon ‘minor hypotheses’ and those that are ‘grand theories’. Middle range theorists tend to focus on measurable aspects of social reality; for example, they focus on issues that are studied within particular settings, rather than seeking to explain the entire social world. This is similar to what Llewelyn refers to as ‘level four theorists’. Llewelyn (2003) also suggests that accepted theories form part of, and are influenced by, the cultural environments in which they are applied. Further, Llewelyn notes that the application of particular theories brings particular objects or phenomena into view that otherwise might go unnoticed, as well as noting that the same objects or phenomena might be seen differently as the result of the application of a different ‘theoretical lens’. Because accounting is a human activity (we cannot have ‘accounting’ without accountants), theories of accounting (and there are many) will consider such things as people’s behaviour and/or people’s needs as regards to accounting information, or the reasons why people within organisations might elect to supply particular information to particular stakeholder groups. For example, this book considers, among others, theories that: • prescribe how, based on a particular perspective of the role of accounting, assets should be measured for external reporting purposes (such prescriptive or normative theories are considered in Chapters 6 and 7) • predict that managers paid bonuses on the basis of measures such as profits will seek to adopt those accounting methods that lead to an increase in reported profits (such descriptive or positive theories are considered in Chapter 8) • seek to explain how an individual’s cultural background will impact on the types of accounting information that the individual seeks to provide to people outside the organisation (such theories are considered in Chapters 5 and 9) • prescribe the accounting information that should be provided to particular classes of stakeholders on the basis of their perceived information needs (such theories are often referred to as decision usefulness theories, and are discussed in Chapter 6) • predict that the relative power of a particular stakeholder group (with ‘power’ often being defined in terms of the group’s control over scarce and necessary resources) will determine whether that group receives the accounting information it desires (which derives from a branch of Stakeholder Theory, which is discussed in Chapter 9) • predict that organisations seek to be perceived by the community as ‘legitimate’ and that accounting information can be used by the organisation as a means of gaining, maintaining or regaining organisational legitimacy (which derives from Legitimacy Theory and Institutional Theory, both considered in Chapter 9) • explain how certain commonly used accounting practices are not neutral in orientation (as conceptual frameworks for financial reporting suggest), but rather act to maintain a social order that privileges those people with financial capital at the expense of workers (some theories with this orientation come from a class of accounting theories known as ‘critical theories’, which are examined in Chapter 13). Why is it important for accounting students to study accounting theory? LO1.2 LO1.7 As a student of, for example, financial accounting, you will be required to learn how to construct and read financial statements prepared in conformity with various accounting standards and 4 Introduction to financial accounting theory CHAPTER 1 other professional and statutory requirements. In your working life (whether or not you choose to specialise in financial accounting), you could be involved in such activities as analysing financial statements for the purposes of making particular decisions, compiling financial statements for others to read, or generating accounting guidance or rules for others to follow. The better you understand the accounting practices underlying these various activities, the more effective you are likely to be in performing these activities – and therefore the better equipped you are likely to be to succeed in your chosen career. Given that accounting theories aim to provide a coherent and systematic framework for investigating, understanding and/or developing various accounting practices, the evaluation of individual accounting practices is likely to be much more effective if the person evaluating these practices has knowledge of accounting theories. Although all students of accounting (like students in any subject) should be interested in critically evaluating the phenomena they are studying, we recognise that, in the past, many students have been content with simply learning how to apply various accounting practices without questioning the basis of these practices. However, in the wake of a growing number of high-profile corporate failures (such as Lehman Brothers, Enron and WorldCom in the United States, HMV Group in the United Kingdom, Parmalat, Lernout and Hauspie Speech in Europe, Wirecard in Germany, and HIH Insurance, One.Tel, Harris Scarfe and Allans Music in Australia), which have subsequently been linked to questionable accounting practices, it has arguably never been more important for accountants to understand thoroughly and be able to critique the accounting practices that they use. Without such a theoretically informed understanding, and with the increasingly relevant role of ‘accounting’ to addressing social and environmental problems such as climate change, it is difficult to evaluate the suitability of current accounting practices, to develop improved accounting practices where current practices are unsuitable for changed business situations, and to defend the reputation of accounting where accounting practices are blamed for causing companies to fail. This is a key reason why it is important for you to study and understand accounting theories. As a result of studying various theories of accounting in this book, you will be exposed to various issues, including: • how the various elements of financial accounting should be measured • what motivates managers to provide certain types of accounting information (whether it be financial, social, environmental or sustainability-related information) • what motivates managers to select particular accounting methods in preference to others • what motivates individuals to support and perhaps lobby regulators for some accounting methods in preference to others • what the implications for particular types of organisations and their stakeholders are if one method of accounting is chosen or mandated in preference to other methods • how different cultural attributes influence accounting practices • how and why the capital markets react to particular accounting information • whether there is a ‘true measure’ of profit • how accounting can contribute to, or be used to solve, social and environmental problems such as climate change, or the incidence of ‘modern slavery’ within supply chains. Accounting plays a very important and pervasive role within society. Simply to learn, for example, the various rules of financial accounting (as embodied within accounting standards, conceptual frameworks for financial reporting and the like), or particular sustainability-related reporting frameworks (such as that of the Global Reporting Initiative or the International Sustainability Standards Board), without considering the implications that accounting information can have, would seem illogical, and potentially dangerous. Many significant decisions, which in turn might lead to various financial, social and environmental impacts, are made on the basis of information that accountants provide (or in some circumstances, elect not to provide), so accountants are often regarded as being very 5 Financial Accounting Theory powerful and influential people. The practice of ‘accounting’, which often relies upon various technical rules, principles or standards, leads to decisions that can create various social consequences. This is why accounting can be considered as both a technical and social practice. The information generated by accountants enables others to make important decisions. Indeed, relevant and reliable information provides the users of accounting information with ‘power’ to make informed decisions. For example: should they support the organisation? What social and environmental impacts is the organisation creating? Is the organisation earning sufficient ‘profits’? Is it earning excessive ‘profits’? Is the organisation fulfilling its social responsibilities by investing in community support programs and environmentally responsible production technologies and, if so, how much? In considering profits, is profitability a valid measure of organisational success? Further, if the accountant/accounting profession emphasises particular attributes of organisational performance (for example, profitability), does this in turn impact on what society perceives as being the legitimate goals of business?1 As a result of considering various theories of accounting, this book provides some answers to these important issues. At a broader level, an understanding of accounting theories can be crucial to the reputation and future of the accounting profession. Unerman and O’Dwyer (2004) have argued that the rise in high-profile accounting failures has raised the level of awareness among non-accountants about some of the significant social impacts that accounting has on their lives. These events have also led to a substantial reduction in the level of trust that many non-accountants place in financial accounts and in accountants. Massive corporate failures, such as those at Enron and WorldCom, fuelled various criticisms of accounting, including that financial accounting practices failed to reveal a deterioration of the financial position and financial performance of such entities to shareholders and other interested groups on a timely basis. Moreover, prior to such corporate collapses, there was evidence that financial accounting was being used to create benefits for managers (for example, by using methods that inflated profits, thereby leading to larger and potentially unjustifiable bonuses) at a time when the company was actually in financial distress. Research could look at devising ways to guard against such practices. If this trust is to be rebuilt, along with the reputation of accountants, it is now more crucial than ever that we develop the capacity to critically evaluate existing (and potential) accounting practices and to refine these practices as the business environment rapidly changes. The insights from a varied range of accounting theories are essential to this process of continual improvement in accounting practices. Why do I need to know about accounting theory? In your career, you might hold various roles. For example, you might be a manager/accountant considering making particular accounting disclosures; you will likely be a reader of various accounting disclosures; or perhaps you might be in a role that involves introducing regulations or standards relating to accounting practice. Some knowledge of accounting theory will allow you to consider the context, implications of 1 6 or motivations for particular accounting practices that might otherwise not be considered. Arguably, your accounting education would be incomplete, and your ability to be a critical thinker with respect to accounting practice would be undermined, if you did not have sufficient exposure to different accounting theories. Chapters 3 and 4 consider some research (for example, Hines, 1988) that suggests that accountants and accounting do not necessarily provide an unbiased account of reality, but rather create reality. If the accounting profession emphasises a measure (such as profitability) as being a measure of success and legitimacy, then, in turn, profitable companies will be considered successful and legitimate. If something other than profitability had been supported as a valid measure, then this may not have been the case. Introduction to financial accounting theory CHAPTER 1 LO1.1 LO1.2 LO1.3 A brief overview of theories of accounting There are many theories of accounting. That is, there is no universally accepted theory of accounting or, indeed, any universally agreed perspective of how accounting theories should be developed. In part, this is because different researchers have different perspectives of the role of accounting theory and/or what the central objective, role and scope of accounting should be. For example, some researchers believe that the principal role of accounting theory should be to explain and predict particular accounting-related phenomena (for example, to explain why some accountants adopt one particular financial accounting method while others elect to adopt an alternative approach), whereas other researchers believe that the role of accounting theory is to prescribe (as opposed to describe) particular approaches to accounting (for example, based on a perspective of the role of accounting, there is a theory that prescribes that assets should be measured on the basis of market values rather than historical costs). Also, the practice of accounting is continuously evolving. For example, financial accounting is not represented by a static set of rules, and many of the accounting rules we learn at university – perhaps as embodied within accounting standards – will be superseded in due course. It is generally accepted that business transactions have, in recent decades, become more varied and complicated, with direct implications for how we account for such transactions. There is also a growing recognition of the role of accounting in addressing issues associated with sustainable development. Societal expectations and priorities change across time, with implications for accounting. Technical capabilities of information (accounting) systems increase across time, as do the size and influence of many corporations. These ongoing changes create new research questions, which then might require the refinement of existing theories, or the development of new theories, to perhaps explain or guide practice. For example: • In recent times, it has been accepted that climate change is a significant issue for societies globally. Accounting has a role in addressing this issue. Relevant research questions would include: how can accounting be used to reduce organisations’ contribution to climate change; what disclosures stakeholders demand in relation to climate change; and what motivates managers to provide particular climate change-related disclosure, or to use particular accounting methods to account for the assets and liabilities associated with emission trading schemes. • The global financial crisis (GFC) (2007–09) and the more recent COVID-19 pandemic (2019–22) created pressures for governments, organisations and societies that had not been encountered in recent history. Interesting research questions would include: the role of poor financial accounting practices in contributing to the GFC; the efficiency of regulatory reactions; the merit of the accounting profession’s response to the GFC in terms of the development of new accounting practices and related governance practices; and whether financial accounting practices appropriately responded to COVID-19 in respect of adjustments to asset valuations and going concern assumptions. • Since 2005, many countries throughout the world elected to adopt the accounting standards issued by the International Accounting Standards Board (IASB), these being known as International Financial Reporting Standards (IFRS). This raises a number of questions, including: how well the IASB standards ‘fit’ local requirements; whether the related financial statements are now more useful to various financial statement users relative to former locally developed reporting standards; or how the switch to IFRS has impacted the way financial accounting numbers are used within debt contracts or management bonus systems. Again, to address the above issues, we can potentially use theory that currently exists, or there may be a need to develop new theory. In the discussion that follows, we consider some general classifications of theories. 7 Financial Accounting Theory Inductive accounting theories Induction The development of ideas or theories through observation. Deductive reasoning A way to explain a set of particular facts which is based more on the use of logic rather than observation. Early development of financial accounting theory relied on the process of induction, that is, the development of ideas or theories through observation. According to Chalmers (1982, p. 4), there are three general conditions that would ideally exist before theory could be developed through observation: 1 The number of observations forming the basis of a generalisation must be large. 2 The observations must be repeated under a wide variety of conditions. 3 No accepted observation should conflict with the derived universal law. From approximately the 1920s to the 1960s, theories of financial accounting were predominantly developed on the basis of observation of what accountants actually did in practice. That is, they were developed by the process referred to as ‘induction’. This can be contrasted with a process wherein theories are developed by deductive reasoning, which is based more on the use of logic rather than observation.2 Returning to the use of observation to develop generalisable theories (inductive reasoning), after observing what accountants did in practice, common practices were then codified in the form of doctrines or conventions of accounting (for example, the doctrine of conservatism). Notable theorists at this time included Paton (1922), Hatfield (1927), Paton and Littleton (1940) and Canning (1929). Henderson, Peirson and Harris (2004, p. 54) describe the approaches adopted by these theorists as follows: Careful observation of accounting practice revealed patterns of consistent behaviour. For example, it could be observed that accountants tended to be very prudent in measuring both revenues and expenses. Where judgement was necessary it was observed that accountants usually underestimated revenues and overstated expenses. The result was a conservative measure of profit. Similarly, it could be observed that accountants behaved as if the value of money, which was the unit of account, remained constant. These observations of accounting practice led to the formulation of a number of hypotheses such as ‘that where judgement is needed, a conservative procedure is adopted’ and ‘that it is assumed that the value of money remains constant’. These hypotheses were confirmed by many observations of the behaviour of accountants. Prescriptive research Research that is generally based on deductive reasoning and provides prescriptions, or suggestions, about what people should do. While there was a general shift towards prescriptive research in the 1960s, some research of an inductive nature still occurs. Research based on the inductive approach (that is, research based on observing particular phenomena) has been subject to many criticisms. For example, Gray, Owen and Maunders (1987, p. 66) state: Studying extant practice is a study of ‘what is’ and, by definition, does not study ‘what is not’ or ‘what should be’. It therefore concentrates on the status quo, is reactionary in attitude, and cannot provide a basis upon which current practice may be evaluated or from which future improvements may be deduced. Inductive approach An inductive approach to research is based upon developing theory through observation of particular phenomena. In generating theories of accounting based on what accountants actually do, it is assumed (often implicitly) that what is done by the majority of accountants is the most appropriate 2 8 Chapter 6 considers various theories of accounting that were developed to deal with problems that arise in times of rising prices – for example, when there is inflation. Such theories include one developed by a famous accounting researcher named Raymond Chambers. His theory of accounting, known as Continuously Contemporary Accounting, was developed on the basis of a number of logical assumptions about what types of information the readers of financial accounting reports needed. His theory was not based on observing what accountants do (which would be inductive reasoning); rather, his theory was based on what he thought they should do. Using various key assumptions about people’s information needs, he derived his theory through deductive (logical) reasoning. His proposals for accounting represented radical departures from what accountants were actually doing in practice. Introduction to financial accounting theory CHAPTER 1 practice. In adopting such a perspective there is, in a sense, a perspective of accounting Darwinism – a view that accounting practice has evolved, and the fittest, or perhaps ‘best’, practices have survived. Prescriptions or advice are provided to others on the basis of what most accountants do, the ‘logic’ being that the majority of accountants must be doing the most appropriate thing. What do you think of the logic of such an argument? As a specific example of this inductive approach to theory development, we can consider the work of Grady (1965). His research was commissioned by the American Institute of Certified Public Accountants (AICPA) and was undertaken at a time when there was a great deal of prescriptive (as opposed to descriptive) research being conducted. Interestingly, in 1961 and 1962, the Accounting Research Division of the AICPA had already commissioned prescriptive studies by Moonitz (1961) and Sprouse and Moonitz (1962), which proposed that accounting measurement systems be changed from historical cost to one based on current values. However, before the release of these research works, the AICPA issued a statement saying that ‘while these studies are a valuable contribution to accounting principles, they are too radically different from generally accepted principles for acceptance at this time’ (Accounting Principles Board, 1962). History shows that rarely have regulatory bodies accepted suggestions (or, as some people call them, prescriptions) for significant changes to accounting practice. This is an interesting issue which is considered more fully in Chapter 7 when the IASB Conceptual Framework for Financial Reporting is discussed. However, it is useful to consider at this point a statement made in the United States by Miller and Reading (1986, p. 64): The mere discovery of a problem is not sufficient to assure that the Financial Accounting Standards Board will undertake its solution … There must be a suitably high likelihood that the Board can resolve the issues in a manner that will be acceptable to the constituency – without some prior sense of the likelihood that the Board members will be able to reach a consensus, it is generally not advisable to undertake a formal project. Grady’s (1965) work formed the basis of APB Statement No. 4, ‘Basic concepts and accounting principles underlying the financial statements of business enterprises’. In effect, APB Statement No. 4 simply reflected the generally accepted accounting principles of the time. That is, the research was inductive in nature (as it was based on observation) and did not seek to evaluate the logic or merit of the accounting practices being used. It was therefore not controversial and had a high probability of being acceptable to the AICPA’s constituency (Miller and Reading, 1986). While some accounting researchers continued to adopt an inductive approach, a different approach became popular in the 1960s and 1970s. This approach sought to prescribe particular accounting procedures, and as such was not driven by existing practices. The period of the 1960s and 1970s is commonly referred to as the ‘normative period’ of accounting research. That is, in this period the financial accounting theories were not developed by observing what accountants were doing; many of the theories being developed at this time were based on arguments about what the researchers considered accountants should do. Rather than being developed on the basis of inductive reasoning, these theories were being developed on the basis of deductive reasoning. At this time, there tended to be widespread inflation throughout various countries of the world and much of the research and the related theories sought to explain the limitations of historical cost accounting and to provide improved approaches (based on particular value judgements held by the researchers) for asset measurement in times of rapidly rising prices. However, while a number of highly respected researchers were arguing that measuring assets on the basis of historical cost was inappropriate and tended to provide misleading information, particularly in times of rising prices, there was a lack of agreement among the various researchers about what particular asset measurement basis should be used. For example, some argued that assets should be measured at replacement costs, some argued that assets should be measured at net realisable 9 Financial Accounting Theory value, and others argued for measurements based on present values. Throughout this debate, there was no clear choice in terms of which approach was best, and, perhaps because it was difficult to resolve the differences in opinions provided by the various normative researchers, the historical cost approach to accounting continued to be used. Explanatory and predictive (positive) accounting theories Positive research Research that seeks to explain and/or predict particular phenomena. Normative research Research that is generally based on deductive reasoning and seeks to develop a basis for informing people as to what they should do. In the mid to late 1970s, there were further changes in the focus of accounting research and theory development. At this time, a great deal of accounting research had the major aim of explaining and predicting financial accounting practice, rather than prescribing particular financial accounting approaches. This was another movement by many accounting researchers away from descriptive research – this time, towards predictive research. Nevertheless, there are many researchers who still undertake descriptive research. What is being emphasised is that a variety of accounting theories have been developed across time; for example, some are descriptive in nature, some attempt to explain and predict particular aspects of financial accounting practice, and others generate guidance about what accountants should do. Different theories serve different purposes. In reading accounting research, you will see that much research is labelled either positive research or normative research. Research that seeks to predict and explain particular phenomena (as opposed to prescribing particular activity) is classified as positive research, and the associated theories are referred to as positive theories. Such theories tend to try to ‘make sense’ of what is currently happening. Henderson, Peirson and Harris (2004, p. 414) provide a useful description of positive theories. They state: A positive theory begins with some assumption(s) and, through logical deduction, enables some prediction(s) to be made about the way things will be. If the prediction is sufficiently accurate when tested against observations of reality, then the story is regarded as having provided an explanation of why things are as they are. For example, in climatology, a positive theory of rainfall may yield a prediction that, if certain conditions are met, then heavy rainfall will be observed. In economics, a positive theory of prices may yield a prediction that, if certain conditions are met, then rapidly rising prices will be observed. Similarly, a positive theory of accounting may yield a prediction that, if certain conditions are met, then particular accounting practices will be observed. Positive theories Theories that provide the basis for explaining or predicting particular phenomena. As noted above, positive theories can initially be developed through some form of deductive (logical) reasoning. Their success in explaining or predicting particular phenomena will then typically be assessed based on observation – that is, observing how the theory’s predictions corresponded with the observed facts.3 The predictions emanating from a positive theory are often framed in terms of hypotheses. Empirically (observation) based theories can continue to be tested and refined through further observation, perhaps in different institutional or geographical settings, and a great deal of published research is undertaken to see if particular results can be replicated in different settings, thereby increasing the generalisability of the theory in question. Apart from providing the basis for predicting future actions or effects, positive accounting research often goes to the next step of attempting to provide explanations for the phenomena in question. Positivistic research, which uses or generates positive theories, 3 10 Again, it is stressed that not all theories will be assessed in terms of how the theory’s predictions match actual behaviour. Normative theories, for example, might provide prescriptions about how accounting should be undertaken, and such prescriptions might represent significant departures from current practice. These theories, which may be developed through logical deduction, should not be evaluated by observing the theories’ correspondence with current behaviours of accountants. Introduction to financial accounting theory CHAPTER 1 typically uses large numbers of observations (often referred to as quantitative research) and seeks to provide theoretical insights that have relevance across different geographical and institutional settings. Chapter 8 considers a positive theory of accounting principally developed by Watts and Zimmerman (relying on the works of other researchers, such as Jensen and Meckling (1976) and Gordon (1964)). Their positive theory of accounting, which they called Positive Accounting Theory, seeks to predict and explain why managers (and/or accountants) elect to adopt particular accounting methods in preference to others.4 Chapter 8 demonstrates that the development of Positive Accounting Theory relied in great part on work undertaken in the field of economics, and central to the development of the theory was the acceptance of the economics-based ‘rational economic person assumption’. That is, an assumption was made that accountants (and, in fact, all individuals) are primarily motivated by self-interest (tied to wealth maximisation), and that the particular accounting method selected (where alternatives are available) will be dependent on certain considerations, such as: • whether the person supporting the use of a particular accounting method, for example a manager or an accountant, is rewarded in terms of accounting-based bonus systems (for example, whether they receive a bonus tied to reported profits) • whether the organisation they work for is close to breaching negotiated accounting-based debt covenants (such as a debt-to-asset constraint) • whether the organisation that employs them is subject to political scrutiny from various external groups, such as government, employee groups or environmental groups (with that scrutiny being focused on the organisation’s reported profits). The assumption of self-interest, as embraced by researchers who use Positive Accounting Theory, challenges the view that accountants will predominantly be objective, and will embrace the qualitative characteristic of ‘representational faithfulness’ when determining which accounting methods to use to record particular transactions and events (‘representational faithfulness’, which is linked to completeness, neutrality and freedom from error, is a qualitative characteristic promoted within the IASB Conceptual Framework, as is seen in Chapter 7).5 Positive theories of accounting do not seek to tell us that what is being done in practice is the most efficient or equitable process. For example, while we have a (positive) theory of accounting, developed to predict which accounting methods most accountants will use in particular circumstances (Positive Accounting Theory), this theory will not tell us what we should do (it is not a ‘prescriptive’ theory), nor will it tell us anything about the efficiency of what is being done. As Watts and Zimmerman (1986, p. 7) state: Positive Accounting Theory A theory that seeks to predict and explain why managers and/or accountants elect to adopt particular accounting methods in preference to others. Developed by Watts and Zimmerman and others, it is concerned with explaining accounting practice. It is designed to explain and predict which organisations will and which organisations will not use a particular accounting method, but says nothing about which method an organisation should use. It is based on the central economicsbased assumption that all individuals’ actions are driven by self-interest. It [Positive Accounting Theory] is concerned with explaining [accounting] practice. It is designed to explain and predict which firms will and which firms will not use a particular [accounting method] … but it says nothing as to which method a firm should use. 4 5 It should be noted at this point that Positive Accounting Theory is one of several positive theories of accounting (other positive theories that relate to accounting include Legitimacy Theory, Institutional Theory and certain branches of Stakeholder Theory). This book uses lower case when referring to the general class of theories that attempt to explain and predict accounting practice (that is, ‘positive theories of accounting’) and refers to Watts and Zimmerman’s positive theory of accounting as ‘Positive Accounting Theory’ (that is, it uses upper case). As emphasised throughout this book, researchers make a choice between the theories they will apply in particular circumstances. In part, the choice of theory will be influenced by the researcher’s own beliefs and values. For example, many accounting researchers will not use Positive Accounting Theory to explain particular phenomena because they reject the central assumption made within the theory that all individual action is best explained on the basis that individuals are driven by self-interest. For example, Gray, Owen and Adams (1996, p. 75) reject Positive Accounting Theory because it portrays ‘a morally bankrupt view of the world’. We will return to Gray, Owen and Adams’ dismissal of this theory later in the chapter. 11 Financial Accounting Theory As will be seen shortly, the practice of electing not to advise others as to what should be done in particular circumstances has been the subject of criticism of positive accounting research. Prescriptive (normative) accounting theories Normative theory or prescriptive theory Based on the norms or values or beliefs held by the researchers proposing the theories, it is usually based on a process of deduction rather than induction. While positive theories tend to be based on empirical observation, there are other theories that are based not on observation but instead on what the researcher believes should occur in particular circumstances. For example, Chapter 6 discusses a theory of financial accounting developed by Raymond Chambers. His theory of financial accounting, called Continuously Contemporary Accounting, describes how financial accounting should be undertaken – that is, his theory is prescriptive. Central to his theory is a view that the most useful information about an organisation’s assets, for the purposes of economic decision making, is information about its ‘current cash equivalents’ – a measure tied to their current net market values. As such, it prescribes that assets should be measured on the basis of their net market values. Theories that prescribe (as opposed to describe) particular actions are called normative theories, as they are based on the norms (or values or beliefs) held by the researchers proposing the theories (they are also often referred to as prescriptive theories). The dichotomy of positive and normative theories is one often used to categorise accounting theories and this dichotomy is adopted throughout this book. A simple diagrammatic representation of some of the differences between normative and positive theories is provided in Figure 1.1. FIGURE 1.1 Some differences between positive and normative theories Normative theories • Provide prescription about particular phenomena • The ‘worth’ of the theory is not evaluated on the basis of empirical data Positive theories • Seek to explain and predict particular phenomena • The worth of the theory is evaluated on the basis of empirical data – that is, on the basis of the correspondence between ‘real world’ observations and the theoretical predictions generated by the theory As noted above, normative theories of accounting are not necessarily based on observation and therefore cannot (or should not) be evaluated on the basis of whether the theories reflect actual accounting practice. That is, many normative accounting theories are based on a process of deduction (logical argument) rather than induction (observing practice). In fact, they may suggest radical changes to current practice. For example, for a number of decades Chambers had been advocating the measurement of assets on a basis related to their net market values – a prescription that challenged the widespread use of historical cost accounting (it is interesting to note, however, that in recent years the use of market values, or more specifically, fair values, for asset measurement has gained popularity with the IASB). Other researchers concerned about the social and environmental implications of business (see, for example, Gray and Bebbington, 2001; Gray, Adams and Owen, 2014; Mathews, 1993) have developed theories that prescribe significant changes to traditional financial accounting practice (Chapters 9 and 10 of this book consider such theories). The IASB Conceptual Framework, which is discussed in Chapter 7, is an example of a normative theory of accounting. Relying on various assumptions about the types or attributes of information useful for decision making, the Conceptual Framework provides guidance on how assets, liabilities, expenses, income and equity should be defined, when they should be recognised, and ultimately how they should be measured. As is seen in later chapters, 12 Introduction to financial accounting theory CHAPTER 1 normative theories can be further subdivided. For example, some normative theories can be classified as ‘true income theories’, and other theories as ‘decision usefulness theories’. The true income theories make certain assumptions about the role of accounting and then seek to provide a single ‘best measure’ of profits (for example, see Lee, 1974).6 REFLECTION QUESTION 1.1 Contrasting positive and normative research Question There are two researchers: • Researcher 1 is undertaking research to determine whether organisations with greater levels of negative media attention directed at their activities are likely to provide greater levels of socially oriented disclosures. • Researcher 2 evaluates the disclosures being made by different organisations with the intention of developing reporting guidance that will assist organisations to provide relevant and reliable information about their contributions to climate change. Would the above research be considered positive or normative research? Solution • Positive research: Positive research seeks to explain or predict particular phenomena. Researcher 1 would be undertaking positive research. • Normative research: Normative research seeks to provide prescriptions about what should be done. Researcher 2 would be undertaking normative researchers. Decision usefulness theories ascribe a particular type of information for particular classes of users on the basis of assumed decision-making needs. According to Bebbington, Gray and Laughlin (2001, p. 418), the decision usefulness approach can be considered to have two branches – the decision-makers emphasis and the decision-models emphasis. The decision-makers emphasis relies on undertaking research that seeks to ask the users of the information what information they want.7 Once that is determined, this knowledge is used to prescribe what information should be supplied to the users of financial statements. Much of this research is questionnaire-based. This branch of research tends to be fairly disjointed, as different studies typically address different types of information, with limited linkages between them. Another variant of the decision-makers emphasis, which is explored in Chapter 11, is capital markets research. Briefly, capital markets research works on the assumption that if the capital market responds to information (as evidenced through share price changes that occur around the time of the release of particular information), then the information must be useful.8 This forms the basis for subsequent prescriptions about the types of information that should be provided to users of financial statements. It also has been used to determine whether particular mandatory reporting requirements (such as the introduction of new accounting standards) were necessary or effective, the rationale being that, if a new accounting standard does not evoke a market reaction, it is questionable whether the new requirement is useful or necessary in providing information to the capital market or investors. Research that evaluates information on the basis of whether it evokes a market reaction, or whether stakeholders indicate that it is useful to them, ignores the possibility that there could be information that is ‘better’ than that provided or sought. There is also the 6 7 8 Decision usefulness theories Theories that ascribe a particular type of information for particular classes of users on the basis of assumed decisionmaking needs. Much of the work undertaken in developing ‘true income theories’ relies on the work of Hicks (1946). Hicks defined ‘income’ as the maximum amount that can be consumed by a person or an organisation in a particular period without depleting the wealth that existed for that person or organisation at the start of the period. For example, in recent years a number of research studies have asked a number of different stakeholder groups what types of social and environmental performance information the stakeholders considered to be useful for their various decision-making processes. Based on the Efficient Markets Hypothesis, which predicts that the stock market instantaneously reacts, through price adjustments (changes), to all relevant publicly available information. 13 Financial Accounting Theory broader philosophical issue of whether the information stakeholders ‘want’ is actually what they ‘need’. These broader issues are explored throughout this book. On the other hand, proponents of the decision-models emphasis develop models based on the researchers’ perceptions of what is necessary for efficient decision making. Information prescriptions follow (for example, that information should be provided about the market value of the reporting entity’s assets). This branch of research typically assumes that classes of stakeholders have identical information needs. Unlike the decision-makers emphasis, the decision-models emphasis does not ask the decision makers what information they want; instead, it concentrates on the types of information considered useful for decision making. As Wolk and Tearney (1997, p. 39) indicate, a premise underlying this research is that decision makers may need to be taught how to use this information if they are unfamiliar with it.9 Critical theories of accounting Another class of accounting theories are those deemed to be part of what are known as ‘critical accounting theories’. These theories are explored in Chapter 13. As Chapter 13 explains, the view promoted by researchers operating from a critical perspective is that accounting, far from being a practice that provides a neutral, unbiased or representationally faithful depiction of underlying economic facts, actually provides the means of maintaining the powerful/privileged positions of some sectors of the community (those currently in power and with wealth) while suppressing the position and interests of those without wealth. These theorists challenge any perspectives that suggest that various rights and privileges are spread throughout society – instead, they argue that most rights, opportunities and associated power reside with a small group. Such researchers seek to highlight the perceived inequalities and structural problems inherent in existing social systems (and how accounting acts to sustain inequitable systems) – systems that are typically taken for granted by other ‘non-critical’ researchers. Critical theorists explore how accounting potentially contributes to elements of society that are not equitable for some stakeholders, such as employees or particular communities. This can be contrasted with most accounting researchers who, while often testing for particular relationships between chosen variables, frequently do not question any inequities associated with the processes or systems that they are investigating. Why do I need to know that there are many ‘theories of accounting’? Different theories have different roles and purposes and provide different insights into – or ‘lenses’ through which to view – the practice of accounting. Learning about different theories will allow us to have a more comprehensive perspective of the potential roles, or influence, of accounting within society and upon particular stakeholders. No accounting theories can provide a complete understanding of the practice of accounting. Different theories make different assumptions about such things as the roles or objectives of different forms of accounting; the motivations of managers/accountants in 9 14 producing particular ‘accounts’; or about how different stakeholders use, or respond to, accounting information. Some theories prioritise the needs or rights of some stakeholders over and above the needs or rights of other stakeholders. Knowledge of different theories will enable us to use theories that correspond with our own assumptions ‘about the world’, and which appear to address the question or objective we are seeking to solve. At times, we will find it useful to combine the insights provided by different accounting theories. As an example, not relating to accounting, about why asking subjects/individuals what they need might not lead to optimal outcomes, we can consider the following scenario. If we were to ask people what they needed/demanded to dig a hole in the garden then, if they had never been exposed to a shovel/spade, they might say ‘a spoon’. Actually showing them that a shovel exists will likely change their future demand for gardening implements towards an instrument that is more efficient/fit for purpose. Similarly, subjects might need to be shown/taught the benefits of using particular information before they can make an informed choice about what information to demand. Introduction to financial accounting theory CHAPTER 1 Do researchers always use pre-existing theories or can they develop their own theory? The aim of research is to advance, refine and expand a given body of knowledge. Commonly, research is performed in a way that utilises a particular theory (or perhaps a combination of theories) that have gained widespread acceptance within a given research community. That is, the theory to be used is usually predetermined by the researcher before entering a particular field or domain to collect data. As we now know, the researcher might use the chosen theory to either explain particular activity or phenomena (for example, a theory might be used to explain which organisations are more likely to make particular financial accounting disclosures, or which organisations are more likely to make particular social disclosures), or the researcher might apply a theory to evaluate particular activities or behaviours (for example, to evaluate the decision usefulness of particular financial accounting information, or the quality of particular social disclosures). Our own personal or philosophical beliefs will influence what theories we choose to apply. If the research evaluates or prescribes particular activities – that is, is ‘normative’ in nature – then the evaluation, or prescription, will be influenced by the philosophical beliefs of those who developed the theory. For example, if research explores the accountability of organisations in respect of animal welfare-related initiatives, then the evaluation will be influenced by the theorist’s views about the ‘rights’ of animals relative to humans. This in turn might be influenced by which philosophical theories/beliefs the researcher embraces (for example, if the researcher is influenced by the ‘deep ecology movement’ then humans would not be considered to have greater rights than animals, and this would influence perceptions about what level of accountability an organisation should demonstrate in relation to animals). In this book, we generally explore theories that have widespread acceptance within the various accounting research communities, and which researchers would then often apply to investigate particular phenomena. Such theories might be used by many hundreds, or thousands, of researchers and might be traced back to the works of particular ‘leading’ (or ‘seminal’) theorists who were credited with developing the theory. Much subsequent research might use such theories without questioning, or justifying, the theories themselves, unless, of course, the theories seem to have lost their relative ability to predict or explain particular phenomena or to enable certain practices to be evaluated in an appropriate sense. It should, however, be noted that not all research starts with an accepted theory. Rather, some research is done in such a way that the theory emerges from the data. That is, the theory itself is grounded in the data being collected by the researcher. This is referred to as ‘grounded theory’. The aim of such research would be to generate theory, rather than to apply theory. Grounded theory Grounded theory has been used by various accounting researchers. Strauss and Corbin (1990, p. 24) define grounded theory as ‘a qualitative research method that uses a systematic set of procedures to develop and inductively derive grounded theory about a phenomenon’. As we know, something is ‘inductively derived’ if its derivation is based upon observing and analysing particular data. Grounded theory generates theory that is ‘grounded’ in the data. Grounded theory is not generated in the absence of immersing oneself in the data. Grounded theories can take on a variety of forms, cover a variety of research questions, be developed from different sets of observations and be based upon different philosophical beliefs. Therefore, ‘grounded theory’ is more correctly considered to be an umbrella term for theories that are developed ‘ground up’ from the data rather than being reflective of theory that shares particular ‘world views’. What grounded theories have in common, however, is that they are generated from observing data relating to various forms of communication between subjects in the research field. Grounded theory A theory that is developed though the collection and analysis of data and which involves the application of inductive reasoning. Ideas, concepts and, ultimately, a theory ‘emerge’ from the data. 15 Financial Accounting Theory Efforts to generate a grounded theory might be undertaken when researchers believe that important data relating to a particular phenomenon have not been considered and/or the relationships between particular ‘concepts’ are not properly understood. Grounded theory is particularly appropriate when little is known about particular phenomena. Grounded theory research questions would tend to be quite broad at the outset of a research project, but would then tend to narrow to more specific research questions as the research proceeds and the theory becomes more refined. When developing grounded theory, the author does not commence with a theory. That is, researchers using grounded theory typically try not to have any form of prior commitment to a particular pre-existing theory (which is not necessarily easy, as we do tend to see the world in accordance with particular theories, and this can shape what data we collect and how we interpret it). Rather, the grounded researcher will commence with an area of study and, as part of the research process, allow research constructs and theory to emerge from the data. In generating grounded theory, relevant data will be collected through interviews, meetings, observations, reviews of documents and so forth (Strauss, 1987). The term ‘grounded theory’ actually implies that the researcher has immersed themselves into a setting where various forms of communication are studied. Emerging concepts are coded with the aim of developing explanations, or core categories, which explain variations in the collected data. According to Glaser (1978), grounded theory seeks to arrange ‘many ideas which have emerged from analysis of the data’. Grounded theory seeks to make sense or give meaning to the data that are collected and to attribute some structure to that data. In doing so, the researcher needs to understand the context in which the subjects are located. This is because people undertaking grounded theory research typically believe that the meaning that different people within a study (the ‘subjects’) attribute to particular items of data potentially only occurs within particular research contexts (‘meanings’ are context specific). Hence, consideration of situational context is important to grounded research (this can be contrasted to ‘grand theories’ that were discussed earlier in this chapter, which are theories that are deemed – rightly or wrongly – to have application across potentially all settings and time). The view that the context (or situation) of the research impacts how the data is analysed and interpreted is in contrast to much research, in accounting and elsewhere, wherein researchers often assume that there is an ‘objective world’ in which we would all see, and interpret, data in much the same way. A grounded researcher will consider the data carefully and continuously throughout data collection. This is in contrast to many other researchers using predetermined theories, wherein a hypothesised outcome is predicted and the data are often all collected before testing of the hypotheses is ultimately undertaken. As with most theories, if the same accounting theory is applied across time, it has the potential to become distant, or decoupled, from everyday phenomena. Society’s behaviour and expectations can change across time, thereby potentially invalidating some central assumptions that were utilised in earlier research. If we have researchers undertaking grounded theory research, then this can provide some level of safeguard against the research community applying ‘obsolete’ theories. Once all the research has been completed by the grounded researcher, it is possible that the grounded theory might ultimately be very similar (or even the same) as pre-existing theories. It might also represent significant and valuable departures from pre-existing theories. Hermeneutics and phenomenology In the discussion above, we have not mentioned ‘hermeneutics’, a term that is often used within certain accounting research communities. Advocates of grounded theory typically explore hermeneutics. This is what differentiates somebody who is referred to as a ‘grounded theorist’ from other researchers. Hermeneutics is a term that refers to written, verbal and non-verbal communication, and ‘hermeneutical research’ seeks to interpret and give meaning to these forms of communication in the context of both the author and the audience of the communication. 16 Introduction to financial accounting theory CHAPTER 1 Grounded theorists, who typically engage in hermeneutical research, would argue – as we have already emphasised – that without considering context, the meanings attributed to particular communication might be easily misconstrued. Hermeneutical research (and grounded research) is often, in turn, linked to what is referred to as ‘phenomenology’, a philosophical movement which has the objective of investigating phenomena as experienced by particular people, and without imposing theories about what might explain how particular events or influences impact those involved. The research would aim to not be bound by previous preconceptions and presuppositions. Phenomenology is the study of lived experiences and seeks to study the world as it is interpreted by, and through, human consciousness. The object being studied should not be considered distinct from its context under this philosophical approach to research. Again, understanding data is considered by these researchers to be context dependent. Researchers working within a ‘phenomenological paradigm’ typically assume that the social world is subject to constant change. While we have dedicated a number of paragraphs to explaining grounded theory, it should again be noted that the vast number of accounting researchers do not seek to generate a grounded theory. That is, most accounting researchers apply predetermined theories. It is generally accepted that research applying grounded research approaches is more difficult to undertake (particularly for early researchers), and consumes greater research time. Nevertheless, very significant knowledge breakthroughs can be generated through the time-consuming work associated with quality grounded research. In the balance of this book, we will not be considering grounded theories, and nor will we be exploring hermeneutics or phenomenology in any depth. They are beyond the scope of this book. Nevertheless, there would be various ‘research methods’ texts that explore these areas in depth for those readers who now have an interest in these areas. REFLECTION QUESTION 1.2 Grounded theorists’ approaches to research Researchers using grounded theory tend to explore various forms of communication (hermeneutics) and consider them in the context of the social environment in which the communication was undertaken. Prior to collecting the data, such researchers try not to have any form of a priori commitment to a particular theory. Rather, they want the data to be analysed in a way that generates theory. Question How might the research approach of a grounded theorist differ from that of a researcher who applies Positive Accounting Theory to explain why managers support the use of particular financial accounting methods? Solution Positive Accounting Theorists will typically apply a predetermined theory developed by other leading researchers (this being Positive Accounting Theory), and will also typically have developed their hypotheses before collecting any data. The data will be reviewed to determine whether it supports the theory, and if not, some consideration will be given to modify the theory. This contrasts with the grounded theorists, who allow the theory to be derived from the data. Positive Accounting Theorists also typically assume that the data they are collecting would be viewed equally by all people and that the context of where the data originates is not important. This means that the data can be extracted from various ‘environments’, or organisations, without adjustment prior to it being used to test the hypotheses that have been developed. That is, the assumption by positive theorists is that we all see ‘the world’ similarly and that different forms of communication are interpreted in the same way by all people, thereby meaning that results are deemed to be generalisable. By contrast, a grounded theorist assumes that how particular communications are interpreted will be influenced by the contexts in which the communications were generated. As such, the results derived from grounded theory will tend to have limited generalisability. 17 Financial Accounting Theory LO1.4 LO1.5 Evaluating theories of accounting As we have now indicated, in the process of studying accounting, students will typically be exposed to numerous theories of accounting, and the accompanying research and argument that attempts to either support or reject the particular theories in question. In undertaking this study, students should consider the merit of the argument and the research methods employed by respective researchers. What students often find interesting is that many researchers seem to embrace one theory of accounting and thereafter adopt various strategies (including overt condemnation of alternative theories) in an endeavour to support their own research and theoretical perspective. In some respects, the attitudes of some researchers are akin to those of the disciples of particular religions. (In fact, Chambers [1993] refers to advocates of Positive Accounting Theory as belonging to the ‘PA Cult’.) Deegan (1997) provides a series of quotes from the works of various high-profile researchers who were opposed to Watts and Zimmerman’s Positive Accounting Theory. In providing arguments against the contribution or validity of Positive Accounting Theory, the opponents – who were advocates of other theories, typically normative in nature – used such terms and descriptions as shown in Figure 1.2. FIGURE 1.2 Arguments against the contribution or validity of Positive Accounting Theory It is a dead philosophical movement (Christenson, 1983, p. 7). It has provided no accomplishments (Sterling, 1990, p. 97). It is marred by oversights, inconsistencies and paradoxes (Chambers, 1993, p. 1). It is imperiously dictatorial (Sterling, 1990, p. 121). It is akin to a cottage industry (Sterling, 1990, p. 132). It is empty and commonplace (Sterling, 1990, p. 130). It is responsible for turning back the clock of research 1000 years (Chambers, 1993, p. 22). It suffers from logical incoherence (Williams, 1989, p. 459). It is a wasted effort (Sterling, 1990, p. 132). These criticisms indicate the degree of emotion that a particular theory stimulated among its critics, particularly those accounting researchers who saw the role of accounting theory as providing prescription rather than description, explanation or prediction. Students of accounting theory will find it interesting to ponder why some people are so angered by such a theory – after all, it is just a theory (isn’t it?). Many proponents of Positive Accounting Theory have also tended to be very critical of normative theorists. 18 Introduction to financial accounting theory CHAPTER 1 The Positive Accounting Theorists and the normative theorists would be considered to be working from different paradigms that provide greatly different perspectives about the role of accounting research. According to Hussey and Hussey (1997, p. 47): The term paradigm refers to the progress of scientific practice based on people’s philosophies and assumptions about the world and the nature of knowledge; in this context, about how research should be conducted. Paradigms are universally recognised scientific achievements that for a time provide model problems and solutions to a community of practitioners. They offer a framework comprising an accepted set of theories, methods and ways of defining data … Your basic beliefs about the world will be reflected in the way you design your research, how you collect and analyse your data, and even the way in which you write your thesis. Paradigm Refers to the progress of scientific practice based on people’s philosophies and assumptions about the world and the nature of knowledge. Hussey and Hussey’s discussion about ‘paradigms’ is consistent with Kuhn (1962), who states that a paradigm can be defined as an approach to knowledge advancement that adopts particular theoretical assumptions, research goals and research methods. For example, earlier in this chapter we briefly discussed the research approach adopted by grounded theorists. They consider that particular forms of communication can have different meanings in different social contexts and therefore it is often inappropriate to generalise about what motivates particular people to initiate certain communications, or to generalise about how receivers of certain communications will react to particular information. By contrast, Positive Accounting researchers typically assume an objective world in which all actors tend to attribute the same meaning to communications. Therefore, Positive Accounting researchers often argue that data collected in one research setting can be pooled with data from another setting when testing various predetermined hypotheses; and because of the pooling of data from different settings, positivists typically have large amounts of data that they then subject to various statistical examination (because of this, ‘positive research’ and ‘quantitative research’ are terms that are often used interchangeably). In explaining or describing why a certain ‘camp’ of researchers might try to denigrate the credibility of alternative research paradigms, it is relevant to consider one of the various views about how knowledge advances (and there are various theories to explain how knowledge, science and theories develop across time – indeed, there are theories about nearly everything!). Kuhn (1962) explained how knowledge, or science, develops: scientific progress is not evolutionary but revolutionary. His view is that knowledge advances when one theory is replaced by another as particular researchers attack the credibility of an existing paradigm and advance an alternative, promoted as being superior, thereby potentially bringing the existing paradigm into ‘crisis’. As knowledge develops, the new paradigm may be replaced by a further research perspective, or a prior paradigm may be resurrected. In discussing the process of how researchers switch from one research perspective (or paradigm) to another, Kuhn likens it to one of ‘religious conversion’.10 While the perspective provided by Kuhn does appear to have some relevance to explaining developments in the advancement of accounting theory, so far no accounting theory has ever been successful in overthrowing all other alternatives. There have been, and no doubt will continue to be, advocates of various alternative theories of accounting, many of which are discussed in this book. Returning to our brief review of accounting theories, we have stated previously that positive theories of accounting do not seek to prescribe particular accounting practices (that is, they do not tell us which accounting practices we should adopt). Some critics of this positive theoretical 10 Kuhn’s ‘revolutionary’ perspective about the development of knowledge is in itself a theory and, as with accounting theories, there are alternative views of how knowledge develops and advances. Although a review of the various perspectives of the development of science is beyond the scope of this book, interested readers are referred to Popper (1959), Lakatos and Musgrove (1974), Feyerabend (1975) and Chalmers (1982). 19 Financial Accounting Theory perspective have argued that the decision not to prescribe could alienate academic accountants from their counterparts within the profession. As Howieson (1996, p. 31) states: … an unwillingness to tackle policy issues is arguably an abrogation of academics’ duty to serve the community which supports them. Among other activities, practitioners are concerned on a day-to-day basis with the question of which accounting policies they should choose. Traditionally, academics have acted as commentators and reformers on such normative issues. By concentrating on positive questions, they risk neglecting one of their important roles in the community. Counter to this view, many proponents of Positive Accounting Theory have, at different times, tried to undermine normative research because it was not based on observation but on personal opinion about what should happen. (Observation-based research was deemed by them to be ‘scientific’, and ‘scientific research’ was considered to be akin to ‘good research’.) Positive Accounting Theorists often argue that in undertaking research they do not want to impose their own views on others as this is ‘unscientific’; rather, they prefer to provide information about the expected implications of particular actions (for example, the selection of a particular accounting method) and thereafter let people decide for themselves what they should do (for example, they may provide evidence to support a prediction that organisations that are close to breaching accounting-based debt covenants will adopt accounting methods that increase the organisation’s reported profits and assets, thereby ‘loosening’ the effects of the accounting-based debt covenants). However, as a number of accounting academics have quite rightly pointed out, and as should be remembered when reading this book, selecting a theory to adopt for research (such as Public Interest Theory, Capture Theory, Legitimacy Theory, Stakeholder Theory, Institutional Theory, Positive Accounting Theory or various critical accounting theories) is based on a value judgement; what to research is based on a value judgement; believing that all individual action is driven by self-interest (as the Positive Accounting Theorists do) is a value judgement; believing that traditional accounting practices sustain the privileged position of particular members of society (as various ‘critical theorists’ do) is based on a value judgement, and so on. Hence, no research, whether using Positive Accounting Theory or otherwise, is value free and it would arguably be quite wrong to assert that it is value free. As Gray, Owen and Maunders (1987, p. 66) state: In common with all forms of empirical investigation we must recognise that all perception is theory-laden. That is, our preconceptions about the world significantly colour what we observe and which aspects of particular events we focus upon. Thus accountants are more likely to view the world through accounting frameworks and conventions. Watts and Zimmerman (1990, p. 146) did modify their original stance in relation to the objectivity of their research and conceded that value judgements do play a part in positive research just as they do in normative research. They stated: Positive theories are value laden. Tinker et al. (1982, p. 167) argue that all research is value laden and not socially neutral. Specifically, ‘Realism operating in the clothes of positive theory claims theoretical supremacy because it is born of fact, not values’ (p. 172). We concede the importance of values in determining research: both the researcher’s and user’s preferences affect the process. Competition among theories to meet users’ demand constrains the extent to which researcher values influence research design. Positive theories are ‘If … then’ propositions that are both predictive and explanatory. Researchers choose the topics to investigate, the methods to use, and the assumptions to make. Researchers’ preferences and expected pay-offs (publications and citations) affect the choice of topics, methods and assumptions. In this sense, all research, including positive research, is ‘value laden’. 20 Introduction to financial accounting theory CHAPTER 1 The position taken in this book is that theories of accounting, of necessity, are abstractions of reality, and the choice of one theory in preference to another is based on particular value judgements. Some of us may prefer particular theories in preference to others because they more closely reflect how we believe people do, or should, act. Apart from issues associated with whether a particular theory is compatible with our own values and beliefs, other factors that might influence whether we accept a theory might include: • the perceived authority or reputation of those responsible for important developments in the theory • the extent of acceptance of the theory by other researchers within our ‘research community’. However, we must remember that just because a reputable researcher or researchers have developed or embraced a theory does not necessarily mean it is ‘right’. We must still consider whether it has been logically developed and provides logical explanations, predictions or prescriptions – something that we consider in the following sections of this chapter. The second point above also deserves further attention. It is common for many researchers to adopt particular theories because the majority of people researching the particular topic use that theory. As Deegan (2019, p. 2317) states when explaining the apparent dominance of Legitimacy Theory (which we explore later in this book), within the social and environmental accounting literature: It is possible that Legitimacy Theory continues to be used because it has effectively become ‘institutionalised’ within the social and environmental accounting literature, albeit that it is clear that alternative theories (particularly various forms of institutional theory) are gaining traction and challenging the previously dominant position of Legitimacy Theory. As indicated earlier, Dumay et al (2018) note that Legitimacy Theory has remained one of the most commonly used theories in the social and environmental accounting literature. Consistent with this, and because many perceived ‘leaders’ in the area were apparent supporters of the theory, then it might have also been seen as potentially the least resistant path to ultimate publication. This, in itself, might have constrained the possibility of other important insights being explored and revealed. This is an interesting way to consider how theories are selected and how theories can tend to have a level of acceptance that gains momentum. But again, we would hope that theories are selected based on their merit! Is the theory parsimonious? Another issue that we might consider when evaluating theories is whether the theories seem to be overly simplistic, or perhaps, too complicated, either of which might not be acceptable. One term that is of relevance here is parsimony. It is generally accepted that a simple explanation for a phenomenon is better and easier to understand than a complicated explanation. The same applies to theories. Generally speaking, a parsimonious theory is preferred, which means that the researcher has applied the most economically logical explanation to explain a particular phenomenon. For example, if one researcher has generated a theory that predicts certain choices of accountants (such as the choice to use a particular financial accounting method) and the theory uses 20 measured variables, but another researcher has developed a theory that appears to have the same explanatory ability, but only uses four explanatory variables, then that latter theory would be preferred. In relation to ‘parsimony’, Deegan (2019, p. 2316) states: Parsimonious theory A theory that performs as well as other theories but, relative to alternative theories, has fewer assumptions and variables. It is a theory that embraces simplicity and is consistent with the view that simpler explanations are preferred to more complex ones. This practice of embracing parsimonious explanations is consistent with what has for a long time been known as ‘Occam’s razor’ (a principle purportedly developed in science and philosophy by English philosopher, William of Occam, circa 1282–1340) in which a preferred explanation of a particular phenomenon is the simplest explanation that provides acceptable answers to a particular, and otherwise complex, problem. Applying 21 Financial Accounting Theory this principle, if multiple theories are available which each satisfactorily explain something that is occurring then the theory making the fewer assumptions/having the fewest variables should be the one that is ultimately chosen. In concluding this section, we note that we cannot really expect to provide perfect explanations or predictions of human behaviour, nor can we expect to assess perfectly what types of information the users of ‘accounts’ actually need – my perceptions of information needs will probably be different from your views about information needs. There is a role for prescription if it is based on logical argument, and there is a role for research that provides predictions if the research methods employed to provide the predictions are assessed as valid. Why do I need to know that it is important to critically evaluate theories? Arguably, we should critically evaluate most of the things we learn. This is particularly important for theories. Theories can provide a very useful lens through which to understand the world in which we exist. However, before we seek to apply particular theories, we need to consider whether the theory was developed to answer the types of problems or questions we want answered; whether the theory adopts certain LO1.5 LO1.6 assumptions that we are likely to accept or reject; whether the theory appears to be logically derived; and whether the previous testing of the theory, which has perhaps created acceptance of the theory, has been undertaken properly, or whether there are flaws in the research design or processes used to previously support the theory. Can we prove a theory? This book does not intend to provide an in-depth insight into the development of scientific thought, but one interesting issue that often arises with students is whether a theory can actually be ‘proved’. In this book various theories are considered, a number of which provide alternative explanations for the same events. Further, there are often alternative theories that relate to a specific phenomenon, and which provide different and even opposite explanations or prescriptions. For example, in relation to climate change, some theories suggest global warming is very much due to the way people are using the planet’s resources and that we need to change or modify our production and consumption activities. Other theories suggest that climate change is a natural event that occurs without human intervention, is cyclical in nature, and therefore there is no need for direct action. We always need to guard against simply accepting a theory – not all theories provide sound explanations, predictions or prescriptions for particular practice, and where theories provide opposite explanations then, generally speaking, both cannot be right. The next section considers how to evaluate a theory in terms of logic and evidence, but first we look at the issue of whether we can prove a theory. One’s view about whether we can prove a theory as ‘correct’ depends on how one views the development of scientific thought. When it comes to accounting theories – which might, for example, consider how people react to particular accounting numbers or why accountants would choose particular accounting methods in preference to others – we need again to appreciate that accounting is a human activity (we cannot have accounting without accountants) and that common sense would dictate that not all people will react in a similar way to specific ‘accounts’. Hence, logic might indicate that a theory of accounting (and therefore a theory that describes human behaviour in relation to preparing and using ‘accounts’) would not provide perfect predictions of behaviour in all cases (and in this explanation we are talking about positive theories – theories that seek to explain and predict particular phenomena). If the theories of accounting were developed to explain and predict people’s actions and reactions to accounting information (that is, they are positive theories), we might consider that if a theory provides sound predictions the majority of the time, then the theory is still of use, albeit 22 Introduction to financial accounting theory CHAPTER 1 that its predictions are not ‘perfect’. That is, we would evaluate it on the basis of the correspondence between the prediction of behaviours provided by the theory and the subsequent behaviour, and we might accept that a theory is useful even though it does not provide accurate predictions in all cases. That is, an ‘acceptable’ theory might admit exceptions.11 It should also be appreciated that, while we might use observations to ‘support’ a theory, it would generally be inadvisable to state that we have proved a theory on the basis of observations. There is always the possibility that one further observation might be made that is inconsistent with our theory’s predictions. Is the theory falsifiable? In relation to the issue of whether we can ‘prove’ a theory (or not), it is useful to refer to insights provided by a group of theorists known as ‘falsificationists’, the major leader of which is considered to be Karl Popper.12 Popper and the falsificationists consider that knowledge develops through trial and error. For example, a researcher might develop hypotheses from a theory.13 To develop scientific knowledge, the falsificationists believe that these hypotheses must be of a form that allows them to be rejected if the evidence is not supportive of the hypotheses. For example, a hypothesis of the following form would be deemed to be falsifiable: Hypothesis 1: Managers who receive bonuses based on accounting profits will select income-increasing accounting methods. According to Popper and other falsificationists, knowledge develops as a result of continual refinement of a theory. When particular hypotheses are deemed to be false through lack of empirical support, the pre-existing theories will be refined (or abandoned). The refined theories will be accepted until a related hypothesis is deemed to be false (falsified), at which time the theory will be further refined. Chalmers (1982, p. 38) provides a useful overview of falsificationism. He states: Falsificationist Describing a philosophy that uses experiment and observation to attempt to show that a theory is false, rather than attempting to verify it. Falsifiable A theory is considered to be falsifiable if it provides predictions that can be tested and ultimately rejected. The falsificationist freely admits that observation is guided by and presupposes theory. He [or she] is also happy to abandon any claims implying that theories can be established as true or probably true in the light of observational evidence. Theories are construed as speculative and tentative conjectures or guesses freely created by the human intellect in an attempt to overcome problems encountered by previous theories and to give an adequate account of the behaviour of some aspects of the world or universe. Once proposed, speculative theories are to be rigorously and ruthlessly tested by observation and experiment. Theories that fail to stand up to observational and experimental tests must be eliminated and replaced by further speculative conjectures. Science progresses by trial and error, by conjectures and refutations. Only the fittest theories survive. While it can never be legitimately said of a theory that it is true, it can hopefully be said that it is the best available, that it is better than anything that has come before. From the falsificationist’s perspective, researchers should not test a theory by finding observations or facts that confirm the theory. Rather, researchers should look for cases that do not fit the theory, thereby effectively disproving the theory. The degree to which we might consider a theory to be acceptable will perhaps depend on the costs or implications associated with the theory ‘getting it wrong’ in a particular circumstance. For example, if the theory related to medicine and the theory was wrong only 10 per cent of the time – thereby causing deaths in 10 per cent of the patients – such a theory might not be acceptable. In accounting, we might tolerate higher levels of inconsistency between theory predictions and related outcomes. 12 One of the first detailed descriptions of falsificationism appeared in Karl Popper, The Logic of Scientific Discovery, Hutchinson, London, 1968. 13 Simply stated, a hypothesis can be defined as a proposition typically derived from theory which can be tested for causality or association using empirical data. For example, a hypothesis might be: the greater the negative media attention given to a particular social issue the greater the amount of organisational disclosures addressing the issue. 11 23 Financial Accounting Theory Popper’s view regarding how theories are developed can be contrasted with the views adopted by the inductivists considered earlier in the chapter. The inductivists construct theories based on typically long periods of careful observation. This discussion will not be pursued any further in terms of how theories develop but, consistent with some of the above discussion, we would caution readers about making any claims to ‘proving’ a theory. It is always safer to say that our evidence ‘supports’ a theory, but that it is also possible that we might embrace an alternative theoretical perspective at a future time should better explanations for a particular phenomenon become available. REFLECTION QUESTION 1.3 Claiming that a theory is ‘proved’ Question If you were attending a research seminar and somebody said they had generated results that proved a theory, would it be appropriate for you to challenge such a claim? Solution You would be correct to challenge such a claim. The view taken by many philosophers is that it is more appropriate to say that the results generated by particular research support a theory, or are consistent with a theory, rather than prove a theory. Theories, particularly theories relating to human behaviour, are necessarily abstractions of reality and therefore provide a simplifying lens through which to view the world. Samples or evidence collected to test theories do not typically include the entire population of a particular item/variable. Rather, samples are typically used and therefore it is always possible that a different sample might include units or items that do not conform with the theory. That is, there is always a chance that other evidence, yet to be collected, could exist which is inconsistent with the theory. So, play it safe, and never say you have proved a theory! Something that researchers often say, which typically is not challenged, is that evidence was collected that proves a theory is wrong and this occurs as a result of having evidence which is inconsistent with the theory. Evaluating theories – considerations of logic and evidence LO1.4 Logical deduction A conclusion or judgement that is made based upon logical argument or reasoning. Often developed through a series of steps, where each step is true if the preceding step is deemed to be true. Represents a process of reasoning using a series of statements (premises) to generate a logical conclusion. 24 LO1.5 Throughout this book, various theories of accounting are discussed. Where appropriate, an evaluation of the theories is also undertaken. The book considers such issues as whether the argument supporting the theories is (or at least appears to be) logical and/or plausible in terms of the central assumptions (if any) that are being made. If possible, the argument or theory should be broken down into its main premises to see if the argument, in simplified form, appears logical. What is emphasised is that we must question the theories that we are exposed to – not simply accept them. Acceptance of a theory and its associated hypotheses must be tied to whether we accept the logic of the argument, the underlying assumptions and any supporting evidence provided. (As indicated previously, hypotheses can be described as predictions typically expressed in the form of a relationship between one or more variables.) Evaluation through logical deduction As an example of logical deduction, consider the simplistic non-accounting-related argument (reflecting the bias of the author, who is an ‘old surfer’, it refers to surfing) shown in Figure 1.3. It demonstrates that, although the argument may be logical (if we accept the premises), if it can be shown that one of the premises is untrue or in doubt, then the conclusions or predictions may be rejected. Where there are a number of premises and a conclusion, it is often referred to as a ‘syllogism’. If we accept the premises in Figure 1.3, we might accept the conclusion. It is logical. To determine the logic of the argument, we do not need to understand what a ‘surfer’ is or what a ‘longboard’ is. That is, we do not need to refer to ‘real world’ observations. We could have deconstructed the argument to the form in Figure 1.4. Introduction to financial accounting theory CHAPTER 1 FIGURE 1.3 An example of a syllogism Premises All surfers over the age of 35 ride longboards. Jack is a surfer over the age of 35. Conclusion Jack therefore rides a longboard. FIGURE 1.4 Deconstructing the argument Premises All As ride a B. C is an A. Conclusion Therefore, C rides a B. An argument is logical to the extent that if the premises on which it is based are true then the conclusion will be true. That is, the argument (even if logical) will only provide a proper account of the real world if the premises on which it is based are true. Referring to the above syllogism, evidence gathered through observation will show that the first premise does not always hold. There are surfers over 35 who do not ride longboards. Hence, we reject the conclusion on the basis of observation, not on the basis of logic. Therefore, we had two considerations. If the argument seeks to provide an account of real-world phenomena, we must consider the logic of the premises and the correspondence between the premises and actual observation. This simplistic example can be extended to a review of theories. We might try to break the theory down into a series of premises. When the central premises are considered, do they lead to a logical conclusion? Further, if the premises are based on ‘real world’ observation, do they seem to be true? However, it should be remembered that not all theories or arguments seek to correspond with real-world phenomena – for example, some normative theories of accounting promote radical changes to existing practices. For many normative theories, we might consider only the logic of the argument and whether we are prepared to accept the premises on which the argument is based. That is, empirical data is not analysed in research that is purely deductive. Returning to the subject of the syllogism provided above, we could have argued alternatively, as shown in Figure 1.5. FIGURE 1.5 An alternative argument Premises A lot of surfers over 35 ride longboards. Jack is a surfer over 35. Conclusion Therefore, Jack rides a longboard. The argument in Figure 1.5 is not a logical argument. The first premise has admitted alternatives and hence the conclusion, which does not admit alternatives, does not follow. We can dismiss the argument on the basis of a logical flaw without actually seeking any evidence to support the premises. 25 Financial Accounting Theory Evaluating the underlying assumptions Assumption An assumption is something taken for granted or accepted as true without further proof. Chapter 8 reviews in greater depth Positive Accounting Theory as developed by such researchers as Jensen and Meckling (1976) and Watts and Zimmerman (1978). As noted earlier, their positive theory of accounting has a number of central assumptions, including an assumption that all people are opportunistic and will adopt particular strategies to the extent that such strategies lead to an increase in the personal wealth of those parties making the decisions. That is, selfinterest is a core belief about what motivates individual action. Wealth accumulation is assumed to be at the centre of all decisions. The theory does not incorporate considerations of morality, loyalty, social responsibility and the like. If we were to accept the economics-based assumption or premise of researchers such as Watts and Zimmerman that: • self-interest tied to wealth maximisation motivates all decisions by individuals, and if we accept the following premises (which we might confirm through direct observation or through research undertaken by others) that: – manager X is paid on the basis of reported profits (for example, he/she is given a bonus of 5 per cent of accounting profits), and – accounting method Y is an available method of accounting that will increase reported profits relative to other methods, then we might accept a prediction that, all other things being equal, • then, manager X will adopt accounting method Y. This argument appears logical. Whether manager X is paid on the basis of reported profits, and whether accounting method Y will increase reported profits, are matters that can be confirmed though observation. But if the premises are both logical and true, then the conclusion will be true. The argument may be logical, but we might accept it only if we accept the critical assumption that the actions of individuals are motivated by the desire to maximise personal wealth. If we do not accept the central assumption, then we may reject the prediction. What is being emphasised here is that you need to consider whether you are prepared to accept the logic and the assumptions on which the arguments are based. If not, then we may reject the theory and the associated predictions. For example, in Gray, Owen and Adams (1996), the authors explicitly state that they reject the central assumptions of Positive Accounting Theory (although by their own admission it has generated ‘some useful insights’) and that they will not use it as a means of explaining or describing the practice of corporate social responsibility reporting. (The topic of corporate social reporting is covered in Chapter 10 of this book.) As Gray, Owen and Adams state (p. 75): There is little doubt that these theories have provided some useful insights into the way in which they model the world. There is equally little doubt that some company management and many gambling investors may act in line with these theories. It is also the case that some authors have found the form of analysis employed in these theories useful for explaining corporate social reporting; but apart from the limitations which must arise from a pristine liberal economic perspective on the world and the profound philosophical limitations of the approach, the approach cannot offer any justification why we might accept the description of the world as a desirable one. It is a morally bankrupt view of the world in general and accounting in particular. Its (usual) exclusion of corporate social reporting is therefore actually attractive as an argument for corporate social reporting. Chapter 7 discusses the IASB Conceptual Framework for Financial Reporting, which is considered to be a normative theory of accounting (applying a decision usefulness perspective). This framework provides a view about the objective of general purpose financial reporting (to provide information that is useful for economics-based decisions) and the qualitative characteristics that 26 Introduction to financial accounting theory CHAPTER 1 financial information should possess. It also provides definitions of the elements of accounting (assets, liabilities, income, expenses, equity) and prescribes recognition criteria for each of the elements. As discussed in Chapter 7, in recent years the IASB made various revisions to its Conceptual Framework. The Conceptual Framework (IASB, 2022, paragraph 1.1) states that: The objective of general purpose financial reporting forms the foundation of the Conceptual Framework. Other aspects of the Conceptual Framework – the qualitative characteristics of, and the cost constraint on, useful financial information, a reporting entity concept, elements of financial statements, recognition and derecognition, measurement, presentation and disclosure – flow logically from the objective. Hence, if we were to decide whether we agreed with the guidance provided within the revised Conceptual Framework as developed by the IASB, which is an example of a normative theory (as already indicated, a normative theory prescribes how we should undertake a particular activity – in this case, how we should do financial accounting), then we clearly would need to evaluate the assumed objective identified in the framework. As everything else is constructed around this objective (as the quote shows, it is deemed to be the ‘foundation of the Conceptual Framework’), then, logically, if we disagree with the stated objective, we would have to disagree with the balance of the prescriptions provided in the revised Conceptual Framework. Within the IASB Conceptual Framework (2022, paragraph 1.2), the objective is identified as: The objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions relating to providing resources to the entity. Those decisions involve decisions about: (a) buying, selling or holding equity and debt instruments; (b) providing or settling loans and other forms of credit; or (c) exercising rights to vote on, or otherwise influence, management’s actions that affect the use of the entity’s economic resources. Therefore, if we believed that the central objective of financial accounting was to provide information to a broad cross-section of stakeholders, inclusive of employees, local communities and other groups that are not directly involved as capital providers, then we would reject the conceptual framework developed by the IASB, despite the fact that it might be considered to be logically structured. While the in-depth study of logic and a critique of argument are beyond the scope of this book, interested readers should consider studying books or articles that concentrate on the development of logical argument.14 For example, Thouless (1974) describes various approaches to identifying logical flaws in arguments and he also identifies 38 ‘dishonest tricks in argument’ that some writers use to support their arguments. Some of the ‘tricks’ he refers to, and which are often used to distract readers from limitations in the logic of an argument or theory, are: • the use of emotionally toned words • making a statement in which ‘all’ is implied but ‘some’ is true • evasion of a sound refutation of an argument by use of a sophisticated formula • diversion to another question, to a side issue, or by irrelevant objection • the use of an argument of logically unsound form • change in the meaning of a term during the course of an argument • suggestion by repeated affirmation • prestige by false credentials • the appeal to mere authority • argument by mere analogy. 14 A good book in this regard is Straight and Crooked Thinking by Robert H. Thouless (1974). Sterling (1970) is also useful. 27 Financial Accounting Theory When reading documents written to support particular ideas or theories, we must also be vigilant to ensure that our acceptance of a theory has not, in a sense, been coerced through the use of colourful or emotive language, or an incorrect appeal to authority. Earlier, reference was made to terms and descriptions used by critics of Positive Accounting Theory, some of which were very emotive. Quite often (but not always) emotive or colourful language is introduced to support an otherwise weak argument. Where emotive or colourful language has been used, we should perhaps consider whether we would take the same position in terms of accepting the author’s arguments if the author had used relatively neutral language. Thouless (1974, p. 24) provides some advice in this regard: The practical exercise which I recommend is one that I have already performed on some passages in which truth seemed to be obscured by emotional thinking. I suggest that readers should copy out controversial passages from newspapers, books, or speeches which contain emotionally coloured words. They should then underline all the emotional words, afterwards rewriting the passages with the emotional words replaced by neutral ones. Examine the passage then in its new form in which it merely states facts without indicating the writer’s emotional attitude towards them, and see whether it is still good evidence for the proposition it is trying to prove. If it is, the passage is a piece of straight thinking in which emotionally coloured words have been introduced merely as an ornament. If not, it is crooked thinking, because the conclusion depends not on the factual meaning of the passage but on the emotions roused by the words. Universal applicability of theories While we must always consider the logic of an argument and the various assumptions that have been made, what we also must remember is that theories, particularly those in the social sciences, are by nature abstractions of reality. We cannot really expect particular theories about human behaviour to apply all the time. People (thankfully) are different and to expect theories or models of human behaviour (and remember, accounting theories relate to the action of accountants and the users of accounting information) to have perfect predictive ability would be naive. If a number of theories are available to describe a particular phenomenon, then considering more than one theory may provide a more rounded perspective. Difficulties will arise if the theories provide diametrically opposite predictions or explanations, and in such cases a choice of theory must generally be made. For those theories that attempt to predict and explain accounting practice (positive theories of accounting), it is common practice to test the theories empirically in various settings and potentially across various types of decisions. But what if the particular theories do not seem to hold in all settings? Should the theories be abandoned? Returning to an issue considered previously in this chapter, can we accept a theory that admits exceptions? Certainly, readings of various accounting research journals will show that some studies that adopt Positive Accounting Theory, or other forms of positivistic accounting theories (for example, capital markets theories, Legitimacy Theory and particular stakeholder theories) as the theoretical basis of the argument, fail to generate findings consistent with the theory (however, many studies do generate results consistent with the respective theory). According to Christenson (1983, p. 18), an outspoken critic of Positive Accounting Theory: We are told, for example, that ‘we can only expect a positive theory to hold on average’ [Watts and Zimmerman, 1978, p. 127, n. 37]. We are also advised ‘to remember that as in all empirical theories we are concerned with general trends’ [Watts and Zimmerman, 1978, pp. 288–289], where ‘general’ is used in the weak sense of ‘true or applicable in most instances but not all’ rather than in the strong sense of ‘relating to, concerned 28 Introduction to financial accounting theory CHAPTER 1 with, or applicable to every member of a class’ [American Heritage Dictionary, 1969, p. 548] … A law that admits exceptions has no significance, and knowledge of it is not of the slightest use. By arguing that their theories admit exceptions, Watts and Zimmerman condemn them as insignificant and useless. Christenson uses the fact that Positive Accounting Theory is not always supported in practice to reject it.15 However, as stressed previously, as a study of people (accountants, not ‘accounting’), it is very hard to see how any model or theory could ever fully explain human action. In fact, ability to do so would constitute a very dehumanising view of people. Hence, the failure of a particular study to support a theory might not in itself provide a basis for rejecting a theory as ‘useless and insignificant’. From another perspective, the failure to support the theory may have been due to the data being inappropriately collected or the data not providing a sound correspondence with the theoretical variables involved. However, if the theory in question continuously fails to be supported, then its acceptance will obviously be threatened. At this point we could speculate whether in fact there are any theories pertaining to human activities that always hold. Generalising theories from the testing of samples In developing and testing accounting theories, many accounting researchers – particularly those embracing positivistic research – use methods borrowed from the pure sciences (such as physics and chemistry) that assume the phenomena being studied will behave in the same way in all similar situations. As we will see when reading accounting (and other) research, these researchers believe that it is possible to develop generalisable accounting theories and therefore that the results they derive from particular samples of observations can be generalised to the broader population of the phenomenon in question. Such researchers would therefore include the generalisability of a theory as one of the key considerations when evaluating the acceptability of the theory (and remember, in this chapter we noted other issues that are also criteria that might be considered when evaluating a theory, such as: the logic inherent in the theory; the key assumptions made within the theory; the reputation of those people who developed the theory; whether the theory is parsimonious; and, whether the theory provides predictions that are falsifiable). Other researchers hold the opposite view – that it is not possible to make any valid generalisations in the social sciences as we are dealing with human activity, and human behaviour varies from person to person. These researchers will develop theories of a fundamentally different nature from those developed by researchers who believe that it is possible to generalise in accounting theory, and these theories will tend to deal with specific localised situations. Hence, generalisability would not be a key criterion these researchers would use when evaluating a theory. Between these two extremes, there are other researchers (such as Laughlin, 1995, 2004) who believe that it is possible to make some very broad generalisations in developing social science theories, but the way these broad generalisations apply to specific situations will vary according to the specific individual factors applicable to each situation. Researchers holding this view regarding the way the world works may use some very broad theories to help understand some aspects of the phenomena they are studying, but are ready to amend and adapt these broad generalisations in light of specific evidence from each individual study. While a comprehensive review of research methods is beyond the scope of this book, if researchers are attempting to generalise the findings of their studies (based on particular samples) to a larger population, we need to consider the data on which the generalisation is 15 Generalisability Generalisability is concerned with whether research findings can be generalised beyond the specific context in which the research was conducted. A study may be valid in one setting but not in another and in this instance the research results would not be generalisable. Where a proposition is not supported in a particular instance, many of us have probably heard the phrase ‘the exception proves the rule’ being applied. Such a statement implies that we cannot accept a rule or proposition unless we find some evidence that appears to refute it. This clearly is an illogical argument. As emphasised above, we must always guard against accepting arguments that are not logically sound. 29 Financial Accounting Theory based.16 For example, if we are going to generalise our findings from a sample (we typically cannot test the whole population), then we must consider how the original sample was chosen. For instance, if we have a prediction that all companies will adopt a particular accounting method in times of inflation, and we test this prediction against the 10 largest companies listed on a securities exchange in a period of inflation, then common sense should dictate that the findings really should not be considered generalisable. Can we really be confident about what small companies will do given that our sample included only large listed companies? Hence, throughout your readings of various research studies, you should consider not only how the argument is developed, but also how it is tested. If there are flaws in how the testing has been done, we may question or reject the significance of the findings. We must evaluate whether the data collected really represent valid measures of the theoretical variables in question. As noted previously, it is usually not appropriate to test normative theories (those theories that provide prescription) empirically. If researchers are arguing that accountants should provide particular types of accounting information, or if other researchers are stating a view that organisations have a social responsibility to consider the needs of all stakeholders, then this does not mean that what they are prescribing actually exists in practice. For example, if Chambers’ model of accounting prescribes that all assets should be measured at their net market value, and we go out and find that accountants predominantly measure their assets on the basis of historical cost, we should not reject Chambers’ theory, as he was prescribing, not predicting or describing. We should always keep in mind what the researchers are attempting to achieve. Our acceptance of Chambers’ theory is dependent on whether we accept the logic of the argument as well as the assumptions made by Chambers, including the assumption that the central role of accounting should be to provide information about an entity’s ability to adapt to changing circumstances (which he argues is best reflected by measures of assets that are tied to their net market values), and the assumption that organisations should exist primarily to increase the wealth of the owners. Can (or should ) more than one theory be used at a time? Most researchers apply a predetermined theory when undertaking research (although there are exceptions, such as the ‘grounded researchers’ discussed earlier in this chapter). They choose a theory from among competing theories. Taking this further, do researchers ever apply a combination of theories when undertaking their research? The answer to this question is ‘yes’. Some researchers do use multiple theories to explore particular research questions. This is often referred to as ‘theoretical triangulation’, or ‘theoretical pluralism’. Logically, and as we have already stressed, no theory can be expected to provide fully comprehensive explanations in relation to a particular social practice, such as accounting practice. For a practice involving human interaction, such as accounting, it is hard to imagine that one theory will ever address and make sense of the many complex issues that arise. Theoretical triangulation allows different theoretical perspectives, which generate different factors or variables to consider, to be used to examine particular research questions. The term ‘theoretical triangulation’ sometimes causes confusion. It does not mean that we are using three different theories (we know there are three angles in a triangle). Rather, the term indicates that we are looking at solving or addressing a particular question from different theoretical angles or perspectives (or looking at an issue through different ‘lenses’). It represents a potential convergence of knowledge as a result of a convergence of insights from quite separate points of origin. 16 30 Entire books are dedicated to research methods. Interested readers may refer to: C. Humphrey and B. Lee (eds) (2004), The Real Life Guide to Accounting Research: A Behind-the-Scenes View of Using Qualitative Research Methods, Kidlington, Oxford: Elsevier; J. Collis and R. Hussey (2021), Business Research: A Practical Guide for Undergraduate and Postgraduate Students, 5th edn, London: Red Globe Press; T. Clark, L. Foster, L. Sloan and A. Bryman (2021), Bryman’s Social Research Methods, 6th edn, Oxford: Oxford University Press; and P. Ghauri, K. Gronhaug and R. Strange (2020), Research Methods in Business Studies, 5th edn, Cambridge University Press, Cambridge. Introduction to financial accounting theory CHAPTER 1 In justifying theoretical triangulation, it is often argued that failure to consider multiple theories may cause the researcher to miss important issues that are not explored because they are not addressed by a particular theory. Different theories provide different insights, and provide ‘multiple lenses’ through which to understand particular phenomena. As Covaleski et al. (2003) argue, research that embraces multiple theories can potentially enable a more complete understanding of a particular phenomenon than is possible through applying a single theory. If we try to use multiple theories to address particular research questions, we need to make sure that it is actually logical to jointly utilise particular theories. Generally, researchers would only use theories in combination when the chosen theories share similar ontological assumptions (which relate to how we ‘see the world’ and whether we believe we all attribute the same meanings to particular phenomena) and similar epistemological assumptions (which relate to how we determine whether certain things are ‘true’ or not, and whether data collected can have a generalised meaning or must be considered relative to its context). Epistemological assumptions are typically linked to ontological assumptions. As an example, we would probably be unwise to consider in combination a theory that assumes that all people are driven by ‘self-interest’ and that there is an objective reality in which all people see and interpret things the same way (which is the cornerstone of various economic and accounting theories, such as Positive Accounting Theory) with a theory that assumes that individual human behaviour is influenced by factors such as culture, education, religion, professional memberships and so forth (as some accounting-related theories do). Arguably, such a combination of theories could lead to ‘theoretical incoherence’, wherein the different theories just do not logically work, or ‘fit’, together – something that we would need to guard against. Where theoretical triangulation has been applied, a single interpretation of the answer to a particular research question might not arise. Indeed, there could be multiple valid interpretations which imply multiple ‘truths’ (Freeman, 2003). This is not a bad thing. However, not all researchers might be comfortable with the view that there can be ‘multiple truths’. We will not pursue the issue of theory triangulation further in this text. But when we discuss particular theories, you might consider which theories could potentially work well together to provide richer insights and which theories would be problematic to utilise in combination. The major point we want to stress here is that theories provide a lens through which to see the world, and sometimes it can be useful to consider multiple ‘lenses’. A given ‘lens’ often will only expose part of the ‘whole story’ or ‘truth’. LO1.3 LO1.4 LO1.6 Key factors that influence the research process We now use some of what we have learned within this chapter to summarise some factors that might influence the research process. As the previous material in this chapter indicates, there is a logical linkage between the theory chosen for particular research, the related research questions raised and research methods used, and the generalisability, or universal applicability, of any results being generated from the research project. That is, for a given research project, issues such as theory selection, development of research questions and selection of research methods should not be considered independently – they are all very interdependent. This is reflected relatively simplistically in Figure 1.6. In explaining the linkages in Figure 1.6, we continue to refer to a theory that we have already used to explain various research and theoretical issues – this being Positive Accounting Theory (discussed in more depth in Chapter 8). As this chapter and Chapter 8 explain, Positive Accounting Theory was developed by researchers who believed that the role of financial accounting theory is to explain and predict the choice of financial accounting practices (rather than providing prescriptions for improved practice). These researchers utilised simplifying assumptions adopted from the economics literature when developing their theory – which matched the researchers’ own values and 31 Financial Accounting Theory FIGURE 1.6 The interdependence of various factors within the research process Ontological assumptions of the researcher (how we see the world) Interests, values, beliefs of researcher Research questions to be addressed Choice of theory to be used Research methods to be used Degree of generalisability or universal applicability of research results beliefs – including the assumption that all individuals are motivated by self-interest, with this self-interest being directly tied to wealth maximisation. It is also assumed within Positive Accounting Theory that individuals will always be opportunistic and will select strategies that are expected to maximise their own wealth, despite any potential implications for other individuals. That is, such a theory assumes that individual actions are predictable and that all individuals see the world in the same way (they have a shared view of the world). It is assumed that there is an ‘objective reality’ in which all individuals (such as managers) will behave identically (due to the same preferences for particular outcomes). These researchers’ perspective of what constitutes a ‘good’ theory is one that provides explanations or predictions that apply to all managers across all types of organisations, and across time. As indicated earlier in this chapter, assumptions about human behaviour, such as those briefly identified above, are often referred to as ontological assumptions, which, simply stated, are assumptions we make about how we see the world. Positivist researchers would have an ontological assumption that the world is objective and external to the researcher and that all observers would see that ‘world’ similarly. By contrast, phenomenologists would believe the world is socially constructed and will be seen and interpreted differently by different social actors. They would also, in contrast to positivists, believe that researchers themselves are affected by the process of research. They would not tend to generalise results from one research location to another. Positive Accounting Theory was developed to explain or predict the accounting practices that managers would elect to adopt in situations where the accounting method choice is not restricted by regulation. This theory was therefore applicable for answering the research questions the researchers were interested in answering – specifically, what accounting methods managers will choose to use when the respective area of financial accounting is unregulated. So, to this point, we can see how the ontological assumptions of the researcher, their values and beliefs, the theory being used and the research questions to be addressed are all highly interdependent and interwoven. With Figure 1.6 still in mind, we can now consider how the particular theory being used impacts the choice of research methods being used. As indicated above, Positive Accounting Theory adopts the assumption that all individuals are motivated by the same thing – wealth maximisation. It also assumes that where managers have a choice with regard to selecting an accounting method, then the method chosen will be the one that ultimately 32 Introduction to financial accounting theory CHAPTER 1 provides the greatest financial benefits to themselves. This theory leads to generalisable hypotheses, such as: managers of organisations with bonus plans [tied to reported income] are more likely to use accounting methods that increase current period reported income. Hence, all managers are perceived as the same and somewhat interchangeable, meaning that large-scale testing across samples of many managers can be undertaken. This has direct implications for the research methods used.17 In this case, large samples of accounting policy choices can be investigated and statistical techniques would be utilised (with the result that this form of research is often classified as belonging within a body of research known as ‘quantitative research’). Again, with Figure 1.6 in mind, the results of the research would be deemed to be generalisable across all managers. That is, there is a direct linkage between the research method used (which might be based on large, randomly selected samples) and the generalisability of the results. By contrast with Positive Accounting Theorists, there will be other accounting researchers who consider that it is unrealistic and perhaps naïve to expect that all individuals are driven by identical motivations. For example, rather than believing that all managers are motivated purely by maximising their own wealth, some researchers might believe that while some managers are primarily motivated by wealth maximisation, other managers might prefer to maximise the wellbeing of the local community or to minimise the environmental impacts caused by their organisation. This does not mean that all managers are not expected to act rationally, but that they have different preferred outcomes. Because managers are considered to have different motivations, a theory other than Positive Accounting Theory would be chosen by such researchers. Further, managers would not be treated as being interchangeable, and this has implications for the type of research methods used (which might tend to be smaller in scale, possibly trying to understand the motivations of a limited number of managers within particular types of organisations and perhaps lending itself to case study style research. This form of research is often classified as belonging within a body of research known as ‘qualitative research’). The results of such research would also not be considered by the researchers to be generalisable across the population of all ‘managers’. Another, somewhat ‘external’ factor, that has been proposed in recent years as influencing the type of research being undertaken, and the theories being applied, is the research assessment exercises (RAEs) being undertaken across various countries. Such exercises can have various unintended consequences. RAEs have been undertaken regularly in a number of countries (for example, the United Kingdom, Australia, New Zealand, Netherlands, France and Italy) and their purpose is to assess the ‘quality’ of research by analysing research outputs of universities at a national level. The scores or ranks generated from such assessment exercises are often linked to university ‘brand’, ‘image’ and marketability, and they are often perceived as being useful in attracting students (and therefore income) to a highly rated university. In some countries, the outcomes of the RAEs also directly influence the research funding provided by government to particular disciplines within universities. Universities are known to strategically appoint staff and to focus on particular areas of research in order to achieve a higher ranking in such assessment exercises. O’Connell et al. (2020) specifically investigated the apparent impact the RAE undertaken within Australia, known as the Excellence in Research for Australia (ERA) review and administered by the Australian Research Council (ARC), had on accounting research undertaken within Australia. The research assessment conducted as part of the ERA assessment is done by a 17 When we refer to research methods, we are referring to the methods or tools used by the researcher to test or explore the research questions, propositions or hypotheses that they have formulated. For example, research methods might include the use of large scale surveys with associated statistical analysis of the survey results. Alternatively, for research where there is no expectation of generating generalisable findings, case study research might be relevant, inclusive of the use of a limited number of in-depth interviews of research subjects. 33 Financial Accounting Theory panel of assessors chosen by the ARC, and is undertaken at the level of disciplines, with the unit of evaluation being a designated field of research, such as ‘accounting’. The results of the investigation by O’Connell et al. (2020) indicated that there appeared to be a form of positive bias applied by the ERA-nominated assessors towards research that was positivistic, and therefore highly quantitative, in nature, and which tended to provide generalisable prescriptions and did not consider individual organisational, or human, differences. That is, those institutions that undertook positivistic, quantitative accounting research appeared to be rated higher by the assessment panel members than those institutions that did not, despite the actual number of publications being generated within different institutions. Such a result created a perception that a focus on positivist research provided a pathway to higher ERA rankings, whereas research of a non-positivist and qualitative nature, such as interpretive or critical research, seemed to go unrewarded within the ratings exercise. Because of quests to ‘play the game’ and achieve higher ratings in subsequent ERA rounds, this arguably leads to an increase in positivistic research and a reduction in non-positivistic research. The positivistic research tends to focus on financial accounting, earnings management, capital markets and audit judgement, but not on areas associated with critiques of accounting practices, social and environmental accountability/responsibility, and broader sustainability issues as they relate to accounting. If the results of the O’Connell et al. (2020) research are reasonably accurate (and, as we have noted in this chapter, before we accept any research results, we need to carefully review how the respective authors performed their research), then this would be a concern for those people who believe that the Earth is in ‘trouble’ environmentally, and that accounting has a role in assisting sustainable development. Such environmentally focused research should arguably be encouraged rather than potentially undermined through such government-sponsored ratings exercises. In trying to understand the reasons why positivistic research seemed to be rated higher within the ERA process, the authors specifically considered the people who were appointed to the assessment panels of the ERA exercise. What was apparently clear was that the assessors themselves undertook positivistic research, and they tended to be employed by institutions that prioritised positivistic (highly quantitative) research. Because assessors tend to be selected from institutions that were highly ranked in previous ERA rounds, and because positivistic research is ranked higher, the ranking exercise becomes a self-sustaining exercise for prioritising and privileging positivistic research. This was deemed to be consistent with the view projected by O’Connell et al. (2020) that the whole research evaluation process had been captured by a particular field of researchers (positivists) who prioritised their own theoretical and philosophical perspectives to the detriment of ‘non-conforming’ (non-positivist) researchers. All this happens while the whole process is outwardly promoted by the government as one that fosters research excellence and which is objective, free from bias and rigorous. That is, the process appears to have a level of ‘legitimacy’ within the broader community. According to O’Connell et al. (2020, p. 1297): Our findings have implications for the literature on governance together with the literature on academic elitism. In the case of university governance, our findings show that a new public management focus on achieving key performance targets in research rankings has impacted on academics by narrowing the type of research undertaken and types of methods chosen. This outcome is unlikely to be in the public interest given that a primary aim of universities should be to study a wide range of problems using diverse methods and to educate future generations well and with breadth. While the discussion in this section is brief, it does indicate that how people undertake their research (including the research methods used) will be influenced by a number of factors, even including the external assessment of research quality (which is undertaken by individuals who have their own views about what constitutes ‘good research’). All these various factors should be kept in mind throughout this book when we consider alternative accounting theories and the related research that has been conducted. 34 Introduction to financial accounting theory CHAPTER 1 STUDY TOOLS OUTLINE OF THE FOLLOWING CHAPTERS OF THIS BOOK A book of this size cannot be expected to cover all the theories of accounting. In this book, we tend to focus on theories that relate to the external reporting of accounting-related information, rather than theories that address how managers use information to manage an organisation (which might be broadly referred to as management accounting theories). In doing so, this book covers those theories that have gained widespread acceptance by various sectors of the accounting community. Chapter 2 introduces a ‘four-step accountability model’ and links it to issues associated with organisational responsibility, accountability and accounting. It is stressed that an individual’s perceptions of organisational responsibility ultimately impact the ‘accounting’ that we do and that we teach, and the theories that researchers apply in their research. The evolving nature of ‘accounting’ and ‘accounting theory’ are also addressed. Corporate governance is introduced and its linkage to corporate mission statements and organisational responsibilities stressed, as is the linkage between ‘accounting’ and different forms of corporate governance. Consideration is also given to what is commonly referred to as the ‘materiality determination process’, wherein the accounting information provided to stakeholders is determined through a process that engages particular stakeholders. Chapter 3 provides an overview of various financial reporting decisions that entities typically face, emphasising that some reporting pertaining to particular transactions and events is regulated and some is unregulated. The chapter emphasises that financial accountants typically make many professional judgements throughout the accounting process, and discusses the qualitative attribute of objectivity; but it emphasises that considerations (other than the pursuit of objectivity) may sometimes influence accounting method selection and disclosure practices. Chapter 4 provides an overview of various arguments for and against the regulation of financial reporting, with an overview of various perspectives on the costs and benefits of regulating financial reporting. The chapter explores why some accounting approaches and/or methods are adopted by regulators and/or the profession, while others are not. The political process involved in the setting of accounting standards is highlighted. Chapter 5 explores the international harmonisation of accounting requirements. In recent decades, moves have been made to standardise accounting practices internationally. Australia and the European Union were at the forefront of such moves. This chapter considers some potential costs and benefits of this process. Particular consideration is given to issues of culture and how cultural differences have typically been proposed as a reason to explain international differences in accounting requirements. International standardisation ignores this research and assumes that all countries (with different cultures) can and should simply adopt the same financial accounting practices. Chapter 6 provides an overview of various normative (or prescriptive) theories of accounting that have been advanced to deal with various accounting issues associated with periods of rising prices (inflation). The chapter considers such issues as whether there is a ‘true’ measure of income. Conceptual frameworks of financial reporting, as normative theories of accounting, are considered in Chapter 7. Applying material covered in Chapter 4, Chapters 6 and 7, we also consider why various normative theories of accounting did not gain favour with the accounting profession or the respective accounting standard-setters. Chapters 8 and 9 show that, while much financial reporting is regulated, managers still have some scope for voluntarily selecting between alternative accounting methods for particular types of transactions. The treatment of many transactions, and the disclosure of many/most issues associated with various social and environmental events relating to an organisation, are unregulated. Chapters 8 and 9 consider some theoretical perspectives (including Positive Accounting Theory, Legitimacy Theory, Stakeholder Theory, Political Economy Theory and Institutional Theory) that explain what drives the various unregulated/voluntary reporting decisions. Chapter 10 considers the development and use of systems of accounting that incorporate the economic, social and environmental performance of an organisation. The relationship between accounting and sustainable development is explored and the role of ‘accounting’ in advancing sustainable development is stressed. This chapter includes a consideration of the limitations of traditional 35 Financial Accounting Theory financial accounting, with particular focus on the failure of financial accounting to incorporate social and environmental issues/impacts in measures of ‘profits’. Chapters 11 and 12 consider how individuals and capital markets react to various corporate disclosures. The chapters consider the various theories that have been used to test whether the market is actually using particular types of disclosures, as well as theories that indicate how individuals use accounting information. The chapters also consider who should be deemed to be the users of various types of disclosures. Issues associated with stakeholder rights to know are also explored. The concluding chapter, Chapter 13, provides an overview of various critical perspectives of accounting – perspectives that tend to criticise entire systems of accounting (accounting practices can be perceived as anthropocentric, masculine, marginalising and so on). Reference is made to theoretical perspectives that claim that accounting tends to support current and ‘accepted’ social systems, which tend to favour those parties with economic power, but marginalise the interests of parties that lack control of necessary resources. In summary, the balance of this book can be presented diagrammatically, as in Figure 1.7. FIGURE 1.7 Diagrammatic overview of accounting theory CHAPTER 1 An introduction and overview of accounting theory CHAPTER 2 The relationship between organisational responsibility, accountability and ‘accounting’. The linkage between perceptions of organisational responsibility and corporate governance is also explored. CHAPTER 3 Building on the material in Chapters 1 and 2, this chapter explores the rationale for ‘why’ particular accounting approaches or methods are adopted. Some accounting policies will be adopted because of regulatory requirements, whereas other accounting policies will be adopted voluntarily and reliant on professional judgement. Regulated reporting decisions Unregulated reporting decisions Chapter 4 Costs and benefits of accounting regulation and political processes associated with regulation accounting Chapter 6 and 7 Normative prescriptions for accounting practice, including different suggestions for measuring assets, inclusive of fair value Chapter 5 A critique of decisions to internationally harmonise accounting practice approaches Chapter 8 and 9 Theories to explain the voluntary choice to adopt particular financial, social and environmental accounting policies and approaches CHAPTER 10 Application of material from previous chapters to explain the practice of, and provide prescriptions for, social and environmental (sustainability) reporting CHAPTER 11 AND 12 Individual and market reactions to particular accounting disclosures CHAPTER 13 Critical perspectives of accounting – an exploration of views that suggest different forms of ‘accounting’ information privilege some members of the society to the detriment of other members of society. ‘Accounting’ is seen as an ‘instrument’ to support the position and status of particular segments of the community 36 Introduction to financial accounting theory CHAPTER 1 ANSWERS TO THE OPENING QUESTIONS At the beginning of the chapter, we asked the following three questions. As a result of reading this chapter, you should be able to provide informed answers to these questions – ours are shown below. 1 Why do students of accounting need to bother with the study of ‘theories’? For example, why not just study some more of the numerous accounting standards (and there are certainly plenty of them!) or other pronouncements of the accounting profession? Accounting can be a very technical practice, with many rules or guidelines about how we perform various forms of ‘accounting’. While it is important to understand how to technically perform various accounting practices, for example, to know when and how to recognise and measure various assets, liabilities, income and expenses, or when and how to measure and report various social and environmental impacts, as thinking individuals, we need more knowledge. Accounting practices can in turn create various social impacts. That is, accounting is both a technical and social practice – it is a rich process that requires ongoing research. We need theory to understand issues such as: • why managers elect to apply particular accounting practices • why regulators mandate particular accounting disclosures • to whom managers will elect to make particular disclosures, and why • how different stakeholders will react to particular disclosures • what disclosures should be made to assist users’ decisions • how particular stakeholders will impact accounting practice and accounting research • what role accounting practice has in supporting particular social structures. As this chapter shows, accounting theories provide us with ‘lenses’ through which to answer questions such as those above. Theory allows us to ‘make sense’ of the world which we inhabit. Therefore, the perspective we adopt in this book is that theory provides valuable insights about what accountants do and about the implications of accounting practice. It would arguably be inappropriate to just consider accounting standards and practice without deeper thinking about the reasons for, and the implications of, accounting practice. 2 Why would (or perhaps ‘should’) accounting practitioners and accounting regulators have knowledge of various theories of accounting? ‘Accounting numbers’ are used throughout society. Accounting numbers are used by various stakeholders to make many decisions that in turn create various economic, social and environmental impacts that affect us all. Accounting practitioners and regulators need to appreciate the factors that influence their various judgements, and they need to understand which stakeholders use the related accounting information, how they use it and the impacts the various accounting-related decisions have on different stakeholder groups. Accounting theories provide us all with knowledge to understand such issues. Accounting theories encourage practitioners and regulators to be ‘critical thinkers’. That is, accounting theory provides insights through which people can critically evaluate and understand the basis and merit (or otherwise) of their various accounting-related decisions. 3 Do all ‘theories of accounting’ seek to fulfil the same role, and, if there are alternative theories to explain or guide particular practice, how does somebody select one theory in preference to another? As this chapter shows, different theories can have very different roles. For example, some theories prescribe particular accounting practice, whereas other theories explain and/or predict why particular accounting practices will be selected. Different theories make different assumptions about what motivates the selection of particular disclosures, and different theories make different assumptions about the generalisability of the theoretical insights to 37 Financial Accounting Theory different organisational settings. Some theories are developed and tested through large-scale (quantitative) data collection, whereas other theories are developed and tested through smallscale, in-depth (qualitative) data collection. This chapter has suggested that the theories that we individually select will be influenced by our view of the world and how closely the available theories match that world view. The research questions we are attempting to answer will also influence our theory selection. Processes such as ‘research assessment exercises’, and the research undertaken by our colleagues, will also potentially influence the theories we embrace. What needs to be appreciated is that different theories provide different ‘lenses’ through which to see the world and answer particular questions. A combination of theories (theory triangulation) may, at times, also be appropriate. QUESTIONS 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9 1.10 1.11 1.12 1.13 1.14 38 What is the difference between a positive theory of accounting and a normative theory of accounting? LO1.3 If you developed a theory to explain how a person’s cultural background influences how they prepare financial statements, would you have developed a positive theory or a normative theory? LO1.3 What is a conceptual framework, and would it be considered to be a positive or a normative theory of accounting? LO1.3 In an article that appeared in The Age (‘Way cleared for Turnbull to challenge’; Grattan, 2008), Peter Costello, former federal treasurer, was quoted as saying, ‘I have a theory that every government wins one more term than it should’. Do you believe he really has a ‘theory’ in terms of the way a ‘theory’ is defined in this chapter? LO1.5 Why would it not be appropriate to reject a normative theory of accounting because its prescriptions could not be confirmed through empirical observation? LO1.3 LO1.4 If some hypotheses developed by a Positive Accounting researcher were not supported by the data that was collected, should we reject the theory? The IASB and the FASB have developed conceptual frameworks for financial reporting. If you have been asked to review these frameworks – which are examples of a normative theory of accounting – why would it be important for you to pay particular attention to how the objective of financial reporting is defined within them? LO1.5 If a normative theory of financial accounting has been developed to prescribe how we should do financial accounting, is it possible that we can decide to reject the theory because we do not agree with a central assumption of the theory (such as an assumption about the objective of financial reporting), but at the same time decide that the theory is nevertheless logical? Explain your answer. LO1.4 LO1.5 What is the difference between developing a theory by induction and developing a theory by deduction? LO1.4 What is theory triangulation, and what are some of the advantages and disadvantages of pursuing theory triangulation? LO1.4 LO1.5 Is the study of accounting theory a waste of time for accounting students? Explain your answer. LO1.7 What is a research question? Why would we expect there to be some form of relationship between the research questions to be addressed and the theories being applied by the researcher? LO1.1 LO1.2 In the 1960s, a number of accounting researchers concentrated on developing theories of accounting based on observing and documenting the behaviour of practising accountants. Do you think that such research is useful in improving the practice of financial accounting? Explain your answer. LO1.1 LO1.5 Gray, Owen and Maunders (1987, p. 66) make the following statement in relation to research based on the inductive approach (that is, research based on observing particular phenomena): Introduction to financial accounting theory CHAPTER 1 Studying extant practice is a study of ‘what is’ and by definition does not study ‘what is not’ or ‘what should be’. It therefore concentrates on the status quo, is reactionary in attitude, and cannot provide a basis upon which current practice may be evaluated or from which future improvements may be deduced. With this comment in mind, do you consider that research based on induction is useful for improving the practice of financial accounting? Explain your answer. LO1.5 1.15 Explain the meaning of the following paragraph and evaluate the logic of the perspective described: In generating theories of accounting that are based upon what accountants actually do, it is assumed (often implicitly) that what is done by the majority of accountants is the most appropriate practice. In adopting such a perspective there is, in a sense, a perspective of accounting Darwinism – a view that accounting practice has evolved, and the fittest, or perhaps ‘best’, practices have survived. Prescriptions or advice are provided to others on the basis of what most accountants do, the logic being that the majority of accountants must be doing the most appropriate thing. LO1.1 LO1.5 1.16 1.17 In 1961 and 1962, the Accounting Research Division of the American Institute of Certified Public Accountants (AICPA) commissioned studies by Moonitz and by Sprouse and Moonitz. These studies proposed that accounting measurement systems be changed from historical cost to a system based on current values. However, before the release of these studies, the AICPA released a statement saying that ‘while these studies are a valuable contribution to accounting principles, they are too radically different from generally accepted principles for acceptance at this time’ (Accounting Principles Board, 1962). Explain why if something is ‘radically different’ (though it might be logically sound) this difference in itself might be enough to stop regulators embracing a particular approach to accounting. LO1.3 LO1.5 Read the following quotation from Miller and Reading (1986, p. 64). In doing so, you should consider that if constituency support is necessary before particular accounting approaches become embodied in accounting standards, then does this have implications for the ‘neutrality’ and ‘representational faithfulness’ (qualitative characteristics that exist in various conceptual framework projects around the world) of reports generated in accordance with accounting standards? The mere discovery of a problem is not sufficient to assure that the Financial Accounting Standards Board will undertake its solution … There must be a suitably high likelihood that the Board can resolve the issues in a manner that will be acceptable to the constituency – without some prior sense of the likelihood that the Board members will be able to reach a consensus, it is generally not advisable to undertake a formal project. LO1.5 1.18 1.19 1.20 1.21 1.22 1.23 1.24 1.25 1.26 1.27 As Watts and Zimmerman (1986, p. 7) state, Positive Accounting Theory ‘is concerned with explaining [accounting] practice. It is designed to explain and predict which firms will and which firms will not use a particular accounting method … but it says nothing as to which method a firm should use’. Do you think that this represents an ‘abrogation’ of the academics’ duty to serve the community that supports them? LO1.1 LO1.3 LO1.5 Briefly identify the two branches of ‘decision usefulness’ theories described in this chapter and explain what they are. LO1.1 Briefly explain the revolutionary perspective of knowledge advancement proposed by Kuhn (1962). LO1.6 What is a ‘paradigm’? Would you expect accounting researchers to embrace more than one paradigm when undertaking research? Explain your answer. LO1.1 LO1.4 LO1.6 Is there a difference between financial accounting theory and financial accounting research? LO1.2 In your opinion, can accounting research be ‘value free’? Explain your answer. LO1.4 Why might particular theories have widespread acceptance within particular research communities? LO1.4 LO1.5 What role do value judgements have in determining what particular accounting theory a researcher might elect to adopt to explain or predict particular accounting phenomena? LO1.4 If an accounting researcher adopts a particular accounting theory to predict which organisations will make particular accounting disclosures, how much supporting evidence must the researcher gather before they can claim that the theory is ‘proved’? Explain your answer. LO1.5 Can we ever claim to have finally ‘proved’ a theory? LO1.5 LO1.6 39 Financial Accounting Theory 1.28 1.29 1.30 1.31 1.32 1.33 1.34 1.35 1.36 1.37 1.38 1.39 1.40 1.41 1.42 1.43 1.44 Should all researchers have a theory in mind before they conduct their research? LO1.6 Identify and explain five different criteria that we might use to evaluate a theory. LO1.5 According to the ‘falsificationists’, what should a ‘good’ theory do? LO1.6 What differentiates a grounded theory from other theories? LO1.3 LO1.6 What is the role of data collection in the research work of a ‘grounded researcher’? Would a ‘grounded researcher’ believe that the results generated within one research setting can be generalised to other settings? LO1.3 LO1.6 Assume that you have been asked to evaluate a particular theory of accounting. What factors would you consider before making a judgement that the theory appears ‘sound’? LO1.5 If you were trying to convince another party to support your theory about a particular facet of financial accounting, would you be inclined to use emotive or colourful language? Why, or why not? LO1.5 The IASB has a number of roles, including formulating accounting standards and developing a conceptual framework. Is the work it does in developing an accounting standard or the conceptual framework normative or positive in nature? LO1.1 LO1.3 What do we mean when we say that ‘theories are abstractions of reality’? Do you agree that theories of accounting are necessarily abstractions of reality? LO1.2 Does a ‘positivist’ believe that there is an ‘objective world’? If they did, how might that influence their perceptions about the generalisability of their research results? LO1.4 LO1.6 If we were to say that a theory provided the most parsimonious explanation of a particular phenomena, would that be good, and if so, why is it good? LO1.2 What is a ‘hypothesis’? Do you consider that accounting research should necessarily involve the development of empirically testable hypotheses? LO1.3 LO1.6 Would you reject as ‘insignificant and useless’ a positive theory of accounting on the basis that in a particular research study the results derived failed to support the hypotheses and the related theory? Explain your answer. LO1.2 LO1.3 LO1.5 If a researcher tested a theory on a particular sample of companies, what factors would you consider before you would agree with the researcher that the results can be generalised to the larger population of companies? In an article by Gray, Owen and Adams (2010), the authors discuss an apparent ‘herding phenomenon’ that seems to be occurring in respect of the selection and use of particular theories. They state: ‘there has been a strange herding tendency, especially around legitimacy theory’, as well as stating they ‘also have a sneaking feeling that institutional theory may be coming up fast as the next theory around which to herd’. What do they mean by this apparent practice of ‘herding’, and what are some possible advantages and disadvantages that are related to this practice? LO1.6 Refer to Figure 1.6 in this chapter and provide an explanation, in no more than 200 words, of what the diagram is trying to emphasise. 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CHAPTER 2 ACCOUNTABILITY AND ITS LINK TO RESPONSIBILITY AND ACCOUNTING LEARNING OBJECTIVES On completing this chapter, readers should: LO2.5 be able to explain the possible influence of ‘stakeholder power’ on corporate accountability and corporate accounting practices LO2.1 be able to explain, for the purposes of this book, how ‘accounting’ and ‘accountability’ are defined LO2.2 understand the relationship between organisational responsibilities, organisational accountabilities, and the accounting practices used within an organisation LO2.6 be able to explain the role of, and logic behind, the four-step accountability model introduced within this chapter LO2.7 understand the influence of organisational objectives on accounting practices LO2.3 be able to explain the meaning of ‘stakeholders’ LO2.8 LO2.4 understand that there can be various perceptions of the responsibilities of an organisation, and be aware of some of the factors that could influence these perceptions understand the meaning of ‘corporate governance’, and understand some of the factors that influence the implementation of specific corporate governance practices. 43 Financial Accounting Theory OPENING QUESTIONS Before reading this chapter, please consider how you would answer the following five questions. We will return to these questions at the end of the chapter, where we suggest some answers. 1 What does ‘accountability’ mean? 2 How do perceptions of organisational responsibility influence perceptions of organisational accountability? 3 How, if at all, is the practice of ‘accounting’ related to perceptions of accountability? 4 If we were to develop a model of ‘organisational accountability’, and if it was to have four sequential steps, what might these steps be? 5 Is there a relationship between an organisation’s corporate governance policies and the managers’ perceptions about organisational responsibility and accountability? Introduction In Chapter 1, we provided an overview of various theories of accounting and noted that the theories which accounting researchers choose to use, or to develop, will be influenced by their own views about various issues, such as their perceptions about: • what constitutes ‘good’ theory, including views about the ‘role’ of theory (for example, is the role of theory to predict or explain practices, or is it to prescribe particular practice?) • how ‘knowledge’ within particular research domains develops across time • what motivates people to undertake certain actions, including selecting particular accounting methods • how, and why, people will react to particular accounting information or disclosures • whether ‘power’ is shared equally throughout society, or whether some particular sections of society hold the power (in which case, accounting theory might be used as a means to demonstrate the partisan role that accounting practices might play in advancing the interests of some members of society, at the expense of others) • whether there is an objective or shared reality ‘out there’ that we can all see and interpret equally, or whether we see and interpret organisations and their activities differently (this has implications for whether we believe theory is generalisable to different settings) • the roles and responsibilities of organisations within society (for example, there will be alternative views about organisational responsibilities in terms of to whom they owe a responsibility and for what aspects of performance they are responsible). Just as views about the various issues or factors described above will influence theory development and selection (from among competing theories), this chapter discusses how such factors also influence the practice of ‘accounting’ utilised within different organisations and societies. For example, perceptions of organisational responsibilities and associated accountabilities will influence the ‘accounting we do’ and, for people teaching ‘accounting’, the forms of accounting we elect to teach our students. As an illustration of this, if managers hold the belief that an organisation has a responsibility and an associated accountability to various stakeholder groups, including future generations, the ‘environment’ or workers across supply chains, then the ‘accounting’ that is undertaken will likely include such issues as accounting for contributions to climate change (carbon emissions), waste generation, impacts upon important areas of biodiversity, support of disadvantaged groups, support of workers throughout supply chains and so forth. By contrast, if managers do not hold such a belief, then they might not think it is important to generate accounts that 44 Accountability and its link to responsibility and accounting CHAPTER 2 address, and therefore help to manage and control, issues such as an organisation’s actions to reduce its contributions to climate change or impacts upon important areas of biodiversity. Similarly, as accounting educators, if we believe that organisations have a responsibility, and an associated accountability, to future generations then we might be more inclined to embed aspects of sustainability throughout an accounting curriculum relative to an accounting educator who held the view that managers’ responsibilities are restricted to ensuring that profitability, and organisational value, is maximised primarily for the benefits of owners and shareholders. This chapter also introduces a ‘four-step accountability model’ and links it to issues associated with organisational responsibility, accountability and accounting. The four sequential steps we explore by way of this accountability model are: 1 Why does an organisation report particular information? 2 To whom shall it report the information? 3 What information shall it report? 4 How shall it report? We apply this four-step accountability model in different chapters of this book. For example, in Chapter 10 we apply it when exploring and explaining the practice of social and environmental (and sustainability) reporting. In this chapter, we also discuss corporate governance. We explain how the systems of corporate governance in place within an organisation, including various accounting systems, will also be influenced by perceptions about the responsibilities and accountabilities of an organisation. We explore the linkage between guiding principles, such as corporate mission statements, and corporate governance mechanisms and emphasise that a ‘one-size-fits-all’ approach to corporate governance (and ‘accounting’) is not appropriate across all organisations. Applying the material learned within this chapter, consideration is also given to what is commonly referred to as the ‘materiality determination process’, wherein the accounting information provided by an organisation to its stakeholders is determined through a process which engages particular stakeholders in order to determine what aspects of ‘organisational performance’ those stakeholders believe is important and about which they wish to be informed. REFLECTION QUESTION 2.1 Why are there differences in the types, or focus, of accounting practices being taught by different ‘accounting educators’? Question If we review the accounting courses being taught across different universities, we will find that some schools of accounting incorporate various issues to do with sustainability and sustainable development across various accountingrelated subjects, whereas other schools provide very little, or no, coverage of such issues. Why might this difference between educators exist? Solution As we shall learn in this chapter, and throughout this book, there will be different views about the responsibilities and accountabilities of managers and their organisations. These views influence judgements made about what types of ‘accounting’ organisations should practise. Those educators who believe that organisations have accountability for their financial, social and environmental performance would tend to be more likely to embed sustainability-related considerations throughout an accounting curriculum. By contrast, for those cases where there is little or no coverage of issues associated with accounting for sustainability, such educators must presumably believe that managers have limited responsibility and accountability for issues of performance beyond simply financial performance. This would represent a very narrow view of organisational responsibility and accountability. Another point is that many accounting programs teach particular topics because this is what has traditionally been done in years gone by (effectively the course contents become institutionalised). Such a fixation does not respond to changing community needs and expectations. 45 Financial Accounting Theory The relationship between ‘accounting’ and ‘accountability’ LO2.1 Accounting A process of collecting, summarising, analysing and communicating information to enable users of that information to make informed decisions. It can involve the provision of information to stakeholders about aspects of the organisation’s social, environmental and economic performance. Accounts Written records detailing an organisation’s performance in relation to a specific aspect of performance. 46 LO2.2 Given that this is a book relating to accounting theory, we cannot ignore the broader issue of accountability. As we shall explain, there is a direct relationship between ‘accounting’ and ‘accountability’, but for our purposes, the significant questions are: • what is ‘accounting’ • what is ‘accountability’? Broadly speaking, ‘accounting’ can be defined as: a process of collecting, summarising, analysing and communicating information to enable users of that information to make informed decisions. It involves the provision of information about aspects of the performance of an entity to a particular group of people with an interest, or stake, in the organisation – we can call these parties stakeholders. (Deegan, 2023, p. 3) This definition of ‘accounting’ is purposely broad. The intention is to emphasise that accounting-related reports (‘accounts’) do not need to be presented in quantitative or financial terms. An account can be descriptive in nature (for example, an ‘account’ of the forms or types of mechanisms that have been put in place to ensure that employees have a safe and healthy work environment). But what ‘aspects of performance’ should ‘accounting’ address and what ‘accounts’ are stakeholders entitled to? These are important questions which necessitate some form of professional judgement, perhaps based on some underlying theoretical framework or philosophical perspective. The nature of the ‘accounts’ being produced by an organisation, and the individuals or groups who will be given access to those accounts (or reports), will be influenced by managers’ judgements about an organisation’s responsibilities and its associated accountabilities. For example, if we were to embrace a view that an organisation was only responsible primarily for its financial performance and that the responsibilities for such performance were restricted simply to owners (shareholders) and loan providers, then such an organisation might decide to only produce financial accounts, and those accounts would only be distributed to owners and lenders. This would be considered as a very restricted, or narrow, view of ‘accountability’. By contrast, if an organisation’s managers believed that they also had a responsibility for the organisation’s social and environmental performance and impacts, and that this responsibility is extended to all affected stakeholders, then such an organisation would also produce various social and environmental accounts (as well as financial accounts) and would generally allow broad access to such accounts (for example, it might make the financial, social and environmental performance information publicly available on its website). This would represent a broader view of ‘accountability’. For example, some clothing companies collect and disclose detailed information about the sources of their clothes and what actions are being taken to ensure that the factories supplying garments are providing a safe and healthy environment for the employees, and this could be in the absence of any regulation requiring them to provide such accounts (see Figure 2.1). By contrast, other clothing companies disclose very little information. The managers of the organisations disclosing the detailed information (that is, those managers providing an ‘account’) would likely be embracing the view that it is their responsibility to be accountable for the health and safety of employees in their supply chain, whereas the managers of other organisations might not accept such a responsibility and hence might disclose little information. As another example, two or three decades ago it would have been very unusual for an organisation to collect and publicly disclose information about its emissions of greenhouse gases (which are known to contribute to climate change; see Figure 2.2). However, as global concerns have increased about climate change, it is now quite common for organisations – particularly Accountability and its link to responsibility and accounting CHAPTER 2 FIGURE 2.1 If a large multinational company is buying some of its products from this factory, then should that multinational company provide publicly available accounts about how the employees are treated within the factory? Source: Shutterstock.com/thomas koch FIGURE 2.2 Who is accountable for these emissions and what sorts of ‘accounts’ should they provide to the public? Source: Shutterstock.com/dugdax large organisations in carbon-intensive industries – to publicly disclose information about their emissions, as well as information about the initiatives being undertaken to reduce these emissions. We consider issues associated with accounting for climate change in Chapter 10 when we look at various reporting frameworks relating to accounting for non-financial aspects of performance. Therefore, when it comes to what ‘accounts’ will be, or should be, prepared, it really is a matter of opinion and often there is no single correct answer. It is what we refer to as a normative judgement (a ‘normative judgement’ being a value judgement about whether a choice, activity or situation is desirable or otherwise, and it is a judgement that reflects what a person believes should, or ought to, be – it represents a person’s preferred ‘norm’). Nevertheless, there is a direct relationship between the responsibilities (or duties) the managers of an organisation believe the organisation has and the accepted accountabilities. The argument is that if managers of an organisation accept a responsibility to particular stakeholders for certain 47 Financial Accounting Theory aspects of performance, then the managers accept that those stakeholders have a right to information about those aspects of the organisation’s performance. That is, they have a right to be provided with ‘accounts’ about various aspects of an organisation’s performance. This is diagrammatically represented in Figure 2.3. FIGURE 2.3 The relationship between responsibility, accountability and accounts Views about organisational responsibilities Views about organisational accountabilities Decisions about what accounts to prepare Why do I need to know about the relationship between accounting and accountability? The argument we adopt in this book is that accounting does not exist in the absence of considerations of ‘accountability’. In simple terms, organisations (and even us individually) will provide an ‘account’ (through the process of ‘accounting’) of those things for which managers believe they are, or for which others (society, legislators, non-government organisations, powerful stakeholders) believe them to be, accountable. Understanding actual or prescribed practices of accounting (and related theories) will necessarily require us to consider what perceived or required accountabilities (and responsibilities) are linked to the particular requirements or prescriptions. In a book that addresses accounting theory, we need to consider accountability, as many of the different theories being addressed either explicitly or implicitly will have some underlying assumptions about the responsibilities and accountabilities of managers and their organisations. Indeed, the type of research LO2.1 Accountability The duty to provide an account of those actions for which an organisation is deemed to be responsible. The accounts can take a variety of forms and would be provided to those stakeholders most affected by the activities of the organisation. 48 LO2.2 that accounting academics individually do will, in some way, be linked to assumptions or judgements they personally make about the role of accounting, and organisations, in society. The relationship is important as it helps us understand why managers of some organisations might report particular information, whereas others might not. The absence of particular accounts being reported potentially indicates to us that the managers in question do not believe they have an ‘accountability’ for particular aspects of performance. This could be due to a belief by managers that they have no ‘responsibility’ with respect to particular aspects of social and environmental performance. Knowing this relationship between responsibilities, accountabilities and accounting allows us to understand the context of particular corporate disclosures and accounting practices. What do we mean by accountability? As is becoming clear, we will not all share the same views about the ‘responsibilities’ and ‘accountabilities’ of organisations, and therefore we will not all share the same views about the role of ‘accounting’. For example, we might not share the same opinion about to whom an organisation is responsible and accountable (that is, who are the stakeholders?), or for what aspects of performance the organisation is accountable. This discussion leads us to a definition of accountability, a useful definition of which is provided by Gray, Adams and Owen (2014, p. 50). They define accountability as: The duty to provide an account or reckoning of those actions for which one is held responsible. We can see in this definition – which has been widely embraced within the accounting literature – that there is a direct linkage between perceptions of responsibilities, or duties, and the provision of ‘accounts’, as reflected in Figure 2.3. Gray, Adams and Owen (2014) emphasise that ‘accountability’ involves two key responsibilities or duties, these duties being: 1 to undertake certain actions (or to refrain from taking actions) in accordance with the expectations of a group of stakeholders 2 to provide a reckoning, or account, of those actions to the stakeholders. Gray, Adams and Owen (2014) also emphasise that the accounts being prepared do not have to be presented in financial terms (although they often are). So, for example, if a clothing company is acquiring Accountability and its link to responsibility and accounting CHAPTER 2 its clothes from a supplier in a developing country, such as Bangladesh, and if its managers accept a responsibility for ensuring that the supplier provides a safe and healthy environment for its employees, then the clothing company would (or should) provide ‘accounts’ that would disclose information about how it is ensuring that the factories are safe and healthy environments for employees. These ‘accounts’ might provide information about working hours, employee training in terms of health and safety, as well as information about checks, or audits, of the safety of the buildings being used by the suppliers. There might be no financial numbers within such an ‘account’, but it would still be considered to constitute part of the organisation’s ‘accounting’. REFLECTION QUESTION 2.2 The subjective nature of views about ‘responsibilities’ Question Do you think that an organisation in a developed country has a responsibility to ensure that workers across its supply chain (and the supply chain comprises the network between an organisation and its suppliers and customers, as necessary to produce and distribute a particular good or service) are treated in a way that is fair and equitable? Solution The point to be made here is that there is no standard answer to such a question. We will have different opinions about this. It is a normative question. We would hope that most managers will believe the organisation does have this responsibility, but this will not be the case for all managers. In part, this is why regulatory requirements like Modern Slavery Acts were introduced in various countries. These Acts legally require certain organisations (typically larger organisations) to explicitly consider the treatment of workers within their supply chains, rather than leaving it to managers’ discretion. Modern Slavery Acts are considered in Chapter 10. If managers do accept a responsibility for a particular aspect of their performance, then ultimately this will influence the ‘accounts’ they elect to provide to stakeholders about the organisation’s operations. We can also consider some other definitions of ‘accountability’. For example: The concept of accountability is a pervasive one … The notions underlying it are those of accounting for, reporting on, explaining and justifying activities, and accepting responsibility for the outcomes. Accountability involves an obligation to answer for one’s decisions and actions when authority to act on behalf of one party (the principal) is transferred to another (the agent)… Accountability requires openness, transparency and the provision of information, and the acceptance of responsibility for one’s actions. (Barton, 2006, p. 257) Accountability is the state of acknowledging, assuming responsibility for, and being transparent about the impacts of an organisation’s policies, decisions, actions, products, services and associated performance. When an organisation holds itself fully accountable, it seeks to involve stakeholders in identifying, understanding and responding to material sustainability topics and concerns, and to communicate with and be responsive to stakeholders regarding one’s decisions, actions and performance. (AccountAbility, 2018, p. 12) The obligation of an individual or organization to account for its activities, accept responsibility for them, and to disclose the results in a transparent manner. (Dictionary. com, 2022) Accountability, as we use the term, implies that some actors have the right to hold other actors to a set of standards, to judge whether they have fulfilled their responsibilities in light of these standards, and to impose sanctions if they determine that these responsibilities have not been met. (Grant and Keohane, 2005, p. 29) 49 Financial Accounting Theory In essence, accountability is an obligation to present an account of, and answer for, the execution of responsibilities to those who entrusted those responsibilities. (Gray and Jenkins, 1993, p. 55) As with the definition of accountability provided by Gray et al. (2014), the above definitions all link an organisation’s responsibilities with the obligation to provide information about the organisation’s performance and its adherence to the expectations of certain others. Reviewing all of the above definitions, we can again see that definitions of accountability, even though quite similar in nature, depend on subjective perceptions of the extent of an organisation’s responsibility. Again, we stress that individually we will have different beliefs about organisational responsibilities and therefore individually we will have some differences of opinion about the accountability of organisations and about the ‘accounts’ the managers of an organisation should prepare. REFLECTION QUESTION 2.3 Can we have ‘accounting’ without ‘accountability’? Question Does ‘accounting’ exist in the absence of any form or consideration of ‘accountability’? Solution The function, or process, of accounting ultimately leads to the generation of ‘accounts’ for use by particular stakeholders. The accounts that are produced will ultimately be linked to perceptions held by the managers about the responsibilities of the organisation in terms of to whom the organisation is responsible and for what aspects of performance it is responsible. That is, the forms of ‘accounting’ that are practised within an organisation are very much linked to perceptions about the responsibilities and associated accountabilities of the organisation. Therefore, ‘accounting’ is directly linked to accountability, and accounting within organisations really cannot logically exist in the absence of some considerations, explicitly or implicitly, of the accountability of managers and their organisations. REFLECTION QUESTION 2.4 The relevance of ‘accountability’ to accounting education Question Despite the linkage between ‘accounting’ and ‘accountability’, as described above, many accounting programs currently being taught within universities and colleges fail to explore the concept of ‘accountability’. Why do you think that many accounting education programs ignore an in-depth exploration of ‘accountability’? Solution The reality is that many accounting programs taught within universities and other places of education spend very little time actually exploring issues of ‘accountability’. In particular, many accounting programs do not explore in depth how considerations of organisational responsibility (including issues associated with to whom an organisation is responsible and for what aspects of performance the organisation is responsible) ultimately impact accounting practice. In large part, this is probably because some 50 accounting educators tend to focus on accounting as a ‘technical process’ rather than accounting as a ‘social practice’. As this entire book demonstrates, accounting is both a technical and social practice. The broader our perceptions of organisational responsibilities and accountabilities, then the broader the forms of accounting that will be undertaken. Logically, we cannot have ‘accounting’ without ‘accountability’, and therefore it is logical for an accounting educational program to commence with an in-depth consideration of the responsibilities and accountabilities of organisations, as this will then provide the necessary foundation for explaining why different forms of accounting (perhaps broadly classified into different forms of financial, social and environmental accounting) will be explored within the respective accounting program. Conversely, it makes little sense to ignore such issues. Accountability and its link to responsibility and accounting CHAPTER 2 So, what are the responsibilities of organisations? LO2.4 Consideration of the responsibilities of organisations is a normative issue. As we now know, definitions of accountability typically link accountability to responsibilities. In this regard, there are many contrasting views about the responsibilities of organisations, and hence there will be different views about the accounting practices that organisations should implement. At one extreme are the views of the famous economist Milton Friedman. In his widely cited book entitled Capitalism and Freedom, Friedman rejects the view that corporate managers have any moral obligations or responsibilities. He notes (1962, p. 133) that such a view: shows a fundamental misconception of the character and nature of a free economy. In such an economy, there is one and only one social responsibility of business [and that is] to use its resources and engage in activities designed to increase its profits as long as it stays within the rules of the game, which is to say, engages in open and free competition, without deception or fraud. Divergent views on the responsibilities of business are nothing new and it is not likely there will ever be agreement on how far, and to whom, the social responsibilities of an organisation should extend. Reflective of this, in an Australian report by the Corporations and Markets Advisory Committee (2006), it was stated (p. 19): In a famous debate in the 1930s, Professor Adolf Berle, in supporting the ‘shareholder primacy’ view, argued that the powers and duties given to directors of a corporation should be exercisable only for the benefit of, and to maximise the profits for, the shareholders, given that they are the investors who have put their capital at risk, and that the directors should be answerable only to them. Any attempt to broaden these responsibilities to persons other than shareholders may result in directors having no legally enforceable responsibilities to anyone. In reply, Professor Merrick Dodd argued that larger corporations owe duties to the broader community, not just shareholders, and that directors should have greater leeway to take non-shareholder interests into account. An argument in support was that, as the act of incorporation confers significant privileges (including perpetual succession and limited liability), society is entitled to expect that a corporation will act in the general public interest, not just out of self-interest. Consistent with the views of Dodd, Mathews (1993, p. 26) also states: Society (as a collection of individuals) provides corporations with their legal standing and attributes and the authority to own and use natural resources and to hire employees. Organisations draw on community resources and output both goods and services and waste products in the general environment. The organisation has no inherent rights to these benefits and, in order to allow their existence, society would expect the benefits to exceed the costs to society. Anita Roddick, founder of The Body Shop, made the following statement in the introduction to her book Business as Unusual: The Journey of Anita Roddick and The Body Shop (2007): In terms of power and influence, you can forget the church, forget politics. There is no more powerful institution in society than business, which is why I believe it is now more important than ever before for business to assume a moral leadership. The business of business should not be about money, it should be about responsibility. It should be about public good, not private greed. 51 Financial Accounting Theory Applying the thoughts of Dodd, Mathews and Roddick, the corporation receives its permission to operate from society, and is ultimately accountable to society for how it operates and what it does (see also Benston, 1982). As societies’ expectations change, we would expect accounting practices to evolve and change. This contrasts with the views of Friedman and Berle, and perhaps also contrasts with the views of many current corporate managers, who often seem to prioritise financial performance above other aspects of organisational performance. Again, we must appreciate the link between perceived corporate responsibilities and associated accountabilities, as reflected in Figure 2.3 earlier in the chapter. If an entity is not considered to have a responsibility in relation to a particular aspect of its performance, it would not be expected to provide an ‘account’ of that performance. Because different teams of managers will have different views about corporate social responsibilities and associated accountabilities, they will inevitably provide different sets of ‘accounts’. REFLECTION QUESTION 2.5 Friedman’s perspective of corporate responsibilities Questions 1 Do you agree with the views of Friedman as provided in the material above? 2 If somebody did agree with Friedman’s perspectives of corporate responsibilities, then do you think they would be likely to be supportive of their organisation collecting and disclosing information about its social and environmental performance? Solution 1 Answers will vary. Many corporate managers seem to agree with Milton Friedman given that they seem to highly prioritise financial performance and the rights of investors over and above other aspects of performance and other stakeholders. But there are also many managers who have broader views of corporate responsibilities. While this text advocates a broader view of corporate responsibilities than Friedman, this is ultimately the individual’s choice. LO2.3 2 If you were to agree with Friedman then, in general, you would not be in favour of collecting and disclosing information about social and environmental performance, unless you were of the opinion that such disclosure would ultimately lead to financial benefits that favour the investors. Managers that embrace the views of Friedman would not be responsive to the concerns of those stakeholders who do not have the power to influence the successful operations of the organisation. As noted above, to be accountable in a broader sense, requires managers to provide information to people that are significantly impacted by an organisation’s operations, regardless of their power. It also requires the managers to be responsive to the legitimate concerns of all stakeholders. That is, to accept that if the evidence (the ‘accounts’) shows that the organisation has not performed in accordance with stakeholder expectations, then to accept a responsibility to amend behaviour accordingly. Who are the ‘stakeholders’ of an organisation? We have mentioned the word ‘stakeholder’ a number of times already – but what is a stakeholder? Individually, we will have different views about who are the ‘stakeholders’ of an organisation. That is, we will have different views about ‘to whom’ an organisation is responsible and accountable. Taking a broader perspective on the responsibilities of business, an entity’s stakeholders have been defined by Freeman and Reed (1983, p. 91) as: any identifiable group or individual who can affect the achievement of an organisation’s objectives, or is affected by the achievement of an organisation’s objectives. (emphasis added) Later in this book (Chapter 9), we consider a group of theories known as stakeholder theories. As we will see, there are two broad branches to these stakeholder theories. One branch, which we might refer to as the managerial branch of Stakeholder Theory, predicts which stakeholders an organisation will respond to on the basis of which stakeholders 52 Accountability and its link to responsibility and accounting CHAPTER 2 have command over resources that are necessary to the functioning of the organisation. Broadly speaking, those stakeholders with control of resources necessary to the organisation’s survival and success (which gives these stakeholders relative ‘power’) will be more likely to have their requirements or expectations met by the managers relative to stakeholders without access or control over necessary resources (relatively low power stakeholders). In such an environment, these would be the stakeholders that are prioritised by management (which coincides with the first part of the definition of ‘stakeholders’ provided by Freeman and Reed above – that is, a stakeholder is ‘any identifiable group or individual who can affect the achievement of an organisation’s objectives’). The other branch of Stakeholder Theory that we explore in Chapter 9, which we might refer to as the ethical or moral branch (also sometimes referred to as the normative branch) of Stakeholder Theory, provides arguments, based upon particular ethical beliefs, that all stakeholders who are impacted by the operations of an organisation have a right to be heard, and to have a voice in the functioning of an organisation (which coincides with the second part of the definition of ‘stakeholders’ provided by Freeman and Reed above – that is, a stakeholder is any identifiable group or individual who ‘is affected by the achievement of an organisation’s objectives’). They would also have rights to information (and therefore to ‘accounts’). If we accept that an organisation has a responsibility to provide information to its ‘stakeholders’, then the more broadly an organisation defines its ‘stakeholders’, the greater the responsibilities and associated accountabilities it will tend to accept. As perceptions of accountabilities become broader, the practice of ‘accounting’ will also expand to focus on a broader group of stakeholders, with a corresponding increase in the types of impacts that will be accounted for. That is, the practice of accounting will correspondingly become broader as perceptions of accountability become broader. Many organisations explicitly identify their stakeholders and provide information on how they engage with them. For example, on the website of BHP Ltd – the world’s largest mining company – BHP (2022) notes that it identifies its stakeholders as: • Industry peers and associations; • Shareholders; • Investment community; • Employees; • Labour unions • Local communities; • Indigenous peoples; • Media; • Non-government organisations and civil society • Host governments • Society partners; • Suppliers; and • Customers. BHP also provides details about how it engages with each of the above stakeholder groups, and about what aspects of BHP’s performance each stakeholder group seemed to prioritise. The determination about who are the stakeholders of an organisation also has implications for any attempt to assess the apparent ‘decision usefulness’ of the information/accounts being generated by an organisation. As we explain in Chapter 7, decisions as to what is useful information (that is, information that is useful for helping people make informed decisions) are generally considered to have two fundamental qualitative characteristics, these being: 1 relevance 2 reliability (or ‘representational faithfulness’). 53 Financial Accounting Theory Information that is ‘relevant’ to some stakeholders will not be relevant to others, and vice versa. That is, different stakeholders will have different information needs or demands. As we further discuss within Chapter 7, information is deemed to be relevant if it has the potential to change the decisions being made by the readers of the information. Information about an organisation’s financial performance will be more relevant to some stakeholders (for example, investors, potential investors, lenders, creditors and employees) in making various decisions (such as whether to invest in an organisation or to loan the organisation some funds), whereas information about an organisation’s social and environmental performance might be relatively more relevant to other stakeholders (for example, consumers, local communities, labour unions and environmental groups might all use such information when determining whether, and how, they might support, or oppose, an organisation). Therefore, the point to be made here is that we should not assess the relevance, and relatedly the decision usefulness, of information without a consideration of who is the audience of the accounts (the stakeholders), what are their information requirements, and what is their expertise and knowledge in relation to the particular form of reporting. Hence, when any reporting framework – for example, the IASB Conceptual Framework for Financial Reporting, the Global Reporting Initiative Sustainability Reporting Standards or the framework of the International Sustainability Standards Board – provides guidance about the qualitative characteristics that useful information shall possess, it necessarily needs to make judgements about the intended audience of the reports, what are their broad information needs, and what is their assumed knowledge and expertise in relation to understanding the related information. At the core of these judgements is the belief that a ‘one-size-fits-all’ approach to formulating accounting practice is inappropriate. Different organisations will have different stakeholders with potentially different characteristics, and these stakeholders will likely have different information needs and expectations. Why do I need to know the relationship between stakeholder identification and accounting practice? As is clear by now, to understand why the managers and accountants of an organisation produce particular information, we need to understand who they perceive to be the organisation’s stakeholders. The determination of who are the ‘stakeholders’ will be directly linked to the perceived responsibilities the managers believe they have, and this will in turn influence managers’ perceptions of accountabilities and explain why certain accounts are being produced. Knowing who the stakeholders are provides context to why certain accounting choices have been made. From a practical perspective, once the stakeholders of an organisation are identified this then helps us to determine, or understand, with whom to engage and what types of information to provide to satisfy the stakeholders’ needs. Assumptions about stakeholder knowledge and expertise with respect to using particular information can also then be more reliably framed. Why might we all have different perceptions of organisational responsibilities, and therefore of organisational accountability? LO2.2 54 LO2.4 As Gray et al. (1997, p. 334) assert, the nature of the responsibility-driven accountability relationship between managers and stakeholders, and the stakeholders’ expectation and rights to information, will be contextually determined by the society in which the relationship occurs. That is, different societies will tend to have different perceptions about the responsibilities and accountabilities of organisations. Within societies, there will also be differences of opinion between managers about the accountabilities of organisations and about the need for particular accounting practices. Accountability and its link to responsibility and accounting CHAPTER 2 In various chapters of this book, we explore theories that explain differences in accounting practices. For example: • In Chapter 4, we discuss the regulation of accounting and explore how different societies and different individuals have different perceptions about the role of regulation, and the role of government, in relation to the regulation of accounting practice. We show that this has implications for accounting practice, and for the accountability required of managers and their organisations. • In Chapter 5, we explore international differences in accounting practice and consider research that explains international differences in accounting practice by linking it back to differences globally in ‘culture’. As discussed within Chapter 5, relative to other cultures, some cultures are more: – individualistic – inclined to seek to avoid uncertainty – ‘masculine’ (or more ‘feminine’) – disposed towards allowing professions to self-regulate accounting practice rather than having statutory control of accounting practice, and this has implications for the accountability of organisations – conservative (or optimistic) – accepting of secrecy than transparency. All these cultural differences can, through theory, be linked to differences in perceptions of organisational accountability, and to differences in beliefs about the accounting practices that are appropriate within a particular cultural setting. Such research further emphasises the point that globally a ‘one-size-fits-all’ approach to accounting is not appropriate. This has implications for the appropriateness of having globally standardised accounting standards, such as the International Financial Reporting Standards (IFRS) of the International Accounting Standards Board (IASB). These accounting standards have been adopted in most countries (with the exception of the United States). • Chapter 7 discusses various normative theories of accounting that prescribe how accounting (in particular, financial accounting) should be undertaken. The prescriptions are based on the respective researchers’ beliefs about the responsibilities of organisations and what information is best in allowing an organisation to demonstrate accountability. • Chapter 8 introduces Agency Theory and further explores Positive Accounting Theory. Such theories were developed by researchers who believed that the role of accounting is to provide information to motivate/control managers in a way that encourages them to work in the interests of owners/shareholders. Such theorists typically fail to consider social and environmental responsibilities. Rather, they focus on responsibilities and accounting practices linked to maximising financial performance, and organisational value, and they tend to prioritise financial accounting above social and environmental accounting. • In Chapter 9, we consider a number of theories. We consider Legitimacy Theory, which directly links the reporting behaviour of organisations to quests to maintain the ‘legitimacy’ of the organisation. This theory suggests that managers’ reporting decisions are really not about ‘accountability’ or ‘responsibility’, but, rather, are about supporting the survival of the organisation (and its managers). Accounting disclosures are linked to efforts to create, maintain or restore corporate legitimacy. We also consider different versions of Stakeholder Theory. As we have already indicated, one branch suggests that the generation of particular ‘accounts’ is more about controlling or managing powerful stakeholders rather than about demonstrating accountability. Another branch of Stakeholder Theory is linked to notions of accountability and prescribes that managers owe a duty of accountability to those parties (stakeholders) that are impacted by the operations of the organisation. Chapter 9 also explores Institutional Theory, which explains how various factors within an ‘institutional environment’ influence the accounts being prepared by the managers of an organisation. 55 Financial Accounting Theory • Chapter 11 explores capital market research. Capital market researchers tend to prioritise the interests of investors and evaluate the usefulness of particular disclosures on the basis of whether the accounting disclosures create a change in share price. Where a disclosure fails to impact share price, the view typically embraced by such researchers is that the information does not have value. Such research ignores the needs and expectations of a broader group of stakeholders beyond capital market participants. • Chapter 13 explores various critical theories of accounting. These theories typically project the view that accounting practices act to subvert the interests of many people in society, in particular, those members of society who do not have control over financial capital. Other research in the accounting literature, some of which we discuss in different chapters of this book, also addresses how managers’ perceptions of organisational responsibility and accountability will be influenced by a variety of factors, as shown in Figure 2.4. FIGURE 2.4 Managers’ perceptions of accountability can be influenced by a variety of factors Cultural background Family, friends and so forth Professional groups with which they are associated Social and sporting clubs with which they are associated Religion Gender Manager’s perceptions of organisational responsibility and accountability The type of education they have received Where they received their education Previous workplaces Prior professional experience Perceptions of organisational accountability will change over time Societal expectations change across time in relation to many issues. If society’s, or stakeholders’, views about organisational responsibilities change across time, then, consistent with the discussion already provided within this chapter, we would expect the related views about organisational accountability to change. This would then have implications for changing accounting practice across time – something that is very evident in any historical review of accounting practices. In our discussion of Legitimacy Theory in Chapter 9, we explain how society’s expectations influence accounting practice. As Deegan (2019, p. 2315) states: Legitimacy Theory – as typically applied within the social and environmental accounting literature – adopts a central assumption that the maintenance of successful organisational operations requires managers to ensure that their organisation appears to be operating in conformance with community expectations, and therefore is attributed the status of being ‘legitimate’. Within Legitimacy Theory, organisations are viewed as being part of 56 Accountability and its link to responsibility and accounting CHAPTER 2 a broader social system and are not considered to have any inherent right to resources. Rather, a right to resources must be ‘earned’ (Mathews, 1997) and it is ‘legitimate organisations’ that are able to sustain their access (or ‘rights’) to needed resources. Deegan (2019, p. 2315) further notes that for organisations to be judged as ‘legitimate’, they need to comply with the social contract in place between the organisation and society. Specifically: Legitimacy as explained within Legitimacy Theory is often linked to the idea of a ‘social contract’ (Patten, 1992; Deegan and Rankin, 1996; Adler et al., 2018) wherein the social contract represents the multitude of implicit and explicit expectations that society has about how an organisation should conduct its operations. The legitimacy of an organisation is considered likely to be challenged when an organisation does not comply with the terms of the ‘social contract’, and therefore with the expectations of the society in which it operates (creating what is referred to as a ‘legitimacy gap’). Deegan further notes: Where departures from the social contract (society’s expectations) occur then it is predicted within Legitimacy Theory (and consistent with the strategic focus embraced by Legitimacy Theorists), that managers will then be motivated to strategically take corrective actions, with disclosure being central to such actions. Corporate disclosures and the production of ‘accounts’ are seen as an integral part of the suite of available managerial strategies to manage, or manipulate, relationships with ‘society’. (p. 2315) Because what is deemed to be ‘legitimate’ behaviour changes across time, the argument embraced by Legitimacy Theorists is that accounting practices will change. For example, some years ago, it was not generally considered that an organisation had a responsibility for employees in unrelated supply factories located within developing countries. As a result, it was very unusual to find that managers provided any accounts of health and safety of these factory workers. These days it is now generally considered within most societies that managers have a responsibility to ensure that those organisations supplying their products treat their workers properly. Accordingly, particularly for larger organisations, it is now common to find publicly available disclosures (accounts) of what the organisation is doing to ensure that they are acquiring their products from organisations that treat their employees equitably. As another example, as community concern about climate change has increased in recent decades, it has become more common for organisations to provide information about their carbon-related emissions and initiatives undertaken to alleviate the organisations’ ongoing contribution to climate change. The influence of stakeholder power on corporate accountability LO2.5 Perhaps somewhat ideally, accountability should be demonstrated by the managers of an entity regardless of the power of particular stakeholders to enforce the organisation to accept such an accountability. That said, in the accounting literature, discussions of the ‘accountability relationship’ is often accompanied by a discussion of power as a determinant of accounting (Barton, 2006; Black, 2008; Gray et al., 1997; Mulgan, 2000). In such a context, power refers to the authority/ability of the particular stakeholders to demand or call for their rights to information to be actioned by managers. This raises the issue of whether the recipient actually has the power to enforce accountability, that is, the power to enforce any perceived rights to, or needs for, information. While some managers will provide information because they believe that stakeholders have a ‘right’ to information regardless of the power of the stakeholder, some managers will only provide information to stakeholders that have the power to enforce their rights/needs for information. 57 Financial Accounting Theory Following on from the above argument, unless a stakeholder can effectively enforce an accountability-related disclosure, then from a practical or realistic perspective, no real accountability relationship might exist, and no real accountability can be expected to be demonstrated. Rather, disclosures may take the appearance of being generated from a perspective of responsibility, whereas in actuality they might be disclosed for the economic benefit of the respective power wielders (argument from Tricker, 1983, as quoted in Gray et al., 1997). A similar argument is articulated by Rubenstein (2007), who suggests that accountability is a ‘crucial tool for limiting constrained power’, and therefore ‘vital for democratic politics’ (Rubenstein, 2007, p. 631). However, she asserts that in many cases, some stakeholders are often too weak to enforce the accountability due to them. This may be due to their social or political exclusion, illiteracy, lack of awareness, remoteness and/or poverty. Rubenstein (2007) suggests the need for a ‘second-best’ form of accountability under conditions of power inequality, which offer as many of the benefits of standard accountability as possible – the idea of ‘surrogate accountability’. The concept of surrogate accountability, as suggested by Rubenstein (2007, p. 617), involves an actor – a surrogate – who substitutes for accountability holders [accountees] during one or more phases of the accountability process: setting standards, finding and interpreting information, and, most importantly, sanctioning the power wielder [accountor] if it fails to live up to the relevant standards. As an example of a surrogate stakeholder, we can refer to a labour rights organisation which perhaps has the power to enforce the rights of workers within factories located within developing countries that might otherwise have no power to force employers to provide safe work environments or to demonstrate proper accountability. We return to the issue of surrogate accountability in Chapter 9. Now that we have some insights into the meaning of ‘accountability’, we can move to our four-step accountability model. Why do I need to know that accountability, and therefore accounting practices, both change over time and are influenced by issues relating to stakeholder power? It is important that we understand that accounting practices evolve over time as various stakeholder and community expectations change. We need to appreciate that accounting practices that are appropriate, or relevant, at one point in time, might not be relevant at another point in time. This insight is important to accounting researchers as it might signal the need to continually engage stakeholders to determine whether existing accounting practices still satisfy the needs of stakeholders. Knowing that accounting practices are often influenced by powerful stakeholders is also important because it provides LO2.6 context to why some accounting methods might be used instead of others. If the accounts produced by an organisation are influenced by the demands of powerful stakeholders, then this might indicate a need to protect the rights and information needs of less powerful stakeholders. This has implications for whether calls should be made by researchers for some form of regulation to protect the information rights of less powerful stakeholders. An accountability model To this point, we have mentioned the idea of ‘accountability’ many times and we have explained how perceptions of accountability are influenced by managers’ perceptions of an organisation’s responsibilities. We now turn our attention to various assessments, or decisions, that need to be made as part of the process of accounting for, and reporting aspects of, an organisation’s performance. We consider four issues here, and also do so many times throughout this book as we study various aspects of accounting. These four issues, or questions, are: 58 Accountability and its link to responsibility and accounting CHAPTER 2 Why do the managers of an organisation decide to collect, and disclose, information (or ‘accounts’) about particular aspects of the organisation’s performance? 2 Who are the stakeholders to whom the disclosures (‘accounts’) will be directed? 3 What types of information will be collected, and what disclosures will be made to stakeholders outside the organisation (that is, what are the information needs of various stakeholders)? 4 How should the information be disclosed (for example, what should be the format and media of the disclosures/accounts)? Figure 2.5 reflects the sequential nature of our four-step accountability model and emphasises how each step then leads to the next – that is, the answers to the previous step (or question) inform the answer to the next step. 1 FIGURE 2.5 A diagrammatic representation of the four-step accountability model Why is the organisation collecting and reporting particular information? To whom is the organisation reporting the information? What information is it collecting and reporting? How is it reporting the information? – where is the information appearing and what reporting frameworks are being used? As we show in the following text, these four issues are usefully addressed at various times throughout the process of ‘accounting’. We now consider each of these steps in turn. Why is an organisation collecting and disclosing particular information? Issues associated with what motivates, or necessitates, managers to make particular disclosures are issues that many accounting researchers spend much of their career investigating. This first issue of data collection and subsequent reporting will be influenced by various factors. In deciding what information to collect, various factors might be considered by managers. Some of these factors are outlined in the following sections. Legal requirements In many cases, managers will effectively have no choice about whether to collect and disclose particular information. Therefore, in terms of why they are reporting, they might simply be complying with legal requirements. For example, the disclosure of various items of information about an organisation’s financial performance is required by law (although not all aspects of financial performance are required to be disclosed by law). We consider theories of regulation in Chapter 4. 59 Financial Accounting Theory They potentially forestall the imposition of reporting requirements Often, various interest groups within society, such as environmental groups or employee trade unions, will lobby government to put in place laws that require organisations to make particular disclosures. Evidence has shown that managers often understand that this lobbying might be happening and might decide to collect particular information, and to make certain public disclosures, in an effort to placate potentially powerful lobby groups and possibly forestall the likelihood that even more onerous disclosure or accounting regulations might be put in place by government. The argument is that if an organisation is making at least some disclosures in respect of certain aspects of performance then the likelihood that related disclosures might be mandated by government will be reduced, and this might explain why the organisation decides to prepare the particular accounts and disclose them publicly. We would consider such disclosure practices to be ‘opportunistic’. We consider the influence of managerial opportunism on accounting practices in Chapter 8. Managers’ perceived responsibilities As discussed earlier in this chapter, managers might want to ensure that their operations do not adversely impact others. Such managers might voluntarily collect a variety of information about the organisation’s social, economic and environmental performance. As an example, if managers are particularly concerned about saving water because the organisation is operating in a populated environment with low water levels then the managers might put in place processes to measure water used in the various activities of the organisation with the intention of monitoring, controlling and reducing water usage. They might then disclose such information publicly because they have a belief that people outside the organisation have a right to know about how much water the organisation is using. By contrast, if managers in other organisations do not believe they have a responsibility to control their water use then they might elect not to collect, or publicly disclose, information about their water use. In this chapter, we have already considered how managers’ perceptions of responsibility impact accounting practice. We further consider this issue in Chapters 9 and 10. Demands of powerful stakeholders As we explain in other chapters of this book, and in particular within our discussion of Stakeholder Theory in Chapter 9, organisations often collect and disclose information because certain powerful stakeholders want to know about particular aspects of their operations, and therefore collecting and disclosing some information is a means of ‘managing’ some powerful stakeholders. While it is common that organisations will only report information because powerful stakeholders want it (and if the powerful stakeholders are not provided with the information, they might withdraw valuable support from the organisation), ideally all stakeholders – regardless of their power – that are significantly impacted by the operations of an organisation will be provided with information to enable them to understand the impacts the organisation is creating and what initiatives the organisation is implementing to reduce the impacts. To increase profits Related to the above point, at times it would appear that some managers elect to make disclosures primarily for purposes related to enhancing the financial position and financial performance of an organisation, rather than because they have a true belief that people have a right to know about particular aspects of organisational performance. What this means is that some managers are simply reactionary and will effectively ‘do the right thing’ because it will generate higher profits and not because they particularly believe they should be responsible, or accountable, for particular actions. As a response to a crisis There is much available evidence that indicates that if the reputation, or legitimacy, of an organisation appears to be badly damaged, the organisation in question (and perhaps even other 60 Accountability and its link to responsibility and accounting CHAPTER 2 organisations within the same industry) will produce public ‘accounts’ of how seriously they are taking the matter and what initiatives they have put in place to help ensure such events will not reoccur in the future. Such disclosure would be considered to be responsive, or reactive, rather than being driven by real concerns about the need to be accountable and responsible (otherwise, why would they wait until the public raises their concerns before making disclosures?). Our discussion of Legitimacy Theory in Chapter 9 provides evidence of how particular crises have motivated managers to make particular disclosures. For example, some of the research embracing Legitimacy Theory has shown that when there has been a significant environmental incident that potentially damages the reputation, or legitimacy, of the organisation, then managers will often generate publicly available information which appears consistent with the aim of winning back support, and legitimacy, for the organisation. The disclosures that managers make might identify other positive aspects of their organisations’ performance, or the disclosures might be of the nature to assure stakeholders that modifications have been made to their organisations’ operations which ensure that similar crises will not recur. What the above discussion seeks to demonstrate is that it is not always an easy exercise to try to understand why some managers elect to make some disclosures, but not others. Some disclosures will be made because managers believe they have an underlying responsibility to inform various people about particular aspects of performance, whereas other managers might make disclosures simply because they think there are business benefits in doing so. That is, the broad objectives driving any particular organisation to generate particular ‘accounts’ for use by stakeholders external to the organisation can range from an ethically motivated desire to be accountable for the positive and negative impacts the organisation has on society and the natural environment, through to an economically focused motive to use reporting to protect, or enhance, profits and therefore owner and shareholder value. Another point to be made here is that before we read particular corporate disclosures, it is useful to try to understand why the disclosures were made in the first place. If a particular management team typically only makes disclosures when there are direct business benefits in doing so, then perhaps we would be right to question the extent to which we should rely upon such disclosures. By contrast, if an organisation seems to always have respected the rights of people to be informed about the various impacts of the organisation, then we might be more inclined to rely upon the organisation’s disclosures, particularly those disclosures that are being made voluntarily. The reason why an organisation has elected to provide particular accounts will have a direct consequence for the next question about ‘to whom’ those accounts are directed, as we now discuss. To whom is the account information being directed? Once it is determined why an entity decides to report, this decision will in turn inform the decision as to whom the information will be directed. If an organisation’s reporting is motivated exclusively by managerial reasoning and ‘strategising’ (for example, it is primarily focused on increasing the wealth of the owners and/or managers), the stakeholders to whom that organisation’s reporting is directed might be narrowly defined as those who hold and exercise the greatest economic power, or influence, over the organisation and who have the greatest ability to influence the economic success of the organisation. Conversely, reporting motivated by ethical and moral reasoning will seek to address the information needs of a broader range of stakeholders. Specifically, a broader ‘ethical’ approach to reporting (providing ‘accounts’) would direct the reports and accounts towards those stakeholders most affected by the operations of the organisation, regardless of the economic or other power held by those stakeholders, and would focus on issues such as various stakeholders’ ‘rights-to-know’. 61 Financial Accounting Theory What is being emphasised is that the question about to whom the reports or ‘accounts’ will be targeted will ultimately be dependent on managers’ views about organisational responsibilities and accountabilities, and hence dependent upon views held about the initial issue of why the organisation has decided to produce a report. That is, what motivated the organisation to make the disclosures in the first place? Again, views will vary from manager to manager. Ultimately, proper or ‘full’ accountability requires that all stakeholders, which includes those with and without power to influence the operations of an organisation, have the ability to hold more powerful people (such as the managers of large companies) to account for the impacts caused by their operations. Proper accountability requires managers to be responsive to legitimate concerns held by those parties who are impacted by the operations of the organisation and who seek information about organisational performance. What information needs to be reported? Once the organisation has determined which stakeholders are the target recipients of the reports (the ‘accounts’) – that is, once it has addressed the first two steps of ‘why report’ and ‘to whom to report’ – it can then move to the next (third) step of considering the information demands of the identified stakeholders. That is, it can address the ‘what to report?’ question in terms of what types of information will be disclosed and what issues the ‘accounts’ should address. Identifying what aspects of performance that various stakeholders believe an entity should be held responsible for and accountable to involves dialogue (discussion) between the organisation and its identified target stakeholders (often referred to as a process of ‘stakeholder engagement’). However, the issue about who to engage will depend upon managers’ motivations for reporting. If managers are simply disclosing information to keep powerful stakeholders happy (and therefore to help bolster the value of the organisation) then they might only concentrate on providing the information that is demanded by powerful stakeholders – that is, those stakeholders that might impact the flow of resources into an organisation (such as investors, lenders and key customers). However, if managers are more concerned about being accountable to those stakeholders impacted the most by their operations, they would consider the nature of their various economic, social and environmental impacts and provide information to the most affected people about the nature of these impacts, and perhaps about what is being done to address, or mitigate, any negative impacts in the future. Various types of accounting research address issues associated with what information to report. For example: • In Chapter 7, we consider qualitative characteristics that information needs to satisfy for it to be ‘useful’ for decision making. These qualitative characteristics include relevance, reliability, comparability, verifiability, timeliness and understandability. Consideration of such qualitative characteristics arguably should be considered prior to the release of particular information. Such consideration requires attention to be directed to the stakeholders involved, their information needs and their knowledge with respect to understanding particular forms of information. • In Chapter 11, we explore capital markets research. Such research, which focuses on the information needs of investors, often evaluates the relevance of particular information on the basis of whether the disclosure of information creates a change in share price. If there is no change in share price following the release of particular information, then capital markets researchers would often argue that there is no ‘information content’ in the disclosure, and therefore the information is relatively irrelevant (at least from the perspective of capital market participants). • In Chapter 12, we consider behavioural research in accounting which explores how individuals react to particular accounting disclosures. If such research shows that particular information did not change individual decisions, then this might also be used as a basis for arguing that the information is not relevant. 62 Accountability and its link to responsibility and accounting CHAPTER 2 How should the information be disclosed? Once the managers of an organisation have determined the first three steps of the four-step accountability model, they will be in a position to answer the fourth question in the model: How should the information be disclosed (for example, what should be the format and media of the disclosures/accounts)? To understand how information should be disclosed, we need to determine if an appropriate reporting framework exists and where the related information should be disclosed. Different chapters of this book address various financial, social and environmental (and sustainability) reporting frameworks. If managers are providing information about the financial performance of a large company then they might elect to use IFRS issued by the IASB, or if they are providing information about social and environmental performance then they might use the framework provided by the Global Reporting Initiative or that developed by the International Integrated Reporting Council. If managers are particularly concerned about providing information about carbon emissions, then they might use the framework developed by Greenhouse Gas Protocol. Alternatively, if managers are concerned about providing information about their organisation’s water use, then they might use standards such as those developed within Australia by the Water Accounting Standards Board. We consider some of these reporting frameworks in other chapters of this book. Where to disclose Apart from considering which reporting frameworks might be appropriate, we also need to consider where the information should be disclosed. For example, should it be provided on corporate websites? Should it be provided within reports mailed to stakeholders? Should it be provided by way of posters provided within particular buildings? There are indeed many choices with regards to the best media to make information, or ‘accounts’, available to interested stakeholders. Research can explore which media are more effective in reaching different stakeholder groups. As an example, if we are dealing with stakeholders with knowledge and access to the internet then it would be quite reasonable to supply the required accounting information on the organisation’s website. However, if the stakeholders were, for example, the employees working within factories in developing countries then it might be more appropriate to provide the information by way of posters on the factory wall or by way of printed documents made available within the factory. So, we can see that in this fourth step of our accountability model, there are many judgements to be made. The normative nature of the four-step accountability model Each of the four steps in our four-step accountability model can represent a ‘departure point’ in opinion between various stakeholders, and this can ultimately lead to significant differences in expectations regarding the types of ‘accounts’ that particular entities should prepare, and therefore in the types or forms of ‘accounting’ that they should undertake. For example, and applying the above four steps, if a judgement (grounded in certain ‘values’) is made from a neo-classical economic perspective (for example, a ‘Friedmanite-type’ perspective) that ‘accounts’ of particular aspects of performance should be prepared only to the extent that the activity of preparing the accounts increases corporate profitability (the ‘why? ’ question), then the target audience of those reports might be those stakeholders who have the power to influence the economic value of the organisation (the ‘to whom?’ question) – for example, shareholders and providers of debt capital. In terms of what aspects of performance should be reflected in the ‘accounts’, in this scenario it would be likely that measures of economic/financial performance 63 Financial Accounting Theory would be prioritised (the ‘what to report?’ question), and the information would be provided in financial reports by use of a financial reporting framework, such as those provided by the IASB or FASB (the final ‘how to report?’ question). By contrast, if a judgement is made that an organisation has a responsibility and associated accountability to a broader group of stakeholders in relation to economic, social and environmental performance (the ‘why?’ report issue), then the audience of the reports would tend to be those stakeholders that are most affected (economically and/or socially and/or environmentally) by the operations of the entity or that work/act in the interests of the affected stakeholders (for example, NGOs) (the ‘to whom?’ question). Issues of stakeholder power would not be particularly pertinent in this ‘view of the world’. Continuing this example, in terms of the aspects of performance that would be reported within the accounts (the ‘what to report?’ question), the information would tend to be prioritised in terms of the perceived (subjectively determined) importance of the various social, environmental and economic impacts. The information would be provided by virtue of frameworks beyond financial reporting, and which would enable (the ‘how to report?’ question) impacts to be reported in a way which promotes further dialogue and improvement in an organisation’s social and environmental performance. What is being demonstrated here is that although we are applying the same four-step accountability model in both scenarios, and therefore the same four broad ‘steps’ in our decision making, we can nevertheless arrive at very different normative prescriptions about how an organisation should ‘account’ for its operations as a result of the different ‘world views’ that we might possess. When we consider the different academics within different schools of accounting nationally and internationally – some schools being very ‘capital market’ focused, while others are more focused on broader stakeholder rights and organisational responsibilities – then this, in part, might explain why different schools of accounting teach and research different aspects of ‘accounting’ and, relatedly, why they might attempt to instil different values about organisational responsibilities within the minds of their students. To explain some of this discussion, and drawing on the earlier example, we again consider how two individuals might answer the four general accountability-related questions and how their answers would influence the ‘accounting’ they believe should be undertaken. In this regard, see Table 2.1. TABLE 2.1 An illustration of the application of an accountability model to different ‘world views’ Question Individual 1 characteristics Individual 2 characteristics Somebody who believes in the efficiencies of the capital market and that maximising shareholder wealth is the central mission and responsibility of management (e.g. Milton Friedman) Somebody who believes that an organisation has a responsibility to a diverse group of affected stakeholders and that this responsibility relates to economic, social and environmental performance Why should an entity report/provide an account? Would likely argue that an ‘account’ should be prepared to the extent that it increases the value of the organisation and therefore shareholder wealth Would likely argue that an organisation has a responsibility or duty to provide an account of the various impacts it has on a diverse group of stakeholders To whom is that account being primarily directed? Those with power to influence the economic value of an organisation, and therefore the wealth of shareholders (and managers). A major focus would be to provide financial performance information to current and potential investors, lenders and creditors Those stakeholders who are most impacted by the operations of an entity and therefore have a right-toknow about such impacts and efforts undertaken by management to reduce such impacts What elements of performance should be accounted for? Predominantly financial information that reflects organisational value and likely dividends to investors A mixture of information about social, environmental and economic performance and impacts How should the account be presented? Typically, in a financial report using generally accepted financial reporting frameworks By virtue of various forms of ‘accounts’ prepared using a variety of financial, social and environmental reporting frameworks 64 Accountability and its link to responsibility and accounting CHAPTER 2 Why do I need to know about the four-step accountability model? Knowing about the four-step accountability model allows us to appreciate the interrelated nature of the decisions involved in ultimately providing information to different stakeholders. Of course, some people might use alternative models, or steps, to explain managers’ decisions to report information, but our model emphasises how particular decisions in the reporting process have implications for subsequent decisions. The model is logical and provides us with a framework to understand some quite interesting factors that influence organisational accountability. The materiality determination process Organisations, particularly larger organisations, will disclose large amounts of information about their financial, social and environmental performance. Some of this information is disclosed because there is a legal requirement to do so, but much information will be disclosed voluntarily. For example, for larger organisations there tends to a great deal of regulation requiring the public disclosure of information about the organisation’s financial position and performance. By contrast, much of the information publicly released about organisational social and environmental (and sustainability-related) performance tends to be disclosed voluntarily by organisations. In making the decisions about what information to report, most larger organisations undertake some form of stakeholder engagement to determine what information would be ‘material’ to the respective stakeholders. Information is considered to be ‘material’ if it is important (material to) the respective individual or group that is making a decision. That is, information is material if its presence or absence is likely to influence the decisions being made by readers of that information. Once the managers of an organisation determine why they are reporting, and then to whom they are reporting, it is appropriate to engage those identified stakeholders to ask them what items of information they would like, or expect, to receive. Because the disclosure of information about social and environmental performance is largely voluntary, it is useful for readers of organisations’ reports to understand why particular information was disclosed and other information was not disclosed. This process is referred to as the ‘materiality determination process’ – the process of determining what to disclose to stakeholders and what not to disclose. Disclosing information about the materiality determination process, which can be directly related to our four-step accounting model, helps stakeholders to understand the context of why particular disclosures are being made by an organisation. To this end, larger organisations that produce social and environmental reports (or sustainability reports) will often provide information about their materiality determination process towards the commencement of the respective report in which they: • identify their key stakeholders (often explaining why they are deemed to be ‘key’) • explain how they engaged with the stakeholders (through general meetings, focus groups, survey, interviews, feedback mechanisms, etc.) • identify the aspects of performance the key stakeholders were most interested in • identify where in the organisational reports this information is reported. 65 Financial Accounting Theory REFLECTION QUESTION 2.6 The importance of disclosing information about the ‘materiality determination process’ Question Information about the ‘materiality determination process’ outlines the processes the managers of an organisation establish to determine which items of information are considered important enough to disclose and, conversely, explain why other information is excluded from reports. In this respect, what are the benefits to report readers of knowing about the materiality determination process? Solution Where the disclosure of information is predominantly voluntary, as is the case with much social and environmental information, then it would be reasonable for readers to question the logic, or merit, of why particular information was, or was not, disclosed. If managers are able to provide a clear, overall rationale for why particular information was deemed important enough to disclose then, even though readers might not agree with the materiality determination processes the managers have employed, the disclosure about the process should enable readers to better understand the context for why some information is reported and other potential information is not reported, and this should increase the understandability of the report. The influence of organisational objectives upon accounting LO2.7 As should be becoming clear by now, an organisation’s assumed responsibilities and objectives will also influence how it does its ‘accounting’. If an organisation’s primary objective is to maximise profits, then the accounting and reporting will tend to fixate on financial measures. If an organisation has an objective of reducing greenhouse gas emissions, then the accounting and reporting will focus on emissions, improvements in emissions, targets and so forth. If an organisation, such as a university, has a goal that research publications must be increased, then this will impact what information is collected and what accounts are generated. Information about who is, and is not, generating publications will be collected, as will publication rates by other universities as a means of comparison and benchmarking. Amounts being spent on initiatives to support publishing would also be collected. Relatedly, if an organisation such as a university has a goal of making sure its students like the lecturers’ way of teaching, then the organisation will collect information from students about their assessment of the lecturers. This is all considered to be ‘accounting’. Many more examples could be provided here, but the point being made is that just as assessments of organisational responsibilities and accountabilities influence the practice of accounting, so will the objectives of the organisation influence the types of accounting being practised. We could imagine that there will also be some form of relationship between organisational objectives and the responsibilities and accountabilities the organisation accepts. For example, if a not-for-profit organisation is established to provide emergency housing for homeless people, then its objectives would tend to focus on helping disadvantaged people in the community and ensuring that the funds provided to the organisation are used as efficiently as possible to create the greatest benefit to the homeless, rather than simply being used to maximise profits. The main accounts would probably provide information about how quickly people are being housed, how many were housed, how many could not be housed, where they were housed, what negative impacts flowed to nearby residents and so forth. The key responsibilities and accountabilities would seem to be to funding bodies, to the homeless and to those interest groups that work for the benefit of the homeless. This example emphasises again that how we do accounting will be impacted by the organisations’ objectives as well as by the responsibilities and accountabilities that the managers within the organisations accept. 66 Accountability and its link to responsibility and accounting CHAPTER 2 Organisations usually have a ‘mission’. Larger organisations will typically document their mission in writing and make this publicly available, such as on corporate websites. An organisation’s ‘mission’ reflects its core purpose and focus and generally does not change that often – for example, it might stay unaltered for several years. It represents a guiding principle. The mission, if well written, acts to identify what aspects of performance are considered important, and it provides overall direction for the managers. We will consider, as an example, the mission statements of three quite different organisations to see how each of them differ. These organisations are: • The Walt Disney Company • Greenpeace • Harvard College. Their respective mission statements are as follows: Walt Disney Mission Statement Our Mission The mission of The Walt Disney Company is to entertain, inform and inspire people around the globe through the power of unparalleled storytelling, reflecting the iconic brands, creative minds and innovative technologies that make ours the world’s premier entertainment company. (The Walt Disney Company, n.d.) Greenpeace Mission Statement Mission Statement Greenpeace is an independent campaigning organisation, which uses peaceful, creative confrontation to expose global environmental problems, and develop solutions for a green and peaceful future. Our goal is to ensure the ability of the earth to nurture life in all its diversity. That means we want to: • protect biodiversity in all its forms • prevent pollution and abuse of the earth’s ocean, land, air and fresh water • end all nuclear threats • promote peace, global disarmament and non-violence. (Greenpeace, 2022) Harvard College Mission Statement Mission The mission of Harvard College is to educate the citizens and citizen-leaders for our society. We do this through our commitment to the transformative power of a liberal arts and sciences education. Beginning in the classroom with exposure to new ideas, new ways of understanding, and new ways of knowing, students embark on a journey of intellectual transformation. Through a diverse living environment, where students live with people who are studying different topics, who come from different walks of life and have evolving identities, intellectual transformation is deepened and conditions for social transformation are created. From this we hope that students will begin to fashion their lives by gaining a sense of what they want to do with their gifts and talents, assessing their values and interests, and learning how they can best serve the world. (Harvard College, 2022) A review of these three mission statements will highlight core issues that subsequent planning should address. For example, when considering the sorts of problems Walt Disney would want to address, a key factor is profitability and this will factor into the planning phase more than it would at Greenpeace or Harvard, albeit that these two other organisations will still need to ensure that their resources are used efficiently so as to enable them to achieve their objectives. 67 Financial Accounting Theory Identifying the problem for Walt Disney We can also see that the focus of Walt Disney is entertainment and the provision of information. Therefore, there would have to be a very good reason to start planning in other areas, such as, for example, commercial construction. A great deal of the information being collected by Walt Disney will relate to addressing the major problem of how to create content, services and products that are accepted by stakeholders as being creative and innovative (two key terms within the mission statement), while at the same time being profitable. This, in turn, might require various forms of research and planning, such as: • current and projected demands of consumers • stakeholder perceptions about what aspects of the industry are reflective of creativity and innovation • research to identify current and projected innovations and innovation opportunities in the intended areas of operation • apparent innovations being introduced by competitors. As potential projects are identified, budgeting will be undertaken to ensure that the intended actions appear likely to generate the desired level of profits. Identifying the problem for Greenpeace Turning our attention to Greenpeace, it is reasonably clear that the planning should not be about generating profits, but rather, the central problems seem to relate to how to create the most positive environmental and social outcomes with the available funds. Problems to be addressed within planning might include: • identifying important areas of biodiversity that are currently, or potentially, at risk and priortising them in terms of importance • identifying and prioritising important initiatives to reduce dangerous levels of pollution in vulnerable areas • identifying and prioritising initiatives to reduce nuclear risk • identifying and prioritising strategies to address global peace • identifying and maintaining sources of funding to enable key initiatives to be undertaken. If a manager within Greenpeace wanted to operate in an area not involved with advancing the interests of particular habitats, species or people then much justification would be required, as it would represent an apparent departure from the organisation’s mission. The mission statement of Greenpeace also emphasises that the organisation is ‘independent’; therefore, planning must ensure that the organisation does not appear to be dependent upon particular stakeholders, for example particular providers of financial resources. Identifying the problem for Harvard When it comes to Harvard, the mission would again seem to have little to do with making profits or other financial gains. Rather, the problems seem to be about creating a place of education excellence that creates future leaders, sets the standards for other universities to follow and transforms the lives of students intellectually, socially and personally. As with all organisations, to achieve the organisation’s goals, Harvard would also need to manage its resources efficiently and be clear about the plans it has for generating funding. While our discussion about the mission statements of the three organisations is rather brief, the point we are making is that the problems managers set, which will then be addressed or solved through establishing plans to be followed (and there can be many levels to these plans), will be influenced by the underlying mission of the organisation. The mission can be considered to be a very ‘high level’ direction, which then will be broken down to manageable plans that are each consistent with achieving the mission of the organisation. Accounting researchers who are attempting to understand why organisations have particular accounting practices in place need to understand the mission and objectives of the organisations being researched. 68 Accountability and its link to responsibility and accounting CHAPTER 2 LO2.8 Corporate governance Appropriate systems of accounting, monitoring and reporting are components of a wellfunctioning corporate governance system – but, what is ‘corporate governance’? According to the ASX Corporate Governance Council (2019, p. 1), governance refers to the framework of rules, relationships, systems and processes within and by which authority is exercised and controlled within corporations. It encompasses the mechanisms by which companies, and those in control, are held to account. As you can see, accountability and accounting are central elements of good governance, and therefore of the proper functioning of an organisation. Achieving the organisation’s mission and objectives typically relies on well-functioning governance systems. The elements shown in Figure 2.6 (which are not all-inclusive) identify several policies that a well-functioning governance system might include. Where governance policies are in place, it is also important that appropriate monitoring systems exist to ensure that formal policies are actually being followed. Having a policy in place without effective monitoring and enforcement mechanisms can render policies relatively useless. Managers’, and stakeholders’, perceptions of organisational responsibilities and accountabilities (to whom and for what) influence the suite of corporate governance policies and procedures that an organisation will have in place. For example, managers who accept that they FIGURE 2.6 Corporate governance systems include many elements Clear ‘whistle-blower’ policies Social and environmental audits/assurances Environmental audits Anti-bribery and corruption policies Managerial budgeting Management remuneration plans Audit committees Boards of management Codes of conduct for directors, senior executives and other employees Accounting and reporting policies Supply chain audits Environmental committees Mission statements Elements of corporate governance systems Waste audits Customer audits Stakeholder engagement policies Environmental management systems Social audits Stakeholder engagement policies Financial statement audits Occupational, health and safety policies Environmental policies 69 Financial Accounting Theory have a responsibility for mitigating their organisations’ contributions to climate change will aim to put in place policies and procedures that seek to measure and control the release of carbonrelated emissions (for example, see Haque, Deegan and Inglis [2016] for details of some climaterelated corporate governance practices that can be implemented). Conversely, an organisation that does not accept responsibility for mitigating its contribution to climate change will be relatively unlikely to have such governance policies. As another example, if managers believe they have a responsibility for ensuring the health and safety of workers across their supply chains, then they will be relatively more likely to have formal policies (governance policies) requiring workplace audits (social audits) of the overseas factories supplying their goods and services. Knowledge of the governance policies in place within an organisation will reduce the risks (financial, social and environmental) that stakeholders face. For example, organisations with poor climate change-related governance policies will suffer increasing likelihood of suffering financial loss as community concerns, and legislation, increase to penalise those organisations with poor climate-related performance. Appropriate climate change-related governance policies will help an organisation respond to the risks (in Chapter 10 we discuss the physical and transitional risks that climate changes poses) and opportunities that climate change poses for it. Providing information about an organisation’s corporate governance systems is therefore an important element in demonstrating organisational accountability. In this regard, internationally, large organisations will typically have website links that provide information about their various governance policies and practices. Different organisations in different industries, and different countries, will require different corporate governance systems. This is because their impacts on stakeholders will be different and there will be differences in the expectations of managers and their stakeholders. Therefore, a ‘one-size-fits-all’ approach to corporate governance is not appropriate. Governance policies will change and evolve over time as community and stakeholder expectations change, as knowledge about effective governance policies increases and as knowledge about the various impacts of organisational activities develops. There has been much published research within the corporate governance literature that has investigated the relationship between various components of an organisation’s total suite of governance policies and procedures, and other variables, such as various types of performance. For example, published research has found that there appear to be links between, for example: • the adoption of particular reporting frameworks and various aspects of organisational performance • the genders of people on the board of directors and aspects of organisational performance • the number and expertise of outside/independent directors and aspects of organisational performance • the diversity of the board of directors and aspects of organisational performance • CEO pay structure and organisational social and environmental performance • board of directors diversity and corporate innovation • audit committee composition and financial performance • management remuneration plans and organisational financial performance • managerial budgeting and financial performance • adoption of particular climate-related reporting practices and actual carbon-related emissions. Research exploring some of the above links typically treats the various aspects of performance as the dependent variable and the respective governance policy as the independent variable. In evaluating much of this research, it is important to determine whether there is simply a statistical association, rather than a causal relationship. To argue that there is a causal relationship (for example, that the greater the number of female members on the board of directors, the better the organisation’s corporate social performance, as has been asserted in some research) requires clear theory and logical argument, which often can be missing in some of this research. Nevertheless, it is clear that different corporate governance policies and practices will impact attributes of organisational performance. 70 Accountability and its link to responsibility and accounting CHAPTER 2 STUDY TOOLS CHAPTER SUMMARY This chapter has addressed a number of issues that are fundamental to the understanding and practice of accounting. We have provided definitions of ‘accounting’ and ‘accountability’, and we have explored the relationship between organisations’ responsibilities, accountability, and accounting practices. We have emphasised that different managers will interpret their responsibilities (to whom, and for what) differently, and this will have implications for the accounting practices that they will have in place. We have also emphasised that perceptions of organisational responsibility will change over time, and this has implications for the evolution of accounting practice. We introduced a four-step accountability model that emphasises how various judgements made as part of an ‘accountability relationship’ between organisations, and their stakeholders, have sequential implications for subsequent judgements. For example, the reasons why managers are reporting information has implications for who is intended to receive the information, which in turn has implications for what is reported, and how it is reported. The chapter concluded with a brief discussion of corporate governance which emphasised that the form of corporate governance employed within an organisation ultimately is influenced by the responsibilities accepted by corporate managers. ANSWERS TO THE OPENING QUESTIONS At the beginning of the chapter, we asked the following five questions. As a result of reading this chapter, you should be able to provide informed answers to these questions – ours are shown below. 1 What does ‘accountability’ mean? In this chapter we have provided a number of definitions of accountability. One useful definition is that provided by Gray, Adams and Owen (2014, p. 50) which is ‘the duty to provide an account or reckoning of those actions for which one is held responsible’. The ‘accountability’ of an organisation is very much linked to judgements made about an organisation’s responsibilities. 2 How do perceptions of organisational responsibility influence perceptions of organisational accountability? In this chapter we provided a simple, but useful, diagram – see Figure 2.1. As we discuss, perceptions of organisational responsibilities directly influence perceptions about to whom an organisation is responsible and for what aspects of performance it is responsible. Where there are responsibilities, managers need to provide an account (that is, be accountable) in relation to whether those responsibilities have been properly demonstrated. 3 How, if at all, is the practice of ‘accounting’ related to perceptions of accountability? The decisions about what aspects of an organisation’s performance are ‘accounted for’ are directly related to the types and extent of accountability accepted by managers. The broader the accountability accepted by managers in terms of to whom they are accountable, and for what aspects of performance they are accountable, then the broader the practice of accounting that will be adopted. If managers accept a responsibility and associated accountability to a broad range of stakeholders, and for a broad range of performance, then such managers will tend to use accounting practices that provide information about various aspects of the organisation’s financial, social and environmental performance. 4 If we were to develop a model of ‘organisational accountability’, and if it was to have four sequential steps, what might these steps be? There could potentially be a variety of steps that could be identified, but this chapter has opted to use a four-step accountability model which identifies four sequential steps, these being ‘why report?’, ‘to whom to report?’, ‘what to report?’ and ‘how to report?’ The answer to each step has implications for the answer to the following step. 71 Financial Accounting Theory 5 Is there a relationship between an organisation’s corporate governance policies and the managers’ perceptions about organisational responsibility and accountability? Yes, there is a relationship. Managers’ assessments of their responsibilities and accountabilities will have direct implications for the corporate governance policies in place. For example, if managers believe that they have a responsibility and an associated accountability to minimise their contribution to climate change, then they would put in place policies and procedures (governance policies) that aim to reduce their emissions (for example, they might have capital investment policies that stipulate that only energy efficient equipment is to be acquired or they might have in place management bonuses that are linked to achieving emission reduction targets). They would also be expected to have reporting practices in place which measure and report the results of efforts undertaken to reduce the organisation’s contribution to climate change. QUESTIONS 2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8 2.9 2.10 2.11 2.12 2.13 2.14 2.15 2.16 2.17 2.18 2.19 Define ‘accountability’. LO2.1 Would different managers necessarily have similar views about organisational accountability? Why? LO2.2 Why might different managers have different perceptions of their organisation’s responsibilities? LO2.4 Does it make sense to study accounting without considering, in some depth, the issue of ‘organisational accountability’? Why? LO2.2 What is a ‘stakeholder’ of an organisation? LO2.3 Does a stakeholder have to be a person or group of people? LO2.3 What is stakeholder engagement, and what is its purpose? LO2.3 LO2.4 What is the connection between stakeholder engagement and organisational accountability? LO2.2 LO2.3 Would you consider that stakeholder engagement should be part of the corporate governance policies of an organisation? LO2.3 LO2.8 Are the views or expectations of all stakeholders likely to be considered/acted upon by an organisation? LO2.5 What is ‘corporate governance’, and would you expect systems of corporate governance to be influenced by managers’ perceptions of their organisational responsibilities? Why? LO2.8 Are systems of corporate governance and accounting practices likely to be related? Why? LO2.7 LO2.8 Some ‘accounting educators’ incorporate issues to do with measuring and reporting information about organisational social and environmental performance across their various accounting subjects/units, whereas other accounting educators do not. Why do you think that such differences between accounting educators exist? LO2.2 LO2.4 LO2.6 What is a ‘surrogate stakeholder’, and what is their role? LO2.3 What is the ‘materiality determination process’? Why would it be useful for readers of organisational accounts to be provided with information about the materiality determination process instigated by the managers of an organisation? LO2.6 Is it important for accounting researchers to explore the factors that motivate managers to make particular accounting disclosures? Why? LO2.6 Explain why each step in the four-step accountability model discussed in this chapter influences the step that follows. For example, why does the answer to the ‘why report?’ step influence the issue about ‘to whom?’ to report, and why does the ‘to whom to report?’ step influence the ‘what to report?’ step? LO2.6 Why might it be useful for stakeholders to have insights into ‘why’ managers are reporting particular information? LO2.6 In this chapter it was stated: Each of the four steps in our four-step accountability model can represent a ‘departure point’ in opinion between various stakeholders, and this can ultimately lead to significant differences in 72 Accountability and its link to responsibility and accounting CHAPTER 2 expectations regarding the types of ‘accounts’ that particular entities should prepare, and therefore, in the types or forms of ‘accounting’ that they should undertake. Explain clearly the logic behind the above quote. 2.20 2.21 2.22 2.23 2.24 LO2.6 Explain the logic of the relationship shown in Figure 2.1. LO2.2 If the managers of an organisation are primarily focused on satisfying the information needs of powerful stakeholders, then how would the managers determine what to disclose? Further, would such an organisation likely be deemed to be demonstrating high levels of accountability? LO2.5 Why will accounting practices evolve over time? LO2.2 LO2.7 If you were a consultant asked to help an organisation produce its first publicly available ‘sustainability report’, then would it be relevant to you to know why the managers are wanting to produce the report? Why? LO2.1 LO2.6 Would you expect similar accounting practices to be used in different countries? Why? LO2.2 LO2.4 LO2.6 REFERENCES AccountAbility (2018), AA1000 AccountAbility Principles 2018, viewed 1 June 2022, http://www.accountability.org/ standards ASX Corporate Governance Council (2019), Corporate Governance Principles and Recommendations, 4th edn, Sydney: ASX. Australian Corporations and Markets Advisory Committee (2006), The Social Responsibility of Corporations, Canberra: Australian Government. Barton, A. D. (2006), ‘Public sector accountability and commercial-in-confidence outsourcing contracts’, Accounting, Auditing & Accountability Journal, 19(2), pp. 256–71. Benston, G. J. (1982), ‘Accounting and corporate accountability’, Accounting, Organizations and Society, 6(2), pp. 87–105. BHP (2022), ‘Sustainability’, https://www.bhp.com/ sustainability/approach Black, J. (2008), ‘Constructing and contesting legitimacy and accountability in polycentric regulatory regimes’, Regulation & Governance, 2(2), pp. 137–64. Deegan, C. (2019), ‘Legitimacy theory: despite its enduring popularity and contribution, time is right for a necessary makeover’, Accounting, Auditing & Accountability Journal, 32(8), pp. 2307–29. Deegan, C. (2023), An Introduction to Accounting: Accountability in Organisations and Society, 2nd edn, Melbourne: Cengage Learning. Dictionary.com (2022), ‘Accountability’, https://www. dictionary.com/browse/business Freeman, R. E. & Reed, D. L. (1983), ‘Stockholders and stakeholders: a new perspective on corporate governance’, California Management Review, 25(3), pp. 88–106. Friedman, M. (1962), Capitalism and Freedom, Chicago: University of Chicago Press. Grant, R. W. & Keohane, R. O. (2005), ‘Accountability and abuses of power in world politics’, American Political Science Review, 99(1), pp. 29–43. Gray, A. & Jenkins, B. (1993), ‘Codes of accountability in the new public sector’, Accounting, Auditing & Accountability Journal, 6(3). Gray, R., Adams, C. & Owen, D. (2014), Accountability, Social Responsibility and Sustainability: Accounting for Society and the Environment, Harlow, UK: Pearson Education. Gray, R., Colin, D., Dave, O., Richard, E. & Simon, Z. (1997), ‘Struggling with the praxis of social accounting: stakeholders, accountability, audits and procedures’, Accounting, Auditing & Accountability Journal, 10(3), pp. 325–64. Gray, R., Owen, D. & Adams, C. (1996), Accounting and Accountability: Changes and Challenges in Corporate Social and Environmental Reporting, London: Prentice Hall. Greenpeace (2022), ‘Our values’, https://www.greenpeace. org/international/explore/about/values Haque, S., Deegan, C. & Inglis, R. (2016), ‘Demand for, and impediments to, the disclosure of information about climate change-related corporate governance practices’, Accounting and Business Research, 46(6), pp. 1–45. Harvard College (2022), ‘Mission’, https://college.harvard. edu/about/mission-vision-history Mathews, M. R. (1993), Socially Responsible Accounting, London: Chapman and Hall. Mulgan, R. (2000), ‘“Accountability”: an ever-expanding concept?’, Public Administration, 78(3), pp. 555–73. Roddick, A. (2007), Business as Unusual: The Journey of Anita Roddick and The Body Shop, London: Anita Roddick Books. Rubenstein, J. (2007), ‘Accountability in an unequal world’, Journal of Politics, 69(3), pp. 616–32. Walt Disney Company, The (n.d.), ‘Our mission’, https://thewaltdisneycompany.com/about 73 CHAPTER 3 THE FINANCIAL REPORTING ENVIRONMENT LEARNING OBJECTIVES On completing this chapter, readers should: 74 LO3.1 be aware of some of the arguments for and against the existence of financial accounting regulation LO3.2 have a broad understanding of the history of the accounting profession and of financial accounting regulation LO3.3 be aware of some of the theoretical perspectives used to explain the existence of regulation LO3.4 be aware of how and why various groups within society try to influence the accounting standard-setting process LO3.5 understand that many accounting decisions are based on professional opinions and have an awareness of some of the theories used to explain what influences the accountant to choose one accounting method in preference to another LO3.6 be aware of some of the arguments advanced to support a view that the accountant can be considered to be a very powerful member of society LO3.7 be aware of some assumptions made by accounting standard setters (in regards to such issues as report readers’ knowledge and information needs), and how such assumptions influence the development of accounting regulation. The financial reporting environment CHAPTER 3 OPENING QUESTIONS Before reading this chapter, please consider how you would answer the following two questions. We will return to these questions at the end of the chapter, where we suggest some answers. 1 Through such mechanisms as conceptual frameworks for financial reporting, accounting professions throughout the world promote a view that accounting reports, when prepared properly, will be objective and will faithfully represent the underlying transactions and events of the reporting entity. Is it in the interests of the accounting profession to promote this view of objectivity and neutrality, and if so, why? 2 Many different types of stakeholders make various decisions (for example, investment or consumption decisions) based – at least in part – on information generated by accountants, and these decisions can in turn create social and/or environmental impacts. Different accounting information is expected to create different decisions, and therefore, different impacts. Because of the potential economic and social impacts created by the accountants’ choice of accounting methods (for example, decisions that involve choosing one method of accounting in preference to another), and because accounting standard-setters take such economic and social impacts into account when developing new accounting standards (accounting standard setters consider the various costs and benefits that might arise from the introduction of an accounting standard), then it can be argued that standard-setters themselves are not developing accounting standards that lead to representationally faithful (and therefore, neutral or balanced) accounts of organisational performance. Do you agree or disagree with this view, and why? Introduction A great deal of this book focuses on accounting theory as it relates to the practice of financial accounting. Therefore, it is quite important that we understand the meaning of ‘financial accounting’. Financial accounting is a process involving the collection and processing of financial information to assist in the making of various decisions by many stakeholders that are internal and external to the organisation. For larger organisations – such as large organisations with their equity listed on a securities exchange – these stakeholders are diverse and potentially include present and potential investors, lenders, suppliers, employees, customers, governments, non-government organisations, the local community, parties that are performing a review or oversight function, and the news media. Financial accounting generates information for use by managers, and also for other stakeholders who are not necessarily involved in the day-to-day running of the organisation. Financial reports that meet the specific information needs of a specifically identified, and potentially narrow group of stakeholders, are often referred to as ‘special purpose financial reports’, and these reports do not need to comply with accounting standards. Special purpose financial reports are prepared for stakeholders who have the power to command reports that satisfy their own information demands, and these ‘powerful’ stakeholders therefore do not typically require that regulation exists to protect their rights to information. For larger organisations, with potentially thousands (or hundreds of thousands, or even millions) of interested stakeholders with various information demands and needs, it is effectively not possible to generate financial reports that will satisfy each and every need of each and every stakeholder. To do so would potentially require the generation of many thousands of specifically tailored reports, and this is obviously not practical. Financial accounting A process involving the collection and processing of financial information to assist in the making of various decisions by many parties internal and external to the organisation. Special purpose financial reports Financial reports that meet specific information needs of particular parties. 75 Financial Accounting Theory General purpose financial statements (GPFSs) Financial statements that comply with conceptual framework requirements and accounting standards and meet the information needs common to users who are unable to command the preparation of reports tailored specifically to satisfy all their information needs. As such, the process of financial accounting as applied by larger organisations (and these financial reports will comply with the financial reporting standards issued by organisations such as the International Accounting Standards Board [IASB] or the Financial Accounting Standards Board [FASB]) leads to the generation of reports deemed to be general purpose financial reports, and more specifically, their externally released financial statements would be referred to as general purpose financial statements (GPFSs). The objective, use and regulation of general purpose financial reports LO3.1 LO3.7 General purpose financial statements are prepared for stakeholders who do not have the power to demand reports that satisfy their own specific information needs; rather, such stakeholders need to rely upon general purpose financial reports that will ‘generally’ meet many, but not all, of their information requirements. Much of the research that is undertaken in the broad area of financial accounting and financial reporting focuses on general purpose financial statements, and not special purpose financial statements. It should be noted that large organisations will also, in addition to releasing general purpose financial statements, also generally privately release a number of special purpose financial reports for a limited number of stakeholders. The IASB Conceptual Framework for Financial Reporting (IASB, 2022) defines general purpose financial reports and general purpose financial statements, as follows: • general purpose financial report: a report that provides financial information about the reporting entity’s economic resources, claims against the entity, and changes in those economic resources and claims that is useful to primary users (existing and potential investors, lenders and other creditors) in making decisions relating to providing resources to the entity • general purpose financial statement: a particular form of general purpose financial report that provides information about the reporting entity’s assets, liabilities, equity, income and expenses. In the IASB Conceptual Framework (IASB, 2022), the objective of general purpose financial reporting is described in the following way (paragraph 1.2): The objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions relating to providing resources to the entity. Those decisions involve decisions about: (a) buying, selling or holding equity and debt instruments; (b) providing or settling loans and other forms of credit; or (c) exercising rights to vote on, or otherwise influence, management’s actions that affect the use of the entity’s economic resources. In terms of the objective of general purpose financial statements – and from what we have already discussed, we know that general purpose financial statements are a form of general purpose financial reports that specifically provide information about the five elements of financial statements (assets, liabilities, equity, income and expenses) – paragraph 3.2 of the IASB Conceptual Framework states: The objective of financial statements is to provide financial information about the reporting entity’s assets, liabilities, equity, income and expenses that is useful to users of financial statements in assessing the prospects for future net cash inflows to the reporting entity, and in assessing management’s stewardship of the entity’s economic resources 76 The financial reporting environment CHAPTER 3 As we discussed in Chapter 1, the IASB Conceptual Framework is based upon this guiding objective. Therefore, if we disagreed with this central objective (as some accounting researchers do), then we might be inclined to disagree with the prescriptions provided within the balance of the Conceptual Framework. In further explaining the role of general purpose financial reports, paragraphs 1.5 to 1.7 of the IASB Conceptual Framework state: 1.5 Many existing and potential investors, lenders and other creditors cannot require reporting entities to provide information directly to them and must rely on general purpose financial reports for much of the financial information they need. Consequently, they are the primary users to whom general purpose financial reports are directed 1.6 However, general purpose financial reports do not and cannot provide all of the information that existing and potential investors, lenders and other creditors need. Those users need to consider pertinent information from other sources, for example, general economic conditions and expectations, political events and political climate, and industry and company outlooks 1.7 General purpose financial reports are not designed to show the value of a reporting entity; but they provide information to help existing and potential investors, lenders and other creditors to estimate the value of the reporting entity There is a great deal of accounting research that explores the role of other sources of information beyond general purpose financial statements in providing information to investors and other stakeholders. For example, research also explores the role and use of reports such as sustainability reports, climate change-related reports, modern slavery statements, social audit reports, and so forth. We consider some of this research in other chapters of this book. At this point it needs to be emphasised that when we talk about the regulation of financial reporting in this chapter, and the chapters that follow, we are typically restricting our discussion to the regulation of general purpose financial reports. General purpose financial reports are subject to high levels of regulation because they are used by a large number of stakeholders who are not involved in the management of the organisation and who do not have the power to demand reports to satisfy their specific information needs, such as investors, lenders and creditors, to make various decisions about providing resources to the organisation. It is considered that because so many stakeholders make resource allocation decisions that are based, at least in part, on general purpose financial reports, then this creates a need for such reports to be regulated to help ensure these reports are of high quality and to provide a faithful depiction of what they purport to represent. Also, consistent with the objective of general purpose financial reporting provided above, while people other than investors, lenders and creditors might use general purpose financial reports, they are not the primary intended audience. This is confirmed by paragraph 1.10 of the IASB Conceptual Framework, which states: Regulation A rule of order, as for conduct, prescribed by authority; a governing direction or law. It is designed to control or govern conduct. Other parties, such as regulators and members of the public other than investors, lenders and other creditors, may also find general purpose financial reports useful. However, those reports are not primarily directed to these other groups. This restricted audience of general purpose financial reports is consistent with the objective provided earlier. Having now provided some insight into what we mean by general purpose financial reporting, and general purpose financial statements, we again need to note that such reporting tends to be heavily regulated in most countries, with many accounting standards and other regulations 77 Financial Accounting Theory governing how particular transactions and events are to be recognised, measured and presented in general purpose financial reports. The reports generated, such as the balance sheet (or, as it is also called, the ‘statement of financial position’), the profit and loss account (or, as it also called, the ‘statement of profit or loss and other comprehensive income’), the statement of cash flows, the statement of changes in equity and the supporting notes, are directly affected by the various accounting regulations in place.1 When existing accounting regulations change, or new accounting regulations are implemented, this will typically have an impact on the various accounting numbers (such as particular items of income, expenses, assets and liabilities) included in the statements provided to the public. To the extent that people make decisions on the basis of accounting numbers, and such decisions have various social consequences (as we explained in Chapter 2), then changing accounting regulations will potentially create various social impacts. The economic and social impacts of changing accounting requirements is an area addressed by many accounting researchers. Ideally, readers of financial statements should have a sound working knowledge of the various accounting standards and other regulations, because without such knowledge it can be difficult (or perhaps near impossible) to interpret what the financial statements are actually reflecting. For example, ‘profit’ is the outcome of applying particular accounting rules and conventions, many of which are contained within accounting standards (or, as they are also called, financial reporting standards). As these rules change (and they frequently do), the same series of transactions will lead to different measures of income and expenses and therefore of ‘profits’ and ‘net assets’ at different points in time.2 Such a situation leads to an obvious question: should readers of general purpose financial statements be expected to understand financial accounting? The answer is ‘Yes’, even though many users of financial statements (including many company directors and financial analysts) have a very poor working knowledge of financial accounting. In this regard, the IASB Conceptual Framework (paragraph 2.36) notes that: Financial reports are prepared for users who have a reasonable knowledge of business and economic activities and who review and analyse the information diligently. At times, even well-informed and diligent users may need to seek the aid of an adviser to understand information about complex economic phenomena. A review of an annual report of a company listed on a securities exchange will soon reveal just how confusing such a document would be to readers with a limited knowledge of accounting (and, as became clear in the aftermath of the collapse of Enron, WorldCom, HIH Insurance and other large entities, many people with formal qualifications in accounting also have trouble interpreting the accounting reports of companies that have complex financial structures and engage in complex financial transactions). Unfortunately, many readers of financial statements have tended to consider figures such as ‘profits’ or ‘assets’ as being ‘hard’ objective numbers that are not subject to various professional judgements. Hence, although such users may not 1 2 78 The names of the financial statements changed as a result of accounting standards being issued by the AASB. There is no clear theory to explain how changing the names of these financial statements provides benefits for financial statement users or preparers. Which brings into question a great deal of published research that looks at trends in company profitability across time. For example, there is a deal of research that looks at trends in corporate profits across time and seeks to link changes in reported profits back to changes in various attributes of an organisation. Such research often fails to adjust for the fact that across time, many accounting standards are changed or introduced which directly affect how we calculate reported profits. Therefore, because accounting rules do change across time, an identical set of events and transactions will generate different profits in different years because they are being calculated using a different set of rules. As such, it really only makes sense to do research that looks at trends in reported profit if some adjustments are made to each year’s profits to ensure that they are actually being calculated using the same set of rules – but such adjustments are often not made, in large part because researchers do not have enough information available about the underlying corporate transactions. The financial reporting environment CHAPTER 3 understand some of the descriptions of accounting methods used, they may believe that they understand what ‘profits’ and ‘net assets’ mean. As we know, however, the financial accounting results (or numbers) will be heavily dependent on the particular financial accounting methods chosen, as well as on various professional judgements made. Different teams of accountants working independently would likely generate quite different results for the same organisation because of different professional judgements being made. That is, depending on who compiles the accounting reports, the measures of profits and net assets can vary greatly.3 Alternative measures of financial performance disclosed within financial reports Many companies provide summary ‘highlight’ statements at the beginning of their annual reports. Often, multi-year summaries are given of such figures as profits, return on assets, earnings per share, dividend yield and net asset backing per share. By highlighting particular information, management could be deemed to be helping the less accounting-literate readers to focus on the important results. However, a downside of this is that management itself is selecting the information to be highlighted (that is, such disclosures are voluntary) and, as a result, a large amount of otherwise important information may be overlooked. While larger organisations are required to produce general purpose financial reports that measure and report profit in accordance with financial reporting standards, it is also becoming quite common to find that many organisations additionally disclose alternative (additional) measures of ‘profits’ that are derived in a way that is inconsistent with financial reporting standards, but which are argued by the managers of the organisation to provide a measure of performance which they believe is more representative of the organisation’s performance. The news media also often refer to these alternative measures of financial performance. The motivations for providing these alternative measures of financial performance might come from a belief by managers that the measures of performance derived by not complying with financial reporting standards provides a relatively superior indicator of the organisation’s underlying performance, and this measure is more useful to both the managers of the organisation in terms of effectively managing the organisation, as well as to the readers of the financial reports. Alternatively, such disclosures might be made opportunistically by managers to generate a result that managers think will provide some form of benefits to the organisation or to themselves. Perhaps it could also be a mixture of both incentives. Evidence indicates that, when calculating these alternative measures of profits, the most commonly excluded expenses are depreciation and amortisation, the costs assigned to share-based remuneration provided to managers, research and development costs, and major impairments of assets. When referring to these alternative measures of financial performance, organisations often refer to the alternative measure as ‘underlying profit’, ‘underlying earnings’, ‘cash earnings’ or ‘underlying profit after tax’ (Chartered Accountants Australia and New Zealand, 2016). Even though many people think it is inappropriate to provide these alternative measures of profits in the same financial reports in which accounting standards must be followed, it is generally permitted in most countries unless the disclosures are considered to be misleading. If the alternative financial performance measures are reported in a way that is misleading, then corporate regulators can potentially take action against the directors of the company. So, the point to be emphasised here is that although larger organisations are required to produce general purpose financial statements that comply with accounting standards, there will nevertheless also 3 Yet the various financial statements prepared by the different teams of accountants for the same organisation may all be deemed to be ‘true and fair’ despite the differences in net assets or reported profits, which implies that different teams of accountants are able to provide different versions of the ‘truth’. 79 Financial Accounting Theory be some financial disclosures within such reports that do not strictly comply with accounting standards, and the reasons for these ‘non-complying’ disclosures is a topic investigated by many accounting researchers through the use of varying accounting theories, some of which we discuss within this book. Financial accounting versus management accounting Financial accounting can be contrasted with management accounting. Management accounting focuses on providing information for decision making by parties who work within an organisation (that is, for internal as opposed to external users) and it is largely unregulated. Generally speaking, there is a whole different body of literature and theory that explores management accounting practices, and this literature is beyond the scope of this book. Whereas most countries have a multitude of financial accounting standards that are often given the force of law (and these standards are typically those of the IASB), the same cannot be said for management accounting. Because management accounting relates to the provision of information for parties within the organisation who have the power to demand the information they need, the view taken is that there is no need to protect their information needs or rights. It is the information rights of outsiders who have funds invested in an organisation, but who are not involved in the day-to-day management of an entity, that must be protected. Because financial statements are often used as a source of information for parties contemplating transferring resources to an organisation, it is arguably important that certain rules be put in place to govern how the information should be compiled. That is (adopting a pro-regulation perspective), to protect the interests of parties external to an organisation, some regulation relating to financial accounting information is required. Why do I need to know about the difference between general purpose financial reports and special purpose financial reports? If we are studying financial accounting theory and some related research that addresses financial reporting and associated regulation, then we need to be aware that the vast majority of this research relates to general purpose financial reports and not special purpose financial reports.Therefore, it is important that we know the difference between these two forms of reporting. Also, in our daily lives we will often hear about the ‘profits’ or ‘assets’ of large, high-profile organisations. It is important to understand that these financial numbers are extracted from general purpose financial statements, and that these financial statements are generated by applying accounting standards. If we also know the contents of the various applicable accounting standards, then that allows us to understand the context of the financial accounting numbers being reported. This further allows us to understand that as accounting standards change, then the same series of transactions and events will be recognised and measured using new rules, meaning that a different measure of ‘profit’ would be calculated. As already noted, much of the research undertaken in financial accounting and reporting relates to general purpose financial statements so it is important that you understand what they are. This overview should make that clear. Figure 3.1 provides a diagrammatic representation of when general purpose financial statements are to be prepared. Application of our ‘accountability model’ to the practice of financial reporting In Chapter 2, we introduced the four-step accountability model, which can be used to explain various forms of ‘accounting’. We recall that the model has four basic questions, these being 80 The financial reporting environment CHAPTER 3 FIGURE 3.1 The requirement to produce general purpose financial statements Is the organisation: (1) relatively large such that there are many stakeholders who have a significant financial interest in the organisation, but (2) who have nothing to do with the ongoing management of the organisation, and (3) who do not individually have the power to demand information that specifically satisfiestheir needs? Yes The organisation’s financial accounting practices will tend to be regulated. The organisation will prepare general purpose financial statements that comply with accounting standards and other financial reporting requirements No The organisation’s financial accounting practices will tend not to be regulated. The organisation will prepare special purpose financial statements that do not need to comply with accounting standards but will be tailored to meet the specific needs of the limited number of users ‘why report?’, ‘to whom to report?’, ‘what to report?’ and ‘how to report?’. We now consider each of these questions in turn as they relate to financial reporting, specifically, general purpose financial reporting. Why disclose financial accounting information? The most obvious answer here is that an extensive amount of regulation requires the disclosure of financial information about an organisation, in particular, for larger organisations. Governments throughout the world typically require larger organisations to prepare general purpose financial statements. As we have discussed, governments impose this regulation so that those stakeholders with a financial interest in an organisation (such as shareholders, creditors and lenders) are more likely to receive relevant and reliable information about financial performance, and therefore more able to adopt strategies which safeguard their financial interests (for example, if an organisation is not performing well financially, then one strategy that investors might adopt would be to sell their investments in the organisation and move their funds to alternative investments). Further, governments typically want people to have confidence in capital markets as this will support economic growth (but, as we explain in Chapter 13, there are diverse views about who in society actually prospers from this ‘economic growth’). Regulating the financial disclosures that larger organisations are required to make helps to promote investors’ confidence in capital markets. Nevertheless, even without regulation, investors and other stakeholders with a financial interest in the organisation would still demand financial statements. Investors (owners) would demand financial statements that allow them to assess how well their funds are being used in terms of their investment aims (which might be high capital growth and receipt of dividends), thereby effectively reducing the risks of the investment. Receiving financial reports reduces the risks of those stakeholders with a financial interest in, or claim on, the organisation because the information provides a means to monitor, on a periodic basis, the financial performance and position of the organisation, thereby assisting the stakeholders to assess, on an ongoing basis, the security of their financial interests in the organisation. Financial accounting is also important for managers as it provides information that is useful for managing an organisation. Hence, it is again stressed that even in the absence of regulation we would still expect financial statements to be prepared, albeit that they might be prepared in a multitude of ways. Indeed, history shows that financial statements were voluntarily prepared long before regulation required them, although in the absence of regulation there was much 81 Financial Accounting Theory variation in reporting practices being adopted by different organisations, thereby making comparisons between organisations difficult. Importantly, in the absence of producing externally available financial statements, organisations would find it very difficult to attract funds. Most of us would be reluctant to invest in an organisation, or loan funds to an organisation, if that organisation was not prepared to provide us with periodic reports about its financial position and financial performance. For example, a lender would want to know that the organisation to which it has loaned funds is in a financial position that enables it to be able to ultimately repay the funds that have been borrowed. To whom are the financial disclosures directed? The primary audience of financial accounting information and, in particular, general purpose financial statements, are, according to the IASB Conceptual Framework, current and potential investors, lenders and other creditors. Managers will also use the information generated by the financial accounting system. Many other stakeholders would also have an interest in the financial position, financial performance and cash flows of an organisation. Employees, and their representatives such as labour unions, might also have an interest in knowing about an organisation’s financial performance, to determine not only whether the organisation can continue to pay current salaries, but also whether the organisation could, or should, pay higher salaries. Customers might also have an interest in the financial performance of an organisation as, for example, if the organisation is earning large profits, then this might justify calls for price decreases on its goods or services. There are many other ways in which financial accounting assists the decisions being made by different stakeholders. What types of disclosures are made? The types of disclosures to be made will be influenced by the expectations of the stakeholders to whom the information is being directed. Accounting standard-setters, such as the IASB, do much research, often in conjunction with university-based accounting researchers, to determine what types of information the main users of general purpose financial reports (who are assumed to be investors, potential investors, lenders and other creditors) want, or need. We consider some of this research throughout this book. Once an accounting standard-setter determines that particular information is justifiably needed by financial statement users, then the standard-setter will tend to initiate actions leading to the introduction of regulations in respect of that information. Managers will also make various disclosures beyond that required by regulation (voluntarily) and we explore motivations driving voluntary disclosure in other chapters of this book, in particular, in Chapters 8 and 9. Requirements for particular financial accounting disclosures will be incorporated within the accounting standards released by accounting standard-setters, and different financial accounting disclosure requirements might also be included within a country’s securities exchange and corporations law requirements. How differences in international cultures influence national accounting and securities regulations is something that we explore in Chapters 5 and 9. How are disclosures made? The format of the disclosures, and the medium for disclosure, will also tend to be regulated (with respect to the general purpose financial statements being issued by larger organisations). For example, there are accounting standards that stipulate how to define, recognise, measure and disclose various transactions and events. Accounting standards also provide guidance about what types of financial statements shall be prepared and what information shall be disclosed within the respective financial statements. 82 The financial reporting environment CHAPTER 3 Having provided a broad overview of current requirements pertaining to the preparation of general purpose financial statements, we now consider the history of accounting practice and its associated regulation.4 An overview of the development and regulation of accounting practice LO3.1 LO3.2 This section examines the development of accounting regulations in jurisdictions where the primary role of general purpose financial reports – which, as we know, are those financial reports that are released by larger organisations such as large public companies – has been to aid investment decisions made by external investors in developed capital markets. Such external investors typically have no role in the management of the entity, and hence rely upon general purpose financial reports as a source of important information. As we will learn in Chapter 5, the primary role of financial reporting in many European countries has historically been different to the capital market-based roles in other countries. This is because in Europe there was traditionally not such a high reliance on publicly raised finance. Rather, finance was often provided by a limited number of investors (including banks) which, because of their ‘closeness’ to the organisation, were able to stipulate the specific information they wanted to receive from the organisation (with such information being incorporated within ‘special purpose financial reports’). However, with increasing globalisation of business and capital markets, the role of financial reporting undertaken by large companies in all European countries is now focused on the provision of financial information to capital markets, with the consequence that regulations developed over a long period of time in economies dominated by capital markets (with a large number of external shareholders) now apply to most large European Union (EU) companies. While the practice of financial accounting can be traced back many hundreds of years, the regulation of financial accounting and, in particular, general purpose financial reporting, in most capital-market-dominated economies (such as the United States, the United Kingdom, Ireland, Australia and Canada) generally commenced in the twentieth century. In part, this lack of regulation in the early days is likely due to the fact that there was limited separation between the ownership and management of business entities, and, as such, most systems of accounting were designed to provide information to the owner/manager. In the twentieth century there was an increase in the degree of separation between ownership and management in many countries, and with this increased separation came an increased tendency to regulate financial accounting disclosures so as to protect the financial interests of the capital providers that otherwise had no direct information about how the organisation was financially performing. Reliance on double-entry accounting Early systems of double-entry bookkeeping and accounting, similar to the system we use today, have been traced back to thirteenth- and fourteenth-century northern Italy. One of the earliest surviving descriptions of a system of double-entry accounting is by the Franciscan monk Luca Pacioli as part of his most famous work, Summa de Arithmetica, Geometrica, Proportioni et Proportionalita, published in Venice in 1494. A review of this work (there are translated versions) 4 Although this text devotes several chapters to financial accounting, a similar argument can be made in favour of the regulation of social and environmental reporting. Corporations generate many social and environmental impacts that can affect a variety of stakeholders. Such stakeholders arguably have a right to know about the social and environmental implications of an organisation’s operations. Such information could then provide the basis for decisions about whether to support the organisation’s operations. Chapter 10 considers various issues associated with social and environmental reporting. 83 Financial Accounting Theory indicates that our current system of double-entry accounting is very similar to that developed many hundreds of years ago. Even in the days of Pacioli there were debits and credits, with debits going on the left and credits on the right.5 There were also journals and ledgers. Reflecting on the origins of double-entry accounting, Hendriksen and Van Breda (1992, p. 36) state: Debits, credits, journal entries, ledgers, accounts, trial balances, balance sheets and income statements all date back to the Renaissance. Accounting, therefore, can claim as noble a lineage as many of the liberal arts.6 Accounting students can take pride in their heritage. Part of this heritage is a rich vocabulary, almost all of which dates back to this period and much of which is fascinating in its origin. Debits and credits have, over the ages, proved to be the bane of many an accounting student. So, did we really need them? Why couldn’t we have simply used positive and negative numbers? For example, if we were to pay wages, why couldn’t we have simply put a positive number under the wages column and a negative number under the cash column? The simple answer to this question appears to be that negative numbers were not really used in mathematics until the seventeenth century. Hence, the t-account was devised to solve this problem, with increases being on one side and decreases on the other. But why keep the t-account, and debits and credits, now that we accept the existence of negative numbers? Pondering this issue, Hendriksen and Van Breda (1992, p. 51) comment: Textbook writers still explain how debits are found on the left and credits on the right and teach students the subtraction-by-opposition technique that was made obsolete in arithmetic three centuries ago. Programmers then faithfully seek to reflect these medieval ideas on the modern computer screen. As is demonstrated in subsequent chapters, there are many criticisms of our financial accounting systems. For example, there is an increasing trend towards the view that financial accounting should reflect the various social and environmental impacts created by an organisation. Unfortunately, however, our ‘dated’ double-entry system has a general inability to take such consequences into account and this means that measures of ‘profits’ using doubleentry accounting typically fail to take account of the vast majority of social and environmental impacts generated by business organisations – but more of this is covered in later chapters, particularly Chapter 10.7 Early development of professional accounting bodies While ‘accounting’ and ‘accountants’ have existed for hundreds of years, it was not until the nineteenth century that accountants within the United Kingdom and the United States banded together to form professional associations. According to Goldberg (1949), a Society of Accountants was formed in Edinburgh in 1854, later to be followed by a number of other bodies, including the Institute of Chartered Accountants in England and Wales (ICAEW), which was established in 1880. According to Mathews and Perera (1996, p. 16), from the early years the 5 6 7 84 According to Hendriksen and Van Breda (1992, p. 36), our use of the word ‘debit’ can be traced back to the word debere (shortened to ‘dr’), which is the Latin word for an obligation and can be interpreted as meaning ‘to owe’. The word ‘credit’ (abbreviated to ‘cr’) can be linked to the Latin word credere, which means to believe or trust in someone. Hatfield (1924) points out that Luca Pacioli (who was a prominent academic of his day) was a close friend of Leonardo da Vinci, and that da Vinci was one of the first people to buy a copy of Summa de Arithmetica and drew the illustrations for one of Pacioli’s later books. At this point, let’s ponder the following question: if a company’s operations led to the release of toxic gases that killed many birds, but no fines were imposed because there were no strict environmental laws, would there be any debits or credits to reflect this cost that was imposed upon nature (and if so, what would be the debits and credits)? Chapter 10 addresses this issue. The financial reporting environment CHAPTER 3 ICAEW was very concerned about the reputation of its members and as a result set conditions for admission, including general education examinations, five years of articles served with a member of the institute, and intermediate and final examinations in a range of subjects. In the United States, the American Association of Public Accountants was formed in 1887 (Goldberg, 1949). This association went on to form the basis of the American Institute of Certified Public Accountants (AICPA). While members of these bodies were often called upon to perform audits in particular circumstances, and while companies were generally required to prepare accounting reports subject to various company laws and securities exchange requirements,8 there was a general absence of regulation about what the reports should disclose or how the accounting numbers should be compiled (that is, there was effectively a ‘free-market’ approach to accounting regulation).9 Early codification of accounting rules In the early part of the twentieth century, limited work was undertaken to codify particular accounting principles or rules. Basically, accountants used those rules of which they were aware and which they (hopefully) believed were most appropriate to the particular circumstances. There was very limited uniformity between the accounting methods adopted by different organisations, thereby creating obvious comparability problems (and one of the enhancing qualitative characteristics as espoused within the IASB Conceptual Framework that useful financial information should possess is ‘comparability’). Around the 1920s, a number of people undertook research that sought to observe practice and to identify commonly accepted accounting conventions that would then be prescribed to other accountants as the most appropriate way to perform financial accounting. That is, they sought to describe ‘what was’, rather than assuming a normative position with regard to ‘what should be’. By simply describing current practice, the researchers gave themselves limited possibilities of actually improving accounting procedures. As Mathews and Perera (1996, p. 20) state: This led to a practice–theory–practice cycle and tended to retard the progress of accounting, because there was no value judgement exercised in respect of the practices which were observed. In other words, there was no opportunity to examine critically what was being practised before the next generation of accountants were prepared in the same manner. Early researchers who provided detailed descriptions of existing conventions of accounting included Paton (1922), Sanders, Hatfield and Moore (1938), Gilman (1939) and Paton and Littleton (1940). These studies described such things as the doctrines of conservatism, concepts of materiality, consistency, the entity assumption and the matching principle – principles which are still often discussed, and taught, today. A great deal of the early work undertaken to establish particular accounting rules and doctrines was undertaken in the United States. In 1930 the accounting profession within the United States cooperated with the New York Stock Exchange (NYSE) to develop a list of broadly used accounting principles which would then be prescribed to all accountants. According to Zeff (1972), this publication is one of the most important documents in the history of accounting 8 9 For example, within the United Kingdom the Joint Stock Companies Act 1844 required that companies produce a balance sheet and an auditor’s report thereon for distribution to shareholders before the annual meeting. This requirement was removed in an 1862 Act, but reinstated in a 1900 Act. In 1929 a requirement to produce a profit and loss account was introduced. In 1900, the New York Stock Exchange required companies applying for listing to prepare financial statements showing the results of their operations as well as details about their financial position. In 1926 the exchange further required that all listed companies provide their shareholders with an annual financial report in advance of the companies’ annual general meetings. The report did not have to be audited. 85 Financial Accounting Theory regulation and set the foundation for the codification and acceptance of generally accepted accounting principles. The NYSE asked the accounting profession to compile the document as it was concerned that many companies were using a variety of (typically undisclosed) accounting methods.10 REFLECTION QUESTION 3.1 Accounting regulation based upon generally accepted accounting practice As the material above describes, much early accounting research focused on investigating what financial accounting practices (including the various assumptions and conventions practised by accountants) were being applied by most financial accountants and these practices were then documented and formed the basis for what accounting practices all accountants were then expected to apply. The rationale was that if most accounting practitioners were applying particular methods, then all practitioners should apply them. Question Why might prescribing accounting practice on the basis of what most accountants do – as was the case several decades ago – not necessarily generate the ‘best’ accounting practices? Solution Somewhat logically, just because most people in a particular profession do something does not mean it’s the best possible, or most efficient, thing to do. For example, the population of home gardeners might all be happy to use a spoon to dig holes for planting small trees if none of them have been exposed to a shovel. If people do not know there are better practices available, then they may be inclined to follow commonly used, but suboptimal, practices. People typically need to be shown that there are better practices available before they change what they do. Accounting researchers, and their appropriate use of theory, have a role in identifying potential improvements in existing accounting practice. Adhering to what most people do will not necessarily reflect best possible practice. Development of disclosure regulations In the United States, it was not until 1934 that specific disclosures of financial information were required by organisations seeking to trade their securities. The Securities Exchange Act of 1934, as administered by the Securities and Exchange Commission (SEC), stipulated the disclosure of specific financial information. The SEC was given authority to stipulate accounting principles and reporting practices. However, it allowed the accounting profession to take charge of this activity as long as it could clearly indicate that it would perform such duties diligently. In an effort to convince the SEC that it could identify acceptable accounting practices, the American Institute of Accountants (one of the predecessors of the AICPA) released, in 1938, a study by Sanders, Hatfield and Moore entitled A Statement of Accounting Principles. In 1938 the SEC stated (within Accounting Series Release No. 4) that it would accept only those financial statements that had been prepared in accordance with the generally accepted accounting principles of the accounting profession, thereby giving a great deal of power to the profession. In part, ASR No. 4 stated: In cases where financial statements filed with the Commission … are prepared in accordance with accounting principles for which there is no substantial authoritative support, such financial statements will be presumed to be misleading or inaccurate despite disclosures contained in the certificate of the accountant or in footnotes to the statements provided the matters are material. In cases where there is a difference of opinion between the Commission and the registrant as to proper principles of 10 86 Five of the identified principles subsequently formed the basis of Chapter 1 of Accounting Research Bulletin No. 43, as issued by the Committee on Accounting Procedure. The financial reporting environment CHAPTER 3 accounting to be followed, disclosure will be accepted in lieu of correction of the financial statements themselves, only if the points involved are such that there is substantial authoritative support for the practices followed by the registrant and the position of the Commission has not previously been expressed in rules, regulations, or other releases of the Commission, including the published opinion of its chief accountant. While the above statement does indicate that the SEC was to allow the accounting profession to determine acceptable practice, many considered that the SEC was also warning the accounting profession that it must take an authoritative lead in developing accounting standards, otherwise the SEC would take over the role (Zeff, 1972). From 1939 the Committee on Accounting Procedure, a committee of the accounting profession, began issuing statements on accounting principles, and between 1938 and 1939 it released 12 Accounting Research Bulletins (Zeff, 1972). Development by the accounting profession of mandatory accounting standards is a relatively recent phenomenon. In the United Kingdom, it was not until 1970, when the Accounting Standards Steering Committee was established (later to become the Accounting Standards Committee and then the Accounting Standards Board), that UK accountants had to conform with professionally developed mandatory accounting standards. Prior to this time, the ICAEW had released a series of ‘recommendations’ to members. In the United States, although there had been Accounting Research Bulletins (released by the Committee on Accounting Procedure, formed in 1938) and Opinions (released by the Accounting Principles Board [APB], formed in 1959), these Bulletins and Opinions were not mandatory. Rather, they indicated perceived best practice. There tended to be many corporate departures from these Bulletins and Opinions and, as a result, in 1965 a rule (Rule 203 of the AICPA) was introduced that required departures from principles published in APB Opinions to be disclosed in footnotes to financial statements. From 1 July 1973 the APB was replaced by the Financial Accounting Standards Board (FASB), which has subsequently released many accounting standards that are mandatory. As might be expected given overseas experience, the history of accounting regulation within a country such as Australia is quite recent. In 1946, the Institute of Chartered Accountants in Australia (ICAA) (which has subsequently become Chartered Accountants Australia and New Zealand, or CAANZ) released five ‘Recommendations on accounting principles’, which were largely based on documents released by the Institute of Chartered Accountants in England and Wales (ICAEW). In 1956, a number of recommendations were released by the Australian Society of Accountants (now known as CPA Australia). In later years the two bodies agreed to issue statements and recommendations jointly through the Australian Accounting Research Foundation (AARF), a body jointly funded by the ICAA and CPA Australia. In 2005, the AARF was disbanded. Its elimination placed the development of accounting standards in the hands of the federal government (through the Australian Accounting Standards Board), rather than in the hands of the accounting profession, thereby effectively reducing the ability of the accounting profession to ‘self-regulate’. Further, with the adoption of International Financial Reporting Standards (IFRS) within Australia from 2005, a great deal of the work involved in developing accounting standards has been centralised with the International Accounting Standards Board (IASB, located in London), such that the scope for the AASB to develop accounting standards independently within Australia has been greatly reduced (although domestic accounting standards will be developed from time to time to fill voids not addressed by the IASB). This situation is common to many other countries that have also adopted IFRS in recent years such that, internationally, most countries now use the IFRS developed by the IASB. However, whether different countries, with potentially different cultures and different information expectations, should all use the same rules for preparing general purpose financial reports is something that we address in Chapter 5. 87 Financial Accounting Theory The development of accounting regulation in Europe is also worthy of consideration. As is explored in greater depth in Chapter 5, financial accounting practices (and therefore the regulation of financial reports) in many European countries were not primarily focused on the provision of information to aid investment decisions by external shareholders in capital markets (in large part because European companies did not typically attract funds from a diverse and large number of shareholders who were not involved in the management of the organisation). The regulation of financial reporting through professionally developed standards is therefore an even more recent phenomenon in large parts of continental Europe than it is, for example, in the United Kingdom, the United States or Australia. However, regulation (through a requirement to follow the accounting standards released by the IASB) of the consolidated financial statements of all companies whose shares are traded on any securities exchange in the EU became compulsory from 1 January 2005. Twenty-first-century political pressure on financial accounting regulation A further significant change in the accounting regulatory frameworks of many countries occurred following several high-profile accounting and audit failures in the United States in 2001 and 2002 (including Enron and WorldCom). Although, as Unerman and O’Dwyer (2004) point out, these were not the first large-scale accounting failures to occur since the inception of regulation through professional accounting standards, they were much larger than previous failures and occurred at a time of sharply falling securities markets. Private investors who were already losing confidence in securities markets due to their financial losses on falling share prices now perceived accounting failures as contributing to even larger losses. In this climate, politicians came under pressure to make accounting regulation more rigorous, and they passed legislation (such as the US Sarbanes–Oxley Act of 2002) to give greater legal force to many existing and new regulations. Significant political pressure for changes in accounting regulations and regulatory regimes was again exerted for a period following the sub-prime banking crisis and ensuing global financial crisis (GFC) from 2007–09 and onwards.11 The sub-prime banking crisis saw several banks fail, including the major financial institution of Lehman Brothers, and other banks needing very large amounts of government support. These failures exacerbated a loss of confidence within the global banking system, with such confidence being an essential element in the smooth running of the banking system, which in turn is essential for economic stability and growth. Among the many practices that have been implicated in causing the sub-prime banking crisis and ensuring the credit crunch and GFC, the effectiveness of financial accounting and its regulation was called into question (for a variety of theoretical perspectives on the role of accounting and accountants in the sub-prime crisis and credit crunch see, for example, Arnold, 11 88 Some readers might not be familiar with the term ‘sub-prime’. As applied to lending, ‘sub-prime lending’ refers to a situation where loans are made to people – known as ‘sub-prime borrowers’ – who have a higher probability of defaulting on loan repayment requirements compared to ‘prime borrowers’. It is generally considered that a key trigger for the GFC was sub-prime lending and the inflated US property market, which peaked in 2005–06. Further, and at the same time, various loan incentives were being offered to borrowers, such as initial discounts on repayments. In the period when property prices had been rising, many ‘sub-prime borrowers’ took loans believing that they would be insulated by continuously rising property prices. However, when property prices started to fall and interest rates rose, defaults and forclosures sharply rose and refinancing became difficult. Many loans could not be repaid and the amount of the loan often greatly exceeded the value of the secured property. Also, many mortgage-backed securities (which arise, for example, where mortgage loans – of which many at the time included sub-prime loans – are purchased from lenders, such as banks, and are placed into ‘pools’ into which investors can acquire an interest) became worth very little. Interestingly, in March 2013 the US Federal Government took legal actions against the credit ratings agency, Standard and Poors, which had provided credit ratings on various mortgage-backed securities funds. The government argued that the ratings attributed to the funds were too high (allegedly to please the banks in charge of the funds and thereby hopefully enable S & P to attract further ratings work from the client), indicating that the investments were of low risk and, as a result, many investors, including financial institutions invested in the securities, on the basis of the ratings and this further helped trigger the GFC. The financial reporting environment CHAPTER 3 2009; Hopwood, 2009; Laux and Leuz, 2009; Roberts and Jones, 2009; Sikka, 2009). Politicians questioned why the financial statements of failed banks had not given adequate warning of the significant risks and problems faced by banks. This political questioning of the role of accounting, and pressure to take action to ensure that financial statements helped to provide greater transparency in the future, reached the highest level when it was placed on the agenda of G-20 leaders’ summit meetings from their inception in 2008.12 At the first of these summit meetings, in November 2008, the first of the five policy areas in the area of reforming financial markets was transparency and accountability. Strengthening Transparency: We will strengthen financial market transparency, including by enhancing required disclosure on complex financial products and ensuring complete and accurate disclosure by firms of their financial conditions. Incentives should be aligned to avoid excessive risk-taking. (G-20, 2008a, paragraph 9) In detailing how they were to achieve the desired reforms in this area, the G-20 leaders agreed to a series of short-term and medium-term actions, most of which require changes in specific accounting regulations or in the manner in which accounting is regulated (G-20, 2008b, p. 1): Immediate Actions by March 31, 2009 • The key global accounting standards bodies should work to enhance guidance for valuation of securities, also taking into account the valuation of complex, illiquid products, especially during times of stress. • Accounting standard setters should significantly advance their work to address weaknesses in accounting and disclosure standards for off-balance sheet vehicles. • Regulators and accounting standard setters should enhance the required disclosure of complex financial instruments by firms to market participants. • With a view toward promoting financial stability, the governance of the international accounting standard setting body should be further enhanced, including by undertaking a review of its membership, in particular in order to ensure transparency, accountability, and an appropriate relationship between this independent body and the relevant authorities. • Private sector bodies that have already developed best practices for private pools of capital and/or hedge funds should bring forward proposals for a set of unified best practices. Finance Ministers should assess the adequacy of these proposals, drawing upon the analysis of regulators, the expanded FSF [Financial Stability Forum], and other relevant bodies. Medium-term actions • The key global accounting standards bodies should work intensively toward the objective of creating a single high-quality global standard. • Regulators, supervisors, and accounting standard setters, as appropriate, should work with each other and the private sector on an ongoing basis to ensure consistent application and enforcement of high-quality accounting standards. • Financial institutions should provide enhanced risk disclosures in their reporting and disclose all losses on an ongoing basis, consistent with international best practice, as appropriate. Regulators should work to 12 The G-20 is a forum for the financial ministers and central bank governors from 19 of the world’s largest economies plus the EU. In responding to the GFC, the G-20 convened a series of semi-annual summits of the leaders of the G-20. 89 Financial Accounting Theory ensure that a financial institution’s financial statements include a complete, accurate, and timely picture of the firm’s activities (including off-balance sheet activities) and are reported on a consistent and regular basis. At the G-20 summit in September 2009, the G-20 called for further strengthening of accounting standards in the form of early completion (by June 2011) of the FASB/IASB convergence project, aiming to produce a single set of accounting standards for use internationally. By the time of the June 2010 summit, this timetable had slipped, with a revised target to achieve convergence by the end of 2011: We re-emphasized the importance we place on achieving a single set of high quality improved global accounting standards. We urged the International Accounting Standards Board and the Financial Accounting Standards Board to increase their efforts to complete their convergence project by the end of 2011. (G-20, 2010, p. 20, paragraph 30) The convergence project was not completed by the end of 2011, which prompted the G-20 to ask that the IASB and FASB set a new deadline of mid 2013 for convergence (as reported by Reuters in an article on 5 November 2012 entitled ‘G20 hopes for fourth time lucky on global accounting’). This deadline was not met and there is an acceptance now that such convergence, if it is to occur, is some time away (in Chapter 5 we examine some arguments that question the logic of international convergence of accounting standards). According to a ‘Final Staff Report’ issued by the US SEC (2012), some of the reasons against the convergence of the accounting standards issued by the IASB and the FASB included: • too much diversity in how IFRS were being interpreted, applied and enforced in various jurisdictions throughout the world • the potentially high costs to US organisations of adopting IFRS • the cost involved in educating US investors • the implications for changes in corporate governance. Interestingly, in 2019 the International Federation of Accountants issued a report entitled The Global Accountancy Profession’s Call to Action for G20 Leaders: Counting on Society 5.0, in which it made various calls for revised regulation across countries that are ‘fundamental to achieving the G20’s aim of fair and sustainable development through an agenda that is people centred, inclusive and forward looking. These are actionable steps toward realizing the United Nations Sustainable Development Goals and Japan’s global vision for ‘Society5.0’” (IAF, 2019). The ‘Call for Action’ is shown in Figure 3.2. We return to issues of international convergence in accounting standards in Chapter 5, but at this stage we can see how various factors can influence the development of accounting regulation, including pressure from powerful groups such as the G-20. Specifically, we can see how significant events such as the GFC create pressures on regulators to change, or create pressures for changes, in accounting practices. In more recent times, the implications of the COVID-19 pandemic have also led to calls for changes in accounting practice, particularly in relation to accounting for the impairment of non-current assets. In Chapter 4, we discuss what motivates regulators or politicians to make changes to regulations in response to such pressures, and see that there are a variety of theories to explain regulators’ actions and motivations.13 13 90 For example, some researchers might assume that regulations were introduced because regulators believed it was in the public interest to introduce such regulation. Alternatively, some researchers who embrace the view that everybody in society is primarily motivated by their own self-interest (perhaps not an overly optimistic view of human nature) would assume that regulators support particular regulation because it is in their own self-interest to do so. For example, Taylor (2009, p. 319) argues that ‘legislative intervention to create new regulations and regulatory apparatus is frequently a reflection of how players in the political arena attempt to ensure they are not held to blame for investor losses’. The financial reporting environment CHAPTER 3 FIGURE 3.2 The Global Accountancy Profession’s ‘Call to Action’ for G20 leaders Smarter regulation 1 Make Regulation Smarter, and More Effective 2 Create a Consistent, Transparent, Global Regulatory Environment 3 Implement Internationally Accepted Standards Heightened transparency 4 Strengthen Governance 5 Embrace Integrated Reporting 6 Enhance Public Sector Financial Management 7 Collaborate to Tackle Corruption Inclusive growth 8 Create an Environment for Small and Medium-sized Entity Growth and Inclusiveness 9 Create a Secure and Digital Ready Investment Environment 10 Collaborate for a Coherent International Tax System Source: Adapted from International Federation of Accountants (2019), The Global Accountancy Profession’s Call to Action for G20 Leaders: Counting on Society 5.0, https://www.ifac.org/system/files/publications/ files/GAP-Counting-on-Society-5.0-paper-v4.pdf, p. 1. Why do I need to know about how the regulation of financial accounting has developed? In some capacity or another, we will all be influenced by numbers generated through general purpose financial reporting. Financial accounting numbers, such as the profits of large organisations listed on securities exchanges, are often given much media coverage. Such numbers, in turn, influence dividend payments, share prices, wage growth expectations and so forth. Knowing about the evolution of financial accounting regulation helps us to be able to place in context such widely used financial numbers. Further, for those of us who will have a career in accounting, whether it perhaps be as a practitioner or as a researcher, it should be of interest to know how events, such as particular global financial, social or environmental crises have influenced the accounting practices we know. For example, in very recent years, regulators throughout the world have required reporting entities to consider how climate change is influencing the financial performance and financial position of organisations and have issued related guidance. In this regard, regulators such as the IASB, International Sustainability Standards Board (ISSB) and the AASB have recently released requirements pertaining to how changing laws and expectations around climate change must be kept in mind when considering the impairment of assets, and the useful lives of assets for depreciation purposes. The COVID-19 pandemic has also led to changing financial reporting guidance. Therefore, to understand current practice, it is useful to understand that the body of accounting regulation in place at a point of time has been influenced by a multitude of past events – some financial, some environmental and some social. The rationale for regulating financial accounting practice LO3.1 LO3.3 LO3.4 As indicated, even though financial reports have been in existence for hundreds of years, the regulation of accounting in economies dominated by capital markets (with large numbers of external investors) is a fairly recent phenomenon. Early moves for regulation of accounting were introduced in the United States around the 1930s and followed events such as the Wall Street stock-market crash of 1929. Rightly or wrongly, it was argued that problems inherent to accounting led to many poor and uninformed investment decisions (Boer, 1994; Ray, 1960), and this fuelled the public desire for information generated by companies to be subject to greater regulation. 91 Financial Accounting Theory In most countries with developed capital markets and large numbers of external investors, there is a multitude of financial accounting regulations covering a broad cross-section of issues. But do we need all this regulation? As the next chapter discusses, there are two broad schools of thought on this issue. There are parties who argue that regulation is necessary, and their reasons include the following: • Markets for information are not efficient and without regulation a sub-optimal amount of information will be produced. • While proponents of the ‘free-market’ (or ‘anti-regulation’) approach to providing accounting information may argue that the capital market on average is efficient, such ‘on average’ arguments ignore the rights of individual investors, some of whom can lose their savings as a result of relying on unregulated disclosures. • Some parties who demand information about an organisation can obtain their desired information due to the power they possess as a result of their control over scarce resources required by the organisation. Conversely, parties with limited power (limited resources) will generally be unable to secure information about an organisation, even though that organisation may impact on their existence. • Investors need protection from fraudulent organisations that may produce misleading information, which, due to information asymmetries, cannot be known to be fraudulent when used. • Regulation leads to uniform methods being adopted by different entities, thus enhancing comparability. Other parties argue that regulation is not necessary, particularly to the extent that it currently exists. Some of the reasons cited against accounting regulation include the following: • Accounting information is like any other good, and people (financial statement users) will be prepared to pay for it to the extent that it has use. This will lead to an optimal supply of information by entities.14,15 • Capital markets require information, and any organisation that fails to provide information will be punished by the market; an absence of information will be deemed to imply bad news.16 • Because users of financial information typically do not bear its cost of production, regulation will lead to an over-supply of information (at a cost to the producing firms) as users will tend to overstate the need for the information. • Regulation typically restricts the accounting methods that may be used. This means that some organisations will be prohibited from using accounting methods that they believe most efficiently reflect their particular performance and position. This is considered to impact on the efficiency with which the organisation can inform the markets about its operations.17 When regulation is introduced, there are various theories available to describe who benefits from such regulation. There is the public interest theory of regulation, which proposes that Advocates of a regulated approach would argue, however, that accounting information is a public good and, as a result, many individuals will obtain the information for free (this is often referred to as the ‘free-rider’ problem). Once this occurs, reliance on market-mechanism arguments tends to be flawed and the usual pricing mechanisms of a market cannot be expected to operate (Cooper and Keim, 1983). 15 This ‘free-market’ perspective is adopted by researchers who work within the ‘agency theory paradigm’. This paradigm is discussed in Chapter 8. 16 Accepting this perspective, and consistent with Akerlof (1970), companies that fail to produce the necessary information, particularly if the information is being produced by other entities, will be viewed as ‘lemons’ (a ‘lemon’ is something of inferior quality), and these ‘lemons’ will find it more costly to attract funds than other (‘non-lemon’) entities. 17 For example, pursuant to IAS 38 Intangibles (which, for example, is equivalent to AASB 138 Intangibles in the Australian context), all expenditure on research has to be expensed as incurred. This means that all companies have to adopt the same ‘one-size-fits-all’ approach, even though some entities may have undertaken very valuable research that will lead to significant future economic benefits. On the basis of efficiency, this regulation is deemed to be inappropriate, as it does not allow annual report readers to differentiate between companies with or without valuable research. 14 92 The financial reporting environment CHAPTER 3 regulation is introduced to protect the public. This protection may be required as a result of inefficient markets. Public interest theory assumes that the regulatory body (usually government) is a neutral arbiter of the ‘public interest’ and does not let its own self-interest impact on its rule-making processes. According to Scott (2003, p. 448), following public interest theory, the regulator ‘does its best to regulate so as to maximise social welfare. Consequently, regulation is thought of as a trade-off between the costs of regulation and its social benefits in the form of improved operation of markets’. A contrary perspective of regulation is provided by Capture Theory, which argues that, although regulation is often introduced to protect the public, the regulatory mechanisms are often subsequently controlled (captured) so as to protect the interests of particular self-interested groups within society, typically those whose activities are most affected by the regulation. That is, the ‘regulated’ tend to capture the ‘regulator’. Posner (1974, p. 342) argues that ‘the original purposes of the regulatory program are later thwarted through the efforts of the interest group’. Empirical evidence of a regulator making individual decisions that favour the groups that it regulates is not sufficient to demonstrate regulatory capture (as each of these decisions might be regarded as the most appropriate in the circumstances). Rather, most of the regulator’s whole program of regulation needs to work in the interests of the regulated and usually against the interests of those who the regulator is intended to protect. This implies that accounting regulations can have a different impact on different people or groups, and there is evidence (discussed in the next chapter) showing that specific accounting regulations do have social and/ or economic consequences that vary between different groups. As an example of Capture Theory, Walker (1987) argues that in less than two years following the establishment of the Accounting Standards Review Board (ASRB) in Australia (subsequently replaced by the AASB), the Australian accounting profession (the ‘industry’ subject to the regulation) was able to control, or capture, the ASRB’s regulatory process. Walker provides evidence to support this claim, including the subsequent merger of the Australian Accounting Research Foundation (the professionally funded body) with the AASB (the government body), and that the great majority of issues to be addressed in accounting standards were raised by the accounting profession itself.18 Both public interest theories and capture theories of regulation assert that initially regulation is put in place to protect the public (Capture Theory simply asserts that the regulated will then subsequently attempt to control the regulatory process). Another view, which is often referred to as private interest theory (or economic interest group theory), is proposed by researchers such as Stigler (1971) and Peltzman (1976). This theory relaxes the assumption that regulations are initially put in place to protect the public interest, as well as the assumption that government regulators are neutral arbiters not driven by self-interest. Stigler (1971) proposes that governments are made up of individuals who are self-interested and will introduce regulations more likely to lead to their re-election. In deciding on a particular regulation, they will consider the impacts on key voters, as well as on election campaign finances. Individuals with an interest in particular legislation are deemed more likely to get their preferred legislation if they can form themselves into large organised groups with strong cohesive voting power. These theories of regulation (public interest theory, Capture Theory and private interest theory), as well as others, are further considered in Chapter 4. 18 The establishment of the ASRB in the first place, however, can be explained by a public interest theory perspective. Prior to the establishment of the ASRB, accounting standards in Australia were released by a private sector body, the Australian Accounting Research Foundation (AARF). The AARF, which was not a government body, had limited ability to impose sanctions against entities that did not follow the AARF standards. This was believed to be a major cause of the numerous corporate non-compliances, and the associated social and economic costs that such non-compliances might cause. The ASRB, a government body, was established to give legal backing to accounting standards through the operation of the Corporations Law. With renewed confidence in the information being produced, there was also a view that the capital markets would function more efficiently, which would be considered to be in the public interest. 93 Financial Accounting Theory If we are to accept the need for accounting regulation, a further issue to consider is who should be responsible for the regulation: should it be in the hands of the private sector (such as the accounting profession) or in the hands of the public (government) sector?19 Can private sector regulators be expected to put in place regulations that are always in the public interest or will they seek to put in place rules that favour their own constituency? Obviously, the answer to such questions will be dependent on our particular view of the world (and our own view of the world will in turn influence which particular theory of regulation we are more likely to embrace). Advocates of private sector accounting standard-setting would argue that the accounting profession is best able to develop accounting standards because of its superior knowledge of accounting and because of the greater likelihood that its rules and regulations would be accepted by the business community. Proponents of public sector accounting standard-setting argue that government has greater enforcement powers, hence the rules of government are more likely to be followed. It might also be less responsive to pressures exerted by business and more likely to consider the overall public interest. What is demonstrated in subsequent chapters is that the regulation of accounting (or indeed an absence of regulation) can have many economic and social consequences. As such, the accounting standard-setting process is typically considered to be a very political process, with various interested parties lobbying the standard-setters. The costs and benefits of accounting regulation At the core of the accounting process is an expectation that accountants should be objective and free from bias when performing their duties. The information being generated should faithfully represent the underlying transactions and events and it should be neutral and free from error (see paragraphs 2.12 to 2.18 of the IASB Conceptual Framework).20 However, can we really accept that accounting can be ‘neutral’ or objective? Throughout the world, accounting standard-setters, such as the IASB and the FASB, have explicitly considered the economic and social implications of possible accounting standards prior to their introduction. (The consideration of economic and social consequences prior to the release of an accounting standard is specifically referred to in the IASB Conceptual Framework.) If the economic or social implications of a particular accounting standard have been deemed to be significantly negative, then it is likely that the introduction of the standard would have been abandoned, even though the particular standard may have been deemed to reflect more accurately particular transactions or events. While it is difficult to criticise a process that considers potential impacts on others, it is nevertheless difficult to accept that accounting standards are neutral or unbiased if the fear of the potential economic or social consequences relating to a potential accounting standard – and the information it will make available – are used as a rationale not to release an accounting standard. In a sense, the acceptance of the need to consider economic and social consequences as part of the standard-setting process has created a dilemma for standard-setters. According to Zeff (1978, p. 62): The board (FASB) is thus faced with a dilemma which requires a delicate balancing of accounting and non-accounting variables. Although its decisions should rest – and be In some countries, accounting regulation is in the hands of both private sector and public sector entities. As an example, within the EU, accounting regulations are developed by the IASB (private sector) but have to be endorsed by the ARC (public sector) before they are enforced for EU companies. In the United States, both the FASB (private sector) and the SEC (public sector) have released accounting standards. In Australia, and following restructuring that occurred a number of years ago, accounting standard-setting is now in the hands of the AASB, a government body. 20 According to Hines (1991, p. 330), it is in the accounting profession’s interest to promote publicly, perhaps through conceptual frameworks, a perspective of objectivity. As she states, ‘the very talk, predicated on an assumption of an objective world to which accountants have privileged access via their “measurement expertise”, serves to construct a perceived legitimacy for the profession’s power and autonomy’. 19 94 The financial reporting environment CHAPTER 3 seen to rest – chiefly on accounting considerations, it must also study – and be seen to study – the possible adverse economic and social consequences of its proposed actions … What is abundantly clear is that we have entered an era in which economic and social consequences may no longer be ignored as a substantive issue in the setting of accounting standards. The profession must respond to the changing tenor of the times while continuing to perform its essential role in the areas in which it possesses undoubted expertise. Referring to the IASB Conceptual Framework (IASB, 2022), we find: Paragraph 2.42: In applying the cost constraint, the Board assesses whether the benefits of reporting particular information are likely to justify the costs incurred to provide and use that information. When applying the cost constraint in developing a proposed Standard, the Board seeks information from providers of financial information, users, auditors, academics and others about the expected nature and quantity of the benefits and costs of that Standard. In most situations, assessments are based on a combination of quantitative and qualitative information. Paragraph 2.43: Because of the inherent subjectivity, different individuals’ assessments of the costs and benefits of reporting particular items of financial information will vary. Therefore, the Board seeks to consider costs and benefits in relation to financial reporting generally, and not just in relation to individual reporting entities. That does not mean that assessments of costs and benefits always justify the same reporting requirements for all entities. Differences may be appropriate because of different sizes of entities, different ways of raising capital (publicly or privately), different users’ needs or other factors. In Chapter 13, we consider the works of researchers whose work is informed by what is referred to as ‘critical accounting theory’. These theorists also question the objectivity of financial reporting standards, and they argue that all the accounting standards in place simply act to support the interests of financial capital providers while effectively marginalising the interests of other stakeholders, such as workers. That is, these theorists believe that the ‘benefits’ generated from general purpose financial reporting disproportionately favour capital market participants to the detriment (cost) of other stakeholders. Regulation and enforcement For regulation to be effective, it also jointly requires appropriate monitoring and enforcement mechanisms to be in place. Logically, the existence of regulation without strong mechanisms to ensure regulatory compliance renders any regulation ineffectual. In this chapter we have discussed the requirement for large organisations to prepare general purpose financial statements. For most countries throughout the world, the requirement in these countries is that these statements shall comply with the accounting standards issued by the IASB, with these standards referred to as International Financial Reporting Standards (IFRS). According to the website of the IASB (https://www.ifrs.org), 144 jurisdictions use IFRS for all, or most, of their publicly listed companies, while a further 12 jurisdictions permit their use. The moves towards international standardisation of financial reporting have been in place now for over two decades and these moves have been there because of the perception that international standardisation of financial reporting practice brings many benefits. In this regard, the IFRS website (2022) states: IFRS Standards provide a high quality, internationally recognised set of accounting standards that bring transparency, accountability and efficiency to financial markets around the world. 95 Financial Accounting Theory IFRS Standards bring transparency by enhancing the international comparability and quality of financial information, enabling investors and other market participants to make informed economic decisions. IFRS Standards strengthen accountability by reducing the information gap between the providers of capital and the people to whom they have entrusted their money. Our Standards provide information that is needed to hold management to account. As a source of globally comparable information, IFRS Standards are also of vital importance to regulators around the world. And IFRS Standards contribute to economic efficiency by helping investors to identify opportunities and risks across the world, thus improving capital allocation. For businesses, the use of a single, trusted accounting language lowers the cost of capital and reduces international reporting costs. The benefits of international standardisation of financial reporting practices, some referred to in the above quote, are premised on the basis that when countries move to adopt IFRS, and later claim that their national organisations are applying IFRS, that they also have in place mechanisms to enforce widespread national compliance with IFRS. However, the reality is that there are many countries (particularly some developing countries) that claim that their large companies are applying IFRS, when, due to ineffective or non-existent national enforcement strategies, they are not. The IASB, which is located in London and is under the auspices of the IFRS Foundation, has no power to enforce its accounting standards. Its role is to develop accounting standards (it is a standard-setting body and not an enforcement body), which it then hopes will be adopted throughout the world, but again, it has no power to enforce compliance. Rather, it is left to national regulators to ensure compliance within their respective countries. Many countries have very poor enforcement programs such that even though companies might be publicly stating that they are applying IFRS, they really are not complying with the requirements of the many accounting standards. Therefore, even though we might be told that IFRS have been adopted in many countries throughout the world, this really needs to be tempered by the fact that many of these countries have very poor enforcement strategies in place such that high levels of non-compliance render any claims that IFRS have been applied as incorrect. We return to this issue of enforcement as it relates to the international standardisation of accounting practice in Chapter 5. The role of professional judgement in financial accounting LO3.5 As we know from studying accounting, the process involved in generating financial statements depends on many professional judgements. While the accounting treatment of many transactions and events is regulated, a great deal of accounting treatment pertaining to other transactions and events is unregulated. Even when particular regulations are in place, for example that property, plant and equipment such as buildings must be depreciated, there is still scope to apply judgement in selecting the useful life of the building and the residual value. Many such judgements must be made. For example, should an item of expenditure be capitalised or expensed, or should an income item be recognised now or deferred to a future reporting period? This in turn will depend on crucial assessments as to whether the expenditure is likely to generate future economic benefits or whether the expected future inflow of economic benefits (the income) is deemed reasonably likely to occur this period, next period or potentially not at all. Chapters 8 and 9 consider various theoretical perspectives proposed as explanations for why particular accounting methods may be implemented by a reporting entity (remember, the 96 The financial reporting environment CHAPTER 3 accounting treatment of many transactions and events is not subject to accounting standards). Consistent with the perspective that managers and their accountants should prepare reports that are representationally faithful is a view that organisations and their stakeholders are best served when managers select those accounting methods that best reflect their underlying performance. This is referred to as an ‘efficiency perspective’ (derived from Positive Accounting Theory, which is explained in Chapter 8). The efficiency perspective asserts that different organisational characteristics explain why different organisations adopt different accounting methods (Jensen and Meckling, 1976). For example, a view often promoted by some accounting researchers is that organisations that have different patterns of use in relation to a particular type of asset will be predicted to adopt different amortisation policies. Advocates of the efficiency perspective argue that organisations should be able to choose those accounting methods that best reflect their performance and circumstances, and that accounting regulations that restrict the set of available accounting techniques will be costly in the sense that they will restrict the ability of managers to provide measures that efficiently represent, or signal, the performance of the organisation. For example, if a new accounting standard is released that bans a particular accounting method being used by a reporting entity, this will lead to inefficiencies as the resulting financial statements may no longer provide the best reflection of the performance of the organisation. Some accounting researchers argue that management is best able to select which accounting methods are appropriate in given circumstances, and government or other bodies should not intervene through the standard-setting process. This perspective, however, does not consider that some financial statement preparers may be less than objective (that is, as with Enron or WorldCom, they may be creative) when preparing the financial reports. The efficiency perspective also dismisses the comparability benefits that may arise if standard-setters reduce the available set of accounting methods. An alternative perspective to explain why particular accounting methods are selected (that is also derived from Positive Accounting Theory, which we explore in Chapter 8) is the ‘opportunistic perspective’. This perspective does not assume that those responsible for selecting accounting methods will be objective. Rather, it assumes that managers and accountants, like most people, will be driven by self-interest (Watts and Zimmerman, 1978). This perspective provides an explanation of the practice of ‘creative accounting’, which is defined as an approach to accounting wherein objectivity, or representational faithfulness, is not prioritised, but rather refers to a situation where those responsible for the preparation of accounts select accounting methods that provide the accounting result desired by the preparers. As an example, an organisation might, like Enron, opportunistically elect to structure certain transactions in a manner designed to remove specific assets and related liabilities from its balance sheet (a technique known as off balance sheet funding). This is not because these assets and liabilities do not ‘belong’ to the organisation, but perhaps because this off balance sheet funding has the effect of reducing the reported debt to equity (capital gearing) ratio at a time when the organisation is close to breaching particular accounting-based agreements negotiated with external parties, such as loan agreements that have a stipulated minimum allowable debt to equity ratio, below which particular assets of the reporting entity may be seized. Apart from the efficiency and opportunistic perspectives, there are a number of other theoretical perspectives proposed to explain why managers might select particular accounting and disclosure policies (other perspectives include those coming from Legitimacy Theory, Political Economy Theory, Institutional Theory, Stakeholder Theory and Critical Accounting Theory). Chapters 9 and 13 further explore some of the alternative theoretical perspectives. However, what is being emphasised at this point is that, although there is much accounting regulation in place (and there are various theories to explain the existence of regulation), there are also many accounting decisions that are unregulated (giving rise to various theories to explain the accountants’ and managers’ choices of particular accounting methods from the set of available alternatives). 97 Financial Accounting Theory REFLECTION QUESTION 3.2 Application of professional judgement in accounting The existence of a high degree of professional judgement in financial accounting practice raises a number of issues, or questions, that we can potentially address or answer through the application of appropriate theory. Question What are some of these issues that we might address through the application of different theories? Solution Some of the questions that researchers might like to address in relation to the application of professional judgement in accounting include: 1 What are some of the costs and benefits associated with government bodies and other regulators allowing professional judgement to be applied in respect of accounting for certain transactions and events? 2 Why do regulators allow professional judgements to be applied by accountants (which is effectively a principlesbased approach to regulation) rather than mandating strict rules that must be followed (which would be considered to represent a rules-based approach to regulation)? We consider theories of regulation in Chapter 4. 3 What are some of the motivations driving managers and their accountants to make certain accounting choices (for example, as Chapter 8 discusses, we can apply efficiency arguments, or opportunism-based arguments, to explain managers’ accounting choices)? 4 How do the users of accounts react to different accounting numbers at both the individual level (perhaps explored through some form of behavioural research, which we look at in Chapter 12) and at an aggregated level (perhaps explored through measuring the movements of share prices within capital markets as particular information is released – an area we explore in Chapter 11)? 5 Does allowing professional judgement to be applied provide relatively greater benefits to particular categories of stakeholders (relative to strictly enforced rules), and what are those respective benefits (we could use some form of stakeholder theory to address this issue – stakeholder theory is addressed in Chapter 9 – or we could use insights from critical accounting theories, which are addressed in Chapter 13)? 6 What are some of the attributes of preparers and/or their organisations that influence accounting policy choice (for example, the organisations’ total debt, closeness to breaching debt covenants, size, industry, profitability, whether managers are on an accounting-based bonus scheme – such issues are addressed in Chapter 8. Behavioural research, which is discussed in Chapter 12, also explains how particular behavioural attributes can influence accounting policy choice)? 7 Whether there are systematic international differences in the accounting choices made by managers and their accountants (we consider international differences in accounting in Chapter 5). Why do I need to know that financial accounting numbers rely very much on the exercise of professional judgement? If you are to read accounting reports, then it is important that you understand that many judgements have been made by the managers, and their accountants, in the formulation of the accounting reports. In respect of financial accounting, and given the amount of professional judgement involved, it is quite true to say that if we had a medium to large organisation with many transactions and events, and if we asked a number of teams of accountants to prepare the financial statements independently, then it would be almost impossible that the different teams of accountants would come up with the same income, expenses, assets and liabilities. Indeed, there could be quite significant differences in the accounting numbers generated. With this in mind, we should think about whether there are particular 98 attributes of an organisation, or the managers, that makes it likely that managers might have used their judgement opportunistically and against the best interests of the various stakeholders, or whether they select those accounting methods that most efficiently represent the actual performance of the organisation. Theory can provide such insights. We should also consider why regulators have potentially opted for ‘principles-based accounting rules’ wherein guidelines or principles for reporting are provided (for example, that property, plant and equipment should be depreciated over their useful lives), rather than prescribing detailed rules that must be adhered to (for example, that buildings must be depreciated over 40 years). The accounting standards of the IASB are considered to be fundamentally principles-based in nature. The financial reporting environment CHAPTER 3 LO3.4 LO3.6 How powerful is the accountant? The idea of accountants being very powerful individuals within society is probably not an idea that is shared by many people. Indeed, accountants might be unfairly seen as being rather boring, unimaginative and methodical individuals. Certainly, this is the stereotype that is attributed to accountants.21 According to Bougen (1994), such a view is, in large part, driven by the interdependency between accounting and bookkeeping. Reflecting on the work of Bougen, Dimnik and Felton (2006, p. 133) state: Although much accounting work requires judgment, imagination and creativity, bookkeeping is boring and routine. Bougen suggests that historically accountants may have been willing to accept a personally disparaging, often laughable image because it was in their professional interest to do so. Since bookkeeping is also identified with positive characteristics such as objectivity, accuracy and conservatism, the stereotype of the unimaginative, harmless, methodical number cruncher may have actually heightened the accountant’s reputation for dependability, giving the profession more credibility with the public. Following from this quote, it could be argued that accountants might actually have decided to embrace an unimaginative and harmless persona because of the financial benefits associated with being seen as ‘dependable’ and ‘credible’. How clever! Nevertheless, accountants are frequently the subject of many a cruel joke. They are often portrayed as small, weak individuals with poor social skills. For example, consider the depictions of accountants in various movies and television programs. In the (in)famous Monty Python lion tamer sketch, in which John Cleese is cast as a recruitment consultant who interviews Michael Palin (who plays Mr Anchovy, the accountant and aspiring lion tamer), Cleese describes the accountant as: An extremely dull fellow, unimaginative, timid, lacking in initiative, spineless, easily dominated … Whereas in most professions these would be considerable drawbacks, in accountancy they are a positive boon.22 Some of us ‘older folk’ might also remember such characters as Louis Tully, the ‘nerd’ accountant in Ghostbusters (1984), who invites business associates to a party rather than friends so as to make the party tax-deductible, and Leo Getz, the bumbling accountant who constantly annoys two police officers in Lethal Weapon 2 (1989) and Lethal Weapon 3 (1992). In past decades, and within the Australian context, CPA Australia tried to distance itself from the accounting stereotype by promoting members of CPA Australia as ‘not being your average accountant’. This form of promotion in itself appears critical of most (the ‘average’) accountants. Many accounting firms within Australia also embraced this approach. A recent search of the internet (2022) using the words ‘not your average accountant’ shows that many accounting firms still attempt to differentiate themselves from other accountants by specifically noting on their website that they are ‘not your average accountants’. Of course, this begs the question – if none of these firms are ‘your average accountant’, then where does one find an ‘average accountant’? While accountants may be the subject of such (poorly informed and unpleasant) depictions and taunts as discussed above, and there might be concerns about the character of abilities of ‘the average accountant’, which might in turn create pressures to create some form of differentiation, According to Dimnik and Felton (2006, p. 131), a stereotype may be defined as a collection of attributes believed to describe the members of a social group. 22 Smith and Briggs (1999) provide a comprehensive overview of how accountants have been portrayed in movies and on television. Other research that looks at how accountants are depicted in movies includes Cory (1992), Beard (1994), Holt (1994) and Christensen and Rocher (2020). 21 99 Financial Accounting Theory we can rest in the knowledge that we accountants are indeed very powerful individuals.23 The assertion that accountants are powerful (which is obviously more flattering than being seen as dull and unimaginative) is based on a number of perspectives, as follows: 1 The output of the accounting process (for example, profits, total assets, total liabilities or net asset backing per share) impacts on many decisions, such as whether to invest in or lend funds to an entity, whether to lobby for increased wages based on profitability, whether to place an entity into technical default for failure to comply with previously agreed accounting-based restrictions, whether to lobby government for intervention because of excessive profits, and so on. That is, many transfers of funds (and therefore wealth) arise as a result of reports generated by accountants through the accounting process. Many extremely large companies throughout the world have had to cease operations because they breached various borrowing agreements, ones that are directly tied to numbers generated by the accountant (for example, organisations might have entered an agreement that restricts the amount of debt they can borrow relative to their total assets). Because accounting is heavily reliant on professional judgement, the judgement of the accountant can directly impact upon various parties’ wealth. 2 There is also a perspective that accountants, in providing relevant and representationally faithful information to interested parties, can, in a sense, provide or transfer to them a source of ‘power’ to drive changes to corporations’ behaviour. That is, accounting information informs people about certain aspects of an organisation’s performance and this information, compiled by accountants, might motivate the people to take various actions that might be advantageous or disadvantageous to the organisation and, indeed, to society more generally (remember we have argued previously that accounting is both a technical and social practice). Such actions might not be initiated in the absence of the accounting information. As Gray (1992, p. 404) states: … power can be exercised in some degree by all … external parties. For that power to be exercised there is a basic need for information (as an essential element of the participatory democratic process …) and this information will be an extension of that currently available. That is, the widest possible range of participants must be emancipated and enabled through the manifestation of existing but unfulfilled rights to information. Accountants generate information that is used to guide the actions of many people throughout society. Indeed, a deal of the ‘language’ used in business is directly tied to the work undertaken by the accountant. 3 By emphasising particular performance attributes (such as profits), accountants can give legitimacy to organisations that otherwise may not be deemed to be legitimate. The financial press often praises companies because of their reported profits. That is, profitability might tend to be a ‘proxy’ for legitimacy and overall ‘success’. However, profitability is also often used as a basis for criticising a company. For example, consumer groups or employee groups might use the reported profits of a company as a justification for demanding that the company reduce the costs of its goods or services, or pay higher salaries to its workforce. What is being emphasised here is that the output of the accounting system is used in many different ways throughout society, which is further evidence of the influence of accounting and therefore of accountants. 23 100 In further research, Dimnik and Felton (2006) undertook a review of 121 movies and, while many accountants are depicted as ‘plodders’ (having low-level jobs with little status) or ‘dreamers’ (deemed to be out of touch with reality), a number of movies actually portray the accountant as a hero. More recently, the release of the movie, The Accountant (2016), depicted the story of a forensic accountant who was an anti-hero who eliminated several people of questionable morality. Perhaps we are finally reaching a point where accountants are deemed more generally to be powerful people. The financial reporting environment CHAPTER 3 When accounting standard-setters, such as the IASB or FASB, create new rules this can lead to economic and social consequences. For example, originally, when a company issued share options to its managers, this was not typically recognised as an expense of the company. However, for a number of years this has no longer been allowed and an expense must now be attributed to the granting of share options. There is evidence to show that this accounting change had a real influence on the use of share options to motivate employees, and the use of share options decreased. As a second example, when Australia adopted IAS 38 Intangibles (which is released as AASB 138 in the Australian context) in 2005, this required all research expenditure to be expensed as incurred whereas previously there was the option within Australia of capitalising applied research. There was widespread concern that this accounting change would negatively impact the amount of research being undertaken given its impact on reported profits or losses. Third, we can consider an accounting standard on leasing that took the IASB years to finalise, in large part because of the potentially significant impacts it was going to have on reporting entities’ balance sheets. This standard, IFRS 17 Leases (AASB 17 in the Australian context), which was operational after 2016, created some reduction in the use of leases of property, plant and equipment because many such leases are now required to be shown on the balance sheet when previously many (those previously designated as operating leases) were not required to be disclosed. We could give many more such examples, but what is being emphasised here is that when a new accounting standard is released the effects can reverberate throughout society, and not just in the offices of accountants. Further reflecting on the above points, consider the work of Hines (1988, 1991). Hines (1991, p. 313) stresses a perspective that ‘financial accounting practices are implicated in the construction and reproduction of the social world’. What she is arguing is that by emphasising a measure such as profits (which ignores many negative social and environmental impacts), accounting can lead people to support particular organisations that may not otherwise be supported. By holding ‘profitability’ out as some ‘ideal’ in terms of performance, profitable companies are often considered to be ‘good companies’, despite the fact that they might generate various negative social and environmental impacts. In terms of everyday experiences, we often find that news media reports emphasise the profits, or perhaps, record profits of organisations – typically larger organisations. If profits increase from one period to the next (or if the profits are larger than those of other organisations in the industry), this is typically portrayed by journalists as a sign of sound management. The earning of profits tends to be seen as consistent with a notion of legitimacy – profits are reported and emphasised as some form of objective measure of performance. But as we know, and what the news media typically neglects to note, the measure of ‘profits’ really depends on the assumptions and judgements made by the particular team of accountants involved. In media reports, no mention is typically made of the accounting methods employed by the organisations being discussed or how the accounting methods or policies being used might have changed from previous periods (perhaps because of a choice made by the managers or because a new accounting standard was released which prohibited previously used methods). Indeed, media articles often compare profits of the different organisations as some form of performance benchmarking. However, some of the differences in reported profits might be due to the fact that the organisations being compared might be using different accounting methods for some types of transactions. Also, news articles often make comparisons with previous years’ profits despite the fact that this is fraught with problems given that accounting methods do change across time, thereby making prior period profit comparisons somewhat problematic (when you get the opportunity, you can look at the financial news media yourself and see how financial measures, such as profits, are discussed and whether the above commentary is applicable). In a sense, there is no ‘shared reality’ between accountants and non-accountants because many nonaccountants, including financial journalists who often have no education in accounting, think that ‘profit’ is a ‘hard’ number that is objectively determined without the need for professional 4 101 Financial Accounting Theory judgement; whereas we, as accountants, know that much judgement is required in calculating profits. This is typical of media coverage given to corporate performance, with accounting results (such as profits) being apparently promoted as hard, objective calculations. Financial accounting can engender such views because it is promoted (through such media as the IASB Conceptual Framework) as being representationally faithful, and therefore complete, neutral and free from error, and having the capacity to reflect accurately underlying facts.24 As Hines (1991, p. 315) states in relation to conceptual framework projects: It appears that the ontological assumption underpinning the Conceptual Framework is that the relationship between financial accounting and economic reality is a unidirectional, reflecting or faithfully reproducing relationship: economic reality exists objectively, inter-subjectively, concretely and independently of financial accounting practices; financial accounting reflects, mirrors, represents or measures this preexistent reality. What also should be appreciated is that the measures of profit calculated for the many organisations discussed in the multitude of news media articles ignore many social and environmental externalities caused by the reporting entity. For example, in recent years there have been many articles about the record profits of banks at the same time that banks continued to retrench workers and, while this ‘slashing of worker numbers’ might have positive impacts on reported profit, such retrenchments cause various social costs for the unemployed (and they also cause costs for governments, and hence taxpayers, in terms of unemployment benefits). Accounting, however, ignores these externalities – something we explore more fully in Chapter 10. A counterview to the perspective provided in frameworks such as the IASB Conceptual Framework (that accounting is complete, neutral and free from error and thereby provides an accurate reflection of a pre-existent reality) is the view adopted by Hines that accountants can, in a sense, create different realities, depending on the particular judgements taken, the accounting standards available, and so on. That is, accounting does not objectively reflect a particular reality – it creates it. This view is also supported by Handel (1982, p. 36), who states: Things may exist independently of our accounts, but they have no human existence until they become accountable. Things may not exist, but they may take on human significance by becoming accountable … Accounts define reality and at the same time they are that reality … The processes by which accounts are offered and accepted are the fundamental social process … Accounts do not more or less accurately describe things. Instead, they establish what is accountable in the setting in which they occur. Whether they are accurate or inaccurate by some other standards, accounts define reality for a situation in the sense that people act on the basis of what is accountable in the situation of their action. The account provides a basis for action, a definition of what is real, and it is acted on so long as it remains accountable. Related to the above points, unless an expense is recognised in relation to particular actions (and the expense will impact profit or loss) then such actions might continue unabated – again reflective of the potential power of accounting. We can consider the issue of carbon taxes (which is a shorthand way of referring to taxes on CO2 emissions) and emissions trading schemes. For many years, companies have treated the atmosphere as a ‘free good’ and have released emissions into the atmosphere with no direct cost implications because, given the way we define both assets and expenses, emissions into the atmosphere were not considered to be expenses of 24 102 Authors such as Molotch and Boden (1985) provide a view that a form of social power is attributed to those people and professions that are able to ‘trade on the objectivity assumption’ (p. 281). The financial reporting environment CHAPTER 3 the reporting entity. Because ‘profits’ were not impacted, many shareholders were indifferent to the emissions. Had organisations been charged an expense for their emissions this might have encouraged them to develop ways to reduce their emissions, and their costs. The recent introduction of carbon taxes and emissions trading schemes in some parts of the world has meant that many organisations will now have to internalise aspects of the environmental impacts of their business that were previously ignored. The philosophy behind the introduction of carbon taxes and related regimes is that, if organisations are required to pay for the amount of pollution they create (which would otherwise be treated as an externality) and to disclose this payment as an ‘expense’ (thereby reducing reported profits), then this will have behavioural implications. Specifically, motivated by efforts to improve corporate profitability, companies will, in the presence of such things as ‘carbon taxes’, focus on reducing emission levels and, therefore, the amount of (carbon) taxes they are required to pay. Again, accounting is a central element in creating behavioural change! Accounting is powerful! REFLECTION QUESTION 3.3 The accountant’s role in defining ‘reality’ In this section, it was noted that accountants, and the accounts and reports they produce, act to define ‘reality’, with different accounts and reports effectively creating different realities, depending on the particular professional judgements made by the accountant, the accounting standards applied and so on. Question Can we apply the above perspective to comment on the way accountants have, or have not, accounted for climate change? Further, has the accounting professions’ recognition or non-recognition of climate change added significantly to the environmental problems we now face? Solution Yes, we can. Organisations have, arguably for centuries, been contributing to climate change. But the way we measure ‘profits’, and the way we have treated the air/atmosphere as a ‘free good’, has meant that greenhouse gas emissions have historically been ignored by the accountant (unless things like carbon taxes, or fines, are introduced). They were not measured and therefore, effectively, they did not exist, and the impacts to climate went unrecognised. Because the atmosphere and the ‘environment’ generally are not ‘assets’ of the organisation (they are not ‘controlled’), the reduction in the quality of the air/atmosphere and environment is not an expense, and therefore the emissions, and any increases therein, had no impacts on ‘profits’. What actually was visible, and ‘real’, were the profits being generated, and the dividends and other distributions paid by organisations. Climate change did not exist from an accounting perspective, and did not attract attention, because the accountant did not recognise its existence. Therefore, as decades and centuries passed, and as organisations’ assets grew and their profits grew, a totally unrecognised problem was climate change. It took scientists and other people to highlight climate change before it became an issue of concern; that is, before it became ‘real’. We can perhaps speculate that if accountants did not use double entry accounting, with its reliance on debits and credits, and if accountants had instead recognised emissions as a ‘cost’ that needed to be reduced, then the planet would not be in the crisis that it is in now. However, under double entry accounting, which has been in use for at least 700 years (and is therefore arguably rather antiquated), a debit has to be matched by a credit, as we know. While we might potentially have been able to notionally come up with some form of cost/expense for the emissions (although it is unclear that accountants would have been happy to estimate such a cost), there would not have been any corresponding/ balancing credit entry given that there would not have been any increase in liabilities (organisations historically had no financial obligations arising from their emissions) and there was no reduction in any asset (as the ‘environment’ is not controlled). Because debit entries must be matched with credit entries, then the double entry system could not incorporate climate change. So, effectively, our double entry accounting system helped to keep climate change unrecognised for centuries. While financial accounting continues to effectively disregard the social and environmental impacts of climate change (unless related fines or taxes are imposed), for a number of decades social and environmental accountants have worked to make the social and environmental impacts of organisations, including those impacts relating to climate change, visible through other forms of reporting. This discussion further emphasises the very real point that accounting is a practice that creates many social and environmental impacts. That is, accounting is both a technical and social practice. Accountants are very powerful members of society. But has this power always been used responsibly? 103 Financial Accounting Theory Returning to the issue of ‘professional judgement’ in accounting, while one team of accountants may make various accounting assumptions and judgements that lead to a profit being reported, it is possible that another team of accountants will make different assumptions and judgements that lead to the same organisation (with the same transactions and events) reporting a loss. Recording a loss may generate many negative reactions from various stakeholder groups (shareholders, media and analysts) and may cause real, negative cash-flow consequences for the reporting entity. Hines (1991, p. 323) further reflects on the power of the accounting profession: If, say, auditors qualify their report with respect to the going-concern assumption, and/ or insist that a corporation’s financial statements be prepared on the basis of liquidation values, this in itself may precipitate the failure of a company which may otherwise have traded out of its difficulties. Another point to be made (which is related to the above point), and one that we have already considered briefly and which is discussed further in Chapter 4, is that few, if any, accounting standards are introduced without some form of economic and social impact (which as we know from previous discussion in this chapter is considered by many accounting standard-setters). As an example, consider the various arguments that were raised over the implementation of International Accounting Standard IAS 39 Financial Instruments: Recognition and Measurement by several EU countries, and its equivalent standard, AASB 139, within Australia (this standard was later superseded by IFRS 9). Many Australian and European banks argued that implementation of AASB 139/IAS 39 would require them to value certain financial assets and liabilities in a manner that would not reflect the underlying economic reality of many financial transactions, and this would result in unrepresentative and highly volatile profit or loss figures and substantially weakened statements of financial position (or as they have traditionally been known, balance sheets). It was further argued that these weakened balance sheets and highly volatile reported profits would impact on market perceptions of banks’ creditworthiness, thus increasing their cost of capital. A number of Australian organisations lobbied the AASB and the IASB to change the requirements of IAS 39; however, such lobbying was not successful. As is shown in Chapter 5, as part of its regulatory process the EU established the Accounting Regulatory Committee (ARC), whose task was to scrutinise all international accounting standards and recommend whether they should be enforced in the EU. Successful lobbying by banks in Italy, Spain, Belgium and France led to these countries’ members of the ARC voting against EU adoption of IAS 39 in July 2004, apparently because of its potential negative economic impact. Further lobbying also delayed EU recognition in 2009 of the new IFRS 9 that replaced IAS 39. Because of the wider social and economic impacts that are potentially created by new accounting standards, perspectives of accounting as being neutral in its effects are now widely dismissed (Zeff, 1978). As already noted in this chapter, the IASB (and the many national standard-setting bodies throughout the world that it effectively replaced) explicitly states within its Conceptual Framework that economic and social implications of particular pronouncements must be considered prior to the introduction of new accounting standards. As Zeff (1978, p. 60) states: The issue of economic consequences has, therefore, changed from one having only procedural implications for the standard-setting process to one which is now firmly a part of the standard-setters’ substantive policy framework. Hence, while the qualitative characteristics of completeness, neutrality and freedom from error (which are attributes of ‘representational faithfulness’) are promoted within various documents such as the IASB Conceptual Framework (perhaps, as Hines suggests, as a means of constructing a perceived legitimacy for the accounting profession), factors such as the possible economic and social implications and the potential influences of management selfinterest (culminating in some form of creative accounting) can lead us to question such claims of 104 The financial reporting environment CHAPTER 3 objectivity. Also, despite the various stereotypes of accountants, accountants are actually a very powerful group of individuals. So we, as accountants, should be very proud of the power we hold within society – but we must use our power wisely! Many decisions with real economic and social implications are made on the basis of accounting information. Whether the supply of accounting information should be left to market forces or subject to regulation is an issue that is investigated further in the next chapter. Why do I need to know that the accountant is arguably a very powerful member of society? Should we practise as accountants, it is important that we appreciate that the information we produce can be used by many different stakeholders to make decisions that might ultimately create various social and environmental impacts. Therefore, we should consider the representational faithfulness of the information we prepare before we release it. As discussed in this chapter, we should also understand that if we, as accountants, ignore an important issue, then other stakeholders might also ignore the issue (we demonstrated this point in this chapter through our discussion of climate change). As accounting practitioners, or as researchers of accounting, we should also understand the importance of the regulation of accounting. If accounting makes things ‘visible’, and if the use of accounting information has the potential to create social and environmental impacts, then this has implications for the regulation of accounting. Because of the influence of accounting information throughout society, this also has implications for other activities, such as independent auditing of accounting information. If accounting information is important to stakeholders, then we should make every effort to make sure that the information meets certain standards of reliability. REFLECTION QUESTION 3.4 The objectivity and impartiality of accounting Question Is it in the accounting profession’s best interests for financial accounting to be perceived as a practice built on objectivity, neutrality and impartiality (as the IASB Conceptual Framework projects)? Solution Arguably, as Hines (1988, 1991) notes, it is in the accounting profession’s best interests to project a view that accountants perform their duties objectively, impartially and reliably. These would be attributes that would be expected to differentiate professional accountants from other potential providers of financial information, thereby possibly securing the profession’s position, and associated income streams, within society. These projected qualities are used as a differentiating quality relative to non-professionals. In a sense, projecting such qualitative characteristics will tend to indicate to many people within society that professional accountants, through their training, have access to a body of skills that enables them to provide some form of ‘truth’ about how an organisation has performed financially, that is reliable and therefore can be trusted. Professional accountants therefore would be considered to be essential to a well-functioning and well-informed capital market. Of related interest is terminology used to describe the general purpose financial statements that are required to be released by large organisations. Specifically, such reports are required to be ‘true and fair’, or ‘present fairly’ the underlying financial performance and financial position (for example, Australia, the United Kingdom, the EU, Singapore and New Zealand all have corporations law requirements that general purpose financial statements must give a ‘true and fair view’ of the financial position and performance of the organisation, while terminology such as ‘presents fairly in accordance with generally accepted accounting principles’ is used within the United States). Being ‘true’ and/or ‘fair’ can be linked to the attributes expected of a professional. The application of such terminology within corporate regulation further reinforces the professional status of accountants. One issue we can speculate about is: if the community was fully aware of the amount of professional judgement involved in preparing financial statements (meaning that different teams of accountants would inevitably produce different measures of financial performance and financial position), or about the research which highlights the amount of ‘earnings management’ and ‘creative accounting’ that occurs within the profession (which we discuss in Chapter 8), then would that undermine the perceptions the community holds about the objectivity, neutrality and impartiality of professional accountants? The answer to this is, ‘Yes, probably’. 105 Financial Accounting Theory STUDY TOOLS CHAPTER SUMMARY This chapter explored how the output of the financial accounting process is used in many different decisions by parties both within and outside an organisation. Because the financial accounting process provides information to parties external to the organisation who otherwise would not have the information, and because this information is used as the basis for many decisions, it is generally accepted that it is necessary to regulate the practice of financial accounting. Financial accounting practices are heavily regulated. However, in countries dominated by strong capital markets (with large numbers of external investors), the history of financial accounting regulation is relatively recent and there was a general absence of such regulation prior to the twentieth century. In the early parts of the twentieth century, accounting research often involved documenting commonly used financial accounting practices. This research led to the development and acceptance of broad principles of financial accounting that all accountants were expected to follow. Over time, broad principles gave way to the development of specific accounting standards. Accounting standards began to be released by various accounting professional bodies throughout the world around the 1970s and standard-setting activity has tended to increase since then. Financial accounting practices throughout the world today are generally regulated by a large number of accounting standards (or as they are also called, financial reporting standards). The act of regulating accounting practices through the continual release of new and revised accounting standards has led to various arguments for and against regulation. The arguments range from the belief that there is no need to regulate accounting practices (the ‘free-market’ approach) to a view that regulation is necessary to protect the interests of those parties with a stake in a reporting entity. Those who argue against regulation often rely on the view that the output of the financial accounting system should be treated like any other good, and if the market is left to operate freely, optimal amounts of accounting information will be produced. They say that introducing regulation leads to an oversupply of accounting information and can cause organisations to use accounting methods that do not efficiently reflect their actual operations, financial position and financial performance. As will be seen in subsequent chapters, such ‘free-market’ arguments are challenged by many people. This chapter has also briefly considered various theories about who is likely to benefit from regulation once it is introduced (Chapter 4 extends much of this discussion). Public interest theory proposes that regulation is introduced to protect the public and, when putting regulation in place, regulators seek to maximise the overall welfare of the community (which obviously requires trade-offs of particular costs and benefits). Capture Theory proposes that while regulation might initially be introduced for the public’s benefit, ultimately the group that is regulated will gain control of the regulation process. That is, the group will eventually ‘capture’ the regulatory process. Private interest theories of regulation propose that the regulators introduce regulation that best serves the regulators’ own private interest. That is, regulators are motivated not by the public interest but by their own self-interest. For example, politicians will introduce regulation likely to generate enough support to ensure their re-election. The chapter also considered issues associated with the ‘power’ of accountants. Arguments were advanced to support a view that accountants hold a very powerful position in society (which is in contrast to how they are often portrayed in the media). Accountants provide information that is used in many decisions, and they are able to highlight or downplay particular facets of an organisation’s performance. ANSWERS TO THE OPENING QUESTIONS At the beginning of the chapter, we asked the following two questions. As a result of reading this chapter, you should be able to provide informed answers to these questions – ours are shown below. 1 106 Through such mechanisms as conceptual frameworks for financial reporting, accounting professions throughout the world promote a view that accounting reports, when prepared The financial reporting environment CHAPTER 3 properly, will be objective and will faithfully represent the underlying transactions and events of the reporting entity. Is it in the interests of the accounting profession to promote this view of objectivity and neutrality, and if so, why? As indicated in the answer to ‘Reflection question 3.4’, by promoting the virtues of objectivity and representational faithfulness, this will tend to bring credibility and trust to the profession with results that professional members might be able to derive an income that they might otherwise not derive. Promoting such attributes would also tend to project the view that professional accountants uniquely have access to some form of ‘truth’ – which can be shared with others that provides representationally faithful insights into an organisation’s financial performance; insights that otherwise not be available, but are necessary for a well-functioning society. 2 Many different types of stakeholders make various decisions (for example, investment or consumption decisions) based – at least in part – on information generated by accountants, and these decisions can in turn create social and/or environmental impacts. Different accounting information is expected to create different decisions, and therefore, different impacts. Because of the potential economic and social impacts created by the accountants’ choice of accounting methods (for example, decisions that involve choosing one method of accounting in preference to another), and because accounting standard-setters take such economic and social impacts into account when developing new accounting standards (accounting standard setters consider the various costs and benefits that might arise from the introduction of an accounting standard), then it can be argued that standard-setters themselves are not developing accounting standards that lead to representationally faithful (and therefore, neutral or balanced) accounts of organisational performance. Do you agree or disagree with this view, and why? We might tend to agree with this view. If there is a correct and objective way to account for something, and if representational faithfulness is a required attribute of general purpose financial reporting, then a method of accounting should be applied regardless of any consequential social and environmental implications that might follow. That is, objectivity should not be swayed by other considerations. For example, if we prioritised the qualitative characteristics of relevance and faithful representation, and if a new accounting standard on, for example, financial instruments required many financial instruments that had been included within corporate balance sheets to subsequently be expensed (perhaps meaning that many billions of dollars of financial instruments will be expensed across the respective corporate sectors), and this new approach provided the best measure of the value of financial instruments, then it would be implemented, despite the fact this could result in the demise of many organisations. However, under the cost versus benefit approach to standard setting that exists, and which is applied by organisations such as the IASB, a judgement might be made that the social costs of potential corporate collapses is too great to ignore, thereby persuading the regulator to abandon the introduction of the new accounting standard. Whenever costs such as these are considered as part of the standard setting process, there is a chance that accounting standards that otherwise would improve financial reporting will not be approved. This has implications for the relevance and reliability of financial reports. QUESTIONS 3.1 3.2 3.3 3.4 What expectations do accounting standard-setters have about the accounting knowledge of financial statement readers? LO3.7 Do you think that users of financial reports should have a sound working knowledge of the various accounting standards in use? Explain your answer. LO3.7 Do you believe that the media portray accounting numbers, such as profits, as some sort of ‘hard’ and objective performance indicator? Why do you think they might do this, and, if they do, what are some of the implications that might arise as a result of this approach? LO3.1 Do you think it is realistic to expect that accountants are always objective when it comes to the practice of preparing financial statements? Explain your answer. LO3.4 LO3.5 107 Financial Accounting Theory 3.5 3.6 3.7 3.8 3.9 3.10 3.11 3.12 3.13 What is ‘creative accounting’ and why does it occur? LO3.1 LO3.5 Briefly outline some arguments in favour of regulating the practice of general purpose financial reporting. LO3.1 Why would developing accounting regulation based upon a survey of what most accountants currently do not necessarily lead to best possible practice? LO3.2 LO3.3 What is the difference between general purpose financial reports and special purpose financial reports? Why is it accepted to be relatively less important to regulate the practice of special purpose financial reporting? LO3.1 LO3.3 Why is management accounting not regulated in the same manner as financial accounting? LO3.1 Why does general purpose financial reporting tend to disregard the social and environmental impacts created by reporting entities? LO3.2 Is it appropriate to look at changes in corporate profits over time without making any adjustments? Explain your answer. LO3.2 Briefly outline some arguments in favour of eliminating the regulation pertaining to financial accounting. LO3.1 LO3.3 What are two possible motivations for regulators to introduce new regulation? LO3.1 LO3.2 LO3.3 3.14 3.15 3.16 3.17 3.18 3.19 3.20 3.21 3.22 3.23 108 LO3.4 Do you think that a general increase in the extent of separation between the ownership and management of organisations leads to a greater or a lesser amount of accounting regulation? Why? LO3.3 In the early part of the twentieth century accounting rules were developed based upon largescale analysis of what methods accountants were using, and on the basis of the assumptions and conventions that they were adopting. What are some criticisms of adopting this approach to develop accounting rules and related theory? LO3.2 LO3.3 Pursuant to Capture Theory, how, by whom and why would a regulator be captured? LO3.4 Stigler (1971) proposes a theory (private interest theory) in which regulatory bodies (including accounting standard-setters) are made up of individuals who are self-interested, and these individuals will introduce regulation that best serves their own self-interest. Under this perspective, the view that regulators act in the public interest is rejected. From your experience, do you think this is an acceptable assumption? Would rejecting this central assumption have implications for whether you would be prepared to accept any predictions generated by the theory? LO3.4 LO3.5 If regulators acted in accordance with predictions provided by the private interest theory of regulation, which assumes that all individuals (including politicians and regulators) are motivated by their own economic self-interest, what is the likelihood of the introduction of regulations aimed at reducing the problems associated with climate change, particularly if business corporations opposed such regulations? LO3.3 LO3.4 Prior to recent decades, was the role of financial reporting in European countries different to the role of financial reporting in countries such as the United States, the United Kingdom, Australia or Canada? If so, why was this the case, and what implications did it have for the regulation of financial reporting? LO3.1 LO3.2 If you believed that regulators acted in accordance with either Capture Theory or the private interest theory of regulation, would you believe that accounting standard-setters will develop accounting standards that most fairly present information about the financial position or performance of a reporting entity? LO3.3 LO3.4 Because accounting standard-setters throughout the world typically consider the potential economic and social consequences of the accounting standards they develop, it has been argued that the general purpose financial reports developed in accordance with the accounting standards cannot be considered neutral or unbiased. Do you agree with this perspective? Is this perspective consistent with the qualitative attributes promoted within the IASB Conceptual Framework for Financial Reporting? LO3.2 Why would ‘free-market’ advocates argue that the regulation of financial reporting leads to an oversupply of accounting rules and standards? LO3.1 What is the basis of an argument that states that accounting regulation can act to undermine the efficiency with which the reporting entities present information about their financial performance and position? LO3.1 LO3.3 The financial reporting environment CHAPTER 3 3.24 According to Hines (1991), it is in the interest of the accounting profession to promote publicly a view that the information it generates is ‘objective’. Why do you think this is the case? LO3.1 LO3.2 3.25 Solomons (1978, p. 69) quotes the American Accounting Association: LO3.3 LO3.4 LO3.6 Every policy choice represents a trade-off among differing individual preferences, and possibly among alternative consequences, regardless of whether the policy-makers see it that way or not. In this sense, accounting policy choices can never be neutral. There is someone who is granted his preference, and someone who is not. Evaluate this statement. 3.26 3.27 3.28 3.29 3.30 LO3.3 LO3.4 LO3.5 LO3.6 ‘While it is difficult to criticise a process that considers potential economic and social impacts on others, at the same time it is difficult to accept that accounting standards are neutral or unbiased.’ Evaluate this statement. LO3.4 Hines (1991, p. 313) stresses a view that ‘financial accounting practices are implicated in the construction and reproduction of the social world’. What does Hines mean by this statement? Do you agree or disagree with her, and why? LO3.6 Provide an example of a situation when the release of a new accounting standard could create social or economic effects that reverberate throughout society. LO3.4 LO3.6 Why might accountants be construed as being powerful individuals? LO3.6 Explain what the following statement by Handel (1982, p. 36) means and provide an argument to either support or oppose the contention. 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(2009), ‘Capital markets regulation: how can accounting research contribute?’, Australian Accounting Review, 51(19), pp. 319–25. Unerman, J. & O’Dwyer, B. (2004), ‘Enron, WorldCom, Andersen et al.: a challenge to modernity’, Critical Perspectives on Accounting, 15(6–7), pp. 971–93. Walker, R. G. (1987), ‘Australia’s ASRB: a case study of political activity and regulatory capture’, Accounting and Business Research, 17(67), pp. 269–86. Watts, R. & Zimmerman, J. (1978), ‘Towards a positive theory of the determination of accounting standards’, The Accounting Review, 53(1), pp. 112–34. Zeff, S. A. (1972), Forging Accounting Principles in Five Countries, Champaign, IL: Stipes Publishing Co. Zeff, S. A. (1978), ‘The rise of economic consequences’, Journal of Accountancy, 146(6), pp. 56–63. CHAPTER 4 THE REGULATION OF FINANCIAL ACCOUNTING LEARNING OBJECTIVES On completing this chapter, readers should: LO4.1 understand the meaning of ‘regulation’ together with some of the various theoretical arguments for regulating the practice of financial accounting and reporting LO4.2 understand some of the theories that explain why regulation is initially introduced LO4.3 understand various theoretical perspectives that describe the parties who are likely to gain the greatest advantage from the implementation of accounting regulation LO4.4 understand some of the various theoretical arguments that have been proposed in favour of reducing the extent of regulation of financial accounting and reporting LO4.5 understand that financial reporting standard-setting is a very political process which seeks, and responds to, the views of a broad cross-section of financial statement users LO4.6 understand the relevance to the financial reporting standard-setting process of potential economic and social impacts arising from accounting regulations. 111 Financial Accounting Theory OPENING QUESTIONS Before reading this chapter, please consider how you would answer the following two questions. We will return to these questions at the end of the chapter, where we suggest some answers. 1 When widely publicised accounting-related ‘scandals’ occur in respect of high-profile organisations (such as Lehman Brothers, Enron and WorldCom), regulators often respond by increasing the amount of accounting regulation. What might motivate regulators to introduce additional regulation to restrict the accounting practices available to corporate managers? 2 If corporate financial reporting was to be deregulated, what market-based incentives or mechanisms might operate to motivate managers to produce publicly available financial reports? Would these mechanisms operate to ensure that an optimal amount of relevant and reliable information is produced? What is an ‘optimal’ amount of information? Introduction Regulation is clearly a large part of all of our lives. For example, the construction of the homes in which we live is regulated through various building and zoning regulations; renting or buying a home is subject to various regulations; what and where we eat and drink is subject to many health regulations; how we travel is subject to a great deal of regulation whether it relates to the cars we drive or the public transport we use; the health services we use are regulated; the news media we read, watch or listen to are regulated; where we and our children are educated is subject to various regulation; and the toys our children, and us, play with are regulated. Regulation really is a very pervasive aspect of all our lives, and this raises various issues: • Does all this regulation actually improve our lives or is there regulation overload? • Does regulation impede economic growth or innovation? • Is there an appropriate amount of regulation from a societal perspective? • Should regulation always be developed and enforced by government or do professional bodies have a role in developing and enforcing regulation? • What factors influence the final regulations that are mandated by particular regulators? The external reporting of information by organisations, particularly larger organisations, is subject to regulation. For example, throughout the world, larger organisations are required to report information about aspects of their: • social performance (for example, occupational health and safety-related performance, and the risks that modern slavery exists within their supply chains) • environmental performance (for example, larger highly polluting organisations are required to report information about their greenhouse gas emissions, releases of other toxic chemicals and compliance with environmental laws) • financial performance (for example, general purpose financial reports that comply with financial reporting standards). We consider the regulation of social and environmental reporting in Chapter 10. In this chapter, we consider the regulation of financial accounting. As we know, financial reporting, particularly by larger organisations, is subject to a great deal of regulation. As we shall learn, there are various theories of regulation that either prescribe how and when government should regulate or provide an explanation of what government actually does. Chapter 3 briefly considered a number of theories to explain the existence of accounting regulation. This chapter extends that discussion. 112 The regulation of financial accounting CHAPTER 4 While financial reporting is quite heavily regulated in many countries, with the level of regulation generally increasing in the aftermath of the recent sub-prime banking crisis1 and high-profile alleged accounting failures at many large multinational companies (such as Enron, WorldCom, HIH Insurance and Parmalat), it is nevertheless interesting to consider arguments for and against the continued existence of, and general growth in, regulation. It is also useful to look at various theories that explain what drives the imposition of regulation. By considering various regulation-related theories we will be better placed to understand why some accounting and reporting prescriptions ultimately become formal regulations, while others do not ultimately get approval from regulators. Perhaps some proposed accounting regulations did not have the necessary support of parties that have influence (or power) over the regulatory process. At issue here is whether the ‘power’ of particular constituents could, or should, be allowed to impact upon the implementation of regulations, including accounting regulations. Is it realistic to expect that the interests of various affected parties will not impact on the final regulations? We will see that the financial reporting standard-setting process is a very political process. While some proposed requirements might appear technically sound and logical, we will see that this is not always sufficient for them to be mandated. What often seems to be important is whether various parts of the constituency, who might be affected either socially or economically by the regulations, are in favour of them. In considering accounting and reporting regulations, this chapter examines arguments for reducing or eliminating regulation, many of which propose that accounting information should be treated like any other good and that forces of demand and supply should be allowed to freely operate to determine the optimal amount of information to be produced. Proponents of this ‘free-market’ approach (that is, proponents of the view that the provision of accounting information should be based on the laws of supply and demand rather than on regulation) have at times relied on the work of the eighteenth-century economist Adam Smith and his much-cited notion of the ‘invisible hand’. However, as we discuss, Smith actually proposed the need for some regulation to support the interests of those individuals who would otherwise be disadvantaged by the functioning of unregulated market systems. The chapter also considers a number of perspectives that explain why regulation might be necessary. The public interest theory of regulation is reviewed. Public interest theory provides an explanation of why regulation is necessary to protect the rights of ‘the public’ and why it is often introduced in an apparent response to perceived ‘market failures’, whereas there are other theories (for example, Capture Theory and economic interest theory of regulation) that provide explanations for why regulations might be put in place that actually serve the interests of some groups at the expense, or detriment, of others (rather than serving the ‘public interest’). The chapter looks at how perceptions about the economic and social consequences of potential accounting requirements affect the decisions of financial reporting standard-setters. It also discusses whether, in the light of regulators considering the economic and social consequences of potential regulation, financial accounting can ever be expected to generate financial statements that meet the test of ‘representational faithfulness’ (and for a faithful representation, a depiction would be complete, neutral and free from error as noted in the IASB Conceptual Framework for Financial Reporting). As with many other chapters of this book, in this chapter we are considering multiple theories about ‘regulation’. As we have already emphasised in previous chapters, there are multiple ways, and different theories, to explore particular phenomena, and therefore it is arguably inappropriate to believe there is a single way to explore a particular ‘reality’. Different theories provide a partial and incomplete depiction of a particular ‘reality’, and as Laughlin (2007) suggests, there is arguably ‘no absolute truth’. Therefore, consistent with this, we apply different theoretical ‘lenses’ to explore the issue of accounting regulation. 1 Sub-prime A classification of borrowers with a tarnished or limited credit history. Free-market approach An approach wherein somebody believes that how and whether a good or service is produced should be left to market forces of supply and demand. Chapter 3 provided a brief explanation of ‘sub-prime lending’ and the sub-prime banking crisis. 113 Financial Accounting Theory LO4.1 What is regulation? As this chapter considers various theories of regulation, and various arguments for and against regulation, it is useful to first define what we actually mean by ‘regulation’ and ‘regulator’. The Oxford English Dictionary defines regulation in terms of a prescribed rule, or authoritative direction. Specifically, the Oxford English Dictionary defines a regulation as: A rule or principle governing behaviour or practice; esp. such a directive established and maintained by an authority. The Oxford English Dictionary further defines a regulator as: An official or agency responsible for the control and supervision of a particular industry, business activity, area of public interest, etc. The above definition of regulation is similar to the definition provided by the Macquarie Dictionary, which defines regulation as ‘a rule of order, as for conduct, prescribed by authority; a governing direction or law’. Therefore, on the basis of these definitions, we can say that regulation is designed to control or govern conduct. Hence, in discussing regulations relating to financial reporting, we are discussing rules that have been developed by an independent authoritative body that has been given the power to govern how financial statements are to be prepared, and the actions of the authoritative body will have the effect of restricting the accounting options that would otherwise be available to the managers of an organisation.2 The regulation would also be expected to incorporate a basis for monitoring and enforcing compliance with the specific regulatory requirements. Regulation without associated monitoring and enforcement mechanisms will be rendered ineffective. While there is a multitude of regulations governing various aspects of behaviour, there are many people who argue against the intervention of government and who propose that markets be allowed to operate in an environment that is not regulated. We now consider some of these arguments. LO4.3 The ‘free-market’ perspective As indicated in Chapter 3, a fundamental assumption underlying a ‘free-market’ perspective on accounting regulation is that accounting information should be treated like other goods, and demand and supply forces should be allowed to freely operate so as to generate an optimal supply of information about an entity. A number of arguments have been used in support of this perspective. One such argument, based on the work of authors such as Jensen and Meckling (1976), Watts and Zimmerman (1978), Smith and Warner (1979) and Smith and Watts (1982), is that, even in the absence of regulation, there are private economics-based incentives for the organisation to provide credible information about its operations and performance to certain parties outside the organisation, otherwise the costs of the organisation’s operations would rise. The basis of this view is that, in the absence of information about the organisation’s operations, other parties, including the owners of the organisation (for example, shareholders) who are not involved in the management of the organisation, will assume that the managers might be operating the business for their own 2 114 While our definition of reporting regulation refers to an independent authoritative body, capture theory (to be discussed shortly) would question whether, in the longer run, regulators will be able to maintain their independence from those individuals or groups that are subject to the regulations. The regulation of financial accounting CHAPTER 4 benefit.3 That is, rather than operating with the aim of maximising the value of the organisation, the managers will be assumed to be operating for their own personal gain (there is assumed to be a lack of alignment of goals between the external owners and the managers).4 It is further assumed that potential shareholders will expect the managers to be opportunistic, and in the absence of safeguards will reduce the amount they will pay for the shares. Likewise, under this economics-based perspective of ‘rationality’ (self-interest), potential lenders (such as banks and bondholders) are assumed to expect managers – like everybody else – to undertake opportunistic actions with the funds the lenders might advance, and therefore in the absence of safeguards the lenders will charge the organisation a higher price for their funds.5 That is, the lenders will ‘price-protect’, such that the higher the perceived risk, the higher the demanded return in the form of higher interest rates in order to compensate the lenders for the higher risk exposure. The expectations noted above (which are based on the rather pessimistic assumption that all parties will assume that others will work in their own self-interest unless constrained to do otherwise) will have the effect of increasing the operating costs of the organisation – the cost of attracting capital will increase and this will have negative implications for the value of the organisation.6 In situations where managers have large investments in their organisation’s shares (that is, where they are a type of ‘internal’ shareholder), it will be in the interests of the managers to maximise the value of the organisation, as they will often gain more economically from an increase in the value of their investment than they would gain in direct ‘spoils’ from opportunistic behaviour. To achieve this maximisation of share value, managers will voluntarily enter into contracts with shareholders and lenders that make a clear commitment that certain management strategies, such as those that might be against the interests of other shareholders and lenders, will not be pursued. For example, management might make an agreement with debtholders that they will keep future debt levels below a certain percentage of total assets (the view being that, all things being equal, the lower the ratio of debt to assets, or debt to total equity, the lower the risk that the organisation will default on paying the debtholders). To safeguard the debtholders’ assets further, the managers might agree to ensure that profits will cover interest expense by a specified number of times (referred to as an ‘interest coverage clause’, and might require, for example, that ‘profit’ should cover interest expense a minimum of, say, five times). In relation to concerns that the manager might ‘shirk’ (which might be of particular concern to shareholders, given that shareholders will share in any profits generated by the actions of the managers), the organisation might require managers to be rewarded on the basis of a bonus 3 4 5 6 The costs that arise from the perspective of the owner when the owner (or principal) appoints a manager (the agent) include those associated with the agent shirking (being idle) or consuming excessive perquisites (using the organisation’s funds for the manager’s private purposes). These are called agency costs. Agency costs can be defined as costs that arise as a result of the delegation of decision making from one party, for example the owner, to another party, for example the manager (representing an agency relationship). Agency costs are more fully considered in Chapter 8, which discusses Agency Theory. Another agency cost that might arise when decision making is delegated to the agent is the cost associated with the manager using information that is not available to the owners for the manager’s personal gain. Smith and Watts (1982) provide an overview of the various conflicts of interest that arise between managers and owners. What should be appreciated at this point is that these arguments are based on a central assumption that individuals will act in their own self-interest, which, in itself, is a cornerstone of many economic theories. If an individual acts with the intention of maximising personal wealth, this is typically referred to as being ‘economically rational’. ‘Economic rationality’ is a theoretical assumption and, as might be expected, it is challenged by advocates of alternative views about what drives or motivates human behaviour. In considering the relationship between managers and lenders, actions that would be detrimental to the interests of lenders include managers paying excessive dividends; taking on additional and possibly excessive levels of debt; and using the advanced funds for risky ventures, thereby reducing the probability of repayment. Smith and Warner (1979) provide an overview of some of the conflicts of interest that arise between managers and lenders. This is based on the assumption that the value of an organisation is the present value of its expected future net cash flows. A higher cost of capital will result in a decreased net present value of future cash flows. 115 Financial Accounting Theory tied to profits, so the higher the organisation’s profit (which is in the interests of shareholders and lenders), the higher the rewards that will be paid to managers. Most business organisations give their managers (particularly the more senior managers) some form of profit share (Deegan, 1997) as well as being involved in negotiated agreements with lenders (such as debt to asset constraints and interest coverage requirements). What should be noted from this discussion is that such contractual arrangements are tied to financial accounting numbers (for example, paying the manager a bonus based on a percentage of profits), and therefore to financial accounting reports. Hence the argument by some advocates of the ‘free-market’ perspective is that in the absence of regulation there will be private incentives to produce accounting information. That is, proponents of this view (based on Agency Theory, which is more fully discussed in Chapter 8) assert that there will (naturally) be conflicts between external owners (such as shareholders) and internal managers (because it is assumed that everybody acts in their own self-interest), and the costs of these potential conflicts will be mitigated through the process of private contracting and associated financial reporting.7 Organisations that do not produce relevant and representationally faithful accounting information will be penalised by higher costs associated with attracting capital, and this will damage the financial interests of those managers who own shares in their organisation. Further, depending on the parties involved and the types of assets in place, the managers within the organisation will be best placed to determine what information should be produced to increase the confidence of external stakeholders (thereby decreasing the organisation’s cost of attracting capital), rather than relying on a ‘one-size-fits-all’ approach to reporting that can be associated with financial reporting regulation. Imposing regulation that restricts the available set of accounting methods (for example, banning a particular method of depreciation or amortisation which has previously been used by some organisations) will potentially decrease the efficiency with which negotiated contracts will reduce agency costs.8 Given the theoretical economics-based assumption that managers (and indeed, everybody else also) will act in their own self-interest (which does represent a rather pessimistic view of humans, but is a maintained assumption of many economic theories), there will also be a contractual demand to have the accounting reports audited by a credible independent external party. Such an activity will increase the perceived reliability or representational faithfulness of the data, and this in turn is expected to reduce the perceived risk of the external stakeholders, thus further decreasing the organisation’s cost of capital (Francis and Wilson, 1988; Watts, 1977; Watts and Zimmerman, 1983). That is, financial statement audits can also be expected to be undertaken, even in the absence of regulation, and evidence indicates that many organisations did have their financial statements audited prior to any legislative requirement to do so (Morris, 1984).9 Hence, if we accept these arguments, we can propose that, in the presence of a limited number of contracting parties, reducing regulation might seem reasonable given the view that various items of financial information (as negotiated between the various parties) will be voluntarily provided. Further, such information will be expected to be subject, where deemed necessary by the contracting parties, to an audit by an independent third party. However, in the presence of many different parties, this argument that private incentives will lead to optimal amounts 7 8 9 116 This is consistent with the usual notion of ‘stewardship’ wherein management is expected to provide an account of how it has used the funds that have been provided. It has also been argued that certain mandated disclosures will be costly to the organisation if they enable competitors to take advantage of certain proprietary information. Hakansson (1977) used this argument to explain costs that would be imposed as a result of mandating segmental disclosures. As Cooper and Keim (1983, p. 199) indicate, to be an effective strategy ‘the auditor must be perceived to be truly independent and the accounting methods employed and the statements’ prescribed content must be sufficiently well-defined’. Public perceptions of auditor independence are damaged as a result of revelations linking audit firms to various corporate collapses (Unerman and O’Dwyer, 2004), and this could have implications for the benefits a company derives from having its financial statements audited by a third party. The regulation of financial accounting CHAPTER 4 of accounting information (and a reduced need for regulation) seems to break down. As Scott (2003, p. 416) states: Unfortunately, while direct contracting for information production may be fine in principle, it will not always work in practice ... In many cases there are simply too many parties for contracts to be feasible. If the firm manager were to attempt to negotiate a contract for information production with every potential investor, the negotiation costs alone would be prohibitive. In addition, to the extent that different investors want different information, the firm’s cost of information production would also be prohibitive. If, as an alternative, the manager attempted to negotiate a single contract with all investors, these investors would have to agree on what information they wanted. Again, given the disparate information needs of different investors, this process would be extremely time-consuming and costly, if indeed, it was possible at all. Hence, the contracting approach only seems feasible when there are few parties involved. Market-related incentives While the ‘free-market’ (or anti-regulation) arguments above are based on a private contracting perspective, there are further arguments that support reducing or eliminating accounting regulation which are based on various market-related incentives, principally tied to the ‘market for managers’ and the ‘market for corporate takeovers’. The ‘market for managers’ argument The ‘market for managers’ argument (see Fama, 1980) relies on an assumption that there is an efficient ‘market for managers’, and that managers’ previous performance will impact on how much remuneration (payment for services) they are able to command in future periods, either from their current employer or elsewhere. Adopting this perspective, it is assumed that, even in the absence of regulations controlling management behaviour and in the absence of other contractual requirements, managers will be encouraged to adopt strategies to maximise the value of their organisation (which provides a favourable view of their own performance) and these strategies would include the manager providing an optimal amount of financial accounting information. However, arguments such as this are based on assumptions that the managerial labour market operates efficiently and that information about past managerial performance will not only be known by other prospective employers, but will also be fully impounded in future salaries. It also assumes that the capital market is efficient when determining the value of the organisation and that effective managerial strategies will be reflected in positive share price movements. In reality, these assumptions will clearly not always be met. Markets will not always be efficient. The arguments can also break down if the managers involved are approaching retirement, in which case future market prices for their services in the ‘market for managers’ may be irrelevant to them, meaning that the potential disciplining effect of the ‘market’ does not apply for retiring managers. Market for managers A market in which managers negotiate their salaries on the basis of their ability and performance. Information about past performance is assumed to be known by participants in this market. The ‘market for corporate takeovers’ argument The ‘market for corporate takeovers’ argument works on the assumption that an under-performing organisation will be taken over by another entity that will see opportunities for financial gain and who will subsequently act to replace the existing management team. With such a perceived threat, managers would be motivated to maximise organisational value to minimise the likelihood that outsiders motivated by maximising their own wealth could seize control of the organisation at low cost. The ‘market for corporate takeovers’ and the ‘market for managers’ arguments assume that information will be produced to minimise the organisation’s cost of capital and thereby increase the value of the organisation. Therefore, the arguments assume that management will know the marginal costs and marginal benefits involved in providing information, and, in accordance with economic theories about the production of other goods, management will provide information to Market for corporate takeovers A market in which corporations are bought and sold. Managers will try to maximise firm value to minimise the likelihood that outsiders could seize control of the organisation at low cost. 117 Financial Accounting Theory the point where the marginal cost equals the marginal benefit. While the disclosure of accounting information will be in the interests of shareholders, it will also be in the interests of managers – there will be an alignment of interests. However, working out the marginal costs and marginal benefits of information production will be difficult, and to assume that the majority of corporate managers have the expertise to determine such costs and benefits is, again, somewhat unrealistic. The ‘market for lemons’ argument There is also a perspective that, even in the absence of regulation, managers would still be motivated to disclose both good and bad news about their organisations’ financial position and performance. Such a perspective is often referred to as the ‘market for lemons’ perspective (Akerlof, 1970), the view being that in the absence of disclosure, the capital market will assume that the organisation is a ‘lemon’.10 That is, the failure to provide information is viewed in the same light as providing bad information. Hence, even though the organisation may be worried about disclosing bad news, the market may make an assessment that silence implies that the organisation has very bad news to disclose (otherwise it would disclose it). This ‘market for lemons’ perspective provides an incentive for managers to release information in the absence of regulation, as failure to do so will have implications for managers’ wealth (perhaps in the form of current lower remuneration and a decreased value in the market for managers). That is, ‘nonlemon owners or managers have an incentive to communicate’ (Spence, 1974, p. 93). Drawing on arguments such as those adopted in the ‘lemons’ argument and applying them to preliminary profit announcements, Skinner (1994, p. 39) states: Managers may incur reputational costs if they fail to disclose bad news in a timely manner. Money managers, stockholders, security analysts, and other investors dislike adverse earnings surprises, and may impose costs on firms whose managers are less than candid about potential earnings problems. For example, money managers may choose not to hold the stocks of firms whose managers have a reputation for withholding bad news and analysts may choose not to follow these firms’ stocks ... Articles in the financial press suggest that professional money managers, security analysts, and other investors impose costs on firms when their managers appear to delay bad news disclosures. These articles claim that firms whose managers acquire a reputation for failing to disclose bad news are less likely to be followed by analysts and money managers, thus reducing the price and/or liquidity of their firms’ stocks. Reviewing previous studies, Skinner (p. 44) notes that there is evidence that managers disclose both good and bad news forecasts voluntarily. These findings are supported by his own empirical research, which shows that when companies are performing well managers make ‘good news disclosures’ to distinguish their companies from those doing less well, and when companies are not doing so well managers make pre-emptive bad news disclosures consistent with ‘reputational-effects’ arguments (p. 58). Evidence provided by Barton and Waymire (2004) showed that shareholders of US companies that made higher quality disclosures preceding the stock-market crash of 1929 experienced significantly smaller losses during the crash. Prior to the crash, there was a general absence of disclosure regulation. In an argument that supports a ‘free-market’ (anti-regulation) approach to accounting regulation, Barton and Waymire state (p. 69): Viewed collectively, our evidence suggests that managers respond to investor demand for information and that managers’ voluntary financial reporting choices can promote investor 10 118 Something is a ‘lemon’ if it initially appears or is assumed (due to insufficient information) to be of a quality comparable to other products but later turns out to be inferior. Acquiring the ‘lemon’ will be the result of information asymmetry in favour of the seller. The regulation of financial accounting CHAPTER 4 protection. That is, economic forces in advanced markets provide managers with incentives for beneficial financial reporting even in the absence of regulatory mandate. These authors argue that economic forces operate to motivate managers to provide information to investors even in the absence of regulation. Arguments that the market will penalise organisations for failure to disclose information (which may or may not be bad) of course assume that the market knows that the manager has particular information to disclose. As has been seen with the many apparently unforeseen accounting failures in recent years (such as Enron, WorldCom and Parmalat), this expectation might not always be realistic, as the market will not always know that there is information available to disclose. That is, in the presence of information asymmetry (unequal distribution of information), the manager might know of some bad news, but the market might not expect any information disclosures at that time. However, if it does subsequently come to light that news had been available that was not disclosed, we could perhaps expect the market to react (and in the presence of regulation, we could expect regulators to react, as failure to disclose information in a timely manner may be in contravention of particular laws in that jurisdiction). Also, at certain times, withholding information (particularly of a proprietary nature) could be in the interests of the organisation. For example, the organisation may not want to disclose information about certain market opportunities for fear of competitors using such information. The role of the courts Building on early work from Coase (1960), and accepting that instances will occur where market competition and private contracting do not provide optimal outcomes, advocates of a free market (anti-regulation) approach argue that courts can be used as impartial arbiters to provide solutions between market participants and thereby enforce aspects of the privately negotiated contracts. In doing so, courts are argued to restore efficiency to the market through application of appropriate case law. The expectation that the courts will award in favour of harmed plaintiffs is assumed to discourage potential ‘contract-breakers’ from not complying with the market-based negotiated agreements or contracts. However, the belief that courts will always make ‘fair and just decisions’ for all participants can be challenged. Court decisions are known to often favour those parties able to acquire better legal representation, and it is not always clear that court representatives will be unbiased or incorruptible. So, in summary to this point, there are various arguments or mechanisms in favour of reducing accounting regulation (including private contracting, markets for managers, markets for corporate takeovers, the ‘market for lemons’ and well-functioning courts), as even in the absence of regulation, managers and their organisations will have incentives to make disclosures. We now consider some counterarguments in favour of regulating financial reporting practices. LO4.1 LO4.2 The ‘pro-regulation’ perspective We have considered a number of reasons in favour of reducing or eliminating financial reporting regulation. One of the simplest arguments is that if somebody really desired information about an organisation, then they would be prepared to pay for it (perhaps in the form of reducing their required rate of return in exchange for receiving relevant and credible information about the organisation), and the forces of supply and demand should be allowed to freely operate to ensure an optimal amount of information is produced.11 11 For example, if a lender is able to receive relevant and credible information about the financial position and financial performance of an organisation, then this will act to reduce the risk inherent in providing funds to the organisation. With reduced risk, the lender would expect and demand a lower rate of interest than it otherwise would. This is in accordance with the general principle that the lower the risk, the lower the expected rate of return. 119 Financial Accounting Theory Public good Something that can be used by people without having to pay for it. Generally, use by one party does not affect the ability of others to use the particular item. Free riders Parties that use goods or services without contributing to costs that are borne by other people. Market failure A situation where market forces of supply and demand do not lead to economically or socially optimal levels of production. Another perspective is that if information is not produced, there will be greater uncertainty about the performance of the entity and this will translate into increased costs of attracting financial capital for the organisation. (For example, in the absence of sufficient information about an organisation, such an organisation will be considered to be of higher risk, and riskier organisations find it relatively more expensive to attract financial capital.) With this in mind, organisations would, it is argued, elect to produce information to reduce costs. However, arguments in favour of a ‘free market’ rely on users paying for the goods or services that are being produced and consumed. Such arguments tend to break down when we consider the consumption of ‘free’ or ‘public’ goods. Accounting information is a public good – once available, people can use it without paying and can pass it on to others. Parties that use goods or services without incurring some of the associated production costs are referred to as ‘free riders’. In the presence of free riders, true demand is understated, because people know that they can obtain the goods or services without paying for them. Few people will then have an incentive to pay for the goods or services, as they know that they themselves might be able to act as free riders. This dilemma is argued to provide a lack of incentive for producers of the particular good or service, which in turn leads to an underproduction of information. As Cooper and Keim (1983, p. 190) state: Market failure occurs in the case of a public good because, since other individuals (without paying) can receive the good, the price system cannot function. Public goods lack the exclusion attribute, i.e., the price system cannot function properly if it is not possible to exclude non-purchasers (those who will not pay the asked price) from consuming the good in question. To alleviate this underproduction, regulation is argued to be necessary to reduce the impacts of market failure.12 In specific relation to the production of information, Demski and Feltham (1976, p. 209) state: Unlike pretzels and automobiles, [information] is not necessarily destroyed or even altered through private consumption by one individual ... This characteristic may induce market failure. In particular, if those who do not pay for information cannot be excluded from using it, and if the information is valuable to these ‘free riders’, then information is a public good. That is, under these circumstances, production of information by any single individual or firm will costlessly make that information available to all ... Hence, a more collective approach to production may be desirable. However, as we often come to expect, there are counterarguments to the perspective that the supply of ‘free goods’ should be regulated. Some economists argue that free goods are often overproduced as a result of regulation. The argument is that segments of the public (the users of the good or service), knowing that they do not have to pay for the free good, will overstate their need for the good or service. This argument can be applied to investment analysts. Investment analysts will typically be a main user of accounting information. If they lobby for additional regulation which requires further disclosure, they will tend to receive a disproportionate amount of the benefits relative to the costs of producing this further information. When considering the consumption of free goods, it is argued by some people that the nonusers of the goods or services effectively subsidise the consumers of the public good as, like other parties, the non-users pay towards the production of the good without benefiting from its consumption. The result of concerted lobbying by particular parties, such as analysts, could in turn lead to the existence of what has been termed an accounting standards overload, which creates 12 120 In relation to the supply of information, Scott (1997, p. 329) defines market failure as ‘an inability of market forces to produce a socially “right” amount of information, that is, to produce information to the point where its marginal cost to society equals its marginal benefit’. The regulation of financial accounting CHAPTER 4 a cost for companies in terms of compliance. However, if we do not regulate, then in the presence of the ‘free riders’ we could arguably have an underproduction of accounting information. Clearly, this is not an easy thing to balance, and we can start to understand the difficult position in which regulators find themselves. As an example of a situation in which an industry body considered that there was ‘regulatory overload’, we can consider a media release by the Institute of Public Accountants (in Australia) in 2019 (IPA, 2019b). In the media release entitled ‘Regulatory overload – a real problem for small business’, and which referred to a report released by the IPA entitled IPA Small Business White Paper: Small Business: Big Visions (IPA, 2019a), the Chief Executive Officer of the IPA stated: When we conducted our nation-wide roadshow to gain direct insight from hundreds of small businesses, dealing with the plethora of compliance was one of the key issues. We also heard of countless stories of the stress of running their businesses and trying to keep up with compliance… We need our small business sector to be productive, to grow and to prosper, so the more we unshackle them from the regulatory burden, the better our economy will be. While this quote refers to regulatory burden, or regulatory overload, it is always a difficult task to determine the ‘right amount’ of regulation to put in place. For example, there has been a steep growth in the amount of financial reporting standards put in place in recent years, and the reporting requirements of organisations also have been steadily increasing. With this in mind, financial reporting regulators throughout the world have been introducing ‘tier systems’ whereby smaller organisations are provided with relief from complying with various financial reporting requirements. However, the reporting obligations of larger organisations continue to grow and this represents an ongoing problem for standard-setters to explore. Many people believe that there is simply too much reporting being done by large organisations and much of the reporting is of limited benefit to the readers of the reports. Regulators and supporters of regulation often use the ‘level playing field’ argument to justify putting regulations in place. From a financial reporting perspective, this means that everybody should (on the basis of fairness) have access to the same information. This is the basis of laws that prohibit insider trading, which rely on an acceptance of the view that there will not be, or perhaps should not be, transfers of wealth between parties simply because one party has access to information that others do not.13 Putting in place greater disclosure regulations will increase the confidence of external stakeholders that they are playing on a ‘level playing field’. If this helps build or sustain confidence in the capital markets, then it is often deemed to be in ‘the public interest’. However, we will always be left with the issue as to what is the socially ‘right’ level of information. Arguably, such a question cannot be answered with any level of certainty. Opponents of ‘free-market’ arguments also often note that discussions about the virtues of ‘free markets’ and minimal or no regulation are naïve. The reality is that we have many regulations and to expect that these will be taken away in favour of free markets is unrealistic. As Shleifer (2005, p. 441) states: Today we live in a much richer, more benign, but also more regulated society, and that as consumers we are generally happy with most of the regulations that protect us. We are happier knowing that trains and airplanes are safe than savouring the thought of a fortune which our loved ones would collect in a trial should we die in a fiery crash. In securities markets, investors prefer a level-playing regulated field to the prospect of loss recovery through litigation. Indeed, there is strong evidence that regulation is beneficial for the development of financial markets and to public participation in them. 13 There is also the view (Ronen, 1977) that extensive insider trading will erode investor confidence such that market efficiency will be impaired. 121 Financial Accounting Theory Pro-regulation A position taken by people who favour the use of regulation, rather than market forces, as a means of influencing particular activities. While proponents of the pro-regulation (anti-free market) view might argue that regulation is necessary to ensure the ethical treatment of various stakeholders, potentially as the result of ‘market failure’, it should also be acknowledged that there can be ‘non-market failure’ (or as it is also called, ‘government failure’). Calls for the intervention of government through regulation seem to implicitly assume that people in government always work in the ‘public interest’, and are well informed about the implications of particular legislation. However, government officials may allow self-interest to dictate their actions and they might introduce legislation to garner support from particular constituents or benefactors (Stigler, 1971). Also, across time, governments can be captured by vested interests who then are able to shape legislation in the best interests of a limited subset of society (Mitnick, 1980). As Andersson (1991, n.p.) states in relation to legislating to improve environmental performance: Governments may respond to political pressure rather than maximize social welfare. Because pollution tends to hurt large unorganized groups, future generations, and those who are uninformed, there is likely to be a ‘government failure’ resulting in too little protection of the environment. Introducing legislation is also not costless and therefore clear benefits should need to be demonstrated before regulation is introduced. Such regulatory-related costs would include those associated with formulating and explaining legislation, monitoring compliance, imposing and enforcing sanctions, compliance costs for companies and so forth. If government believes that markets are working appropriately and there are no compelling justifications for introducing legislation, then it might be more ‘efficient’ and in the ‘public interest’ to leave various responsibilities effectively in the hands of organisations. The ‘invisible hand’ Many theories that provide support for free-market approaches to accounting regulation rely on the work of the eighteenth-century economist Adam Smith (originally published in 1776 but republished in 1937). Smith has become famous for his notion of the ‘invisible hand’. The ‘invisible hand’, which was mentioned only once in his five-book treatise, The Wealth of Nations, appears in Book Four, referring to the distribution of capital in society: the annual revenue ... is always equal to the whole product of its industry ... as every individual attempts to employ his [her] capital in the support of the domestic industry and so to direct that industry that its produce may be of the greatest value, every individual necessarily labours to render the annual revenue of the society as great as he [she] can ... he intends only his own security ... he attends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was not part of it. By pursuing his [her] own interest he [she] frequently promotes that of the society more effectually than when he [she] really intends to promote it.14 Subsequent free-market exponents have drawn on the notion of the ‘invisible hand’ to promote a belief in ‘market omnipotence’, arguing against state involvement because it ‘disturbs the spontaneous order and the spontaneous society’ (Lehman, 1991, p. xi). That is, without regulatory involvement, productive resources will, as a result of individuals pursuing their own self-interest, somehow, as if by an ‘invisible hand’, find their way to their most productive uses. Some writers actually went to the next step by arguing that allowing activities to be controlled by market mechanisms will actually protect market participants. For example, Milton Friedman (1962, p. 82) states: 14 122 This quote is reproduced from Lehman (1991). The regulation of financial accounting CHAPTER 4 The central feature of the market organisation of economic activity is that it prevents one person from interfering with another in respect of most of its activities. The consumer is protected from coercion by the seller because of the presence of other sellers with whom he can deal. The seller is protected from coercion by the consumer because of other consumers to whom he can sell. These views ignore market failures (such as unequal access to information) and uneven distributions of power. Smith was concerned with particular problems that occur in monopolistic situations where prices for needed goods might be driven up by suppliers. According to Collison (2003, p. 864): Smith ... was against legislation that protected the strong and the privileged either by conferring monopoly powers over consumers, or by worsening the already weak position of employees. He did not counsel against steps taken to protect the weak and was not against regulation per se. Smith did not advocate that there should be no regulatory intervention. He was aware of the problems that might arise in an unregulated free market, and, although it is rarely mentioned by the advocates of the ‘free market’, he actually wrote of the need for the government to be involved in the ‘public interest’ to protect the more vulnerable. As Lehman (1991, p. x) states: Among the passages revealing Smith’s concern for harmful unintended consequences [of the free-market approach] are those appearing in Book V, Chapter 1, where Smith writes that in the progress of the division of labour, the progress of the great body of people will be the man [or woman] who spends much time doing a few simple operations, with no invention, with no tender sentiment, incapable of judging, incapable of defending the country in war. In every society, the great body of people will fall this way, ‘unless the government takes some pains to prevent it’. This view is also supported by Collison (2003, p. 863), who states: Adam Smith himself was well aware that conditions in the world he inhabited did not conform to the competitive ideal: he was not opposed to government action in pursuit of general welfare; indeed he favoured it, and was acutely conscious of the danger of undue power in the hands of the capitalist class. So, if we accept that Smith’s work has been misrepresented as a treatise in favour of the ‘free market’ (as a number of authors suggest), why has it been misrepresented? Collison (2003) argues that it is in the interests of many businesses that regulatory interference (such as the introduction of minimum wage controls, or disclosure requirements) be reduced. As such, he provides a view that many businesses used the work of acclaimed economists (such as Adam Smith and Milton Friedman) as a form of ‘propaganda’ to support their arguments for reduced regulation.15,16 According to Collison, arguments such as those presented by famous economists such as Smith or Friedman, and ‘the corporate propaganda which is used to sell it to the public’, were anticipated by Adam Smith, who warned of the negative impacts that could be caused by Other authors (such as Carey, 1997) have argued that many larger businesses were able to influence academics (through the provision of funding) to support particular views. The results of the academic research studies, which often supported the views held by the groups that provided the research funding, were then provided to government to substantiate or support particular positions. 16 Collison also argues that the works of other well-respected economists have been misrepresented by vested interests. For example, the works of Berle and Means (1937) have ‘become identified with conflicts of interest between owners and controllers of wealth when they explicitly argued that both should be subservient to wider interests ... They commended public policy rather than self-interest as the proper mechanism for allocating corporate income streams. As with Adam Smith, their names have arguably become misleadingly linked with a particular agenda’. 15 123 Financial Accounting Theory economically powerful interests, particularly when they are unrestrained due to an absence of adequate regulation or competition. According to Smith (as quoted in Collison, 2003): The clamour and sophistry of merchants and manufacturers easily persuade ... that the private interest of a part, and of a subordinate part of the society is the general interest of the whole (Smith, 1776/1880, Bk I, Ch. X, Pt II, p. 101). In other words, as far back as 1776 Adam Smith wrote that it is predictable that business managers will argue that what is in the interests of the business organisations will actually be in the interests of the society as a whole – an argument that is still heard today, about 250 years later. That is, it is in the interests of managers to argue that if businesses prospers, then society will also prosper. This perspective is consistent with the economic interest theory of regulation, which is discussed later in the chapter. It is also consistent with what is often referred to as the ‘trickledown effect’, or ‘trickle-down theory’, which we explore more fully in Chapter 10. Under this perspective, if large organisations are allowed to freely operate and to grow, thereby making the related investors and managers wealthy, then these wealthy people will spend more, pay more taxes and invest more, and this will create further jobs for others, and the less powerful or less privileged workers would benefit from ‘trickle-down economics’ as production and consumption across the community increases. However, evidence does clearly show that there is still great disparity in wealth within society and that despite increases in productivity, some people remain very poor, so the validity of such claims about ‘trickle-down effects’ are questionable. In relation to how business will oppose the need for regulation on the basis of the argument that ‘what benefits business will also benefit society’, we can consider an Australian Government inquiry into corporate social responsibility and associated reporting. In 2005 the Federal Government established through its Parliamentary Joint Committee on Corporations and Financial Services (PJCCFS) (under the auspices of the Australian Securities and Investments Commission Act 2001) an Inquiry into Corporate Responsibility. Public submissions were invited, with submissions being received up to early 2006. The purpose of the inquiry was to consider the merit of introducing greater regulatory requirements in relation to corporate social responsibility and associated reporting (an issue that is investigated in Chapter 10). Specifically, the government was exploring opinions with regard to whether the Corporations Act 2001 should be amended to include specific corporate social responsibilities and specific social and environmental reporting requirements. Deegan and Shelly (2014) undertook an analysis of the submissions that were made to the inquiry. In summary, their analysis indicated that the managers of business corporations and related associations overwhelmingly favoured an anti-regulation (‘free market’) approach whereby corporations and their managers should be left to voluntarily determine their social responsibilities and their associated accountabilities, the view being that markets will ultimately penalise organisations with poor social and environmental records. (That is, the business organisations argued that if people in the marketplace expect a corporation to perform soundly in relation to its social and environmental activities, and if the organisation subsequently does not perform in accordance with these expectations, then market participants will penalise the organisation.) For example, Deegan and Shelly quoted from the submission made to the inquiry by QBE Insurance, one of Australia’s largest insurance companies. QBE Insurance stated: The market is the natural mechanism under which the issue of corporate social responsibility will continue to thrive. Seeing the market as ‘a natural mechanism’ is an interesting perspective. In stark contrast, social and environmental groups, consumer associations, employee groups and individuals who made submissions to the inquiry tended to adopt a pro-regulation view; they believed that regulation needs to be put in place to protect the interests of various stakeholders and that, when left to the ‘invisible hand’ of the market, corporations do not operate in the ‘public interest’ (other than perhaps when they are persuaded through ‘enlightened self-interest’). 124 The regulation of financial accounting CHAPTER 4 Deegan and Shelly (2014) made specific reference to statements in various organisations’ submissions to the inquiry. Of particular interest was a submission made by the Chamber of Commerce and Industry of Western Australia. The Chamber of Commerce was particularly critical of calls for the introduction of legislation in relation to corporate social responsibilities and associated reporting, stating: Above all, it (calls for regulation to require corporations to undertake certain social activities and to provide information about their social and environmental performance) is indicative of a lack of faith in the capacity of the ‘invisible hand’ of the free market to deliver a better economic, environmental and social outcome than the good intentions of business leaders, suitably stiffened by laws, incentives and stakeholder responsibilities ... But those who doubt the efficacy of markets have never yet been able to point to an economy or society where a ‘visible hand’ has done better, whether that hand is guided by the state, a plurality of stakeholders, or well-intentioned business leaders. ... The advocates of mandated corporate social responsibility and stakeholder entitlements would impede the business sector’s capacity to make this valuable contribution to the economy and society. It is interesting that a number of submissions to the inquiry made specific reference to the works of Adam Smith (and the ‘invisible hand’) to justify their particular anti-regulation viewpoint. Deegan and Shelly also found that many of the submissions made by business organisations suggested that the introduction of legislation was against the interests of Australia, as it would ‘stifle’ any form of innovation in social and environmental reporting. For example, the Australian Institute of Company Directors’ submission stated: The AICD believes that reporting on corporate social responsibility in Australia is at a very early stage and mandating any particular approach is likely to stifle innovation and experimentation by companies and to lead to a mentality where directors and management focus on compliance only. Deegan and Shelly challenged the view that introducing mandatory reporting requirements would stifle innovation. Rather, they believed that regulation would simply establish a minimum level of disclosure which organisations could elect to exceed. Apart from the risk that legislation would ‘stifle innovation’, many of the submissions from business and industry organisations referred to the risk that the introduction of specific legislative requirements pertaining to corporate social responsibilities would tend to engender a compliance mentality and increase compliance costs. Numerous submissions from the business community also stated that a ‘one-size-fits-all’ approach (legislation that applies to all entities) is highly inappropriate and that given market efficiencies and the managers’ quests for maximising shareholder value, these factors alone should lead to innovation and benefits for all (as if by an ‘invisible hand’). Evidence provided by Deegan and Shelly indicates that it is common for business organisations to oppose the introduction of various forms of legislation, and it is also common for business leaders to argue that if society expects corporations to undertake particular actions, then corporations will undertake these actions because failure to do so will impose costs on the organisation. For example, if society expects a company to adopt high standards of environmental performance (it is part of the so-called ‘social contract’ between the organisation and society), and the company is then shown to be damaging the environment, consumers will elect not to buy the company’s products, banks will not lend funds to the organisation, people will not want to work for the company and so forth. The argument is that regulation is not needed and will actually impede the ‘natural functioning’ of the market. The market is seen as the best mechanism to discipline poorly performing managers. 125 Financial Accounting Theory Enlightened self-interest Enlightened self-interest This would be in operation when managers of an organisation respond to community concerns (as if to appear to be caring) in those situations where doing so also fulfils the goal of maximising the value of the organisation, and therefore the wealth of owners and managers. The above arguments indicate that organisations driven by ‘enlightened self-interest’ will be expected to respond to community concerns.17 Enlightened self-interest is considered to be demonstrated when a person, or an organisation, that appears to be acting in the interests of other stakeholders’ interests ultimately generates outcomes that serve their own self-interest. Interestingly, at the completion of the inquiry into corporate social responsibility, the Australian Government decided against introducing any regulation to specifically identify corporate social responsibilities. In justifying the conclusion that there was no need to introduce additional legislation, the final report of the inquiry made specific reference to the benefits of allowing ‘enlightened self-interest’ to dictate behaviour (PJCCFS, 2006, p. xiv): This ‘enlightened self-interest’ interpretation is favoured by the committee. Evidence received suggests that those companies already undertaking responsible corporate behaviour are being driven by factors that are clearly in the interests of the company ... Maintaining and improving company reputation was cited as an important factor by companies, many of whom recognise that when corporate reputation suffers there can be significant business costs. Evidence also strongly suggested that an ‘enlightened self-interest approach’ assists companies in their efforts to recruit and retain high quality staff, particularly in the current tight labour market. Hence, in relation to corporate social responsibilities, the government clearly favoured an anti-regulation approach, driven perhaps by ‘free market’ arguments, as discussed in this chapter. Not surprisingly, there were many individuals and groups that criticised the decision made by the government and that favoured the introduction of regulation, perhaps driven by ‘proregulation’ perspectives, as discussed also in this chapter.18 Again, as emphasised throughout this book, there will be different views about different issues – in this case, about the advantages or disadvantages of regulation. Whether we personally favour one approach or the other will be based on our own values and whether we are prepared to accept the arguments (and theories) proposed by ‘free market’ proponents or those proposed by ‘pro-regulation’ proponents. It is of interest that the ultimate position taken by the Australian Government in relation to the PJCCFS was similar to the position of the government in Britain in regards to its Operating and Financial Review (OFR) and the introduction of mandatory corporate social responsibility reporting. Under the proposed OFR regulations, a company would have been required to provide information on its policies towards employees, customers and suppliers, as well as its impact on the environment, on society and on the wider community where the information was necessary for an assessment of the company (Department of Trade and Industry, 2004, in Cooper and Owen, 2007, p. 651). Owen, Shaw and Cooper (2005) investigated whether the mandatory reporting requirements of the OFR would provide the catalyst for improving corporate disclosure of social and environment information and they concluded that for already active social and environmental disclosers, the mandatory reporting requirement would have limited effect. However, for current non disclosers the OFR requirements ‘may mean that As an example of the ‘enlightened self interest’, Deegan and Shelly (2014) note that Origin Energy made the following submission to the inquiry: ‘Successful companies can obtain competitive advantage by being considerate of wider ‘duties’ that may not be the subject of specific legislation. Companies that ignore these wider duties may suffer disadvantage in their product or investment markets and may suffer loss of value through damage to their reputation.’ 18 As an example of the ‘pro-regulation’ perspective, Deegan and Shelly (2014) note that Amnesty International made the following submission to the inquiry: ‘There are numerous cases of Australian companies that have acted with gross disregard of the environment and the communities in which they operate. It is also apparent that none of the supposed controls on corporate malfeasance – enlightened self interest, enlightened shareholder value, corporate reputation, voluntary commitments, personal ethics – were sufficient to prevent these events.’ 17 126 The regulation of financial accounting CHAPTER 4 social and environmental issues become more mainstream in strategic terms’ (Owen, Shaw and Cooper, 2005, p. 8). However, after a six-year consultation period and less than a year after the introduction of the OFR, the legislation was repealed on the basis of concerns by the business community about the additional ‘administrative costs of the gold-plated regulatory requirements’ and the view that market mechanisms adequately ensure that corporations attend to their social responsibilities therefore making the OFR requirements redundant (Brown, 2005, as cited in Cooper and Owen, 2007, p. 664). We have discussed how various people have used the work of Adam Smith to support their arguments. Of interest is that reference to the work of Smith continues to be made in the news media to support or justify calls for removal of regulation and ‘government interference’ (although, as we noted, Smith also wrote of the need for regulation to moderate adverse impacts caused by large organisations). As a recent example of this, in an article entitled ‘WA government, Lib MPs slam push for $250b mining back-up’ (Coorey, 2021), a state politician criticised potential federal government intervention into the mining industry. Arguing against federal government intervention into the funding of mining activities, the politician stated that there was ‘already plenty of finance’ and that ‘Adam Smith told us the free market will drive investment towards what’s needed’, thereby justifying the argument that no federal government intervention was warranted. Free-market versus pro-regulation debates are ongoing in respect of many activities and industries, with various vested interests putting forward many different and often conflicting arguments for or against regulation. It is an argument that is often the subject of heated debate within university economics and accounting departments throughout the world. What do you think? Should financial accounting be regulated, and, if so, how much regulation should be put in place? Figure 4.1 provides a summary of some of the various arguments for and against regulation of financial reporting, and some of the assumptions adopted by the advocates of free markets and the advocates of regulation. Having discussed the arguments for and against regulation, we now consider a number of theories that describe why regulation is put in place, and discuss which stakeholders are expected to benefit from regulation. The following theories might assist our understanding of why, in particular situations, decisions were made for legislative reform. For example, according to Barton and Waymire (2004, p. 67): The October 1929 market crash is seen as among the most significant financial crises in US history (Galbraith, 1972) and was followed within five years by the most extensive changes in financial reporting requirements in US history. Why would there be such reform? Barton and Waymire further state (2004, p. 69): Regulators often cite investor protection as a basis for more stringent financial reporting requirements enacted after financial crises. The investor protection justification has a long history dating back at least to British legislation passed in the wake of corporate bankruptcies in the 19th century (Littleton, 1933, pp. 272–87). Investor protection arguments surfaced in the US after the 1929 stock market crash as justification for the financial reporting requirements embodied in the Securities Act of 1933 and the Securities Exchange Act of 1934 (Pecora, 1939; Parrish, 1970). The intent of the Securities Acts was to protect investors from exploitation by informed traders in the large-scale securities markets that developed to support financing of enterprises with diffuse ownership structures (Berle & Means, 1932). More recently, the US Congress and Securities and Exchange Commission (SEC) have cited investor protection as the basis for recent reporting rules following the market decline of the past few years (US House, 2002). Implicit in the investor protection justification for financial reporting 127 Financial Accounting Theory FIGURE 4.1 Summary of free market and pro-regulation arguments ‘Free market’ perspective Pro-regulation perspective The nature of accounting information Accounting information is like any other good, and forces of supply and demand should be left to operate in an unhindered manner to provide optimal amounts of information. Information is a ‘public good’ and due to ‘free riders’ will be under-produced in unregulated markets. Regulatory intervention is therefore necessary. The nature of markets Markets are efficient and provide disciplining mechanisms for managers who do not produce the information that is required by the market. Managers know that should they fail to provide demanded information then their cost of attracting financial capital will increase. Markets are not efficient or equitable and therefore regulation is supplied in response to the need for a correction of inefficient or inequitable market practices. The nature of government Government regulators are not objective, but like everybody else, are driven by their own self-interest. They will introduce regulation that ultimately benefits them, or particular vested interests. Government regulators act in the public interest. The beneficiaries of regulation Regulation, if introduced, will ultimately serve the interests of politically effective groups as well as potentially the regulators themselves. Regulation will serve the general interests of society. The role of government in developing regulation There are government failures that provide inefficient outcomes. Government intervention will lead to regulation overload as well as many costs associated with regulatory compliance. Government is a relatively costless and dependable vehicle for altering market behaviour in a way that is in the public interest. The independence of the regulator The political process of regulation will ultimately be captured by the industry that is being regulated or, alternatively, legislation will be introduced to serve the interests of powerful groups who are able to reward regulators. Regulation will not be captured as this would be against the public interest. Regulators will remain independent in the interests of serving the public. regulation is that higher quality reporting would have lessened investor losses during the recent crisis and that managers lacked incentives to supply higher quality financial information voluntarily.19,20 Legislators might have justified the introduction of new legislation in terms of protecting investors, but does this mean that investor protection was their real motivation? Or did they have other private incentives? The following theories provide different perspectives on why the ‘extensive changes’ were made. For example, public interest theory of regulation would propose that such regulatory changes were brought about in the interest of the public, which would be consistent with an ‘investor protection’ style of argument. By contrast, economic interest theories of regulation would suggest that the regulations might have been put in place so that regulators themselves, who would have been under pressure due to the large losses that had been suffered, Consistent with a free-market approach to accounting information, Barton and Waymire (2004, p. 70) note: ‘of course, mandatory disclosure requirements need not be the sole source of investor protection – self-interested managers supply information voluntarily to reduce agency costs (Jensen and Meckling, 1976; Watts and Zimmerman, 1986) and information costs in securities markets (Dye, 2001; Verecchia, 2001)’. 20 Interestingly, the US Securities and Exchange Commission website (as accessed November 2021) states: ‘The mission of the U.S. Securities and Exchange Commission is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation’. It is interesting that the mission of the SEC does not embrace a responsibility to stakeholders other than investors, such as local communities, employees and so forth. Perhaps there is a view that if ‘investors’ are protected the rest of society will benefit. This issue is explored more fully in Chapter 10. 19 128 The regulation of financial accounting CHAPTER 4 looked like they were doing something and this might help them retain their positions as regulators (and therefore help them retain their related income stream). In such an explanation, the introduction of the legislation is not so much about the public interest as about the private interests of those in charge of introducing the legislation. Again, as emphasised throughout this book, there are different ways of looking at the same phenomenon: some researchers may view the introduction of legislation as being in the public interest (a view embodied within public interest theory), whereas other researchers, viewing things through an alternative ‘theoretical lens’, may consider that the same action was taken because it best served the private interests of those in control of introducing the legislation (economic interest group theory of regulation). Why do I need to know about the arguments for and against the introduction of regulation? Throughout our lives, we will all be exposed to a great deal of regulation. It is inescapable. We might also have a role that requires us to generate, or read, financial reports, which in themselves are subject to much regulation. Rather than simply accepting that all regulations are beneficial, we should attempt to critically evaluate whether regulations are necessary or whether other, perhaps marketrelated, mechanisms should have been allowed to operate to provide the optimal amount of a particular product or service. By knowing about theories of regulation, we will be able to make more sense of the world in which we live – a highly regulated world. Also, in the future, we might find ourselves in a role that involves developing regulation, or supporting or opposing regulation. The insights provided within this chapter will allow us to perform our role more effectively and with greater insight. REFLECTION QUESTION 4.1 To regulate, or not to regulate, accounting practice? Question Given everything you have just read, should financial reporting be regulated or left to market forces? Solution We will likely have different views about this issue depending upon the extent to which the ‘free market’ or ‘pro-regulation’ arguments resonate with us. In answering this question, we need to consider the merits of the arguments provided by different researchers (as discussed in this chapter); whether we are prepared to believe that freely operating ‘market forces’ generate outcomes that are equitable to all stakeholders (do we believe that there is some form of ‘invisible hand’ that moves things towards equitable outcomes?); or, whether we have faith in those parties potentially charged with developing regulation (are the regulators likely to act in the public interest or in their own self-interest?). It is the opinion of the author of this text that some financial reporting regulation is necessary to protect the interests of different market participants, particularly those people who have much of their wealth invested in organisations with which they have no direct relationship, other than being an investor. Also, other stakeholders (such as employees, consumers and local communities) arguably have a right to receive information about an organisation’s financial performance, and these rights might not be addressed in the absence of regulation. But it would be naïve to believe that the benefits of all regulations exceed the associated costs or that regulations are never established to promote the vested interests of some people over and above the interests of others. As members of society, and as accountants, we need to critically review, and possibly challenge, the regulations that act to control our behaviour or to define our rights. However, we need to understand that regulatory overload and accounting standard overload can exist, and therefore we should consider whether any proposed regulations we support are likely to provide sufficient benefit (which in itself raises questions about how these costs and benefits would be determined and from whose perspective). So, while it is probably easy to justify that some regulation is needed, it becomes tricky when deciding what the optimal amount of regulation is and from whose perspective an optimal amount of regulation should be determined. Like the practice of accounting itself, the regulation of financial reporting is indeed a fascinating topic! 129 Financial Accounting Theory LO4.2 Public interest theory A theory of regulation which suggests that regulation is developed in the ‘public interest’. Regulators are assumed to be motivated by the ‘public interest’ and will select regulation on the basis that the social benefits of the regulation exceed the social costs. Public interest theory Public interest theory was the dominant theory of regulation until the 1960s, and still has many supporters. According to Posner (1974, p. 335), public interest theory ‘holds that regulation is supplied in response to the demand of the public for the correction of inefficient or inequitable market practices’. That is, regulation is initially assumed to be put in place to benefit society as a whole, rather than particular vested interests, and the regulatory body is considered to be a neutral arbiter that represents the interests of the society in which it operates, rather than the private interests of the regulators.21 The enactment of legislation is considered a balancing act between the social benefits and the social costs of the regulation. Applying this argument to financial accounting and reporting, and accepting the existence of a capitalist economy, society needs confidence that capital markets efficiently direct (or allocate) resources to productive assets. Regulation is deemed to be an instrument to create such confidence. As a past high-profile example of regulation being introduced in the ‘public interest’, and therefore consistent with the public interest theory of regulation, we can consider the introduction in 2002 of the Sarbanes-Oxley Act in the United States – an Act that was developed following the collapses of large corporations such as Enron and WorldCom and because of the apparent failures at the (then) leading accounting firm, Arthur Andersen. The Sarbanes-Oxley Act (often simply referred to as SOX) was developed to try to reduce the possibility of large-scale corporate collapses and poor accounting and auditing practices, and to increase the confidence of investors. Increased confidence within capital markets was considered to be in the ‘public interest’. The Act was named after its sponsors, US Senator Paul Sarbanes and US Representative Michael G. Oxley. Following SOX, senior corporate management within the US must individually certify the accuracy of financial information, and penalties for fraudulent financial activity are now stronger. The independence of outside auditors has also been enhanced, as has the oversight role of boards of directors. Various requirements have also been introduced in relation to corporate governance, internal control assessment and enhanced financial disclosures. In response to global perceptions that stricter financial governance laws were needed, similar laws were introduced in Japan, Germany, France, Italy, Australia, Israel, India, South Africa and Turkey. As might be expected, there is still some debate over the costs and benefits of SOX. Opponents of the Act, who tended to favour ‘free-market’ mechanisms as described earlier in this chapter, argue that it has reduced the United States’ ability to be competitive internationally because it has introduced an overly complex regulatory environment that creates high compliance costs. Supporters of the Act argue, however, that SOX has had an important hand in improving the confidence that investors and other parties have in corporate financial statements. Many people are critical of the perceived simplistic ‘public interest’ perspective of why regulation is introduced (for example, Peltzman, 1976; Posner, 1974; Stigler, 1971). Posner (1974) questions the ‘assumptions that economic markets are extremely fragile and apt to operate very inefficiently (or inequitably) if left alone; the other questionable assumption being that government regulation is virtually costless’ (p. 336). Posner also criticises arguments that suggest legislation is typically initially put in place for ‘the public good’ but only fails to achieve its aims due to government ineptitude, mismanagement or a lack of funds. As he states (p. 337): [There is] a good deal of evidence that the socially undesirable results of regulation are frequently desired by groups influential in the enactment of the legislation 21 130 This perspective would not be accepted by advocates of the ‘rational economic person’ assumption, as they would argue that all activities, including the activities of regulators and politicians, are primarily motivated by a desire to maximise personal wealth rather than any notion of acting in the public interest. The regulation of financial accounting CHAPTER 4 setting up the regulatory scheme ... Sometimes the regulatory statute itself reveals an unmistakable purpose of altering the operation of markets in directions inexplicable on public interest grounds ... The evidence that has been offered to show mismanagement by the regulatory body is surprisingly weak. Much of it is consistent with the rival theory that the typical regulatory agency operates with reasonable efficiency to attain deliberately inefficient or inequitable goals set by the legislature that created it. Laughlin (2007) also noted that while governments might argue they are putting regulations in place for the ‘public interest’, they might actually be introducing regulations or legislation that best serve their particular political interests or ideologies. As a case in point, Laughlin (2007) noted the initial support for a report in the United Kingdom known as The Corporate Report (1975), which had proposed that accounting, and accounting regulation, needed to serve the information needs of many different stakeholders and not just shareholders and lenders. The Corporate Report led to a UK Government Green Paper that supported the development of accounting frameworks which would have a broader stakeholder (as opposed to a narrow shareholder) focus. However, when a new government was elected in the United Kingdom, it embraced a view that supported the information needs of the providers of financial capital over and above the needs, or information rights, of other stakeholders. As Laughlin (2007, p. 278) states: The new Conservative Government, led by Margaret Thatcher, banished such a compassionate understanding of stakeholders, and their information needs, and put in their place the information needs of finance capitalists – notably shareholders and other finance providers…. Had the Conservative Government, in 1979, wanted to, they could have supported the work that the previous Labour administration had started and accounting regulation could have been totally different. They didn’t and they didn’t because they believed it would not be in the ‘public interest’ to develop a stakeholder emphasis… Government can and does allow quasi-independence of the accounting regulators to regulate the profession, both generally as well as specifically, providing it is working in whatever they deem to be the ‘public interest’. Where this is perceived not to be occurring then they will intervene, and these interventions cannot and should not be ignored. Proponents of the economics-based assumption of ‘self-interest’ would argue against accepting that any legislation was put in place by particular parties because they genuinely believed that it was in the public interest. Rather, they consider that legislators will put in place legislation only because it might increase their own wealth (perhaps through increasing their likelihood of being re-elected), and people will lobby for particular legislation only if it is also in their own self-interest. Obviously, as with most theoretical assumptions, this self-interest assumption is one that (hopefully!) does not always hold. The private interest group theory of regulation, which assumes self-interest, is considered later in the chapter. In the next section, the regulatory Capture Theory of regulation is discussed. Unlike the private interest group theory of regulation, Capture Theory admits the possibility that regulation might initially be put in place for the public interest. However, it argues that the regulation will ultimately become controlled by those parties whom it was supposed to control. 131 Financial Accounting Theory REFLECTION QUESTION 4.2 The public interest perspective Question If government has said that an accounting regulation was introduced for the ‘public interest’, would you believe them? Solution Our answer to such a question will be influenced by our own assumptions about what motivates government regulators – is it public interest, self-interest or perhaps a mixture of both? We can consider the evidence of research that has investigated people in governments’ motivation for particular decisions. Broadly speaking, the evidence is mixed – some points to selfinterest and some points to public interest. Another point to be noted is that we will all potentially have different views about what is in the ‘public interest’. Some people might believe in the ‘trickle-down effect’ such that any regulation which directly supports or protects the interests of investors will likely be in the broader public interest, because confidence in the capital markets benefits everybody. LO4.2 Capture Theory This theory suggests that although regulation is often introduced to protect the public, the regulatory mechanisms are often subsequently captured so as to protect the interests of particular self-interested groups within society, typically those whose activities are most affected by the regulation. LO4.3 Conversely, other people, on the basis of their own research or evidence, might dispute such flow-on effects and argue that the government is simply supporting already rich investors because such investors have the financial means to help reelect the government. As we have also discussed, different political parties have different ideologies and will have different views about the responsibilities and accountabilities of organisations, and what is in the ‘public interest’. Therefore, it is very possible that different political parties will have diametrically opposing views on the needs for particular regulation, including the regulation of corporate reporting, but all will be arguing that their views are in the ‘public interest’. Therefore, the solution to this question is clearly not an easy ‘Yes’ or ‘No’ answer. We need to consider existing research, the philosophical views of the researchers involved and our own notions about what represents the ‘public interest’. Capture Theory Researchers who embrace Capture Theory (capture theorists) would typically argue that, although regulation might be introduced with the aim of protecting the ‘public interest’ (as argued in public interest theory described above), this laudable aim will not ultimately be achieved because, in the process of introducing regulation, the organisations that are subject to the regulation will ultimately come to control the regulator. The regulated industries will seek to gain control of the regulatory body because they know that the decisions made by the regulator will potentially have a significant impact on their industry. The regulated parties or industries will seek to take charge of (capture) the regulator with the intention of ensuring that the regulations subsequently released by the regulator (postcapture) will be advantageous to their industry. Regulatory capture is a common phenomenon in which regulators, governments, regulatory authorities and professional bodies come to identify more with the interests of the people they are supposed to be regulating than with the interests of the people they are supposed to protect. This capture might occur in the following situations: • Particular industry bodies, or large organisations within an industry, are known to offer jobs to people who previously worked within regulatory bodies. This strategy might encourage people within such regulatory bodies to be ‘friends’ of their future potential employers. As an example of this, we can refer to an Australian Financial Review article entitled ‘Bank boards are full of former regulators’ (Kehoe, 2018). In this article, it was reported that Graeme Samuel, former chairperson of the Australian Competition and Consumer Commission (ACCC), had stated that Australian economic regulators are ‘at risk of capture from the financial services industry because of the potential lure of working in a highly paid and powerful job at a big bank in their post-public service career’. It was also reported that Samuel was of the view that: there is a risk that regulatory personnel may pull their regulatory punches, knowing a future employer could be on the receiving end. Samuel said there was a danger of the ‘vulnerable regulator’ – junior or senior – ‘feeling the need to be liked’ and wanting to 132 The regulation of financial accounting CHAPTER 4 feel they are ‘mixing it with the big end of town’. ‘The most serious risk for regulators is industry capture,’ said Samuel. ‘Industry is adept at implementing regulatory capture strategies.’ Applying such concerns to the Australian corporate regulator, an article that appeared in The Australian entitled ‘Overseas watchdogs can end “cosy” alliance’ (Rodden, 2019, p. 2) argued that senior representatives in the Australian Securities and Investments Commission (ASIC) became too close to the banking sector and, as a result, Australia’s corporate watchdog ‘too often failed to regulate the banking sector properly because they were captured by the industry’. The concerns were raised because many senior officers within ASIC were ultimately offered senior appointments within banking organisations, and therefore, knowing that banks would make such appointments, the senior ASIC officials were perceived to be less inclined to make tough decisions against the industry when acting as regulators, because to do so might mean they would be shunned from appointments on leaving ASIC. • From the reverse perspective, regulatory bodies often offer jobs to people who held senior roles in the industries being regulated. This might occur when, for example, a large corporate regulator such as the Securities and Exchange Commission (SEC) in the United States, or ASIC in Australia, offers jobs to former members of industries or organisations that it used to regulate. These potential new employees will likely have close relationships with the people and organisation they would thereafter be regulating. As an example of this form of industry capture, we can consider a Washington Post article entitled ‘Watchdog’s report raises concerns about SEC’s revolving door’ (Elboghdady, 2013). The report described the possible capture of the SEC – a very important body in terms of regulated corporate disclosures within the United States. A newly appointed head of the SEC had previously been a private sector lawyer acting on behalf of large companies, large banks and large accounting firms. Of concern was that she would be regulating many organisations with whom she had previously developed a close working relationship. Within the newspaper article, a senator was reported as saying: It’s especially important for the SEC to fix this problem with the arrival of a new chairman who, if confirmed, would bring a lot of good things to the commission but also a lot of connections to the securities industry she’d be regulating. • When industry bodies or particular organisations provide certain benefits of value to individuals within regulatory bodies. As an example of this, we can consider the contents of a report in the West Australian entitled ‘Crown Perth paid for casino watchdog boss Barry Sergeant to travel to Macau’ (Moulton, 2021), in which reference was made to a report from the Perth Casino Royal Commission that noted the large casino, Crown Perth, paid for the Chairperson of the state’s Gaming and Wagering Commission (GWC) to accompany senior executives of Crown to travel to Macau and stay in premium accommodation, all for the supposed purpose of ‘educating’ the Chairperson about the work of Crown. This ‘education’ was reported as coming at the same time that Crown was lobbying the government to reduce the tax being imposed upon the casino, which it subsequently did one year later. In the article, the Interim Report of the Perth Casino Royal Commission (issued 4 August 2021) was reported as stating: ‘The preliminary view ... is that the capability and effectiveness of the GWC may have been hampered,’ the report said. Significantly, the report said on first look, major relaxations of rules governing the Perth casino could have been influenced by ‘regulatory capture’ – where a regulator becomes dominated by the industry it oversees. • When industry bodies partner with government regulators to tackle particular problems. 133 Financial Accounting Theory • When industry bodies or large organisations make donations to government to support their electoral campaigns. Financial support might encourage any elected regulator to be favourable towards donors. ASIC also has recognised the risk of it being the subject of regulatory capture. The Final Report of the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry, in relation to the proposal to establish a new enforcement body within ASIC, noted (Hayne, 2019, p. 441): The risk of regulatory capture is well acknowledged. One means of avoiding regulatory capture affecting enforcement decisions is to have the enforcement arm of ASIC separated from day-to-day dealings with the entities it regulates to the greatest possible extent. Enforcement staff will have to meet with regulated entities to discuss enforcement decisions. So, for example, enforcement staff will have to negotiate about litigation that is on foot. But those meetings should be conducted through the parties’ legal representatives and with appropriate formality. Enforcement staff should not be responsible for the general relationship between the regulator and the regulated entity. Their involvement with an entity should be matter-specific. Within the regulator, enforcement officers must be relied upon for clear and objective advice and action. Those responsible for continuing supervision of an entity may give too much weight to past good conduct, or may – even subconsciously – explain away conduct that would otherwise raise a red flag. Obviously, there are economic benefits to an entity if it is able to ‘capture’ the body that regulates it. According to Mitnick (1980), and consistent with some of the material discussed above, there are at least five ways in which a regulated entity or industry will be able to capture a regulatory body (Mitnick, 1980, p. 95, as reproduced in Walker, 1987, p. 281): 1 2 3 4 5 Capture is said to occur if the regulated interest controls the regulation and the regulated agency; or if the regulated parties succeed in coordinating the regulatory body’s activities with their activities so that their private interest is satisfied; or if the regulated party somehow manages to neutralise or ensure nonperformance (or mediocre performance) by the regulating body; or if in a subtle process of interaction with the regulators the regulated party succeeds (perhaps not even deliberately) in co-opting the regulators into seeing things from their own perspective and thus giving them the regulation they want; or if, quite independently of the formal or conscious desires of either the regulators or the regulated parties, the basic structure of the reward system leads neither venal nor incompetent regulators inevitably to a community of interests with the regulated party. Thus, while the introduction of regulation can in many cases be explained in terms of protecting the ‘public interest’, it is argued that inevitably it will be difficult for a regulator to remain independent of those parties or industries being regulated, as the survival of the regulatory body over a period of time often depends on satisfying the expectations of those parties or groups being regulated. Further, the greater the industry’s total resources relative to those of the regulator, the greater will be the chance that the regulator will ultimately be unable to remain independent. By contrast, non-industry members, inclusive of consumers and the general public, could individually be impacted relatively minimally by proposed legislation and therefore will have little incentive to act. Further, even if they are particularly concerned by 134 The regulation of financial accounting CHAPTER 4 potential legislation, to the extent that they act individually or within small groups, their ability to influence the legislation might be low. As with various industries, including those discussed above, at various times and in various jurisdictions, it has been argued that large accounting firms have captured the accounting standard-setting process. This was of such concern in the United States that in 1977 the US Congress investigated whether the (then) Big Eight accounting firms had ‘captured’ the standardsetting process (Metcalf Inquiry). In the Australian context, Walker (1987) argued that the Australian Accounting Standards Review Board (ASRB) (which was subsequently replaced by the Australian Accounting Standards Board) was apparently ‘captured’ by the accounting profession.22 He cites a variety of evidence in support of this argument, concluding that within two years of its formation: the profession had managed to influence the procedures, the priorities and the output of the Board. It was controlling both the regulations and the regulatory agency; it had managed to achieve coordination of [its] activities; and it appears to have influenced new appointments so that virtually all members of the Board might reasonably be expected to have some community of interests with the professional associations. (Walker, 1987, p. 282) As we know, proponents of Capture Theory typically argue that regulation is usually introduced, or regulatory bodies are established, to protect the public interest. For example, from an accounting perspective, new regulatory systems and regimes are often established in response to high-profile accounting failures, where members of the public are perceived to have suffered a financial loss and it is argued that new regulations will help prevent a repeat of the accounting failures. This happened with the establishment of: • the SEC in the United States in the early 1930s, which was formed in response to the Wall Street Crash of 1929 • the UK Accounting Standards Steering Committee in the early 1970s following negative publicity over accounting failures at some large UK companies in the late 1960s • the Accounting Standards Board in the United Kingdom in 1990 following further large-scale accounting failures in the late 1980s • many tighter accounting and corporate governance regulations being imposed in many countries following the accounting failures at Enron, WorldCom, Parmalat and other companies in the early 2000s • recent high-level political pressures for global convergence on a single set of high-quality accounting standards following the sub-prime banking crisis and ensuing global financial crisis (GFC). While the resultant regulatory bodies are often portrayed as ‘objective’ and ‘independent’, in the past their members have predominantly been professional accountants and finance directors (the preparers of accounts whom these regulatory bodies are meant to be regulating!), which Walker (1987) argues is an important component of regulatory capture. However, mechanisms have been put in place to help ensure greater independence of accounting regulators. For example, the International Accounting Standards Board (IASB) has 16 members, of whom all but three have to work full-time and exclusively for the Board, and are required to sever their ties with previous employers. They are also appointed by the board of 22 Trustees of the International Financial Reporting Standards (IFRS) Foundation who have all agreed that they will act in the public (not their own private) interest and whose appointments must in turn be approved by a ‘Monitoring Board’ that represents a broad cross-section of interests. While this may help in giving an image of detached and impartial objectivity to the 22 Walker was a member of the ASRB from 1984 to 1985. In commenting on his motivation for documenting the case study of the ASRB, Walker states (p. 285) that: ‘The main concern was to highlight the way that a set of standard setting arrangements designed to permit widespread consultation and participation were subverted by some likeable, well-meaning individuals who were trying to promote the interests of their fellow accountants’. 135 Financial Accounting Theory IASB standard-setting process (which is discussed in the next chapter), it should be remembered that the members of the IASB are still mostly professionally qualified accountants whose views are bound to be conditioned to a certain extent by their previous experiences and training. Furthermore, the constitution of the IFRS Foundation, whose Trustees appoint IASB members, stipulates that: ‘The mix of Trustees shall broadly reflect the world’s capital markets and diversity of geographical and professional backgrounds to ensure a broad set of skills, experience and perspectives. The Trustees shall be required to commit themselves formally to acting in the public interest in all matters’ (IFRSF, 2021, paragraph 7). In these circumstances, it is reasonable to question how independent and impartial the accounting standard-setting process can be. Returning to Walker’s analysis of the ‘capture’ of financial reporting standard-setting within Australia, Walker argues that prior to the establishment of the ASRB, accounting standards were issued by the accounting profession and sanctions for non-compliance (which were very rarely imposed) could only be made against members of the profession. Walker (p. 270) notes that throughout the 1970s (which was prior to the establishment of the ASRB in 1984), monitoring activities by government agencies revealed a high incidence of non-compliance with profession-sponsored accounting rules.23 This non-compliance was argued to reduce the confidence of the public in the capital market, which was not in itself deemed to be in the public interest. Government-sponsored standards, with associated legal sanctions, should, it was thought, increase the level of compliance and hence the confidence of the public in company reporting practices. Interestingly, in the 1970s the profession acknowledged the high level of non-compliance but argued that the best alternative was to give automatic statutory backing to professionally developed standards (thereby increasing the ‘force’ of the standards, but leaving the standard-setting process in the hands of the profession). While discussions proceeded relating to the establishment of the ASRB (a government body), suggestions were received by government from various sources that the possibility of statutory accounting standards being developed other than by the accounting profession should be considered. It was also suggested that the ASRB be given the power to determine the priorities of various standard-setting issues, as well as to appoint a ‘research director’. The accounting profession was quite vocal in its opposition to such moves, as it was against the idea of government itself (through the ASRB) being involved in the actual development of accounting standards. The accounting profession wanted to retain control over the standard-setting rather than having the power transferred to government. According to Walker (1987, p. 271): The accounting profession strongly opposed the ‘costly and possibly bureaucratic step’ of involving government in the preparation of accounting rules. It publicised counter-proposals that existing rules contained in the Companies Act and Codes should be scrapped and that legislative backing be extended to the profession’s own standards. The files of the Commonwealth Attorney-General’s Department relating to the establishment of the ASRB (copies of which were obtained in terms of Commonwealth Freedom of Information legislation) record that National Companies and Securities Commission Chairman Leigh Masel referred to a ‘concerted lobby by the accounting profession’ on these matters. According to Walker, Masel contacted members of the Commonwealth Government’s Ministerial Council advising that the National Companies and Securities Commission (NCSC) had received submissions opposing the profession’s proposals. Part of the message stated: A particular concern expressed in discussions with some respondents was that, if the accounting profession’s proposals are accepted, the status and income on the profession 23 136 According to Walker, the New South Wales Corporate Affairs Commission reviewed the financial statements of 8699 companies during the period 1978–82, and found that 3528 (41%) had failed to comply with one or more professionally sanctioned accounting standards. The regulation of financial accounting CHAPTER 4 would, effectively, be accorded statutory protection without any corresponding requirement for public reporting and accountability by that profession. For reasons readily apparent, there are many in the profession who would welcome the safe harbour which legislative recognition would provide. (Walker, 1987, p. 271) After reviewing the available evidence, Walker argues that ‘the ASRB’s early history can be considered a case study in regulatory capture’. He provides the following evidence (p. 282): 1 Before the board was established the accountancy bodies lobbied to ensure that the government body (the ASRB) would not have an independent research capability, would not have an academic as chairperson, and would be provided with an administrative officer rather than a research director (all of which would undermine its capabilities); all of these objectives were achieved. 2 In 1984 the board established its priorities on the basis of public submissions; by November 1985 its agenda represented the standards that the Australian Accounting Research Foundation intimated it was prepared to submit (the AARF was a professionally sponsored body funded by the accounting profession – that is, it was under the direct control of the accounting profession); in December 1985 new ASRB procedures ensured that ‘priorities would only be set after consultation with the Australian Accounting Research Foundation’ (the profession’s own research body). 3 In 1984 the board published a set of procedures (Release 200) which placed the AARF and other interests groups on a similar footing. Accordingly, the board refused to place a standard submitted earlier by the Australian Shareholders’ Association on its agenda, on the ground that the association had not provided all the supporting documentation and an assignment of copyright as required by Release 200. Yet in November 1985 an ASRB advertisement announced that the board would be reviewing a series of standards yet to be submitted by the AARF; the board, while abandoning the requirement of Release 200 for the AARF, continued to impose it on the Australian Shareholders’ Association. In December 1985 the ASRB reported that it had adopted ‘fast-track’ procedures for handling standards, but after six months had applied these only to submissions from the AARF, while it imposed more stringent requirements on submissions from other sources. 4 Prior to its establishment, it was suggested that the ASRB would be independent of the accounting profession and representative of a wide range of community interests. In 1984 the board membership included nominees of the Australian Council of Trade Unions, the Australian Shareholders’ Association and (it is understood) the Australian Merchant Bankers Association. The 1986 membership consisted of two former national presidents of the Australian Society of Accountants (which is now CPA Australia) - including one who was then a member of AARF’s Accounting Standards Board), a former national president of the Institute of Chartered Accountants in Australia (which is now Chartered Accountants Australia and New Zealand), a former state president of the Australian Society of Accountants, a state councillor of the Australian Society of Accountants (and former chairperson of the AARF), an academic active in committee work for the Australian Society of Accountants, and only one other (the executive director of the Australian Associated Stock Exchanges). 137 Financial Accounting Theory In providing a concluding comment on the ASRB’s ‘capture’, Walker (p. 282) states: During 1984–5 the profession had ensured the non-performance of the ASRB, and by the beginning of 1986 the profession had managed to influence the procedures, the priorities and the output of the Board. It was controlling both the regulations and the regulatory agency; it had managed to achieve co-ordination of the ASRB’s activities; and it appears to have influenced new appointments so that virtually all members of the Board might reasonably be expected to have some community of interests with the professional associations. The ASRB had been ‘captured’ by the profession within only 24 months. Chand and White (2007) also consider the issue of regulatory capture. In doing so, they explain government involvement in the accounting standard-setting process and explain why, in the Australian context, the Financial Reporting Council was established to oversee the activities of the AASB. Chand and White (p. 612) state: Some jurisdictions, notably the US and Australia, have taken the regulatory process under the wing of a government agency, to efface or avoid its being captured by the profession. For example, the US has taken steps through the Sarbanes-Oxley legislation to strengthen the regulator’s independence (Herz, 2002; Schipper, 2003). Similarly, in Australia the new standard setting arrangements were introduced in 1997, including the Financial Reporting Council to oversee the Australian Accounting Standards Board (Haswell and McKinnon, 2003, p. 10). Such remedial measures were seen as necessary in these countries, demonstrating that the regulatory process may have been captured. We can also consider what happened when the IASB, and its predecessor, the International Accounting Standards Committee (IASC), attempted to develop the accounting standard for the extractive industry some years later. In 1998, due to concern about the lack of uniformity in accounting for pre-production costs, the IASC proposed the development of an international accounting standard that would improve consistency and comparability of reporting practices in the extractive industries internationally. To do this, it sought to reduce the available alternatives by supporting the use of the successful-efforts method (which is very similar to the area-ofinterest method) and the discontinuation of the full-cost method. As part of the process of developing the accounting standard, submissions were sought. In relation to the submissions, Cortese, Irvine and Kaidonis (2007, p. 2) report: There was overwhelming support for the use of the successful efforts method of accounting with 87 percent of respondents commenting on this issue indicating a preference for the successful efforts method only. In contrast, only 13 percent of respondents commenting on this issue indicated their support for having the option of both the successful efforts and full cost methods. Thus, the Steering Committee’s tentative view on this issue was supported, with the majority of respondents preferring a single method of accounting for pre-production costs consistent with the successful efforts concept. However, when the accounting standard IFRS 6 Exploration for and Evaluation of Mineral Resources was issued in December 2004, the contents were not as expected. Rather than reducing the number of alternative accounting treatments, and thereby moving towards the goals of comparability and consistency that were previously promoted, the accounting standard effectively allowed organisations to use whatever was their preferred approach for accounting for exploration and evaluation expenditure. Therefore, IFRS 6 effectively ‘codified existing industry practice, perpetuating the disparate methods of accounting for exploration and evaluation, and maintaining the status quo for extractive industries companies’ (Cortese, Irvine and Kaidonis, 138 The regulation of financial accounting CHAPTER 4 2007, p. 3). IFRS 6 provides organisations with flexibility by virtue of paragraph 7 of IFRS 6, which states: Paragraphs 11 and 12 of IAS 8 specify sources of authoritative requirements and guidance that management is required to consider in developing an accounting policy for an item if no IFRS applies specifically to that item. Subject to paragraphs 9 and 10 below, this IFRS exempts an entity from applying those paragraphs to its accounting policies for the recognition and measurement of exploration and evaluation assets. The paragraphs within IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors that are referred to above, which IFRS 6 specifically says do not need to be followed in relation to exploration and evaluation assets, would otherwise require an organisation to comply with IFRS that deal with ‘similar and related issues’, as well as requiring compliance with the IASB Conceptual Framework. This effectively provides entities applying IFRS (other than those within Australia, given that the Australian equivalent – AASB 6 – deviates from IFRS 6 as a result of the insertion within Australia of paragraphs that require the use of the area-of-interest method) with the flexibility to account for their exploration and evaluation assets in the manner they prefer. If, by contrast, it had been required that the Conceptual Framework be followed (as would be usual practice), then this would have meant the use of the full-cost method would have been eliminated. In trying to explain the apparent ‘backflip’ of the IASB, Cortese, Irvine and Kaidonis (2007, 2010) and Cortese (2013) point to the political power of the extractive industries and how that power arguably helped them ultimately see their preferred accounting standard be released. In explaining this power, Cortese, Irvine and Kaidonis (2007) note that the functioning of the IASB is dependent upon funding from external sources and that among those sources are significant contributions from the minerals and petroleum industry, which lobbied on the standard. They also point to the fact that the major companies in the extractive industries are richer and more powerful than many of the states and countries that seek to regulate them, and this in itself brings great influence. Cortese, Irvine and Kaidonis (2007) note that in their submissions to the IASC/IASB, both the American Petroleum Institute (a USA-based lobbying group for the extractive industries) and the Oil Industry Accounting Committee (a UK-based lobbying group) argued strongly for the retention of both the full-cost and successful-efforts methods of accounting. Cortese, Irvine and Kaidonis (2007, p. 9) argue that it was the power of the industry that contributed to the outcome, and that the result was: consistent with Mitchell and Sikka’s (1993, p. 29) observation that the ‘institutions and practices of accountancy are collusive and undemocratic’ and that institutions, such as the IASC/IASB, are ‘dedicated to defending the status quo and sectional interests rather than wider interests’. Cortese (2013, p. 55) further reflects on this outcome and cautions that: This places in doubt the proclaimed transparency and independence of the IASB as a standard setting institution, and although it is widely acknowledged that the accounting standard setting process is political, this research highlights the source, nature and effect of this politicisation . . . The potential for the IASB to be ‘captured’ by those companies that are intended to be bound by the standards it issues is of particular concern given that the IASB claims to be an independent organisation acting in the public interest seeking worldwide diffusion of its accounting standards that will, ultimately, affect global capital markets. These results are consistent with Watts and Zimmerman (1979) who argued, consistent with their maintained economic assumption that individuals seek to maximise their own wealth, that 139 Financial Accounting Theory managers will lobby for those accounting standards that benefit them most and that regulators will also respond in a way that provides the greatest economic benefits to themselves. The results are also consistent with those generated some years earlier by Hansen (2010), who found that the level of financial contributions made by lobbyists influenced the decisions made by the IASB. As we discuss in Chapter 5, there were efforts to converge the accounting standards of the IASB and the US Financial Accounting Standards Board (FASB) some years ago, but for various reasons, this did not proceed. One consideration of the SEC was whether the ‘IASC Foundation, which oversees the IASB, has a secure, stable funding mechanism that permits it to function independently and that enhances the IASB’s standard setting process’ (SEC, 2008). Perhaps the SEC made the judgement that such independence was problematic. As is emphasised in a number of chapters in this book, the material discussed here again highlights the political nature of the accounting standard-setting process and how various stakeholders might try to influence the standard-setting process so as to achieve results that are advantageous to themselves. Of course, not all people will believe that the IASB was ‘captured’, or that it can be influenced by organisations and industries that provide funding to it. Nevertheless, authors such as Cortese, Irvine and Kaidonis highlight the possibility of political interference within standard-setting – something that is always possible. While a particular theory, such as Capture Theory, may be embraced by some researchers, there will be others who oppose such theories. Posner (1974), an advocate of the economic (private interest) theory of regulation (which we shall look at next), argues against a regular sequence wherein the original purposes of a regulatory program are subsequently thwarted through the efforts of the regulated group. He states (p. 340): No reason is suggested as to why the regulated industry should be the only interest group to influence an agency. Customers of the regulated firm have an obvious interest in the outcome of the regulatory process – why may they not be able to ‘capture’ the agency as effectively as the regulated firms, or more so? No reason is suggested as to why industries are able to capture only existing agencies – never to procure the creation of an agency that will promote their interests – or why an industry strong enough to capture an agency set up to tame it could not prevent the creation of the agency in the first place. A key component underlying all the perspectives on regulatory capture is that different groups will have different interests and that accounting regulations will have an impact on these social and/or economic interests. If particular groups did not perceive a potential threat (or opportunity) from a regulator to their specific social or economic interests, why would they devote resources to attempting to capture the regulator? The remainder of this chapter discusses perspectives on the impact of these private interests on the regulatory process. Why do I need to know about theories of regulation? The practice of financial reporting is heavily regulated. As students of accounting, it is important that we understand some of the potential reasons why regulation might have been introduced, or why regulation might have been introduced and subsequently amended or removed. As we have learned, while 140 regulation is often assumed to be in place for the ‘public interest’, this is not always the case. To be able to critically evaluate the practice of accounting and to exercise our need to be critical thinkers, we need to be aware of these insights. The regulation of financial accounting CHAPTER 4 Economic and social impacts of accounting regulation LO4.3 LO4.4 LO4.5 LO4.6 Before further examining various theories that address the influence of private interests on the accounting regulatory process, it is necessary to establish whether accounting regulations, such as financial reporting standards, can and do have a social and/or economic impact on the interests of preparers or users of accounts. Although many people might argue that accounting regulations only affect how underlying economic transactions and events are reflected in the financial reports, without any impact on the nature or shape of this underlying economic reality, there is a considerable body of evidence that accounting regulations actually have real social and economic consequences for many organisations and people. For example, an accounting standard issued by the IASB some years ago dealt with the accounting treatment of share options (IFRS 2 Share-based Payment). Although many companies use large numbers of share options as part of their management remuneration and incentive plans, prior to the release of IFRS 2 in 2005 most companies simply ignored the costs associated with issuing share options to employees when calculating their annual profit or loss. The justification for this practice was that when executives exercised the share options, and the company issued new shares to these executives at below market value, this did not apparently cost the company itself anything, despite it diluting the value of existing shareholders’ investments. However, the IASB view was that, by granting valuable share options to employees, companies were able to pay these employees a lower amount of money than if they had not been granted the share options. As the company receives valuable services from employees in exchange for these options, which would have been recorded as an expense if they had been paid for in cash, under IFRS 2 (AASB 2 in Australia), the fair value of share options now has to be recognised as an expense in the statement of profit or loss and other comprehensive income. Although implementation of IFRS 2 should have had no direct impact on underlying cash flows, during the development of IFRS 2 it was extensively argued that it would have many indirect negative economic and social consequences for a multitude of people. As some companies would be required to recognise a potentially large share option expense each year, some people maintained that these companies would be less likely to use share options as part of their pay and rewards packages. If valuable share options are an effective way to motivate managers and help align their self-interests with those of shareholders, a reduction in use of this form of incentive could lead to less-motivated executives (or a less-motivated workforce overall if share options were granted to many employees). This could lead to a reduction in underlying company performance, simply because IFRS 2 changed the manner in which a specific item was reflected in the financial statements. Therefore, while it was argued that IFRS 2 (in common with most, if not all, other accounting standards) should not lead to any direct changes in underlying business performance or cash flows, its indirect economic consequences could be potentially large and negative. As another example, with the adoption of IFRS in many countries, companies were required to follow IAS 38 Intangibles (which in Australia is known as AASB 138 Intangibles). This standard is particularly harsh on assets such as internally developed brand names, mastheads and research expenditure. Effectively, it requires expenditure on such internally developed intangible assets to be written off as an expense when incurred. Previously, within many countries, including Australia, there was no accounting standard preventing such expenditure from being recognised as an asset. As a result of the introduction of this accounting standard, many accounting commentators argued that expenditure on such items would be expected to reduce given the adverse impact that such expenditure would have on reported profits. It can be imagined how a reduction in expenditure on research could cause social and economic impacts that would flow throughout the society. Before the release of the standard, it was argued that its introduction would ‘reverberate’ throughout society and would impact on the ability of companies to pay dividends and also affect corporate relationships with banks. As a reflection of this, a newspaper 141 Financial Accounting Theory article published in The Australian and entitled ‘Firms to fight writedown rules – new standards could wipe $50 billion from balance sheets’ (West, 2004) reported: Australia’s biggest companies are fighting a rearguard action to win an exemption from new international accounting rules that will carve up to $50 billion off the value of corporate balance sheets next year…. The reforms would reverberate all the way down the corporate food chain to smaller companies, whose return on equity, return on assets, debt gearing levels and banking covenants could be affected. A reduction in retained profits caused by the removal of intangible assets could also affect a company’s ability to pay dividends, which could hit its share price. As a more recent example, there has been some evidence that the release of IFRS 16 Leases (effective from 2020) created changes in the ways organisations funded their acquisition of property, plant and equipment, with organisations more likely to acquire assets through loans rather than by way of leasing arrangements. This change in funding policies would have created social and financial impacts for various stakeholders. There are many other examples of accounting standards that have potential indirect economic and social impacts. Indeed, some people might argue that all accounting regulations will have an impact on managerial decisions (as managers will seek to manage their business so as to optimise their reported accounting numbers), and the resulting changes in managerial decisions will have a social and/or economic impact on those affected by the decisions. Several academic studies, which are discussed in the next section, have illustrated how the consideration of the potential economic consequences of proposed accounting standards motivated particular organisations to lobby regulators either in opposition to particular accounting standards or in support. This lobbying attempts to shape the regulations in a manner that will maximise the expected positive, or minimise the expected negative, economic consequences from the new accounting regulations for the lobbying organisations. In Chapter 8, through the theoretical lens of Positive Accounting Theory, we further examine how managers lobby accounting standard setters because of concerns of how new or revised accounting standards might impact the contractual arrangements that managers have negotiated with parties, such as lenders. Lobbying and the economic interest group theory of regulation LO4.2 LO4.3 LO4.5 The economic interest group theory of regulation (or, as it is sometimes called, the private interest theory of regulation) assumes that groups will form to protect particular economic interests. Different groups, with incompatible or mutually exclusive interests and objectives, are viewed as often being in conflict with each other and they will lobby government or other regulators to put in place legislation that economically benefits them (at the expense of the others). As an example, consumers might lobby government for price protection or producers might lobby government for tariff protection. This theoretical perspective adopts no notion of public interest – rather, private interests are considered to dominate the legislative process.24 Within this perspective, regulation is effectively viewed as a product which is allocated to particular constituents in accordance with the basic principles of supply and demand. This theory directs our attention to factors that influence the value of regulation to particular individuals or groups. The expectation is that the product – in this case regulation – will ultimately be demanded by, and supplied to, those parties who value it the most. In relation to financial accounting, particular industry groups may lobby the regulator (the accounting standard-setter) to accept or reject a particular accounting standard. For example, 24 142 As Posner (1974) states, ‘the economic theory of regulation is committed to the strong assumptions of economic theory generally, notably that people seek to advance their self-interest and do so rationally’. The regulation of financial accounting CHAPTER 4 Hope and Gray (1982) show how a small number of aerospace companies were successful, during a consultation process, in changing the detailed requirements of a UK accounting standard on research and development in favour of their (private) interests. This was despite the overwhelming majority of participants in the consultation process not sharing the objections that had been made to the original proposals by the aerospace companies. These original proposals required all research and development expenditure to be charged as an expense in the year in which it had been incurred. The aerospace companies successfully argued that in certain circumstances they should be allowed to treat development expenditure as a form of capital expenditure, and charge it as an expense in future years by matching it against the income that it eventually generated. Although the impact on reported profits over the life of a project would be nil (the accounting treatment simply allowed a deferral of the expenditure between years), this accounting treatment resulted in higher net assets being reported in the balance sheet (statement of financial position) each year during a project than would have been the case if the development expenditure had been expensed in the year it was incurred. At the time, the prices that these aerospace companies could charge the UK Government for large defence contracts was based on a percentage return on the organisations’ net assets. Clearly, the higher the reported net assets in any particular year, the more a company could charge the government for a contract, so it was clearly in the private interests of the aerospace companies that the accounting standard permitted deferral of development expenditure. Another example of successful lobbying of an accounting regulator by an industry group, apparently seeking outcomes that were in the industry’s own interests, was the lobbying by some European banks against revised requirements in International Accounting Standard (IAS) 39 Financial Instruments: Recognition and Measurement. Banks in several European countries, as in Australia, argued that some of the provisions of IAS 39 (which has now been superseded by IFRS 9 Financial Instruments) would result in their accounts showing significant volatility that did not reflect the underlying economic reality, and this could be damaging to a bank’s perceived financial stability. The IASB made some limited changes in response to the banks’ concerns, but refused to change IAS 39 substantially. As shown in the next chapter, from 1 January 2005 accounting standards issued by the IASB became the accounting regulations that must be followed by companies in many countries including all companies that have their shares traded on any securities exchange in the European Union (EU). However, as part of the EU accounting regulatory process, for any accounting regulation to be mandated for use by EU companies it has first to be endorsed by the European Commission. The endorsement of each IAS/IFRS follows advice from the Accounting Regulatory Committee (ARC), which has one member from each of the 27 EU member states. At a meeting of the ARC in July 2004, four member states (out of the 25 that were then members) voted against full EU endorsement of IAS 39 and a further six states abstained, principally objecting to the elements of IAS 39 that banks in their countries had lobbied against. The 15 states that voted in favour of full endorsement were insufficient to form the two-thirds majority of the ARC required for approval by the EU of an IAS/IFRS.25 Subsequently, the IASB replaced IAS 39 with IFRS 9 Financial Instruments. The implementation of changes that IFRS 9 made to the provisions of IAS 39 were accelerated in response to pressure from the G-20 following the sub-prime banking crisis and ensuing GFC.26 However, in response In recent years, environmental groups have also lobbied government to introduce requirements for organisations to report various items of social and environmental information. Such submissions could perhaps prove a problem for advocates of the view that lobbying behaviour is dictated by private concerns about wealth maximisation (the rational economic person assumption). Perhaps (and we are clutching at straws here!) to maintain support for their ‘self-interest’ view of the world, proponents of the economic interest theory of regulation might argue that the submissions are made by officers of the environmental and social lobby group in an endeavour to increase their probability of reappointment. Alternatively, they might be lobbying because they believe that they have a moral obligation to do so. 26 The G20 is a group of finance ministers and central bank governors from 20 major economies: 19 countries plus the European Union, which is represented by the President of the European Council and by the European Central Bank. 25 143 Financial Accounting Theory again to lobbying from interests in certain EU member states, the EU delayed recognition of IFRS 9 so companies listed on securities exchanges within the EU could not initially use it in preparing their financial statements. While some companies in EU countries were opposed to the provisions of IFRS 9, others supported them and were not happy with the EU’s actions. By comparison, while Australian banks lobbied against AASB 139 within the Australian context, the full requirements of IAS 39 were incorporated within AASB 139. Hence, unlike their European counterparts, Australian banks were unable to coerce the local regulator into amending the requirements of IAS 39. In an early study on lobbying of accounting regulators, Watts and Zimmerman (1978) reviewed the lobbying behaviour of US corporations in relation to a proposal for the introduction of general price level accounting – a method of accounting that, in periods of inflation, would lead to a reduction in reported profits. They demonstrated that the managers of large politically sensitive companies favoured the proposed method of accounting, which led to reduced profits. This was counter to normal expectations that managers generally would prefer to show higher rather than lower earnings. It was explained on the (self-interest) basis that it was the larger companies that could be subject to negative public sentiment (and pressures for regulation of their prices) if their profits were seen to be abnormally high, and they might therefore be seen more favourably if they reported lower profits. Hence, by reporting lower profits there was less likely to be negative wealth implications for the organisations (perhaps in the forms of government intervention, consumer boycotts or claims for higher wages). Accounting firms also make submissions as part of the accounting standard-setting process. If we were to apply the economic interest group theory of regulation, we would argue that these submissions can be explained as efforts to protect the interests of professional accountants. Perhaps auditors favour rules that reduce the risk involved in an audit, as more standardisation and less judgement reduces the risk of an audit and therefore the potential for costly lawsuits. Evidence in Deegan, Morris and Stokes (1990) supports the view that audit firms are relatively more likely to lobby in favour of particular accounting methods if those methods are already in use by a number of their clients. Analysts also frequently lobby regulators for increased disclosure, perhaps because they can use the information in their job but pay only a very small amount for it (other non-users will effectively subsidise the costs of the information – part of the free-rider issue discussed earlier in the chapter). Under the economic interest group theory of regulation, the regulator itself is an interest group – one that is motivated to embrace strategies to ensure re-election or to ensure the maintenance of its position of power or privilege within the community. For example, Broadbent and Laughlin (2002) argue that in the UK lobbying surrounding the development of accounting regulations applicable to governmental accounting for projects involving private sector provision of public services (known as Private Finance Initiative projects, or public private partnerships), various regulatory bodies adopted positions that could be interpreted as seeking to defend or enhance their standing with the groups who appoint them and give them legitimacy. It should be remembered that regulatory bodies can be very powerful. The regulatory body, typically government controlled or influenced, has a resource (potential regulation) that can increase or decrease the wealth of various sectors of the constituency. As Stigler (1971, p. 3) states: The state – the machinery and power of the state – is a potential resource or threat to every industry in society ... Regulation may be actively sought by an industry, or it may be thrust upon it ... as a rule, regulation is acquired by the industry and is designed and operated primarily for its benefit ... We propose the general hypothesis: every industry or occupation that has enough political power to utilise the state will seek to control entry. 144 Under this ‘economic interest’ perspective of regulation, rather than regulation initially being put in place for the public interest (as is initially assumed within Capture Theory and also in public interest theory), it is proposed that regulation is put in place to serve the private interests of particular parties, including politicians who seek re-election. According to Posner (1974, p. 343), The regulation of financial accounting CHAPTER 4 economic interest theories of regulation suggest that economic regulation serves the private interests of politically effective groups. Further, Stigler (1971, p. 12) states: The industry which seeks regulation must be prepared to pay with the two things a party needs: votes and resources. The resources may be provided by campaign contributions, contributed services (the businessman heads a fund-raising committee), and more indirect methods such as the employment of party workers. The votes in support of the measure are rallied, and the votes in opposition are dispersed, by expensive programs to educate (or uneducate) members of the industry and other concerned industries ... The smallest industries are therefore effectively precluded from the political process unless they have some special advantage such as geographical concentration in a sparsely settled political subdivision.27 Under the economic interest theory of regulation, the regulation itself is considered to be a commodity subject to the economic principles of supply and demand. According to Posner (1974, p. 344): Since the coercive power of government can be used to give valuable benefits to particular individuals or groups, economic regulation – the expression of that power in the economic sphere – can be viewed as a product whose allocation is governed by laws of supply and demand ... There are a fair number of case studies – of trucking, airlines, railroads, and many other industries – that support the view that economic regulation is better explained as a product supplied to interest groups than as an expression of the social interest in efficiency or justice. Posner’s position is consistent with that adopted by Peltzman (1976), who states (p. 212): The essential commodity being transacted in the political market is a transfer of wealth, with constituents on the demand side and their political representatives on the supply side. Viewed in this way, the market here, as elsewhere, will distribute more of the good to those whose effective demand is the highest ... I begin with the assumption that what is basically at stake in the regulatory process is a transfer of wealth. The idea being promoted by the advocates of economic interest group theories of regulation is that if a particular group (perhaps a minority) does not have sufficient power (which might be reflected by the numbers of controlled votes or by the potential funds available to support an election campaign) then that group will not be able to successfully lobby for regulation that might protect its various interests. This view is compatible with some of the arguments used by a number of critical theorists (discussed in Chapter 13), who often contend that the legislation supporting our social system (including corporations law and financial reporting standards) acts to protect and maintain the position of those with power (financial capital) and suppresses the ability of others (those without financial wealth) to exert a great deal of influence within society. Consistent with this view, advocates of the economic interest group theory of regulation would also argue that regulators will use their power to regulate to transfer wealth from those people with low levels of political power (and who have a limited ability to influence the appointment of the regulator) to those parties with greater levels of political power. Reflective of this possibility, in a review of the US Securities Acts of 1933 and 1934, Merino and Neimark (1982, p. 49) conclude that ‘The security acts were designed to maintain the ideological, social and economic status quo while restoring confidence in the existing system and its institutions’. They further state (p. 51) that the establishment of the Securities Acts ‘may have further contributed to the 27 As an example, Stigler (1971, p. 8) refers to the railroad industry: ‘The railroad industry took early cognizance of this emerging competitor, and one of the methods by which trucking was combated was state regulation. By the early 1930s all states regulated the dimensions and weights of trucks.’ 145 Financial Accounting Theory virtual absence of any serious attempts to ensure corporate accountability by broadening the set of transactions for which corporations are to be held accountable’. The works of some critical theorists are discussed in greater depth in Chapter 13. REFLECTION QUESTION 4.3 Public interest or private interest? Question Having just read the above material, do you believe that accounting standard-setters would put the ‘public interest’ before their own ‘self-interest’ when developing financial reporting standards? Solution This is another one of those questions where we might all have different opinions depending upon the ‘theoretical lens’ through which we view the world. Our own views will be influenced by our beliefs about what motivates people in general, and regulators in particular. If we believe that regulators are not motivated by their own selfinterest, then we might believe that they will have the ‘public interest’ in mind when supporting particular regulation. However, if we believe that individuals will generally be motivated by their own self-interest – which is a maintained assumption of many economics theories – then we must accept that accounting standard setters will consider their own self-interests when developing regulation. Further, the evidence provided by critical theorists (the focus of Chapter 13) suggests that those in charge of developing regulations will support rules that tend to sustain current social systems (which critical theorists argue tend to favour those constituents already with wealth and economic power), rather than regulation that tends to be equitable to all society members. Critical theorists would therefore also caution us not to simply accept that regulators act at all times in the public interest. As critical thinkers, we need to consider the evidence at hand and accept that it is very possible that some regulators will not always be objective when making decisions about accounting regulation. Accounting regulation as an output of a political process LO4.5 Due process A process wherein the regulator involves those parties likely to be affected by the proposed regulation in the discussions leading to the regulation; it provides an opportunity to ‘be heard’. LO4.6 If we accept that accounting standard-setting is a political process, then the view that financial reporting should be objective, neutral and apolitical (as espoused internationally within the IASB’s Conceptual Framework for Financial Reporting) is something that can be easily challenged. As seen in the previous section, because financial reporting affects the distribution of wealth within society, it consequently will be political.28 Standard-setting bodies typically encourage various affected parties to make submissions on draft versions of proposed accounting standards. This is deemed to be part of the normal ‘due process’.29 If the views of various parts of the constituency are not considered, the implication might be that the very existence of the regulatory body could be challenged. As Gerboth (1973, p. 497) states: When a decision making process depends for its success on the public confidence, the critical issues are not technical; they are political ... In the face of conflict between competing interests, rationality as well as prudence lies not in seeking final answers, but rather in compromise – essentially a political process. In the earlier example of objections made by banks in some EU countries to certain detailed provisions of IAS 39, the failure of the IASB to compromise or concede to the wishes of these banks, and the willingness of certain EU governments to fight the banks’ case, led to a For example, whether dividends are paid to shareholders will be dependent on whether there are reported profits. Further, whether a company incurs the costs associated with defaulting on an accounting-based debt agreement (such as a debt-to-asset constraint, or an interest coverage requirement) can be dependent on the accounting methods it is permitted to apply. 29 The ‘due process’ can be defined as a process wherein the regulator involves those parties likely to be affected by the proposed regulation in the discussions leading to the regulation; it provides an opportunity to ‘be heard’. 28 146 The regulation of financial accounting CHAPTER 4 confrontation between two regulators – the EU and the IASB. At the time, this confrontation was seen as potentially highly damaging to both regulators. If the EU endorsed a revised EU regulation on accounting for financial instruments that had important (although possibly only small) differences from IAS 39, then rules underlying the accounts of EU companies would be different from the rules underlying the accounts of non-EU companies, and this would frustrate the objectives of international accounting standardisation (which is discussed in the next chapter). A common accounting regulation required both sides to compromise. An obstacle to reaching compromise between two powerful (and sometimes apparently intransigent) international regulatory bodies is that, as discussed earlier in the chapter, financial reporting standards (and therefore financial reports themselves) are the result of various social and economic considerations.30 Hence, they are very much tied to the values, norms and expectations of the society in which the standards are developed. Therefore, it is questionable whether financial accounting can ever claim to be neutral or objective (Hines, 1988, 1991). While it is frequently argued within conceptual frameworks that proposed disclosures should be useful for decision making, this in itself is not enough. The proposed requirements must be acceptable to various parts of the constituency, and the benefits to be derived from the proposals must, it is argued, exceed the costs that might arise. Obviously, determining these costs and benefits is very problematic and this is an area where academic advice and academic research are often used. According to Beaver (1973, p. 56): without a knowledge of consequences ... it is inconceivable that a policy-making body ... will be able to select optimal accounting standards. May and Sundem (1976, p. 750) take the argument further, stating: If the social welfare impact of accounting policy decisions were ignored, the basis for the existence of a regulatory body would disappear. As noted above, while accounting standard-setters need in principle to consider the potential costs and benefits of particular financial reporting requirements before they are put in place, this is not a straightforward exercise. As the IASB stated in an exposure draft released in 2008 (released as part of a joint process between the IASB and the US FASB to develop a new conceptual framework of financial reporting – the joint working relationship has since been abandoned): The boards (IASB and FASB) observed that the major problem for standard-setters in conducting rigorous cost–benefit analyses in financial reporting is the inability to quantify the benefits of a particular reporting requirement, or even to identify all of them. However, obtaining complete, objective quantitative information about the initial and ongoing costs of a requirement, or the failure to impose that requirement, would also be extremely difficult. Regardless of the difficulty, standard-setters should endeavour to take into account both the benefits and the costs of proposed financial reporting requirements. (p. 61) Any consideration of possible economic and social consequences (the costs and the benefits) necessarily involves a trade-off between the various consequences. For example, if neutrality/ representational faithfulness is sacrificed to reduce potential negative impacts on some parties (for example, preparers who might have otherwise been required to disclose proprietary information or to amend their accounting policies with the implication that they will default on existing debt contracts), this may have negative consequences for users seeking to make decisions on the basis of information provided. While it is accepted that accounting standards are developed having regard to social and economic consequences, it is also a requirement in many jurisdictions, such as Australia, that corporate financial statements be ‘true and fair’. Australian research indicates (Deegan, Kent and Lin, 1994) that auditors 30 The perspective adopted by the economic interest group theory of regulation will not be pursued at this point. If we had persisted with this perspective, we would argue that the standard-setters would support those submissions which best served the standard-setters’ self-interest. 147 Financial Accounting Theory generally consider that compliance with accounting standards is necessary and often sufficient for them to decide that the auditee’s financial statements are true and fair. But can we really say they are true when the development of financial reporting standards has been influenced by judgements about various economic and social consequences? Perhaps it is easier to say they are fair in the sense that they are drawn up in accordance with the rules incorporated within financial reporting standards. ‘Truth’ itself is obviously a difficult concept to define and this might explain why in some jurisdictions it was decided that ‘true and fair’ was achieved if financial reports simply complied with relevant accounting regulations and generally accepted accounting practice. As another issue to consider, would it be reasonable to assume that readers of financial reports generally know that financial reports are the outcome of various political pressures, or would they expect that the reports are objective and accurate reflections of an organisation’s underlying performance and financial position? There could in fact be a financial reporting expectations gap in this regard, although there is limited evidence of this.31 According to Solomons (1978, p. 71): It is perfectly proper for measurements to be selected with particular political ends if it is made clear to users of the measurement what is being done. However, is it realistic or practical to assume that users of financial statements would be able or prepared to accept that financial accounting necessarily needs to accommodate political considerations? Further, could or would users rely on financial reports if they had such knowledge? Would there be a reduction of confidence in capital markets? The argument that economic consequences need to be taken into account before new rules are introduced (or existing rules are changed) also assumes that in the first instance (before any amendments are to be made) there was some sort of equity that did not need addressing or rebalancing. As Collett (1995, p. 27) states: The claim that all affected parties such as the preparers of reports are entitled to have their interest taken into account in deciding on a standard, and not only dependent users, assumes that the position immediately prior to implementing the standard was equitable. If, however, users were being misled prior to the standard – for example, because certain liabilities were being kept off the balance sheet – then the argument that the interests of preparers of reports were being neglected in the standard-setting process would lose its force. This was the case at Enron, where substantial liabilities were ‘hidden’ from users of the financial accounts through complex financial arrangements which resulted in these liabilities ‘being kept off the balance sheet’. As Unerman and O’Dwyer (2004) explain, the false image portrayed by Enron’s financial statements led many people, including Enron’s employees, to lose money which they would probably not have invested if they had been aware of the true extent of Enron’s liabilities. The senior executives ultimately responsible for preparing Enron’s financial statements appear to have provided misleading information, which resulted in the economic resources of external parties being allocated in a highly inefficient manner – but a manner that might have been perceived at the time by Enron’s senior executives as being in their own personal interests. Perhaps the absence of adequate regulation had very real and significant economic consequences in this case, which potentially demonstrates that regulation might be needed in some instances to protect the interests of less powerful stakeholders. As a further related issue for readers to ponder, is it appropriate for regulators to consider the views of financial statement preparers when developing financial reporting standards, given that accounting standards are put in place to limit what preparers are allowed to do, that is, to regulate their behaviour in the public interest? As we can see, regulating accounting practice requires many difficult assessments. 31 148 Liggio (1974) and Deegan and Rankin (1999) provide definitions of the expectations gap. An expectations gap is considered to exist when there is a difference between the expectations users have with regard to particular attributes of information and the expectations preparers believe users have in regard to that information. The regulation of financial accounting CHAPTER 4 Why do I need to know that financial reporting standards are the output of a political process? As students of accounting, we will likely prepare or be users of financial reports that are prepared in accordance with financial reporting standards. As such, it is important that we understand the processes through which financial reporting standards are developed. Such knowledge allows us to understand the context of both financial reporting standards and general purpose financial reports. It also allows us to understand why some proposed financial reporting standards fail to ultimately be released or take many years to be finalised – perhaps they were particularly contentious with various constituents. Knowing that financial reporting standards are developed through a political process that seeks input from constituents and encourages lobbying, and which considers the various costs and benefits likely to flow from the release of a standard, allows us to critically evaluate guidance included in documents such as the IASB Conceptual Framework for Financial Reporting. For example, the Conceptual Framework identifies ‘representational faithfulness’ as a fundamental qualitative characteristic of useful financial information, which is explained in terms of financial information necessarily being complete, neutral and free from error. As critical thinkers, and with the knowledge we have, we can now question whether financial reports prepared in accordance with financial reporting standards that have been developed through a political process can really be considered ‘neutral’. REFLECTION QUESTION 4.4 Will compliance with financial reporting standards lead to organisations producing ‘representationally faithful’ financial information? Question The IASB Conceptual Framework prescribes that useful financial information should be both relevant and provide a faithful representation of the phenomena that it purports to represent. To be representationally faithful, the Conceptual Framework tells us that information needs to be complete, neutral and free from error. Given what you have just read about the political nature of the accounting standard-setting process, do you believe that general purpose financial reports prepared in conformity with financial reporting standards can be ‘representationally faithful’? Solution Arguably, a faithful representation of a particular transaction or event would require that the most objective process be pursued when determining how to disclose a particular transaction or event. An objective, or neutral, process would seek the best way to recognise, measure and disclose a particular transaction or event regardless of the social or economic consequences associated with providing particular information. That is, a ‘truly objective’ approach would determine what disclosures best reflect particular transactions and events and would require such disclosures, even if it means many companies might breach borrowing agreements or it leads to negative consequences for the share prices of many organisations or particular stakeholders within the community. However, a balancing of the ‘public interest’ could justify a consideration of the concerns of different constituents and therefore a move away from otherwise objectively determined standards. Pragmatically, if financial reporting standard-setters did not consider potential financial and social impacts, and if the likely impacts were potentially significant throughout various parts of the community, then we could expect significant lobbying against the standard-setter, and this would have implications for the survival of that standard-setter. Governments that oversee standard-setters could, in the interests of their own political survival, likely take actions against standard-setters if those standard-setters become unpopular with voters. In conclusion, the more we open the standard-setting process up to lobbying from constituents, and therefore the more ‘political’ we make the standard-setting process, then we must accept that financial reporting standards are the outcome of a political process. Financial reports developed by applying these standards are therefore also influenced by a political process, meaning that consequently there are implications for a potential reduction in the ‘representational faithfulness’ of financial statements. Again, we see that the process of accounting is indeed a fascinating one! 149 Financial Accounting Theory STUDY TOOLS CHAPTER SUMMARY This chapter considered various arguments that either supported or opposed the regulation of financial reporting. Advocates of the ‘free-market’ (anti-regulation) approach argue that there are private economic incentives for organisations to produce accounting information voluntarily, and imposing accounting regulation leads to costly inefficiencies. To support their argument for a reduction in financial reporting regulation, the ‘free-market’ advocates rely on such mechanisms as private contracting (to reduce agency costs), the market for managers and the market for corporate takeovers. By contrast, advocates of the ‘pro-regulation’ perspective argue that accounting information should not be treated like other goods. As it is a ‘public good’, it is unrealistic to rely on the forces of supply and demand. Because users of financial information can obtain the information at zero cost (they can be ‘free riders’), producers will tend to produce a lower amount of information than might be socially optimal (which in itself is obviously difficult to determine). Further, there is a view that the stakeholders of an organisation have a right to various information about an entity, and regulation is typically needed to ensure that this obligation is adhered to by all reporting entities. Regulation itself is often introduced with a related justification that it is in the ‘public interest’ to do so, the view being that regulators balance the costs of the regulation against the economic and social benefits that the legislation will bring. Clearly, assessments of costs and benefits are difficult to undertake and will almost always be subject to critical comment. There are alternative views as to why regulation is introduced in the first place. There is one perspective (referred to above) that legislation is put in place for the public interest by regulators who are working for the interests of the constituency (public interest theory). Public interest theory does not assume that individuals are primarily driven by their own self-interest. Hence, public interest theory makes assumptions that are not in accordance with economic theories that have as their core assumption that all individuals are driven by self-interest, with this self-interest being tied to efforts to maximise personal wealth. However, an assumption of self-interest is made by other researchers who argue in favour of an economic interest theory of regulation. They argue that all action by all individuals can be traced back to self-interest in which all people will be seeking to increase their own economic wealth.32 Under this perspective, regulators will be seeking votes and election funding/support, and through embracing self-interest will tend to provide the legislation to groups who can pay for it in terms of either providing votes or providing funds to support the regulators’ re-election. Capture Theory provides another perspective on the development of regulation. It argues that, while regulation might initially be put in place for well-intentioned reasons (for example, in the ‘public interest’), the regulated party will, over time, tend to gain control of (or capture) the regulator so that the regulation will ultimately favour those parties that the regulation was initially intended to control. We referred to many ‘real life’ examples of possible regulatory capture. This chapter has also considered how perceptions about potential economic and social consequences impact the development of financial reporting standards. In the light of this, the chapter has questioned whether financial reports can really be considered as neutral, objective and representationally faithful, as the IASB Conceptual Framework for Financial Reporting would suggest. 32 150 There are, of course, many researchers who oppose this (rather cynical) view of human behaviour. Authors such as Gray, Owens and Adams (1996) refer to this perspective as being ‘morally bankrupt’ and providing very little hope for efforts to address pressing global problems, such as issues surrounding sustainable development, modern slavery, and climate change. Some of these alternative perspectives are discussed in Chapters 9 and 10. The regulation of financial accounting CHAPTER 4 ANSWERS TO THE OPENING QUESTIONS At the beginning of the chapter, we asked the following two questions. As a result of reading this chapter, you should be able to provide informed answers to these questions – ours are shown below. 1 When widely publicised accounting-related ‘scandals’ occur in respect of high-profile organisations (such as Lehman Brothers, Enron and WorldCom), regulators often respond by increasing the amount of accounting regulation. What might motivate regulators to introduce additional regulation to restrict the accounting practices available to corporate managers? As we learned in this chapter, there are different theories to explain why regulators might introduce regulations. Some of the different perspectives are: a Regulation is introduced because regulators believe it is in the public interest to do so (public interest theory). However, what represents the ‘public interest’ from the perspective of regulators will be influenced by a variety of factors, such as their respective political ideologies. b Regulation might be introduced because it favours particular constituents over and above others. As we learned in this chapter, ‘regulatory capture’ is a common phenomenon in which regulators, governments, regulatory authorities and professional bodies come to identify more with the interests of the people they are supposed to be regulating than with the interests of the people they are supposed to protect (Capture Theory). c Another perspective is that regulators will introduce regulations if it benefits them. That is, their support for regulation will be motivated by self-interest. Under this perspective (economic interest group theory of regulation), the regulator itself is an interest group – one that is motivated to embrace strategies to ensure re-election, or to ensure the maintenance of its position of power or privilege within the community. 2 If corporate financial reporting was to be deregulated, what market-based incentives or mechanisms might operate to motivate managers to produce publicly available financial reports? Would these mechanisms operate to ensure that an optimal amount of relevant and reliable information is produced? What is an ‘optimal’ amount of information? As this chapter has indicated, researchers have suggested a number of mechanisms that can operate to motivate managers to produce financial information about the organisation, even in the absence of regulations requiring them to do so. Some of these mechanisms include: • the market for managers • the market for corporate takeovers • the market for lemons • efficiently operating courts Whether mechanisms, such as those above, will lead to optimal levels of information being produced will depend upon the theoretical perspective adopted. One of the key problems with this argument is that accounting information is effectively a ‘free good’ and market mechanisms do not tend to work when it comes to free goods. Also, the above market mechanisms rely upon the ‘markets’ operating efficiently, but there is much evidence to suggest that these markets do not operate efficiently in all circumstances. In theory, an optimal amount of information will be produced if the benefits generated by each additional amount of information exceed the costs. Information should continue to be produced up to the point where the marginal cost of the additional information equals the marginal benefit of that information. As long as the benefit exceeds the cost, more information should be produced. But, in practice, this is very hard to determine. How do we actually measure such costs, and from whose perspective are we making such an assessment? So, in reality, it would be very hard to win an argument about what is the precise amount of information necessary to reach optimality. Nevertheless, all decisions about producing information need to consider information costs and benefits. 151 Financial Accounting Theory QUESTIONS 4.1 4.2 4.3 4.4 4.5 What is regulation? LO4.1 As this chapter indicates, some people argue that the extent of regulation relating to financial accounting is excessive and should be reduced. a What arguments do these people use to support this view? b How would you rate the arguments in terms of their logic? LO4.4 What is the basis of the ‘market for lemons’ argument? LO4.4 Given the process involved in developing accounting standards, do you believe that financial reporting standards can be considered to be ‘neutral’ (that is, not serving the interests of some constituents over others)? LO4.3 LO4.5 In the IFRS Foundation’s 2020 publication International Accounting Standards Board and IFRS Interpretations Committee Due Process Handbook, paragraph 1.2 states: The IFRS Foundation Constitution (Constitution) gives the Board full discretion in developing and pursuing its technical programme and in organising the conduct of its work. The Trustees and the Board have established consultative procedures with the objective of ensuring that, in exercising its independent decision-making, the Board conducts its standard-setting in a transparent manner, considering a wide range of views from interested parties throughout all stages of the development of International Financial Reporting Standards (IFRS Standards). The Board uses these procedures to gain a better understanding of different accounting alternatives and the potential effect of the proposals on affected parties. A comprehensive and effective due process is essential to developing high-quality IFRS Standards that serve investors and other primary users of financial statements. Do you believe that the IASB will always act in an independent manner? Further, will the engagement with various stakeholders have any potential implications for claims that IFRS Standards are developed to provide financial information that is representationally faithful? Clearly identify the theoretical basis that you have applied in arriving at your answer. LO4.2 LO4.3 LO4.6 4.6 4.7 4.8 4.9 4.10 4.11 4.12 4.13 4.14 What is meant by saying that financial accounting information is a ‘public good’? LO4.1 LO4.3 Is regulation more likely to be required in respect of public goods than other goods? Why? LO4.2 What is ‘accounting standards overload’ and why might it occur? LO4.3 LO4.4 Can regulatory intervention be explained on fairness or equity grounds? If so, what is the basis of this argument? LO4.1 LO4.2 Try to summarise the concept of the ‘invisible hand’. Do you think that the invisible hand actually ‘works’? LO4.5 It is argued by some researchers that even in the absence of information, organisations have an incentive to provide credible information about their operations and performance to certain parties outside the organisation; otherwise the costs of the organisations’ operations would rise. What is the basis of this belief? LO4.4 Would you expect independent financial statement audits to exist for listed companies even in the absence of regulation requiring them to be undertaken? Why? LO4.1 LO4.4 Some companies argue that introducing mandatory reporting requirements will tend to stifle innovation in relation to the reporting. Do you believe that the introduction of mandatory reporting requirements in relation to a particular area of reporting (for example, social and environmental reporting) will act to stifle innovation in reporting? Explain your view. LO4.1 LO4.4 Read and evaluate the following paragraph extracted from Cooper and Keim (1983, p. 202): It should also be noted that the nature and degree of the effect of disclosure requirements (and other aspects of security regulation) on public confidence in the financial markets is unknown. Investors who have never read a prospectus or even thumbed through a 10-K report may have a great deal more confidence in the capital markets because the SEC and its regulations are an integral aspect of the financial system. The salutary effect of such enhancement of the perceived integrity and credibility of the investment process is to reduce the cost of capital for all firms, and the magnitude of this effect may be quite significant. LO4.1 LO4.2 LO4.3 4.15 152 Private contractual incentives will assist in ensuring that, even in the absence of regulation, organisations will provide such information as is demanded by their respective stakeholders. Evaluate this argument. LO4.1 LO4.4 The regulation of financial accounting CHAPTER 4 4.16 4.17 4.18 4.19 Why would the managerial labour market motivate the manager to provide information voluntarily to outside parties? LO4.4 What is the ‘market for corporate takeovers’ and how would its existence encourage organisations to make accounting disclosures even in the absence of regulation? LO4.4 Market failure has been defined as the inability of market forces to produce a socially ‘right’ amount of information; that is, to produce information to the point where its marginal cost to society equals its marginal benefit. While in theory this calculation may be possible, in reality there are problems with applying such a definition of market failure. What are some of the problems? LO4.1 LO4.2 A newspaper article entitled ‘Westpac insider trading case set for 2023 trial date’ (Shapiro, 2021) reported a case allegedly involving traders at one of Australia’s leading banks being engaged in insider trading. In part, the article stated: On May 5, the Australian Securities and Investments Commission filed a civil claim in the Federal Court alleging that Westpac’s interest rate traders engaged in insider trading in the hours leading up to the announcement of the October 2016 $16 billion Ausgrid privatisation. The case relates to interest rate trades enacted by Westpac traders on the morning of October 20, 2016, before an announcement that a consortium would buy a 50.4 per cent stake in Ausgrid for $16.2 billion. Westpac was awarded the mandate to hedge the $12 billion of debt from adverse interest rate movements. But ASIC alleges the traders jumped the gun, and in doing so locked in a certain profit. The allegations include insider trading, unconscionable conduct and breaching financial services licensee obligations. (p. 21) 4.20 4.21 4.22 4.23 4.24 4.25 4.26 4.27 4.28 4.29 a Which of the theoretical perspectives of regulation reviewed in this chapter might best explain the existence of laws that prohibit insider trading? b How would advocates of a ‘free-market’ approach justify the removal of legislation pertaining to insider trading? LO4.1 LO4.2 Do you believe that the members of the IASB are guided by ‘public interest’ when developing international financial reporting standards? LO4.5 LO4.6 Explain why a well-functioning court system is an important aspect of a free market approach to financial reporting. LO4.4 What assumptions are made about the motivations of the regulators in: a the public interest theory of regulation? b the Capture Theory of regulation? c the economic interest theory of regulation? LO4.2 LO4.3 LO4.6 Given the contents of this chapter, why do you think that corporate managers will make lobbying submissions to the IASB when it is in the process of developing new international financial reporting standards? LO4.5 LO4.6 Is it realistic to assume, in accordance with ‘public interest theory’, that regulators will not be driven by their own self-interest when designing regulations? LO4.2 LO4.3 Is it in the public interest for regulators to be driven by their own self-interest? LO4.1 LO4.3 Identify and evaluate the key negative economic and social consequences that might potentially arise following the introduction of a financial reporting standard with which you are familiar. LO4.6 Under the economic interest theory of regulation, what factors will determine whether a particular interest group is able to secure legislation that directly favours that group above all others? LO4.2 LO4.3 What do we mean when we say that financial reporting standards are the outcome of a political process? Why is the process ‘political’? LO4.5 LO4.6 Provide a comment on the following statement: Accounting information is a ‘public good’ and therefore is likely to be under-produced in the absence of regulation. Therefore, the production of accounting information and financial statements should be regulated. LO4.1 LO4.2 153 Financial Accounting Theory 4.30 4.31 4.32 4.33 4.34 Is the fact that financial reporting standard-setters consider the economic and social consequences of potentially introduced financial reporting standards consistent with a view that financial reports, if compiled in accordance with financial reporting standards and other generally accepted accounting principles, will be neutral and objective? LO4.3 LO4.6 If an accounting standard-setter deems that a particular accounting standard is likely to adversely affect some preparers of financial statements, what do you think it should do? Justify your view. LO4.6 Earlier in this chapter, we referred to instances where people holding senior positions in corporate regulators were subsequently offered jobs by corporations that they previously acted to regulate or where regulatory bodies offer jobs to people who held senior roles in organisations the regulator used to regulate. From a Capture Theory perspective, would these job offers raise concerns for you? Why? LO4.3 LO4.5 Assume that a government regulator makes a decision that all companies with a head office in Australia must separately disclose, within their annual financial report, the amount of expense incurred in relation to the training of employees. The companies must also spend at least 5 per cent of their reported profits on training employees. You are required to: a explain the decision made by the regulator in terms of public interest theory b explain the decision made by the regulator in terms of the economic interest group theory of regulation. LO4.1 LO4.2 LO4.3 LO4.6 In this chapter, we discussed how European banks were able to lobby the EU so as to be regulated by a ‘watered-down’ version of the accounting standard IAS 39. In this regard, an article in the Australian Financial Review entitled ‘IAS 39 dawns for local firms’ (Fenton-Jones, 2004) reported: Last Friday, after a year-long impasse, EU member states adopted the International Financial Reporting Standards (IFRS) with a watered-down version of IAS 39. This particular standard deals with accounting for financial instruments such as derivatives, guarantees and loans. The modified version excludes provisions relating to hedge accounting and the fair-value option for financial assets and liabilities. The modified rule will become part of the new IFRS that will come into force for about 7000 EU stockmarket-listed companies on January 1, 2005 … Allen Blewitt, the London-based chief executive of the Association of Chartered Certified Accountants, said the debate around IAS 39 had opened up the scope for lobbying by interest groups and for political interference in the standard-setting process. Opposition to IAS 39 in its original form was driven mostly by the French banks, which were concerned that valuing derivatives at market prices rather than at cost as required by the rule could cause harmful volatility in their accounts. Explain whether the decision of the EU to embrace a ‘watered-down’ version of the standard is consistent with a ‘public interest theory of regulation perspective’, or whether it can be explained by an alternative theoretical perspective (which you should attempt to identify). LO4.1 LO4.5 4.35 Referring to the lobbying of the EU by certain corporate interests, an article in The Australian, entitled ‘EU defers accounting standards’ (Senior, 2004) reported: THE EU Commission caved in to lobbying from bankers and the French Government yesterday when it pledged to postpone new derivative accounting standards drafted following the Enron affair. Frits Bolkestein, the EU commissioner responsible for leading the drive towards pan-European financial services, said he would shelve plans to impose the two new accounting standards next year if the warring parties could not reach an agreement by next month… Banks and insurers are lobbying against the standards amid fears the new rules would create massive holes in their balance sheets… Mr Bolkestein’s comments follow intense lobbying against the new rules, which has gained the public support of the French Government. President Jacques Chirac wrote to the European Commission last year, saying that the new standards ‘would have harmful consequences on financial stability’. But proponents of the accounting standards say they are essential to understanding companies’ true financial health. They say that the new rules would have made it impossible for Enron, the US energy company, to shift its underperforming assets into private partnerships, known as special purpose 154 The regulation of financial accounting CHAPTER 4 vehicles. The firm collapsed after the sudden disclosure of huge debts that had not been revealed in its accounts. Using a particular theory of regulation (choose the most appropriate one), explain what factors might have motivated the then French President Jacques Chirac to lobby against the accounting standards in question. LO4.2 LO4.3 4.36 In a Business Review Weekly article referring to then head of the IASB, and entitled ‘Tweedie the unrelenting’ (Andrews, 2003), it was reported: Global standards will be released early next year come what may, says IASB chairman Sir David Tweedie. European and Australian companies are wary of adopting some of the new international accounting standards, fearing the effects they will have on balance sheets and profit-and-loss statements. However, the chairman of the International Accounting Standards Board (IASB), Sir David Tweedie, is determined to have all the new standards released by the first quarter of next year. He is meeting resistance. The zeal for reform that followed the collapse of companies such as Enron, WorldCom, HIH and One.Tel has slowed in Australia. After compromising with European banks on the standard for financial instruments, Tweedie’s fight to have the rest of the standards adopted without further changes is now against European insurance companies. Tweedie has been in Australia to iron out any misunderstandings in government and business about the standards. The conflict between Tweedie and the big European corporations has created uncertainty about the content of the final standards, making it difficult for accountants to advise their clients. A financialservices partner at PricewaterhouseCoopers, Ian Hammond, says the uncertainty is causing some Australian companies to procrastinate over preparing for the new standards. …. Insurers, encouraged by seeing the banks winning concessions, called for talks of their own. In late July, a group of chief executives from European insurance companies called for a meeting with the IASB to change the standard on financial instruments that the banks had fought over. The insurers are also concerned that the standard will add volatility to their reported profits, because it calls for them to measure investment assets by market value and record the gains and losses from these assets on profit-and-loss statements. Tweedie insists he will not back down to pressure from big business unless he is proved wrong. He says some European companies, unhappy about having to adopt the new standards for financial instruments, are waging a personal campaign against him. ‘They have been telling politicians that I don’t listen, that I don’t understand industry. I understand industry too well.’ Tweedie is also battling the Australian Accounting Standards Board (AASB). Its acting chairperson, Ruth Picker, wants to negotiate with the IASB for an easier transition to the new rules on valuing internally generated intangibles. Australian business supports the board’s efforts. John Stanhope, president of the Group of 100, which represents the chief financial officers of 93 of Australia’s largest companies and government-owned entities, says the group wrote to Tweedie this year to express its members’ concerns about the effect the IASB’s decision on intangibles will have on Australian business. ….Picker says the AASB is being compelled to negotiate with Tweedie and the IASB over the transition to the intangibles standard by founding legislation that says it must act in the best interests of the Australian economy. It does not regard wiping up to $40 billion from Australian balance sheets as in the economy’s best interests. ‘It will affect companies’ abilities to pay dividends ... it might affect share prices, it will affect loan covenants, and it will affect interest deductions,’ Picker says. ….Picker and Stanhope say that Australian companies still support adopting the new standards because of the long-term benefits they will bring. Overseas investors will be more inclined to invest their capital in Australia when they can easily compare the financial reports of Australian and overseas companies. However, Picker says that the European banks’ success in lobbying against the standard on financial instruments might encourage Australian companies to join in the lobbying of Tweedie and the IASB for more changes to the international standards. a What theory of regulation seems to explain the actions of Sir David Tweedie? b What theories of regulation would appear to explain the lobbying efforts of the European banks? c What theories of regulation would appear to explain the lobbying efforts of the European insurance companies? d Do Ruth Picker’s actions appear to be consistent with a view that she has been ‘captured’ by business organisations? Explain your answer. LO4.1 LO4.3 155 Financial Accounting Theory 4.37 Comment on the following statement from Shleifer (2005): The public interest theory of regulation has become the cornerstone of modern public economics, as well as the bible of socialist and other left-leaning politicians. It has been used to justify much of the growth of public ownership and regulation over the twentieth century. LO4.1 LO4.3 4.38 4.39 One of the most pressing problems confronting the world is climate change. To effectively address this issue, governments across the world will be required to introduce regulations to mitigate the impacts of business activities on the environment. This regulation would necessarily require organisations to make significant changes to how they operate and this will undoubtedly have negative implications for the profitability of many organisations. (However, in the long run, no organisations will exist and there will be no profits if action is not taken.) You are required to describe whether the various theories discussed in this chapter provide hope, or otherwise, that regulations will be introduced that will ultimately benefit future generations and will require corporations to change how they do business. LO4.1 LO4.2 Let us assume that the government has become concerned that existing disclosure regulations tend to fixate on the financial performance of organisations but fail to address other aspects of corporate performance, including a failure to provide information about corporate social and environmental impacts as well as about various initiatives and investments an organisation has undertaken to improve its social and environmental performance. As such, the government has decided to introduce legislation that will require business corporations to provide information about the social and environmental impacts of their operations, as well as the social and environmental initiatives undertaken by the corporations. 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CHAPTER 5 INTERNATIONAL ACCOUNTING LEARNING OBJECTIVES On completing this chapter, readers should: LO5.1 understand the background to, and the motivations for, the International Accounting Standards Board implementing a uniform set of financial reporting standards for worldwide use (this set of standards being known as International Financial Reporting Standards [IFRS]) LO5.2 understand some of the perceived advantages and disadvantages for countries that adopt IFRS LO5.3 appreciate that prior to many countries adopting IFRS there were a number of important differences between the accounting policies and practices adopted within various countries LO5.4 understand various theoretical insights about why countries might adopt particular accounting practices in preference to others, and be able to evaluate whether, in light of the various theories and related insights, it is appropriate to actually have one globally standardised set of financial reporting standards LO5.5 be able to explain what is meant by the terms ‘harmonisation’ and ‘standardisation’ of financial reporting LO5.6 be able to identify and explain some of the perceived benefits of, and obstacles to, standardising financial accounting and reporting practices on an international scale LO5.7 understand the key factors that are leading to greater international standardisation of financial accounting and reporting. 159 Financial Accounting Theory OPENING QUESTIONS Before reading this chapter, please consider how you would answer the following two questions. We will return to these questions at the end of the chapter, where we suggest some answers. Since the start of 2005, financial reporting standards issued by the International Accounting Standards Board (IASB) have become the financial reporting standards that are applied within many countries. 1 Do you believe that all countries should adopt the same financial reporting standards – that is, do you think that a world-wide ‘one-size-fits-all’ approach to financial accounting and reporting is appropriate? If not, what might be some reasons against such international standardisation? 2 What are some of the advantages and disadvantages that arise as a result of a country adopting the financial reporting standards issued by the IASB? Introduction The previous chapters looked at how regulation shapes the practice of financial reporting. We saw that various factors can influence the actions of regulators (for example, the regulators’ perceptions about what is in the ‘public interest’ or about what the economic implications of a newly proposed accounting standard might be), and that various theoretical perspectives can be applied when making a judgement about the factors that are likely to impact upon a regulator’s ultimate decision to support, or oppose, particular financial accounting requirements. Differences in, or changes to, accounting regulations can result in different accounting ‘numbers’ being reported for a given transaction or event, and these differences in reported accounting results can lead to both positive and negative social and economic consequences. Clearly, therefore, any differences in accounting regulations between different countries are likely to result in the accounting outcomes reported from a specific set of transactions and/or events varying from country to country. This chapter discusses theoretical explanations as to why, in the absence of efforts to globally harmonise or standardise financial accounting and reporting practices, accounting regulations and practices could, and perhaps should, be expected to vary between countries. It explains why there was a large degree of variation in accounting practices internationally prior to recent decisions by many countries to adopt the financial reporting standards issued by the International Accounting Standards Board (IASB). In light of previous research that indicates that people in different countries, or from different cultures, will have different information demands and expectations, this chapter also explores the logic of establishing one set of accounting standards for worldwide use. It addresses the question of whether it makes sense that organisations in diverse countries all adopt the same financial reporting standards in an apparent acceptance of a ‘one-size-fits-all’ approach to financial reporting. The chapter provides a discussion of initiatives undertaken, principally driven by the IASB, to establish a uniform set of accounting standards for global use. More than 100 countries have adopted the accounting standards issued by the IASB, even though these standards often represent a significant change to the accounting standards that had been developed domestically and used formerly within the respective countries. A significant exception to this general trend has been the United States, which decided against adopting the accounting standards released by the IASB. To date, the United States continues to use its own domestic standards – those issued by the Financial Accounting Standards Board (FASB) – although the US Securities and Exchange 160 International accounting CHAPTER 5 Commission (SEC) did pass a ruling allowing foreign listed entities that are also listed on the US stock exchange to lodge their reports in accordance with International Financial Reporting Standards (IFRS) without the necessity to provide a reconciliation to US generally accepted accounting procedures. The FASB and the IASB had entered into an arrangement whereby they were trying to eliminate major differences between their respective standards (converge their standards) and, once this had been achieved, it was proposed that the SEC would require US companies to use IFRS. However, as noted in Chapter 4, the SEC subsequently moved away from this direction. The chapter begins with a brief discussion of the international differences that existed between various countries’ accounting practices prior to their recent adoption of IFRS. Evidence of international differences in accounting prior to recent standardisation initiatives LO5.1 LO5.3 LO5.5 More than 100 countries (including Australia, the United Kingdom, New Zealand, Canada and countries in the European Union [EU]) have elected to adopt the financial reporting standards (or we might just call them ‘accounting standards’) issued by the IASB, with such implementation typically being effective from 2005. However, to understand how different nations’ financial accounting rules had led to vastly different accounting results prior to the standardisation efforts (and hence to put into context some of the arguments for standardisation), it is useful to consider some past examples of how a particular company’s financial results varied dramatically, depending on which nation’s accounting standards were being used to account for its transactions before the adoption of IFRS. In research undertaken prior to the widespread adoption of IFRS, Nobes and Parker (2004, p. 4) compared the results of a small number of European-based multinationals that reported their results in accordance with both their home nation’s accounting rules and US accounting rules. Their comparative analysis showed, for example, that the underlying economic transactions and events of the Anglo-Swedish drug company AstraZeneca in the year 2000 produced a profit of £9521 million when reported in conformity with UK accounting rules, but a profit of £29 707 million when reported pursuant to US accounting rules – a difference of 212 per cent in reported profits from an identical set of underlying transactions and events! Extending this analysis to a subsequent reporting period, the 2006 annual report of AstraZeneca (the final year that companies with a dual home country US listing were required to provide a reconciliation between their results using IFRS and US accounting rules) shows that a profit of $6043 million derived from applying IFRS became a profit of $4392 million when calculated in accordance with US accounting rules – this time a difference of 27 per cent (Nobes and Parker, 2010). In its balance sheet (or, as it is also known, its statement of financial position), AstraZeneca’s shareholders’ equity at 31 December 2006 was $15 304 million when reported in accordance with IFRS, but this became $32 467 million when determined in accordance with US accounting rules, a difference of 112 per cent. Although percentage differences of this size might be unusual, an examination of the past financial reports of almost any company that reported its results in accordance with more than one nation’s set of accounting regulations will have shown differences between the profits reported under each set of regulations and between the financial position reported under each set of regulations. In this regard, consider the following statement from an article in the Australian Financial Review (Hamilton, 1998): From time to time, the fundamental differences in accounting and reporting standards among the various countries of the western world hit the headlines. This was never 161 Financial Accounting Theory more dramatically demonstrated than when Daimler-Benz achieved a listing on the New York Stock Exchange (the first German company to do so) in October 1993. When the group accounts were converted from German accounting rules to US GAAP (generally accepted accounting practice), a DM168 million profit for the first half year became a staggering DM949 million loss. More recently, German conglomerate Hoechst, which had adopted international accounting standards (IAS) in 1994, also listed in New York. In the process of reconciling its accounts with US GAAP an IAS profit of DM1.7 billion became a loss of DM57 million. In another newspaper article, entitled ‘News learns wealthy lesson: don’t move to US’ (Burke, 2000), it was also illustrated how a large accounting profit according to Australian accounting standards became a significant loss for the Australian company News Corporation Ltd when US accounting standards were applied. As the article stated: US accounting principles have turned The News Corporation Ltd.’s $1.92 billion net profit in fiscal 2000 as reported within Australia into a $329 million loss, according to documents filed with the US Securities and Exchange Commission. Under US Generally Accepted Accounting Principles (US GAAP), companies are not allowed to capitalise start-ups, book abnormal losses or gains, or revalue mastheads or television licences. Depreciation is also treated differently. A further dramatic example of the existence of differences between the accounting rules of different countries is provided by the US corporation Enron. As Unerman and O’Dwyer (2004) explain, in the aftermath of the high-profile collapse of Enron, many accounting regulators, practitioners and politicians in European countries claimed that the accounting practices that enabled Enron to ‘hide’ vast liabilities by keeping them off their US balance sheet would not have been effective in Europe. In the United Kingdom this explanation highlighted the differences between the UK approach and the US approach to accounting regulation. It was argued that under UK accounting regulations these liabilities would not have been treated as ‘off balance sheet’, thus potentially producing significant differences between Enron’s balance sheet under UK and US accounting practices. Lantto and Sahlstrom (2009) also provide evidence that when Finland adopted IFRS this caused significant changes in the reported financial position and performance of Finnish companies. Because Finnish Accounting Standards were similar to the domestic accounting standards in place in other continental European countries (before adoption of IFRS) the authors argue that their results would also be representative of the changes that would have occurred in the financial statements of other European countries around the time of adopting IFRS.1 We can now consider whether the fact that different countries’ financial accounting rules can generate significantly different profits or losses is a justification for the decision by many countries to adopt accounting standards issued by the IASB. Obviously, if various countries actually adopted the same accounting rules, the differences between the results reported in different countries would disappear. What do you think? Is removing international differences in accounting results sufficient justification for standardising international accounting? Certainly, this justification was used by the IASB and regulators within the EU and in other countries (such as Australia) to justify the use of IFRS. The following section looks at some of the factors that have been used to justify the efforts to standardise financial accounting and reporting internationally. However, it should be appreciated 1 162 According to the authors, the main reasons for the changes in accounting results were that IFRS required extensive use of fair values and the rules embodied within IFRS relating to lease accounting, income tax accounting, and financial instruments were very different to the rules previously used in Finland and other continental European countries. International accounting CHAPTER 5 that there are many accounting researchers who argue that there are very good reasons for accounting rules to be different in different countries (some of these reasons include underlying national differences in culture, legal systems, finance systems and so forth). The theoretical reasons given to explain why international differences are expected to exist, and perhaps should still exist, can in turn be used as possible arguments against the international standardisation of accounting – something that nevertheless has occurred. Towards the end of the chapter, the various theoretical arguments that have been proposed in opposition to standardising international accounting are considered. Does it really matter if different countries use different financial accounting methods? LO5.1 LO5.2 LO5.5 LO5.6 Before considering some of the perceived advantages associated with having a standardised system of financial accounting and reporting, it is useful to first clarify some important terminology. Nobes and Parker (2010, p. 80) distinguish between ‘harmonisation’ and ‘standardisation’ of accounting. They define ‘harmonisation’ as ‘a process of increasing the compatibility of accounting practices by setting bounds to their degree of variation’ (p. 80). ‘Standardisation’ of accounting is explained as a term that ‘appears to imply the imposition of a more rigid and narrow set of rules [than harmonisation]’ (p. 80). Therefore, harmonisation seems to allow more flexibility than standardisation, but, as Nobes and Parker (2010) point out, the two terms have been used almost synonymously in international accounting. Nevertheless, what has happened through the efforts of the IASB is standardisation. Nobes and Parker (2010) explain that the reasons for the efforts to increase international standardisation of financial accounting are similar to the reasons previously used to justify standardising financial accounting within an individual country. If investors are increasingly investing in companies from diverse countries, and those investors use financial statements as an important source of information on which to base their investment decisions, there is a view held by many people (but not all people) that standardisation is important to enable them to understand the financial statements and to have a reasonable basis for comparing the financial accounting numbers of companies from different countries. Just as is the case domestically (see the arguments in Chapters 3 and 4), the understandability and interpretation of financial accounting information should be more effective if all accounts are compiled using the same set of underlying assumptions and accounting rules. If an international investor has to understand numerous different sets of financial accounting assumptions, rules and regulations, the task of making efficient and effective international investment decisions becomes considerably more complicated. Further, if the long-term finance needs of a multinational company are too great for the providers of finance in a single country, the company may need to raise finance by listing its securities on the securities exchanges of more than one country. For reasons of domestic investor protection, the securities exchange regulators in a particular country might be reluctant to permit a company’s shares to be traded on its exchange if that company does not produce financial reports that are readily comparable with the financial reports of all other companies whose shares are traded on that exchange – that is, reports that have been prepared using comparable assumptions (or rules). Also, where a company has to produce financial reports in accordance with the financial accounting rules of each of the securities exchanges where its shares are traded, its accounting procedures would be considerably simplified if there was a single set of internationally recognised accounting rules that were acceptable to all the securities exchanges where its shares are traded. It makes sense to use a single set of international financial accounting rules and regulations for all companies listed on any securities exchange. Harmonisation In relation to accounting, refers to a process of increasing the compatibility of accounting practices by setting bounds to their degree of variation. Standardisation A process that imposes a given set of rules or requirements on a particular item, process or practice. From an accounting perspective it effectively means that every nation applies the same accounting standards. 163 Financial Accounting Theory A further reason for the international standardisation of financial reporting provided by Nobes and Parker (2010) is that it will facilitate greater flexibility and efficiency in the use of experienced staff by multinational firms of accountants and auditors. Without standardisation, the different accounting regulations in different countries act as a barrier to the transfer of staff between countries. However, whether such a factor provides real benefits to parties other than large accounting firms and multinational companies is not clear. Reflective of the perceived advantages of international standardisation, the Australian Government was concerned for a number of years about the differences between Australian accounting standards and their international counterparts. In response to this concern, from 1995 Australia was involved in a process that would harmonise (but not initially ‘standardise’) Australian accounting standards with accounting standards being released by the International Accounting Standards Committee (the forerunner to the IASB). The ‘harmonisation process’ required Australian accounting standards to be as compatible as possible with International Accounting Standards (IAS), but still allowed some divergence where the Australian treatment was considered to be more appropriate (that is, provided more relevant and reliable financial information) than the international counterpart. A document released in 1997 as part of the Australian Government’s Corporate Law Economic Reform Program (entitled Accounting Standards: Building International Opportunities for Australian Business) discussed the rationale for the harmonisation efforts. It stated (p. 15): There is no benefit in Australia having unique domestic accounting standards which, because of their unfamiliarity, would not be understood by the rest of the world. Even if those standards were considered to represent best practice, Australia would not necessarily be able to attract capital because foreign corporations and investors would not be able to make sensible assessments, especially on a comparative basis, of the value of the Australian enterprises.2 The need for common accounting language to facilitate investor evaluation of domestic and foreign corporations and to avoid potentially costly accounting conventions by foreign listed companies are powerful arguments against the retention of purely domestic financial reporting regimes. This view was also consistent with the view provided in Policy Statement 6: International Harmonisation Policy (issued in April 1996 by the Public Sector Accounting Standards Board which was under the auspices of the Australian Accounting Research Foundation), which emphasised the need for international comparability of financial statements. As Policy Statement 6 noted in paragraph 1.2: The globalisation of capital markets has resulted in an increased demand for high quality, internationally comparable financial information. The Boards believe that they should facilitate the provision of this information by pursuing a policy of international harmonisation of Australian accounting standards. In this context the international harmonisation of Australian accounting standards refers to a process which leads to those standards being made compatible, in all significant respects, with the standards of other national and international standard-setters. Ball (2006, p. 11) identifies a number of other advantages that are often advanced to support the case for the global standardisation of financial reporting. First, the adoption of IFRS might be done on the premise that the decision will lead to more accurate, comprehensive and timely financial statement information, relative to the information that would have 2 164 The view that harmonisation might lead to Australia abandoning particular standards that might represent ‘best practice’ is very interesting. It implies that harmonisation might lead to systems of accounting that are less than ideal. Also, moving away from ‘best practice’ obviously has implications for fundamental qualitative characteristics such as representational faithfulness and relevance. International accounting CHAPTER 5 been generated from the national accounting standards they replaced. To the extent that the resulting financial information would not be available from other sources, this should lead to more-informed valuations in the equity markets, and hence lower the risks faced by investors. Another perceived benefit of adopting IFRS relates to the increased financial information that would be available to small and large investors alike. Small investors might be less likely than larger investment professionals to be able to access or anticipate particular financial statement information from other sources. Improving financial reporting quality will allow smaller investors to compete more equitably with professional (larger) investors, and hence will reduce the risk that smaller investors are trading with better-informed professional investors (such a risk is known as ‘adverse selection’).3 While there are many perceived advantages that could be listed in relation to standardising international accounting, it is obviously very difficult to quantify such benefits or advantages. For example, Australia adopted IFRS because of the perceptions that various economic benefits would follow, but there is no real evidence that the country is any better off economically than it would have been had the use of domestically developed accounting standards been maintained. As Ball (2006, p. 9) states: there is very little empirical research or theory that actually provides evidence of the advantages or disadvantages of uniform accounting rules nationally, or internationally. Hence, it is not at all clear from an empirical perspective whether the decision made in Australia by the Financial Reporting Council (FRC) back in 2002 (that Australia would adopt IFRS in 2005) was the ‘right’ one, or whether the decision by the EU, or other countries that adopted IFRS, was right. Also, it is a matter of conjecture whether the benefits of adopting IFRS are shared by a majority of corporations within a country or are confined to large multinational corporations. If it is only the larger organisations that benefit, then perhaps we may need to question the equity associated with a process that required all companies within a country (other than small private companies, which typically do not have to apply financial reporting standards) to switch from domestic standards to IFRS. In this regard, Chand and White (2007) question the relevance of IFRS to a small, less-developed country such as Fiji, which has a relatively small capital market. They ask (p. 607): Why would a developing country such as Fiji that does not have a well-established capital market adopt the IFRSs? Questions concerning the effects of harmonized accounting standards on domestic users and local communities have largely been left unanswered. Having identified some of the perceived advantages relating to standardisation (some perceived disadvantages are discussed later in the chapter), it is useful now to consider the main organisation involved in standardising accounting on an international basis – this being the IASB. A brief overview of the IASB and its globalisation activities LO5.1 LO5.2 LO5.7 The following pages describe recent initiatives that have been implemented to standardise financial accounting and reporting on a global basis. A brief description and history of the IASB – the organisation at the centre of the global standardisation of accounting – is provided, along with a brief description of the standardisation efforts in the EU and Australia. 3 ‘Adverse selection’ is an economics term that represents a situation in a market where buyers cannot accurately gauge the quality of the product they are buying, but where sellers have knowledge about the quality of the product they are selling. 165 Financial Accounting Theory In describing the history of the IASB, we perhaps need to go back about 60 years and make reference to a former president of the Institute of Chartered Accountants of England and Wales (ICAEW), Henry Benson. Benson was elected president of the ICAEW in 1966. He was the grandson of one of the four brothers who, in 1854, founded the accounting firm Coopers (which through various mergers and so forth has become part of PricewaterhouseCoopers, or PwC). Veron (2007, p. 10) outlines Benson’s influence on international accounting: When elected (in 1966), Benson gave a short address to the Institute’s Council, in which he mentioned invitations he had received to visit his counterparts at the Canadian Institute of Chartered Accountants and the American Institute of Certified Public Accountants. He then added: ‘I have had the feeling for a long time that our relations with those Institutes were very friendly but somewhat remote and, with the Council’s approval, I shall see whether I can perhaps get them on to a more intimate basis’. These characteristically understated words marked the beginning of international accounting standard-setting. Benson recalls the moment in his autobiography, published in 1989 under the title Accounting for Life: My private but unstated ambition at that stage was to make it, as I think it turned to be, a turning point in the history of the accountancy profession. The United Kingdom, America and Canada were the three most important countries at that time in the world of accountancy, but there was very little dialogue between them. No attempt had been made to make them closer together to advance the interests of the profession as a whole or to get a common approach to accountancy and audit problems. The Canadian institute was closer to the American institute than we were because of their geographical position but each of the three pursued its own policies without reference or collaboration with the other two. I hoped to change this. Following Benson’s visits, the three bodies jointly established an Accountants’ International Study Group in February 1967, which soon published papers on accounting topics and gradually developed its own doctrinal framework. This then formed the basis for the creation in 1973 of the International Accounting Standards Committee (IASC) by an extended array of accounting bodies from Australia, France, Germany, Japan, Mexico and the Netherlands, in addition to Canada, the United Kingdom (plus Ireland associated with it) and the United States. The IASC’s stated aim was to issue international standards of reference that would guide the convergence of national standards over time. Benson was duly elected the IASC’s first chairman, and opened its offices in London. When the IASC was established in 1973 it had the stated objectives of: formulating and publishing in the public interest accounting standards to be observed in the presentation of financial statements and promoting their worldwide acceptance and observance; and working generally for the improvement and harmonisation of regulations, accounting standards and procedures relating to the presentation of financial statements. (IASC, 1998, p. 6) Veron (2007, p. 11) provides a description of the work performed by the IASC in the years following its formation in 1973: In the ensuing years, the IASC prepared and published a growing number of documents constituting an increasingly comprehensive body of rules, eventually completed in 1998 as a set of 39 so-called ‘core’ International Accounting Standards (IAS). Simultaneously, its governance evolved constantly to accommodate a growing and increasingly diverse 166 International accounting CHAPTER 5 stakeholder base. Belgium, India, Israel, New Zealand, Pakistan and Zimbabwe joined as associate members as early as 1974, and many other countries later followed suit. In 1981, the IASC’s Consultative Group was formed with representatives of the World Bank, United Nations, OECD, and various market participants. This group was joined in 1987 by the International Organization of Securities Commissions (IOSCO, which brings together the SEC and its national counterparts around the world), and in 1990 by the European Commission and FASB, the US standard-setting body, as these two organisations joined IASC meetings as observers. In 2000, IOSCO recommended the use of IAS for cross-border offerings or listings. By the same time, a number of developing countries had taken the habit of using them as the reference for drafting their own national standards. Some, like Lebanon and Zimbabwe, had even made their use a requirement for banks or publicly listed companies. Several developed countries, such as Belgium, France, Italy and Germany, had also adopted laws allowing large listed companies to publish consolidated accounts using IAS or standards very similar to them, without having to ‘reconcile’ them with national standards. Following the Asian crisis of the late 1990s, international accounting standards were also endorsed by the G7 Group of industrialised countries and by the Financial Stability Forum, a group of financial regulators hosted by the Bank for International Settlements in Basel. The IASC’s approach to accounting regulation essentially followed the Anglo-American model (which we explain later in this chapter), but initially many of the International Accounting Standards (IAS) it published permitted a wide range of accounting options. As such, they were not particularly effective at standardising accounting practices internationally, as different companies (or countries) could use substantially different accounting policies while all being able to state that they complied with the single set of IAS regulations. Therefore, compliance with IAS did not ensure or enhance the comparability or understandability of financial statements – a key purpose of financial accounting regulation – and was not accepted by securities exchanges as a basis for the preparation of financial reports to support a listing on their exchange.4 In the late 1980s, the International Organization of Securities Commissions (IOSCO), a body representing government securities regulators worldwide, recognised that to foster a greater number of multinational companies raising funding from securities exchanges in more than one country it would be useful to have a single set of rigorous international accounting standards, compliance with which would be acceptable to any securities exchange regulated by an IOSCO member. This would then reduce the costs of companies that had to produce a different set of financial accounting results for each of the countries in which their shares were listed. However, for IAS to be acceptable for this purpose, it would have to be much more effective at standardising accounting practice, and would therefore need to permit a much narrower set of accounting practices or options. Accordingly, the IASC then embarked on a comparability and improvements project to reduce the range of permitted options in IAS and thereby make them acceptable to IOSCO (Purvis et al., 1991). This project culminated in the publication of a revised core set of IAS by 1999, which was then accepted by IOSCO members, with the important exception of the US Securities and Exchange Commission (SEC). After this endorsement by IOSCO, any company that drew up its financial reports in accordance with the revised IAS could use this single set of IAS-based accounts to support its listing on any securities exchange regulated by any IOSCO member anywhere in the world – again, with the exception of the United States. 4 The IASB’s Conceptual Framework for Financial Reporting identifies comparability and understandability as two ‘enhancing’ qualitative characteristics of financial information (the other two enhancing qualitative characteristics being verifiability and timeliness). Enhancing qualitative characteristics rank after ‘fundamental’ qualitative characteristics, with the IASB Conceptual Framework identifying the fundamental qualitative characteristics of financial information as being relevance and faithful representation. 167 Financial Accounting Theory After completion of the core of this comparability and improvements project, the IASC was replaced in 2001 by the IASB, which adopted all existing IAS and, from 2001, has published new regulations in the form of IFRS.5 The IASB has a structure that is seen to be considerably more independent and rigorous than the former IASC (although there are still some concerns about the independence of the IASB, as we discuss later in this chapter). The replacement of the IASC by the IASB was one key element of significant changes made in the late 1990s to how the IASC/IASB conducted its operations. The IASC Foundation, through a group of trustees, was established to supervise the operations of the newly created IASB. Subsequently, between February 2008 and January 2010, the IASC Foundation reviewed its constitution, and introduced an amended constitution from 1 March 2010. Further amendments to the constitution were approved and then released in January 2013 (and again in 2018 and 2021). As part of the revised constitution, the IASC Foundation was renamed the International Financial Reporting Standards Foundation (or the IFRS Foundation), and it has the following objectives (IFRS Foundation, 2021a, paragraph 2):6 (a) to develop, in the public interest, a single set of high quality, understandable, enforceable and globally accepted financial reporting standards (referred to as ‘IFRS Standards’) for general purpose financial reporting based upon clearly articulated principles. The IASB is responsible for developing a set of accounting standards (referred to as ‘IFRS Accounting Standards’) and the ISSB is responsible for developing a set of sustainability disclosure standards (referred to as ‘IFRS Sustainability Disclosure Standards’). These complementary sets of IFRS standards are intended to result in the provision of high-quality, transparent and comparable information in financial statements and in sustainability disclosures that is useful to investors and other participants in the world’s capital markets in making economic decisions.7 (b) to promote the use and rigorous application of those standards. (c) in fulfilling the objectives associated with (a) and (b), to take account of, as appropriate, the needs of a range of sizes and types of entities in diverse economic settings. (d) to promote and facilitate adoption of IFRS Standards through the convergence of national accounting standards and IFRS Standards. The revised constitution established a new ‘Monitoring Board’ whose purpose is to ‘provide a formal link between the Trustees and those public authorities that have generally overseen standard-setters’ (IFRS Foundation, 2021a, paragraph 19). In addition, the Monitoring Board is required to approve the appointment of all IFRS Foundation Trustees. The 22 Trustees of the IFRS Foundation are responsible for the IASB’s governance and oversight, including funding (IFRS Foundation, 2021a). However, the Trustees are not to be involved in any technical matters relating to the standards. The responsibility for technical matters associated with accounting standards rests solely with the IASB. The Trustees of the 5 6 7 168 When the IASC issued accounting standards, they were referred to as International Accounting Standards (IAS). When the IASB now issues accounting standards, they are referred to as International Financial Reporting Standards (IFRS). Many of the IASC standards are still in existence, although many have been modified or updated by the IASB. These modified standards are still referred to as IAS and retain the same title and number, rather than becoming an IFRS, such that at the international level there are many IAS as well as numerous newly released IFRS. A list of the currently applicable accounting standards can be found on the IASB’s website: https://www.ifrs.org. The IFRS Foundation has 22 trustees of which six trustees are appointed from North America, six from Europe, six from the Asia/Oceania region, one from Africa, one from South America and two ‘from any area, subject to establishing overall geographical balance’. As we discuss in Chapter 10, the International Sustainability Standards Board (ISSB) – which is also under the auspices of the IFRS Foundation – was established in 2021 and its purpose is to develop reporting standards with respect to sustainability-related financial disclosures and climate change-related financial disclosures. International accounting CHAPTER 5 IFRS Foundation also appoint the members of the IASB, the members of the ISSB, the IFRS Interpretations Committee and the IFRS Advisory Council. The IFRS Interpretations Committee is the interpretative body of the IFRS Foundation and its mandate is to ‘interpret the application of IFRSs and provide timely guidance on financial reporting issues not specifically addressed in the Standards, in the context of the Board’s Framework, and undertake other tasks at the request of the Board’ (IFRS Foundation, 2021a, paragraph 43(a)). The Interpretations Committee comprises 14 voting members who are drawn from a variety of countries and between them have a balance of technical expertise. Its interpretations and guidance are subject to IASB approval and have the same authority as a standard issued by the IASB. The IFRS Advisory Council is a forum for the IASB to consult a wide range of representatives ‘with an interest in international corporate reporting, having diverse geographical and functional backgrounds’ (IFRS Foundation, 2021a, paragraph 60). The IFRS Foundation Constitution requires that the IASB shall normally comprise 14 members. Up to three members may be part-time members and shall meet appropriate guidelines of independence established by the Trustees. The remaining members shall be fulltime members. Together, IASB members must: comprise a group of people representing, within that group, the best available combination of technical expertise and diversity of international business and market experience, including auditors, preparers, users, academics and market or financial regulators, in order that the IASB as a group can contribute to the development of high quality, global financial reporting standards. The members of the IASB shall be required to commit themselves formally to acting in the public interest in all matters. No individual shall be both a Trustee and a member of the IASB at the same time. (IFRS Foundation, 2021a, paragraph 26) According to paragraph 36 of the IFRS Constitution (IFRS Foundation, 2021a), publication of an Exposure Draft or an IFRS Standard shall require approval by eight members of the Board, if there are 13 members or fewer, or by nine members if there are 14 members. Other decisions of the Board, including the publication of a Discussion Paper, shall require a simple majority of the members of the Board present at a meeting that is attended by at least 60 per cent of the members of the Board, in person or by telecommunications. It should be noted, however, that while the IASB develops standards, it does not have any power of enforcement of their use in particular jurisdictions. As we will see later in this chapter, the IASB’s lack of ability to enforce accounting standards has meant that there is a potential that different countries will not enforce the requirements of various IFRS in a uniform manner. In terms of the origin of the membership of the IASB, paragraph 27 of the IFRS Constitution (IFRS Foundation, 2021a) states: In a manner consistent with the ‘Criteria for IASB members’ as set out in the Annex to the Constitution and in order to ensure a broad international balance, there shall normally be: (a) four members from the Asia/Oceania region; (b) four members from Europe; (c) four members from the Americas; (d) one member from Africa; and (e) one member appointed from any area, subject to maintaining overall geographical balance. The work of the IASB shall not be invalidated by its failure at any time to have a full complement of members according to the above geographical allocation, although the Trustees shall use their best endeavours to achieve the geographical allocation. 169 Financial Accounting Theory Despite the reforms to the IASB and the IFRS Foundation discussed above, IFRS/IAS have still not been accepted by the US SEC as an adequate basis for the preparation of financial reports by US companies.8 The IASB and the US standard-setter (the FASB) had been working for a number of years to reduce the differences between international standards and US accounting standards in what was referred to as its ‘convergence project’ (Nobes and Parker, 2010). We return to a discussion of that project shortly. Why do I need to know about the functionings of the IASB and the IFRS Foundation? Arguably, from a broader corporate accountability perspective, the IASB – which is under the auspices of the IFRS Foundation – is one of the most influential organisations in the world. Many decisions by a multitude of stakeholders worldwide are made on the basis of information about an organisation’s financial performance and position, and these decisions then create many social and environmental impacts (reflecting the fact that accounting is both a technical and social practice). Therefore, as members of society and as members of the accounting profession, and given the centrality of the IASB (and its governing body, the IFRS Foundation) to financial reporting globally, it seems important that we understand the nature and functioning of the IASB. By knowing about the functioning of the IASB, we can also be better placed to critically evaluate its processes and also its independence, and this allows us to more fully participate in debates about financial reporting at the international level. Role of the European Union A very significant participant in the process of standardising accounting practices internationally was the EU.9 A key reason for the EU becoming involved in accounting regulation at the EU level (rather than leaving this to individual member states) is that a founding principle of the EU is freedom of movement within the EU of people, goods and capital. As discussed earlier, differing accounting principles in different countries have been noted by various individuals, researchers and organisations as impediments to investors seeking to understand and compare the financial statements of companies in different countries, and thereby acted as impediments to them freely investing their capital in companies from different EU member states (an inhibition to the free movement of capital). The approach towards harmonisation and standardisation of accounting in the EU has historically differed from the IASC/IASB approach. This should be of little surprise, given that most countries in the EU, by definition, follow a continental European system of financial accounting (to be discussed shortly) rather than the Anglo-American model of the IASC/IASB, so the EU approach to accounting harmonisation has historically been through legislation. This legislation has primarily been in the form of EU directives on company law, which have to be agreed upon by the EU and then implemented in the domestic legislation of each EU member state. This is a very lengthy process, and during the 1990s the EU recognised that it was far too inflexible to respond to the requirements of a dynamic business environment where financial accounting practices need to adapt quickly to rapidly changing business practices – especially for companies that rely on ‘outsider’ forms of finance, as an increasing number of the largest companies in many continental European nations do. (‘Outsider forms of finance’ refers to finance received from parties, such as shareholders, that do not get involved in the management of the organisation.) 8 9 170 As noted elsewhere in this chapter, foreign listed companies are allowed to lodge their financial statements within the US in accordance with IFRS. This concession, however, is not extended to US companies. The European Union was formerly known as the European Community (and prior to that it was known as the Common Market). It is an intergovernmental organisation of 27 European nations created by the Maastricht Treaty of December 1993 with its own institutional structures and decision-making framework. It comprises Austria, Belgium, Bulgaria, Croatia, Cyprus, the Czech Republic, Estonia, Denmark, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, the Netherlands, Poland, Portugal, Romania, Spain, Slovakia, Slovenia and Sweden. The United Kingdom was a founding member of the EU, but left the EU in 2020. International accounting CHAPTER 5 Following proposals made in 2000, the EU agreed in 2002 that from 1 January 2005 companies whose shares were traded on any securities exchange in the EU would have to compile their consolidated accounts in accordance with IAS/IFRS. This was seen as ensuring that accounting rules were flexible enough to suit the needs of a dynamic business environment and that the financial accounts of EU-listed companies maintained international credibility. A press release was issued by the European Commission when this route for accounting regulation was formally adopted in 2002. Because of the importance of this initiative to global financial reporting, the contents of the press release are reproduced below as Figure 5.1. FIGURE 5.1 European Commission view on global financial reporting Press release of the European Commission regarding IFRS adoption The European Commission has welcomed the Council’s adoption, in a single reading, of the Regulation requiring listed companies, including banks and insurance companies, to prepare their consolidated accounts in accordance with International Accounting Standards (IAS) from 2005 onwards (see IP/01/200 and MEMO/01/40). The Regulation will help eliminate barriers to cross-border trading in securities by ensuring that company accounts throughout the EU are more reliable and transparent and that they can be more easily compared. This will in turn increase market efficiency and reduce the cost of raising capital for companies, ultimately improving competitiveness and helping boost growth. The IAS Regulation was proposed by the Commission in February 2001. It is a key measure in the Financial Services Action Plan, on which significant progress has been made in the last few weeks (see IP/02/796). Unlike Directives, EU Regulations have the force of law without requiring transposition into national legislation. Member States have the option of extending the requirements of this Regulation to unlisted companies and to the production of individual accounts. Although the Commission put forward the IAS proposal long before the Enron affair, this is one of a series of measures which will help to protect the EU from such problems. Others include the Commission’s recent Recommendation on Auditor Independence (see IP/02/723) and its proposal to amend the Accounting Directives (see IP/02/799). Internal Market Commissioner Frits Bolkestein said: ‘I am delighted that the IAS Regulation has been adopted in a single reading and am grateful for the positive attitude of both the Parliament and the Council. I believe IAS are the best standards that exist. Applying them throughout the EU will put an end to the current Tower of Babel in financial reporting. It will help protect us against malpractice. It will mean investors and other stakeholders will be able to compare like with like. It will help European firms to compete on equal terms when raising capital on world markets. What is more, during my recent visit to the US, I saw hopeful signs that the US will now work with us towards full convergence of our accounting standards.’ To ensure appropriate political oversight, the Regulation establishes a new EU mechanism to assess IAS adopted by the International Accounting Standards Board (IASB), the international accounting standard-setting organisation based in London, to give them legal endorsement for use within the EU. The Accounting Regulatory Committee chaired by the Commission and composed of representatives of the Member States, will decide whether to endorse IAS on the basis of Commission proposals. In its task, the Commission will be helped by EFRAG, the European Financial Reporting Advisory Group; a group composed of accounting experts from the private sector in several Member States. EFRAG provides technical expertise concerning the use of IAS within the European legal environment and participates actively in the international accounting standard setting process. The Commission invites all parties interested in financial reporting to contribute actively to the work of EFRAG. The Commission recently proposed amendments to the Accounting Directives which would complement the IAS Regulation by allowing Member States which do not apply IAS to all companies to move towards similar, high quality financial reporting (see IP/02/799). Source: European Commission press release, Reference: IP/02/827, Date: 7 June 2002. CC BY 4.0 Licence (https://creativecommons.org/licenses/by/4.0/) 171 Financial Accounting Theory The press release demonstrates that the views being embraced in favour of the adoption of IAS/IFRS are based on beliefs about the information people need in making various decisions (which can be tied back to decision usefulness theories – some of which are considered in Chapters 6 and 7), beliefs about how individuals and capital markets react to accounting information (which can be tied back to behavioural and capital markets research – the topics we cover in Chapters 11 and 12 of this book), and a view that the adoption of IAS/IFRS is in the public interest, rather than being driven by the private interests of particular constituents (public interest theories and private interest theories are discussed in Chapter 4). There also appears to be a view that new accounting methods will be embraced in a similar manner across different countries (which perhaps differs from some of the insights to be noted later in this chapter – for example, that religion, culture or taxation systems influence the usefulness of various alternative accounting approaches). Despite the European Commission’s enthusiasm for the adoption of IAS/IFRS, there were concerns that, for both legal and political reasons, the EU could not be seen to endorse in advance regulations that might be developed at any time in the future by an international body not under control of the EU (Nobes and Parker, 2010). That is, the EU was unwilling to give a blanket approval covering all future IFRS (that would apply to many EU companies) without considering the details of those IFRS. Therefore, as can be seen in the press release, the EU established a mechanism whereby each IAS/IFRS would have to be endorsed separately by the EU before becoming mandatory for listed companies in the EU. This endorsement process involves a 17-member Board of the European Financial Reporting Advisory Group (EFRAG – see https:// www.efrag.org), whose members are drawn from the preparers and users of financial statements, and who comment on each IAS/IFRS to a new EU Accounting Regulatory Committee (ARC). According to the website of EFRAG (n.d.): EFRAG’s mission is to serve the European public interest by developing and promoting European views in the field of financial reporting and ensuring that these views are properly considered in the IASB’s standard-setting process and in related international debates. EFRAG ultimately provides advice to the European Commission on whether newly issued or revised IFRS Standards meet the criteria of the IAS Regulation for endorsement for use in the EU, including whether endorsement would be conducive to the European public good ... EFRAG seeks input from all stakeholders, and obtains evidence about specific European circumstances, throughout the standard-setting process and in providing its endorsement advice. Its legitimacy is built on transparency, governance, due process (which may include field tests, impact analyses and outreaches), public accountability and thought leadership. This enables EFRAG to speak convincingly, clearly and consistently, and be recognised as the European voice in financial reporting. The ARC, which receives recommendations from EFRAG, has a member from each EU state, and the members vote on whether to recommend approval of the IAS/IFRS to the EU Commission, with a two-thirds majority of the 27 members being required to recommend approval. This mechanism was used in 2004 to block recommendation of full EU endorsement of IAS 39 (on financial instruments) by governments who argued that aspects of IAS 39 were unrealistic and would have potentially significant negative economic consequences on banks in their nations. It is interesting to speculate whether this action by the EU to modify an accounting standard issued by the IASB (and thereby move away from full standardisation) undermined the efforts that were being undertaken by the IASB to encourage other countries, most notably the United States, to adopt IFRS. The benefits of international standardisation are potentially reduced when some countries, such as the member countries of the EU, decide to make alterations to the standards issued by the IASB. 172 International accounting CHAPTER 5 Australia adopts IFRS The efforts undertaken within Australia to harmonise or standardise Australian accounting practice with international practice are now considered. As indicated earlier, from the mid-1990s Australia adopted a policy of harmonisation. This process led to revised Australian accounting standards which, although not the same, were very comparable with those issued by the IASC. Once these revisions were almost complete and many revised accounting standards had been issued, a decision was made in 2002 by the Financial Reporting Council (FRC) that Australia would ‘adopt’ accounting standards being issued by the IASB and no divergence was to be acceptable (that is, there was a shift from harmonisation to standardisation).10 This led to yet another set of accounting standards being released, for application in 2005. This was a very frustrating time for Australian accountants. Just as they were getting used to a new set of accounting standards that had been released to harmonise Australian accounting standards with IAS, the revised (harmonised) standards were dumped in favour of a standardisation process that involved the adoption of IAS/IFRS. The Bulletin released by the FRC outlining its direction on the adoption of international accounting standards is reproduced in Figure 5.2. As can be seen, there is much FIGURE 5.2 Bulletin released by the Financial Reporting Council (Australia) in 2002 Adoption of International Accounting Standards by 2005 The Chairman of the Financial Reporting Council (FRC), Mr Jeffrey Lucy, AM, today announced that the FRC has formalised its support for the adoption by Australia of international accounting standards by 1 January 2005. Subject to the Government’s support at the appropriate time for any necessary amendments of the Corporations Act, this will mean that, from 1 January 2005, the accounting standards applicable to reporting entities under the Act will be the standards issued by the International Accounting Standards Board (IASB). After that date, audit reports will refer to companies’ compliance with IASB standards. The FRC considered the issue at its meeting on 28 June and formally endorsed the 2005 objective, in line with statements made recently by the Parliamentary Secretary to the Treasurer, Senator the Hon. Ian Campbell. Mr Lucy paid tribute to the Government’s strong leadership over the last five years in pressing for the international convergence of accounting standards. This objective is reflected in the Government’s 1997 Corporate Law Economic Reform Program initiative (CLERP 1) and amendments made in 1999 to the Australian Securities and Investments Commission Act 2001. The FRC fully supports the Government’s view that a single set of high-quality accounting standards which are accepted in major international capital markets will greatly facilitate crossborder comparisons by investors, reduce the cost of capital, and assist Australian companies wishing to raise capital or list overseas. Mr Lucy said he understood that the 1 January 2005 timing is somewhat later than the Government would have liked. However, it is determined by the decision of the European Union to require EU listed companies to prepare their consolidated accounts in accordance with IASB standards from that date, in support of the EU single market objective. Australia certainly cannot afford to lag [behind] Europe in this regard, Mr Lucy said. He also expressed his support for efforts to encourage the United States to further converge its standards with IASB standards with a view to eventual adoption. Mr Lucy was pleased to note that the Chairman of the IASB, Sir David Tweedie, had issued a statement in London welcoming the FRC’s decision. Sir David said that the FRC’s announcement demonstrates growing support for the development and implementation of a single set of highquality global accounting standards by 2005. 10 The FRC has an oversight function in regard to the Australian Accounting Standards Board (and the Australian Auditing Standards Board) and appoints members of the AASB (other than the chairperson). There are nine members on the FRC inclusive of the chairperson. See https://www.frc.gov.au for more details about the FRC. 173 Financial Accounting Theory ‘This vote of confidence is a reflection of the leadership role that Australia continues to play in standard-setting, and will increase momentum for convergence towards high-quality international standards. The input and active participation of interested parties in Australia and the Australian Accounting Standards Board (AASB), under the leadership of Keith Alfredson, are and will remain a vital element in ensuring the IASB’s success. It is through national standard-setters, such as the AASB, and the members of our various committees that we are able jointly to develop high-quality solutions to accounting issues, leverage resources to research topics not yet on the international agenda so as to expedite conclusions, reach interested parties throughout the world and better understand differences in operating environments, thus fulfilling our role as a global standard-setter.’ The full statement is available on the IASB’s website www.iasb.org.uk. While there will be a need for business and the accounting profession to adapt to significant changes in some standards, and to some complex new standards, the AASB has been harmonising its standards with those of the IASB for some years, resulting in substantial synergies between the two. Nevertheless, Mr Lucy urged the accounting bodies to prepare for the changeover through their programs of professional development and their influence on accounting education. He also urged the business community to participate fully in commenting on exposure drafts of IASB standards issued in Australia in the period ahead. Mr Lucy noted that implementation issues would also need to be considered by the FRC (to the extent they did not involve the content of particular standards) and the AASB between now and 2005. These could relate, for example, to the timing of introduction of particular IASB standards in Australia before 1 January 2005 (which would be AASB standards until that date), as well as to issues of interpretation. The FRC and AASB will be doing everything they can to keep constituents informed about these issues and to communicate an overall strategy for adoption, Mr Lucy said. Mr Lucy also confirmed that Australia would be making a substantial financial contribution, through the FRC, to the International Accounting Standards Committee (IASC) Foundation in 2002–03. This contribution will be sourced from funds available to the FRC for the standardsetting process contributed by the Commonwealth, State and Territory governments, the three accounting bodies, the Australian Stock Exchange, and from the Financial Industry Development Account (as announced by Senator Campbell on 12 June). Among the FRC’s functions are to further the development of a single set of accounting standards for world-wide use and to promote the adoption of international best practice accounting standards in Australia if doing so would be in the best interests of both the private and public sectors in the Australian economy. The IASB, which is based in London, is committed to developing, in the public interest, a single set of high-quality, global accounting standards that require transparent and comparable information in financial statements. In pursuit of this objective, the IASB cooperates with national standard-setters, including the AASB, to achieve convergence in accounting standards around the world. The AASB has been harmonising its standards with IASB standards for a number of years and is now working in close partnership with the IASB as a liaison standard-setter, aligning its work program with that of the IASB and standing ready to allocate resources to lead or support projects on the IASB agenda. Recently, the AASB issued to its Australian constituents invitations to comment on a number of exposure drafts of IASB standards. Australians are actively involved in the work of the IASB. Mr Ken Spencer is a member of the oversight body for the IASB, the IASC Foundation Trustees (and Chairman of the Foundation’s Nominating Committee). Mr Warren McGregor is a member of the IASB, also designated the Liaison Member for Australia and New Zealand. Mr Kevin Stevenson, a former director of the Australian Accounting Research Foundation, is the IASB’s Director of Technical Activities. Australians are also on the IASB’s Standards Advisory Council (Mr Peter Day and Mr Ian Mackintosh) and its Interpretations Committee (Mr Wayne Lonergan). Source: Bulletin of the Financial Reporting Council, 2002/4, 3 July 2002 Based on © Commonwealth of Australia material 174 International accounting CHAPTER 5 REFLECTION QUESTION 5.1 To accept international standardisation, or not? Question Do you think it is a good idea that a country, such as Australia, New Zealand or Singapore, effectively allows its financial reporting standards to be developed by a standard-setting body in another country? Solution This is a very interesting question with no clear answer. As we read through this chapter, we will be better able to provide a critically considered response to this question. One of the key rationales for why a country should adopt IFRS in preference to its own nationally developed standards is that having a globally standardised set of financial reporting standards will enhance financial report comparability internationally. This in turn is expected to lead to increased flows of financial capital internationally and reduced costs of capital for those organisations able to produce financial reports in compliance with IFRS. However, there is no clear evidence that these enhanced capital flows actually occurred or that the cost of attracting capital declined. Also, it has been frequently argued that some national accounting standards were superior to their replacement IFRS (a case in point within Australia was that the domestic standard on intangible assets was widely considered to be superior to its IFRS equivalent yet the domestic standard was ‘dumped’ in the pursuit of greater international comparability). In this chapter, we discuss the fact that many countries have relatively poor mechanisms to enforce compliance with IFRS, and such countries also often have low-quality auditing practices. This undermines international comparability of financial reporting – which was one of the justifications the IASB used to explain the need for standardisation. Comparability is also an enhancing qualitative characteristic within the IASB Conceptual Framework for Financial Reporting. Further, we also discuss research that shows that when IFRS are translated from their initial English form into various domestic languages, meanings of key terms are often changed, also undermining comparability. We will also learn that some countries make changes to IFRS before endorsing them locally, which further undermines the international comparability of financial reports. Apart from these issues, there are other broader issues to consider. Does it make sense to have one set of financial reporting guidance for all countries – that is, to have a ‘onesize-fits-all’ approach to financial reporting? We see in this chapter that various researchers question whether people within different nations and different cultures have the same information needs and expectations. As we read through the chapter, we discuss how issues such as culture, legal systems, financing systems, taxation systems, language, political systems and religion influence demands for information, including financial information. A system of standardised reporting effectively ignores such important differences. So, in terms of our question about whether it is a good idea that a country adopts IFRS, different people have different views. However, generally speaking, the majority view would arguably be that the efforts undertaken to standardise financial reporting practices has created more benefits than costs – but the argument is far from settled. similarity between the arguments in favour of standardisation provided in the press release from the European Commission and the supporting arguments expressed in the press release from the FRC. However, as has already been mentioned, there have been no known attempts to quantify the costs and benefits of these standardising activities. The United States’ role in the international standardisation of financial accounting LO5.1 LO5.7 The major event that triggered the adoption of IFRS by more than 100 countries was the decision taken by the EU to adopt IFRS as the accounting standards to be used for preparing the consolidated financial statements of publicly listed companies from 2005.11 In Australia, the FRC followed the lead of the EU, and in 2002 decided that Australia would adopt IFRS from 2005. Prior to the adoption of IFRS, these countries used accounting standards that were typically developed on a domestic basis. 11 The proposal to adopt IFRS was confirmed in a regulation of the European Parliament and European Council released on 19 July 2002. IFRS and IFRIC interpretations, once adopted by the IASB, need to be specifically acknowledged (and translated into various languages) by the European Commission to become part of EU law. National standards are still commonly used in European countries for individual (non-consolidated) financial statements. 175 Financial Accounting Theory One notable exception to the global adoption of IFRS is the United States. But before considering the US position on global standardisation, it is useful to briefly consider the two main bodies responsible for accounting regulation within the United States – the SEC and the FASB. In relation to their history, following the US stock-market crash of 1929, newly established US securities legislation of 1933 and 1934 led to the creation of the SEC. The SEC was given the authority to develop accounting regulation, but it decided to rely on the expertise of the US accounting profession to develop accounting standards. Over the following decades, the US accounting profession developed various documents that became known as ‘generally accepted accounting principles’ (GAAP). In 1973 the SEC entrusted the task of developing accounting standards to the newly formed FASB.12 The FASB is a private-sector body that was established to act in the ‘public interest’. While the FASB was established as an independent body, the SEC has the power to override the accounting standards issued by the FASB should it see fit to do so.13 In the United States, reliance is still placed on accounting standards issued by the FASB, rather than on the standards issued by the IASB. That is, unlike many other countries, the United States did not adopt IFRS. Given that the United States represents the world’s major capital market, its non-involvement represents a significant limitation in the global acceptance of IFRS. The United States was, for many years, very strong in its resolve not to adopt IFRS, believing that its ‘rules-based’ standards were superior to the more ‘principlesbased’ standards of the IASB.14 However, this resolve appeared to diminish around 2001–02 with the various ‘accounting scandals’ involving organisations such as Enron.15 As Veron (2007, p. 23) states: The context was profoundly modified by the Enron bankruptcy in December 2001 and other accounting scandals that erupted in 2002, following the bursting of the late-1990s stock market bubble. Before this wave of controversy, specific US GAAP standards had been occasionally criticised but overall it was widely considered, in the US and elsewhere, that US GAAP as a whole were the best available set of accounting standards … But Enron’s collapse shattered the perception of high quality. It exposed the shortcomings of some detailed US GAAP rules, most notably those on consolidation which gave Enron enough leeway to hide its now famous ‘special-purpose entities’ (with their funny names such as Chewco, Raptor, Jedi, or Big Doe) off its balance sheet, packing them with real debts backed by flimsy assets … In February 2002, a Senate Committee investigating the Enron debacle heard the testimony of IASB Chairman Prior to this time, the Accounting Principles Board (a committee of the American Institute of Certified Practicing Accountants) was responsible for developing US GAAP. 13 See the following websites for further information about the SEC and FASB respectively: https://www.sec.gov and https://www.fasb.org. 14 In basic terms, rules-based accounting standards tend to be relatively lengthy and provide explicit guidelines on how to account for specific attributes of different transactions and events. By contrast, principles-based accounting standards tend to be less detailed and more concise. Rather than providing detailed rules for particular transactions and events, in principles-based standards reference is made to general principles that should be followed. These principles might be incorporated within a conceptual framework of accounting. Principles-based accounting standards require the exercise of greater levels of professional judgement relative to rules-based accounting standards. As an example of the difference, a rules-based accounting standard might say that a particular type of intangible asset should be amortised over twenty years, whereas a principles-based standard might require that the intangible assets be amortised to the extent that the economic value of the asset has declined since the beginning of the accounting period. Accounting standards released by the FASB are generally considered to be more rules-based than accounting standards issued by the IASB (which are considered to be principles-based). 15 Enron was an energy company based in Texas. Prior to its bankruptcy in late 2001, it employed approximately 22 000 people and was one of the world’s leading electricity, natural gas, pulp and paper, and communications companies, with reported revenues of $111 billion in 2000. At the end of 2001, it became apparent that the company’s financial position was generated through extensive accounting fraud. Enron represented one of the biggest and most complex bankruptcy cases in US history. 12 176 International accounting CHAPTER 5 David Tweedie who explicitly criticised the rules-based approach which is prevalent in US GAAP, contrasting it with the more principles-based stance adopted by the IASB. Shortly thereafter, the Sarbanes-Oxley Act specifically mandated the SEC to study how a more principles-based system (such as IFRS) could be introduced in the United States. With the perceived limitations of some US accounting requirements in mind, the FASB and the IASB entered a joint agreement in 2002 to converge and improve the standards of both the IASB and the FASB. The intended consequence of the Convergence Project would be that the United States would ultimately adopt IFRS. As Veron (2007, p. 24) states: Since the early 2000s the FASB has been working with the IASB to narrow the differences between US GAAP and IFRS – a process they call ‘convergence’, but which in fact is very different from the unilateral convergence of, say, Australian or South Korean accounting standards towards IFRS. The premise, enshrined in the so-called Norwalk Agreement of September 200216 and renewed by an FASB–IASB Memorandum of Understanding in February 2006, is that both the FASB and the IASB would need to move some way towards each other. In this process, on some issues FASB adopts standards identical or near identical to existing IFRS (e.g. for stock option expensing); on other issues the IASB adopts standards identical or near identical to existing US GAAP rules, as with the IFRS 8 standard on ‘operating segments’; and on yet other issues the two bodies jointly develop entirely new projects. Although there appeared to be a long-term aim that ultimately there will be one set of standards used internationally, including within the United States, this now appears unlikely – at least in the relatively near future. Obviously, for the IASB – and its governing body, the IFRS Foundation – to achieve their aim of developing ‘a single set of high-quality, understandable, enforceable and globally accepted accounting and sustainability disclosure standards – IFRS Standards – and to promote and facilitate adoption of the standards’ (IFRS Foundation, 2021c), it needed to encourage the United States to adopt its standards. Nevertheless, from late 2007 the SEC adopted rules that permit foreign private issuers (but not US domestic companies) to lodge, with the SEC, their financial statements prepared in accordance with IFRS without the need to provide a reconciliation to GAAP as used in the United States. That is, foreign companies that are listed across a number of securities exchanges internationally, including within the United States, can lodge their reports in the United States even though the reports have not been prepared in accordance with US accounting standards and do not provide a reconciliation to US GAAP. The ruling of the SEC requires that foreign private issuers that take advantage of this option must state explicitly and unreservedly in the notes to their financial statements that such financial statements are in compliance with IFRS as issued by the IASB (without modifications), and they must also provide an unqualified auditor’s report that explicitly provides an opinion that the financial statements have been compiled in accordance with IFRS as issued by the IASB. In explaining the basis for its decision to provide this concession to foreign companies, the SEC stated (2007, p. 16): We believe that investors can understand and work with both IFRS and U.S. GAAP and that these two systems can co-exist in the U.S. public capital markets in the manner described in this rule making, even though convergence between IFRS and U.S. GAAP is not complete and there are differences between reported results under IFRS and U.S. GAAP. 16 It was signed in the FASB’s home city of Norwalk, Connecticut, hence becoming known as the Norwalk Agreement. 177 Financial Accounting Theory Hence, effectively there are two types of financial statements being lodged within the United States (as is the case in many other countries). Foreign companies can lodge their reports within the United States in accordance with IFRS, whereas domestic US companies must lodge their reports in accordance with US GAAP. It is interesting that the SEC states that these two systems can co-exist. If different systems can co-exist, does that question the need for all countries to adopt IFRS? What do you, the reader, think? Does the US position of supporting dual reporting systems undermine the view of the FRC in Australia, which argued back in 2002 that if Australia retained its own accounting standards (which were fundamentally similar to IFRS) it would be damaging to Australian capital markets? In terms of some of the opposition within the US to adoption of IFRS, we can consider some of the issues raised by the US Financial Accounting Foundation (FAF).17 The FAF was particularly concerned about the perceived independence of the IASB, and it wanted certain changes to be made to the governance policies of the IASB before the United States would be willing to adopt IFRS (which emanate from the IASB). Of particular concern was the uncertain nature of the funding being received by the IASB and the fact that a great deal of the funding comes from the ‘Big 4’ accounting firms (Deloitte, PricewaterhouseCoopers (PwC), KPMG and Ernst & Young), which each donate annual funding to the IASB and are organisations that are directly affected by the operations of the IASB (and therefore have an incentive to ‘capture’ the IASB).18 The FAF (2007, p. 8) called for mechanisms to be established ‘to provide the IASB with sufficient and stable funding and staffing levels, thereby ensuring its sustainability as an independent setter of high-quality accounting standards’. The FAF further stated (2007, p. 8) that it did not ‘support moving U.S. public companies to IFRS until mechanisms to adequately fund the IASB’s activities over the long term are developed’.19 The FAF was also concerned that in many jurisdictions amendments are being made to IFRS at a local level before the standards are used in that particular country. This has the obvious implications of undermining the consistency of financial accounting being undertaken across countries that otherwise state they have adopted IFRS. As the FAF (2007, p. 3) states: Agreements are needed to eliminate the separate review and endorsement processes that various jurisdictions apply to each IFRS after it is issued by the IASB. These afterthe-fact jurisdictional processes are inconsistent with the objective of a single set of high-quality international accounting standards, as evidenced by the local variants of IFRS that have developed in some jurisdictions. In 2008 the IASC Foundation proposed a number of changes to the IASB’s organisational and governance practices, which were later implemented. However, such changes were not sufficient to lead to the United States adopting IFRS. The Financial Accounting Foundation was established in 1972 and is the independent, private-sector organisation with responsibility for the oversight, administration and finances of the FASB. It also selects the members of the FASB. 18 A review of the IFRS Foundation Annual Report 2021 (IFRS Foundation, 2021b) shows that each of the ‘Big 4’ international accounting forms donated US$550 000 in 2021. See https://www.ifrs.org/content/dam/ifrs/ about-us/funding/2021/ifrs-annual-report-2021.pdf. 19 In Chapter 4 we discussed some research which noted concerns around the possible ‘capture’ of the IASB in relation to decisions it made in relation to some accounting standards, the concern being that some stakeholders that made significant financial contributions to the IASB might have been able to influence the contents of certain accounting standards. 17 178 International accounting CHAPTER 5 Does the international standardisation of accounting standards necessarily lead to the international standardisation of accounting practice? LO5.2 LO5.6 LO5.7 The international adoption of IFRS is claimed by the IASB as a means of improving the reporting practices of organisations in many countries and improving the ability of report readers to compare the financial performance and position of organisations in different countries. A document entitled ‘Use of IFRS Standards around the world, 2018’ (IFRS Foundation, 2018) referred to the benefits of IFRS in a diagram that is reproduced in Figure 5.3. FIGURE 5.3 IASB’s perspective of the role of IFRS Source: IFRS Foundation (2018), Use of IFRS standards around the world, https://www.ifrs.org/content/dam/ifrs/ around-the-world/adoption/use-of-ifrs-around-the-world-overview-sept-2018.pdf. 179 Financial Accounting Theory The standardisation of accounting standards by a multitude of different countries, with different enforcement mechanisms, different forms of capital markets, different cultures and so forth, might be considered to lead to the standardisation of accounting practice. Certainly, this seems to be a central assumption of the IASB. But is this a realistic belief? Will international standardisation of accounting standards lead to international standardisation of accounting practice? Evidence provided by Kvaal and Nobes (2010) indicates that where there will still be flexibility within options provided by individual IFRS and IAS, companies in different countries tend to choose the options that reflect the requirements within their previous (pre-IFRS adoption) national accounting regulations. As such, Kvaal and Nobes (2010, pp. 173–4) indicate that despite the international standardisation intended by the widespread adoption of IFRS, national differences still persist and limit the international comparability of financial statements drawn up by companies in different countries: We document formally that there are different national versions of IFRS practice. Related to this, we show that companies not only have an opportunity to pursue pre-IFRS practices originating in their national GAAP, but also extensively use this opportunity. These findings are important for several reasons. For financial statement users, they imply that full international comparability has not yet arrived. Therefore, it has been suggested, investors might be misled by an apparent uniformity (Ball, 2006: 15). As long as accounting standards contain options and require use of judgment, some variation in accounting practice is inevitable. However, the existence of systematic differences in practice related to national borderlines is clearly in conflict with the objective of international harmonisation and may mislead financial statement users who do not pay attention to them. Some differences within IFRS practice are observable and can be adjusted for by alert analysts (e.g. the location of dividends in a cash flow statement); other differences are easily observable but cannot be adjusted for without a large degree of estimation (e.g. the effects of the inventory flow method on profit, or the absence of a gross profit figure in a by-nature income statement); yet others are not observable (e.g. the application of criteria for making impairments or for capitalising development costs). Some users of financial statements might be misled by even the first type of differences, but many might be misled by the third type. The second and third types create difficulties for international comparative analysis. Nobes (2013) also notes that although Australia claims to have adopted IFRS, some disclosure requirements have been added, other material has been added to make the standards applicable to not-for-profit organisations, and for those organisations not deemed to have ‘public accountability’, reduced disclosure requirements have been included within the standards. Further, in some countries, only consolidated financial statements are required to comply with IFRS, some countries provide exemptions for certain companies, and in some countries IFRS are only required for listed companies. The discussion that follows shows that there are a number of reasons why the standardisation of accounting standards will not necessarily lead to standardisation in practice. Hence, consistent with Nobes (2006), the study of international differences in accounting (and the reasons and motivations for them) will remain an important area of research despite the ongoing standardisation efforts of the IASB.20 It will be seen that there are various reasons why international differences will survive beyond the introduction of IFRS. 20 180 As Nobes (2006) noted, there has historically been a number of accounting researchers who specialised in studying the reasons and rationale for differences in the accounting methods or practices adopted in different countries. Many such researchers considered that their area of specialisation might become defunct as a result of the global adoption of IFRS. However, as this chapter demonstrates, despite the widespread adoption of IFRS there will continue to be many differences in the accounting methods adopted across different countries, and hence many areas to consider for research into international accounting differences. International accounting CHAPTER 5 Differences in taxation systems Nobes (2006, p. 235) uses a comparison of differences in taxation systems between Germany and the United Kingdom to identify why financial reporting practices in the two countries might be systematically different despite both countries adopting IFRS. As he states: In Germany, companies are required to continue to prepare unconsolidated financial statements under the conventional rules of the Handelsgesetzbuch (HGB) for calculations of taxable income and distributable income. This is irrespective of any use of IFRS for consolidated or unconsolidated statements (Haller and Eierle, 2004). In some areas, the tax-driven accounting choices of the unconsolidated statements might flow through to consolidated IFRS statements. For example, asset impairments are tax deductible in Germany (but not in the UK), so there is a bias in favour of them. They might survive into IFRS consolidations in Germany, given the room for judgment in IFRS impairment procedures. In the UK, IFRS is allowed for individual company financial statements and therefore as a starting point for calculations of taxable income. The tax authorities generally expect the statements of a parent and other UK group members to use the same accounting policies as group statements. To take an example, the recognition and measurement of intangible assets has tax implications. Consequently, given that IFRS requires considerable judgment in this area, individual companies using IFRS will have an incentive to make interpretations of IAS 38 (Intangible Assets) in order to minimise capitalisation and therefore tax, and then these will flow through to consolidated financial statements. Differences in economic and political influences on financial reporting There is also an expectation that differences in the economic and political forces operating within a country will have implications for various decisions and judgements made throughout the accounting process regardless of whether IFRS have been adopted. As Ball (2006, p. 15) states: The fundamental reason for being sceptical about uniformity of implementation in practice is that the incentives of preparers (managers) and enforcers (auditors, courts, regulators, boards, block shareholders, politicians, analysts, rating agencies, the press) remain primarily local. All accounting accruals (versus simply counting cash) involve judgments about future cash flows. Consequently, there is much leeway in implementing accounting rules. Powerful local economic and political forces therefore determine how managers, auditors, courts, regulators and other parties influence the implementation of rules. These forces have exerted a substantial influence on financial reporting practice historically, and are unlikely to suddenly cease doing so, IFRS or no IFRS. Achieving uniformity in accounting standards seems easy in comparison with achieving uniformity in actual reporting behaviour. The latter would require radical change in the underlying economic and political forces that determine actual behaviour. Nobes (2013) also refers to the various professional judgements in IFRS (which are deemed to be more principles-based than US financial reporting standards), such as judgements about useful lives, residual values, existence of impairment losses, and depreciation methods and notes that many of these differ at a national level. As Nobes (2013) notes, many of these accounting differences might be influenced by the same forces that drove national financial reporting practices to be different in the first place. Nobes (2013) also notes that there seem to be differences in the determination of ‘fair values’, which can be explained through national differences, as well as differences in the selection of options relating to balance sheet and income statement presentation. 181 Financial Accounting Theory Modifications made to IFRS at a national level As indicated earlier, an issue that was of concern to the FAC in the United States and perhaps contributed to the decision of the United States to step away from the adoption of IFRS, is that the IASB has no ability to enforce the application of its accounting standards in countries that have made the decision to adopt IFRS. The effect of this is that regulatory bodies in particular countries might make a decision to modify a particular IFRS before it is locally released. This was the case in the EU in relation to its acceptance of IFRS 39 (which has since been replaced by IFRS 9). If modifications to IFRS are made at a national level, the result will be international inconsistencies in accounting practice. As Ball (2006, p. 16) states: The most visible effect of local political and economic factors on IFRS lies at the level of the national standard adoption decision. This already has occurred to a minor degree, in the EU ‘carve out’ from IAS 39 in the application of fair value accounting to interest rate hedges. The European version of IAS 39 emerged in response to considerable political pressure from the government of France, which responded to pressure from domestic banks concerned about balance sheet volatility. Episodes like this are bound to occur in the future, whenever reports prepared under IFRS produce outcomes that adversely affect local interests. In relation to local modifications to IFRS, Veron (2007, p. 41) also makes the following comment: If implementation is guided by nationally determined recommendations, then they may gradually diverge from one country to another … The main promise of IFRS, of making the accounts of companies comparable for investors to make the right choices across countries and sectors, would be in jeopardy. The SEC’s Chairman recently insisted that ‘We have got to be able to demonstrate that IFRS is indeed a single set of international accounting standards, and not a multiplicity of standards going by the same name’. Issues of translation IFRS are initially developed in English. They are then translated to various other languages for local use. But how accurate are such translations? Nobes (2013) notes that there are some ‘clear errors’ in many translations of IFRS. Dahlgren and Nilsson (2012) also note many errors in translation. Of course, if there are errors in translation, this effectively means that different countries are using different accounting standards. In a study of errors in translation, Nobes and Stadler (2018) specifically focused on how the term ‘impairment’ was translated by various national financial reporting standard-setters. In the context of IAS 36 Impairment of Assets, they found many errors in translation. In part, some of these problems were potentially related to the failure of the IASB to define ‘impairment’ within IAS 36. Differences in implementation, monitoring and enforcement The argument here is that unless there is consistency in the implementation of accounting standards and subsequent enforcement mechanisms, we cannot expect accounting practices to be uniform despite the actions of the IASB. For example, Australia made the decision to adopt IFRS from 2005. However, the IASB has no power or authority within Australia (or elsewhere) to enforce standards. Rather, accounting standards are required to be followed by Australian companies by virtue of the Corporations Act 2001, and it is the Australian Securities and Investments Commission (ASIC) that has the power to enforce compliance with the requirements of the Act. It is generally accepted that compliance with IFRS is fairly strongly enforced within Australia as a result of the actions of ASIC and a high-quality independent auditing profession. However, in other countries that adopted IFRS there might not be the same level of monitoring and enforcement, meaning that while companies in a particular country might say they have 182 International accounting CHAPTER 5 adopted IFRS, we really cannot be sure that the level of compliance is consistent internationally. That is, inconsistencies internationally in how the adoption of accounting standards are implemented, monitored and enforced will lead to inconsistencies in how the standards are applied, which in turn will diminish the international comparability of financial reports. In relation to the implementation of accounting standards, different countries will have varying levels of expertise in applying IFRS. Using China as an example, Veron (2007, p. 20) states: In China as in other developing economies, any reference to financial statements prepared ‘in accordance with IFRS’ needs to be taken with a pinch of salt. The most daunting challenge there is not the standards’ adoption, but their proper enforcement in a context of massive underdevelopment of the accounting profession, both quantitatively and qualitatively: China has no more than 70,000 practising accountants (many of them poorly trained), while the size of its economy would probably require between 300,000 and one million. As Nobes (2006, p. 242) explains when considering differences between accounting practice in Germany and the United Kingdom: Enforcement (including monitoring) of compliance with IFRS remains a national matter within the EU. It has been suggested (La Porta et al., 1997) that enforcement of accounting rules is stronger in the UK than in Germany. Hope (2003) constructed an index of compliance and registered Germany substantially lower than the UK. Furthermore, a great deal of evidence has been amassed that compliance by German groups with international standards was lax despite an audited statement of compliance by directors (e.g. Street and Bryant, 2000; Street and Gray, 2001). By contrast, compliance with standards in the UK since the creation of the Financial Reporting Review Panel (FRRP) in 1990 is generally regarded as having been high (Brown and Tarea, 2005). Questioning the logic behind any belief that the efforts of the IASB will realistically lead to international consistencies in accounting practice, Ball (2006, p. 16) states: Does anyone seriously believe that implementation will be of an equal standard in all the nearly 100 countries that have announced adoption of IFRS in one way or another? The list of adopters ranges from countries with developed accounting and auditing professions and developed capital markets (such as Australia) to countries without a similarly developed institutional background (such as Armenia, Costa Rica, Ecuador, Egypt, Kenya, Kuwait, Nepal, Tobago and Ukraine). Even within the EU, will implementation of IFRS be at an equal standard in all countries? The list includes Austria, Belgium, Cyprus, Czech Republic, Denmark, Germany, Estonia, Greece, Spain, France, Ireland, Italy, Latvia, Lithuania, Luxembourg, Hungary, Malta, Netherlands, Poland, Portugal, Slovenia, Slovakia, Finland, Sweden and the UK. It is well known that uniform EU economic rules in general are not implemented evenly, with some countries being notorious standouts. What makes financial reporting rules different? Accounting accruals generally require at least some element of subjective judgment and hence can be influenced by the incentives of managers and auditors. Consider the case of IAS 36 and IAS 38 which require periodic review of long-term tangible and intangible assets for possible impairment to fair value. Do we seriously believe that managers and auditors will comb through firms’ asset portfolios to discover economically impaired assets with the same degree of diligence and ruthlessness in all the countries that adopt IFRS? Will auditors, regulators, courts, boards, analysts, rating agencies, the press and other monitors of corporate financial reporting provide the same degree of oversight in all IFRS-adopting countries? In the event of a severe economic downturn creating widespread economic impairment of companies’ assets, will the political and regulatory sectors of all countries be equally likely to turn a blind eye? 183 Financial Accounting Theory Will they be equally sympathetic to companies failing to record economic impairment on their accounting balance sheets, in order to avoid loan default or bankruptcy (as did Japanese banks for an extended period)? Will local political and economic factors cease to exert the influence on actual financial reporting practice that they have in the past? Or will convergence among nations in adopted accounting standards lead to an offsetting divergence in the extent to which they are implemented? Ball (2006) also discusses how the general trend inherent within IFRS of adopting asset measurement bases tied to ‘fair value’ will in itself create inconsistencies, because in many countries there is an absence of markets for many types of assets, including financial assets. In countries with ‘thinly trading markets’, relatively more estimation of ‘fair values’ will be required. Ball (2006, p. 17) states: To make matters worse, the countries in which there will be greater room to exercise judgment under fair value accounting, due to lower-liquidity markets and poorer information about asset impairment, are precisely the countries with weaker local enforcement institutions (audit profession, legal protection, regulation, and so on). Judgment is a generic property of accounting standard implementation, but worldwide reliance on judgment has been widely expanded under IFRS by the drift to fair value accounting and by the adoption of fair value standards in countries with illiquid markets. The ultimate implication of the potential variation in accounting practice (for the reasons discussed in this section) is that investors might be misled into believing that IFRS adoption has created a consistency in international accounting practices. That is, the adoption of IFRS might (incorrectly) be construed as a signal that a country has improved its quality of reporting. In a sense, the adoption of IFRS brings a level of legitimacy to a country’s financial reporting despite any limitations in the level of enforcement of the standards. Ball (2006, pp. 22–3) states: Substantial international differences in financial reporting quality are inevitable, and my major concerns are that investors will be misled into believing that there is more uniformity in practice than actually is the case and that, even to sophisticated investors, international differences in reporting quality now will be hidden under the rug of seemingly uniform standards … But the problem with IFRS adoption, as a signal to investors about the financial reporting quality of a preparer, is that it is almost costless for all countries to signal that they are of high quality: i.e., to adopt the highest available accounting standards on paper. Worse, IFRS adoption most likely costs less to the lower-quality countries, for two reasons. First, the lower-quality regimes will incur fewer economic and political costs of actually enforcing the adopted standards. It is the higher quality reporting regimes that are more likely to incur the cost of actually enforcing IFRS. Because they have the institutions (such as a higher-quality audit profession, more effective courts system, better shareholder litigation rules) that are more likely to require enforcement of whatever standards are adopted. Second, by wholesale adoption of IFRS, the lower-quality regimes can avoid the costs of running their own standard-setting body, which likely are proportionally higher than in larger economies. Ball discusses the ‘free rider’ problem associated with IFRS.21 If a ‘symbol of legitimacy’ – such as IFRS – can be acquired at low cost, some countries with low levels of financial accounting proficiency will make the choice to adopt IFRS because of the reputational benefits such a choice may generate. However, such a choice will have costly implications for countries with higher 21 184 As explained in Chapter 3, a free rider can be defined as a party that takes advantage of particular goods or services without incurring some of the associated production or establishment costs. International accounting CHAPTER 5 levels of accounting proficiency and who put in place appropriate implementation, monitoring and enforcement mechanisms. As Ball (p. 23) states: A classic ‘free rider’ problem emerges: it is essentially costless for low-quality countries to use the IFRS ‘brand name,’ so they all do. If IFRS adoption is a free good, what companies or countries will not take it? When it is costless to say otherwise, who is going to say: ‘We will not adopt high standards’? As a potential solution to the problem, Ball (2006, p. 24) makes the following proposal: The only way to make the IFRS signal informative about quality is for the worldwide financial reporting system to incorporate a cost of signalling that the lower-quality agents are not prepared to pay. This would necessitate an effective worldwide enforcement mechanism under which countries that adopt but do not effectively implement IFRS are either penalised or prohibited from using the IFRS brand name. In the absence of an effective worldwide enforcement mechanism it is essentially costless for low-quality countries to use the IFRS brand name, and local political and economic factors inevitably will exert substantial influence on local financial reporting practice, IFRS adoption notwithstanding. If allowing all countries to use the IFRS label discards the information in accounting standards about reporting quality differences, then the available quality signal could become the quality of the enforcement of standards, not standards per se. In subsequent research undertaken by Ball (Ball, 2016), his concerns had not diminished. Ball (2016) raises further issues associated with the ongoing international differences in reporting within countries claiming to adopt IFRS. He notes (p. 556): One potential effect is dilution of the IFRS brand name. Another is that a uniform IFRS label discards information about reporting quality differences. Ball (2016) also raises other concerns relating to having a centralised accounting standardsetting body. One concern is the possible implications for reducing innovation in reporting. As he states (p. 556): Competition among alternative economic systems, including financial reporting systems, is conducive to healthy innovation. History is replete with examples of one system learning from the institutional structure of a competing system, the most famous example in accounting being the near worldwide adoption of the Italian method of double entry bookkeeping … In my view, adopting uniform worldwide standards invites risky centralisation and reduced innovation. Another concern raised by Ball (2016) is that the standardised set of financial reporting standards (IFRS) does not support effective debt contracting. Some of these concerns particularly relate to the reliance of IFRS on ‘fair values’, which can be subject to much professional judgement and potentially ‘creativity’. As he states (p. 560): Relative to the prior domestic standards of IFRS-adopting countries, the new standards provide borrowing firms with more discretion over the reported numbers than would be used in accounting-based debt covenants. First, IFRS make considerably more use of fair value accounting measurements. The subjectivity involved in estimating fair values, particularly for longer-cycle assets, impairs contractibility. Second, many IFRS standards provide borrowers with choice among accounting methods, as documented in Nobes (2013). Third, IFRS are principlesbased, providing fewer implementation rules and accordingly giving managers wide discretion in implementation. 185 Financial Accounting Theory With the above concerns in mind, Ball (2016) notes that the use of accounting-based debt covenants could decrease. He states (p. 560): For many firms, the more efficient response would be to simply reduce the use of accounting-based covenants such as leverage and interest coverage restrictions, and perhaps substitute non-accounting covenants such as restrictions on new investment, assets sales, and new debt issuance. What is the evidence? A study of 3037 new debt issuances over 2001–2010 investigated how their contractual terms changed after the 2005 IFRS adoption date. It compared 1362 new issuances in 22 IFRS-adopting countries (the treatment sample) with 1675 new issuances in 21 non-IFRS-adopting countries (the control sample). There was a substantial fall of approximately 50% in accounting covenant use post-adoption. Conversely, there was an increase in no-accounting covenant use. Another factor contributing to varying levels of compliance are the auditing standards or principles being applied in different countries. As Nobes (2013) notes, corporations law in many countries that adopt IFRS does not require financial statement auditors to report whether the respective financial statements and supporting notes comply with IFRS. Given the material in this section, the belief that the global adoption of IFRS will lead to consistency in international financial reporting practices could, and arguably should, be questioned. There will continue to be international differences in accounting practice and such differences provide an ongoing and interesting area of research for accounting academics. However, at a more fundamental level, is it really a good idea to have global consistency in accounting practice anyway? That is, is the central quest of the IASB that there be global standardisation of accounting standards logically flawed? Is it appropriate to have a global ‘one-size-fits-all’ approach to financial reporting when there are international differences in the nature of capital, labour and product markets; differences in monitoring and enforcement mechanisms; differences in economic and political influences; and differences in cultures? The next section explores various reasons why, in the absence of globalisation efforts such as those being undertaken by the IASB, we would expect to find international differences in accounting practices. Why do I need to know that the international adoption of IFRS does not necessarily lead to internationally standardised financial reports? In our daily lives, we often hear, or read about, the profits being reported by large organisations in different countries. Often these profit numbers are translated into our own currency before being reported to us so that we can notionally compare them with the profits of local organisations. By knowing that the ‘standardisation’ of IFRS is somewhat problematic – as the research we have been discussing shows – then we can understand that we need to undertake such comparisons with caution. It also alerts us to the need to carefully review the accounting policy notes being reported by organisations, and also to consider the auditors involved, as well as the local corporate regulators. This knowledge allows us to place the reported financial performance and financial position 186 of organisations from different countries into their appropriate context. As accounting researchers, we need to understand the problematic nature of financial accounting numbers being reported internationally. For example, if we are using large data sets in which we pool such numbers as ‘profits’, ‘sales’ or ‘total assets’ from organisations from different countries, then we need to understand that these numbers might not be as directly comparable as we might otherwise believe. Perhaps some form of notional adjustment is necessary before we consider particular variables (independent variables) that might be influencing, or driving, these accounting numbers. International accounting CHAPTER 5 LO5.2 LO5.4 Explanations of differences in accounting Will financial reporting standards developed in London by the IASB necessarily meet the information needs of financial report users in all countries? Does it make sense that a given suite of financial reporting standards will be equally applicable for a service company operating in South America as it would for a mining company operating in Australia or a manufacturing company in China? What do you, the reader, think? In this regard, Chand and White (2007, p. 606) make the following comment: Once the IFRSs are adopted by a particular country, both the multinational and domestic enterprises may be required to follow the standards. A suite of standards developed with the needs of international users of financial reports in mind, specifically those seeking international comparability, will not necessarily meet the needs of users in a particular jurisdiction. The IASB cannot take cognisance of the individual national, cultural and political factors of all its member nations while preparing IFRSs. Transporting IASB standards to developing countries – which have their own disparate group of external information users that operate within internationally diverse cultural, social, and political environments – should not be expected to have optimum results (Hopwood, 2000; Ngangan et al., 2005). Therefore, of critical importance is the fundamental question, who gains the most from harmonization/convergence? Chand and White’s point is interesting and reflects some of earlier discussion within this chapter. Given that more than 100 countries have now adopted IFRS, is there any clear evidence that all countries have benefited from the adoption, or that the benefits are spread across different types or sizes of organisations within particular countries? Authors such as Perera (1989) have argued that accounting practices within particular countries have traditionally evolved to suit the circumstances of a particular society at a particular time. While there was a large variation in accounting systems used in different countries prior to 2005 (from 2005 many, but not all, countries adopted IFRS), it has been commonly accepted that there were two main models of financial accounting that had evolved within economically developed countries: the Anglo-American model and the continental European model (Mueller, 1967; Nobes, 1984).22 The Anglo-American model is characterised by a system of accounting that is strongly influenced by professional accounting bodies rather than government; it emphasises the importance of capital markets (the entities within the countries that use this model of accounting are typically very reliant on public sources of equity and debt finance), and relies on terms such as ‘true and fair’ or ‘presents fairly’, which in turn are based on considerations of economic substance over and above legal form (legal form being bound by legislation). The continental European model of accounting, on the other hand, typically is characterised by a relatively small input from the accounting profession, little reliance on qualitative requirements such as true and fair, and stronger reliance on government. The accounting methods tend to be heavily associated with the tax rules in place, and the information tends to be of a nature that protects the interest of creditors rather than investors per se. (The entities within countries that use the continental European model have historically tended to obtain most of their long-term funds from family sources, governments or lenders, often banks rather than through issuing shares to the public.) Over time, numerous reasons have been given for the differences in the accounting methods of different countries. Mueller (1968) suggests that such differences might have been caused 22 Anglo-American model An approach to accounting embraced within the United Kingdom and United States (and some other countries) where accounting practices are oriented towards meeting the general decision-making needs of large numbers of investors, lenders and creditors who are not directly involved in the management of the organisation. Continental European model An approach to accounting where financial accounts are primarily prepared for an environment in which funding mainly comes from lenders and there are relatively low numbers of outside investors, and where financial reports are prepared primarily with taxation and other statutory requirements in mind rather than other qualitative requirements, such as truth and fairness. For example, France, Italy, Spain and Germany are often presented as examples of the continental European group, while countries such as the United States, the United Kingdom, Ireland, the Netherlands, Canada, Australia and New Zealand are often presented as examples of the Anglo-American group. 187 Financial Accounting Theory by differences in the underlying laws of the country, the political systems in place (for example, a capitalistic/free-market system versus a centralised/communistic system), or their level of development from an economic perspective. As Mueller (p. 95) explains: In society, accounting performs a service function. This function is put in jeopardy unless accounting remains, above all, practically useful. Thus, it must respond to the ever-changing needs of society and must reflect the social, political, legal and economic conditions within which it operates. Its meaningfulness depends on its ability to mirror these conditions. Other factors such as tax systems, level of education and level of economic development have also been suggested as explanations for historical differences in accounting practices (Doupnik and Salter, 1995). At present there is no single clear theory that explains why, in the absence of efforts to standardise accounting, we would expect to find international differences in accounting practices. Many different causes have been suggested. Nobes (1998) reviewed the literature and confirmed that numerous reasons have been proposed to explain differences in financial reporting practices. These reasons are given in Figure 5.4. According to Nobes, many of the factors are interrelated. A number are deemed to be ‘institutional’, and a number relate to the broader notion of culture. The next sections look more closely at some of these factors. Again, it is emphasised that many differences in financial FIGURE 5.4 Possible reasons for differences in financial reporting practices Invasions Language Geography Age and size of accountancy profession Colonial inheritance Nature of business ownership and financing system Legal systems Taxation Inflation Reasons for difference in financial reporting practices Level of education Culture Stage of economic development 188 History Influence of theory Religion Political systems, social climate International accounting CHAPTER 5 accounting practices have been eliminated (but not all, as we have discussed earlier) due to many countries adopting IFRS. After reading the material, readers might question whether it is appropriate for such a diverse group of countries to adopt one set of accounting standards in a ‘one-size-fits-all’ approach. Culture Culture is a broad concept that would be expected to impact on legal systems, tax systems, the way businesses are formed and financed, and so on. For many years culture has been used in the psychology, anthropology and sociology literatures as the basis for explaining differences in social systems (Hofstede, 1980). In recent decades, it has also been used to try to explain international differences in accounting systems. An early paper that considered the impact of culture on accounting was one by Violet (1983), who argued that accounting is a ‘socio-technical activity’ (which is consistent with what we noted previously – that accounting is both a technical and social practice) that involves interaction between both human and non-human resources. Because the two interact, Violet claims that accounting cannot be considered culture-free. Relating accounting to culture, Violet (p. 8) claims: Culture The collective programming of the mind which distinguishes the members of one human group from another. According to Takatera and Yamamoto (1987) culture can be defined as ‘an expression of norms, values and customs which reflect typical behavioural characteristics’. Accounting is a social institution established by most cultures to report and explain certain social phenomena occurring in economic transactions. As a social institution, accounting has integrated certain cultural customs and elements within the constraints of cultural postulates. Accounting cannot be isolated and analyzed as an independent component of a culture. It is, like mankind and other social institutions, a product of culture and contributes to the evolution of the culture which employs it. Since accounting is culturally determined, other cultural customs, beliefs, and institutions influence it. Takatera and Yamamoto (1987) defined culture as ‘an expression of norms, values and customs which reflect typical behavioural characteristics’. Hofstede (1980, p. 25) has defined culture as ‘the collective programming of the mind which distinguishes the members of one human group from another’. It describes a system of societal or collectively held values (Gray, 1988, p. 4) rather than values held at an individual level. ‘Values’ are deemed to determine behaviour. Gray (p. 4) explains that the term ‘culture’ is typically reserved for societies as a whole, or nations, whereas ‘subculture’ is used for the level of an organisation, profession (such as the accounting profession) or family. It is expected that different subcultures within a particular society will share common characteristics. In the discussion that follows, the work of Professor Sid Gray is explored in some depth. This work is generally acknowledged as constituting some of the most rigorous research into accounting’s relationship to, and to some extent dependence on, national culture. Gray (1988, p. 5) argues that ‘a methodological framework incorporating culture may be used to explain and predict international differences in accounting systems and patterns of accounting development internationally’. Any consideration of culture necessarily requires difficult choices as to the aspects of culture that are important to the issue under consideration, and, in turn, how one goes about measuring the relevant cultural attributes. As Perera (1989, p. 43) states, ‘the study of culture is characterized by a unique problem arising from the inexhaustible nature of its components’.23 Accounting researchers who have examined the possible impact of culture on the financial accounting practices in different countries have tended to draw on the work of Hofstede (1980, 1983) and Hofstede et al. (2010) to understand differences in national cultures. Gray (1988, p. 5) explains: 23 Perera (1989, p. 43) further states that ‘it is essential, therefore, that in analysing the impact of culture upon the behaviour of the members of any particular subculture, a researcher must select the cultural components or dimensions most pertinent to the particular facet of cultural behaviour being studied’. This is clearly not a straightforward task. 189 Financial Accounting Theory Hofstede’s (1980, 1983) research was aimed at detecting the structural elements of culture and particularly those which most strongly affect known behaviour in work situations in organizations and institutions. In what is probably one of the most extensive cross-cultural studies ever conducted, psychologists collected data about ‘values’ from the employees of a multinational corporation located in more than fifty countries. Subsequent statistical analysis and reasoning revealed four underlying societal value dimensions along which countries could be positioned. These dimensions, with substantial support from prior work in the field, were labelled Individualism, Power Distance, Uncertainty Avoidance, and Masculinity. Such dimensions were perceived to represent a common structure in cultural systems. It was also shown how countries could be grouped into culture areas, on the basis of their scores on the four dimensions.24 Gray argues that the value systems of accountants in each country will be derived from and related to the societal values of that country (which are reflected by Hofstede’s initial cultural dimensions of Individualism, Power Distance, Uncertainty Avoidance and Masculinity, to which Hofstede later added a fifth dimension of Long-Term Orientation).25 These social values that are also held by accountants (which Gray terms the ‘accounting subculture’) will in turn, it is believed, impact on the development of the respective accounting systems at the national level. Therefore, at this point we can perhaps start to question whether accounting systems should be developed in a ‘one-size-fits-all’ perspective – the approach that the IASB has adopted. However, while it is argued that there should be some association between various value systems and accounting systems, many events would typically have occurred over time that confound this possible relationship. For example, in relation to developing countries, Baydoun and Willett (1995, p. 72) state: It is quite possible that had accounting systems evolved independently in developing countries they would have a rather different form from any we now witness in present day Europe. However, most accounting systems used in developing countries have been directly imported from the West through a variety of channels: by colonialism in the past; and through Western multinational companies, the influence of local professional associations (usually founded originally by Western counterpart organizations) and aid and loan agencies from the industrialised countries. Furthermore, as with any theoretical perspectives in social sciences, we need to bear in mind that Hofstede’s propositions regarding the presence, nature and influence of ‘cultural dimensions’ are themselves open to challenge. For example, McSweeney, who is one of the most high-profile and influential critics of Hofstede’s findings (see, for example, McSweeney 2002a, 2002b, 2009a, 2009b), has argued that the ‘national cultural model’ proposed by Hofstede was developed using flawed research methods and questionable assumptions. In one paper, McSweeney (2009a, p. 934) posed the question: In the face of extensive empirical data of variations within countries across social and geographical contexts and also across time, how does the national culturalist literature continue to rely on spatial reductionism: on the ‘fallacious assumption of cultural homogeneity within nations’ (Tung, 2007: 41)? Hofstede’s work is based on international surveys conducted within IBM. The attitude surveys were conducted between 1967 and 1973 and resulted in 117 000 responses from 88 000 employees in 61 countries (Baskerville, 2003). Hofstede was the senior researcher in charge of the survey. 25 Hofstede’s theory, while being applied to accounting issues, is from the cross-cultural psychology literature and was of itself not directly concerned with accounting. 24 190 International accounting CHAPTER 5 McSweeney (2009a, p. 934) proceeded to provide, in great depth, the following reasons in response to the above question: It does so by making the following problematic moves. I: By denying agency. This is achieved by assuming that national culture is: (a) coherent; (b) stable; (c) pure; (d) by excluding any independent role of other cultural influences; and (e) excluding any independent role of non-cultural influences. II: By unwarranted depictions. This is done by: (a) conflating nation and state; (b) making unwarranted generalizations from singular instances and/or treating unrepresentative averages as nationally representative; and (c) confusing statistical averages with causal forces. And, III: By ignoring prior and pertinent intellectual developments elsewhere, it fails to engage with the peripheralization in anthropology and cultural geography (and in other disciplines) of the assumptions of national and other spatial cultural uniformity. Specifically from the perspective of accounting research, Baskerville (2003) raises similar concerns about the validity and reliability of Hofstede’s national cultural dimensions. In his study, Baskerville identifies and explores a number of theoretical and methodological issues in prior studies that, he concludes, have been problematic in developing reliable insights in the role of national cultures, including (p. 1): (i) the assumption of equating nation with culture (ii) the difficulties of, and limitations on, a quantification of culture represented by cultural dimensions and matrices; and (iii) the status of the observer outside the culture. Despite these issues, McSweeney (2009a) notes that the ‘national cultural model’ continued to be used in many areas of organisational studies (and we might include accounting as one such discipline). He comments that the national cultural model (associated most commonly with Hofstede, but augmented by many other researchers) was, in the past, also used by researchers within several different social science disciplines. However, he highlights that in many of these disciplines, this model’s explanations of the development, presence and influence of national cultural differences have now been largely found to lack credibility. McSweeney (2009a, p. 949) argues that the persistence of the national cultural model in organisation studies research, despite it being discredited in other disciplines, seems to be due to many researchers in sub-disciplines within organisation studies (such as accounting) being unwilling to engage with critiques of the model, and thus ignoring clear flaws in the model:26 Within organization studies, a knowledge community has been built around the model. It [the national cultural model] has achieved a scholarly identity, being employed in papers across a wide range of peer-reviewed journals. The consensus on fundamentals within the community and the embeddedness it has achieved within areas of organization studies have created defences against the impact of critiques. It is rare for users of the model to acknowledge critiques – far less to engage with them. Two characteristics of organization studies which enable the advocates of the model to avoid engagement with critique are described here. First, disregard is facilitated by the fragmentation of organization studies into many relatively autonomous communities with a high degree of internal consensus and self-referentiality (March, 2004, Whitley, 2000). The balkanization of organization studies is arguably greater than in many other disciplines (Pfeffer, 1993) and is certainly far in excess of the 26 As we have emphasised throughout this book, just about all research can, and should be, open to critical analysis. Knowledge develops as a result of different people challenging accepted ideas and research, and proposing their own ideas which in turn will be subject to critical review. 191 Financial Accounting Theory degree of separateness which existed in anthropology at the time of the model’s demise in that discipline. Secondly, while it is, of course, not possible to examine a situation uninfluenced by categories, theories and hunches, a tendency to build one-sided stories has been a powerful factor. Such bias is a deleterious tendency to search for or interpret new information in a way that confirms one’s preconceptions and avoid information and interpretations which contradict them (Nickerson, 1998). It is widely tolerated in organization studies (Miles and Michael, 1984). Within the national cultural community this bias includes a tendency not to consider alternative explanations and a widespread readiness to cite, or to generally refer to, studies which support the model but neglect contradictory studies. Consistent with these observations from McSweeney, researchers who have drawn on and applied Hofstede’s propositions about national cultures as part of their research into international differences in financial accounting have tended to do so largely uncritically. Specifically, from an accounting perspective, Baskerville (2003, p. 11) raises similar concerns to some of those raised by McSweeney, and urges greater criticality by accounting researchers: Such problems have ramifications for the utilization of Hofstede’s cultural indices, and implications for cross-cultural accounting research which should not be ignored. The use of Hofstede’s indices of cultural dimensions appeared to give cross-cultural studies in accounting stature and scientific legitimacy, and respectability within accounting research. Those researchers who utilize these dimensions successfully should be prepared to include in their application of the cultural indices a consideration of how their research addressed the problems of the concept of nations versus cultures, and the problems inherent in the universalist approach as debated earlier last century during the formative years in anthropology. Despite various criticisms, Hofstede’s propositions have been influential in developing comparative international accounting research. We will now explain key aspects of the theories in this area. But when reading about and considering these theories, you should bear in mind the criticisms we have just outlined of some of the assumptions underlying these theories. Again, please always remember that theories are ‘lenses’ through which to make sense of the world and, in doing so, theories should not be expected to provide perfect, or complete, explanations. Financial accounting theories in this area have principally used the initial four societal value dimensions identified by Hofstede. These can be summarised as follows (quoted from Hofstede, 1984): • Individualism versus collectivism Individualism stands for a preference for a loosely knit social framework in society wherein individuals are supposed to take care of themselves and their immediate families only. Its opposite, Collectivism, stands for a preference for a tightly knit social framework in which individuals can expect their relatives, clan, or other in-group to look after them in exchange for unquestioning loyalty (it will be clear that the word ‘collectivism’ is not used here to describe any particular social system). The fundamental issue addressed by this dimension is the degree of interdependence a society maintains among individuals. It relates to people’s self concept: ‘I’ or ‘we’. (p. 83) With regard to the cultural dimension of individualism versus collectivism, it is interesting to note that a great deal of economic theory is based on the notion of self-interest and the rational economic person (one who undertakes action to maximise personal wealth at the expense of others). This is very much based in the individualism dimension. In a culture that exhibited 192 International accounting CHAPTER 5 collectivism, it is expected that members of the society would look after each other and issues of loyalty would exist.27 • Large versus small power distance Power Distance is the extent to which the members of a society accept that power in institutions and organisations is distributed unequally. This affects the behaviour of the less powerful as well as of the more powerful members of society. People in Large Power Distance societies accept a hierarchical order in which everybody has a place, which needs no further justification. People in Small Power Distance societies strive for power equalisation and demand justification for power inequities. The fundamental issue addressed by this dimension is how a society handles inequalities among people when they occur. This has obvious consequences for the way people build their institutions and organisations. (p. 83) • Strong versus weak uncertainty avoidance Uncertainty Avoidance is the degree to which the members of a society feel uncomfortable with uncertainty and ambiguity. This feeling leads them to beliefs promising certainty and to sustaining institutions protecting conformity. Strong Uncertainly Avoidance societies maintain rigid codes of belief and behaviour and are intolerant towards deviant persons and ideas. Weak Uncertainty Avoidance societies maintain a more relaxed atmosphere in which practice counts more than principles and deviance is more easily tolerated. The fundamental issue addressed by this dimension is how a society reacts to the fact that time only runs one way and that the future is unknown: whether it tries to control the future or to let it happen. Like Power Distance, Uncertainty Avoidance has consequences for the way people build their institutions and organisations. (p. 83) • Masculinity versus femininity Masculinity stands for a preference in society for achievement, heroism, assertiveness, and material success. Its opposite, Femininity, stands for a preference for relationships, modesty, caring for the weak, and the quality of life. The fundamental issue addressed by this dimension is the way in which a society allocates social (as opposed to biological) roles to the sexes. (p. 84) Again, when countries are given scores on the four value dimensions, a number of countries can be clustered together, reflecting that they have similar cultural values.28,29 Having considered Hofstede’s value dimensions, the next step for Gray was to relate them to the values that he perceived to be in place within the accounting subculture. Gray developed four Positive Accounting Theory, a theory developed by Watts and Zimmerman (and which is discussed in depth in Chapter 8), attempts to explain and predict managers’ selection of accounting methods. In developing their theory, Watts and Zimmerman assume that individuals will always act in their own self-interest. Such an assumption would be invalid in a community that embraces a collectivist perspective. In a similar vein, Hamid, Craig and Clarke (1993) suggest that finance theories developed in Western cultures will not apply in Islamic cultures. According to these authors, the Islamic principles do not allow the payment of interest. They argue (p. 146) therefore that ‘much of Western finance theory, in particular the capital asset pricing model, which draws upon interest-dependent explanations of risk, cannot be part of the (Islamic) accounting and finance package’. 28 For example, of the many groups, one group with similar scores on each of the four societal values comprises Australia, Canada, Ireland, New Zealand, the United Kingdom and the United States. Another group is Denmark, Finland, the Netherlands, Norway and Sweden, while another group comprises Indonesia, Pakistan, Taiwan and Thailand. The view is that people within these various groupings of countries share a similar culture and therefore share similar norms and value systems. 29 As we know, a number of authors have been critical of Hofstede’s work. One particular criticism is that Hofstede equated nations with cultures (that is, each nation was deemed to be one culture), when in fact numerous cultures can exist within a particular country (Baskerville, 2003). 27 193 Financial Accounting Theory accounting values that were deemed to relate to the accounting subculture, with the intention that the accounting values would then be directly linked to Hofstede’s four societal values (discussed above). Gray’s four accounting values (1988, p. 8) were defined as shown in Figure 5.5. Gray (1988, pp. 9–11) then developed a number of hypotheses relating Hofstede’s four societal cultural dimensions to each one of his four accounting values.30 His first hypothesis was: FIGURE 5.5 Gray’s four accounting values Professionalism versus statutory control A preference for the existence of individual professional judgement and the maintenance of professional self-regulation, as opposed to compliance with prescriptive legal requirements and statutory control. Secrecy versus transparency A preference for confidentiality and the restriction of disclosure of information about the business only to those who are closely involved with its management and financing, as opposed to a more transparent, open and publicly accountable approach. Uniformity versus flexibility A preference for the enforcement of uniform accounting practices between companies and the consistent use of such practices over time, as opposed to flexibility in accordance with the perceived circumstances of individual companies. Conservatism versus optimism A preference for a cautious approach to measurement so as to cope with the uncertainty of future events, as opposed to a more optimistic, laissez-faire, risk-taking approach. Source: Based on Gray, S. J. (1988), ‘Towards a theory of cultural influence on the development of accounting systems internationally’, ABACUS, 24(1), pp. 1–15, p. 5. 30 194 Although Gray (1988) developed four hypotheses, he did not test them empirically. To test them, as others have subsequently done, one must determine whether an accounting subculture scores high or low in a particular country on the four dimensions developed by Gray. International accounting CHAPTER 5 H1: The higher a country ranks in terms of individualism and the lower it ranks in terms of uncertainty avoidance and power distance, then the more likely it is to rank highly in terms of professionalism. The basis for the first hypothesis was that a preference for applying judgement (for example, determining whether something is ‘true and fair’) rather than strict rules is more likely where people tend to be individualistic, where people are relatively more comfortable with people using their own judgement, rather than conforming to rigid codes of rules, and where different people are allowed to make judgements rather than relying on strict rules ‘from above’ (lower power distance). Gray’s second hypothesis was: H2: The higher a country ranks in terms of Uncertainty Avoidance and Power Distance and the lower it ranks in terms of Individualism, then the more likely it is to rank highly in terms of Uniformity. (emphasis added) The basis for the second hypothesis is that communities that prefer to avoid uncertainty prefer more rigid codes of behaviour and greater conformity. A desire for uniformity is also deemed to be consistent with a preference for Collectivism (as opposed to Individualism) and an acceptance of a relatively more Power Distance society in which laws are more likely to be accepted. Gray’s third hypothesis was: H3: The higher a country ranks in terms of Uncertainty Avoidance and the lower it ranks in terms of Individualism and Masculinity, then the more likely it is to rank highly in terms of Conservatism. (emphasis added) Individualism Stands for a preference for a loosely knit social framework in society wherein individuals are supposed to take care of themselves and their immediate families only. Uncertainty avoidance The degree to which the members of a society feel uncomfortable with uncertainty and ambiguity. Power distance The extent to which the members of a society accept that power in institutions and organisations is distributed unequally. Professionalism A preference for professional judgement and self-regulation as opposed to compliance with legal requirements enforced through statutory control. As noted previously, Conservatism implies that accountants favour notions such as prudence (which traditionally means that profits and assets are calculated in a conservative manner with a tendency towards understatement rather than overstatement). The basis for the third hypothesis is that communities that have strong Uncertainty Avoidance characteristics tend to prefer a more cautious approach to cope with existing uncertainties. On the other hand, Conservatism is expected to be associated with communities that care less about individual achievement. Communities that tend to demonstrate masculine tendencies emphasise achievement – hence the expectation that lower levels of Masculinity will lead to higher preferences for conservative accounting principles. A more highly masculine community would be deemed to prefer to use methods of accounting that lead to higher levels of performance being reported. Gray’s fourth hypothesis was: H4: The higher a country ranks in terms of Uncertainty Avoidance and Power Distance and the lower it ranks in terms of Individualism and Masculinity, then the more likely it is to rank highly in terms of Secrecy. (emphasis added) The basis for the fourth hypothesis is that communities that have a higher preference for Uncertainty Avoidance prefer not to disclose too much information because this could lead to conflict, competition and security problems. Also, communities that accept higher Power Distance would accept restricted information, as this acts to preserve power inequalities. Also, a community that prefers a collective approach, as opposed to an individualistic approach, would prefer to keep information disclosures to a minimum to protect those close to the organisation and to reflect limited concern for those external to the organisation. A more Masculine community would be expected to provide more information about its financial position and performance to enable comparisons of the level of performance of different entities. (Masculine communities would be deemed to be more concerned with issues such as ranking the performance of one entity against another.) However, as a caveat to the general position that more Masculine communities disclose more accounting information, Gray (1988, p. 11) argues that 195 Financial Accounting Theory a significant but less important link with Masculinity also seems likely to the extent that more caring societies, where more emphasis is given to the quality of life, people and the environment, will tend to be more open, especially as regards socially related information.31 Table 5.1 summarises the hypothesised relationships between Gray’s accounting values and Hofstede’s cultural values. TABLE 5.1 Summary of the hypothesised relationships between Gray’s accounting values and Hofstede’s cultural values Accounting values (from Gray) Cultural values (from Hofstede) Professionalism Uniformity Conservatism Secrecy Power Distance - + ? + Uncertainty Avoidance - + + + Individualism + - - - Masculinity ? ? - - Note: ‘+’ indicates a positive relationship; ‘–’ indicates a negative relationship; and ‘?’ indicates that the direction of the relationship is unclear. Gray (1988) further hypothesised that relationships can be established between accounting values and the authority and enforcement of accounting systems (the extent to which they are determined and enforced by statutory control or professional means), and the measurement and disclosure characteristics of the accounting systems. According to Gray (p. 12): Accounting value systems most relevant to the professional or statutory authority for accounting systems and their enforcement would seem to be the professionalism and uniformity dimensions, in that they are concerned with regulation and the extent of enforcement and conformity ... Accounting values most relevant to the measurement practices used and the extent of information disclosed are self-evidently the conservatism and the secrecy dimensions. Gray’s linkage between societal values, accounting values and accounting practice are summarised in Figure 5.6. Perera (1989, p. 47) provides additional discussion in respect of the relationships summarised in Figure 5.6. He states: The higher the degree of professionalism the greater the degree of professional self-regulation and the lower the need for government intervention. The degree of uniformity preferred in an accounting sub-culture would have an effect on the manner in which the accounting system is applied. The higher the degree of uniformity the lower the extent of professional judgment and the stronger the force applying accounting rules and procedures. The amount of conservatism preferred in an accounting subculture would influence the measurement practices used. The higher the degree of conservatism the stronger the ties with traditional measurement practices. The degree of secrecy preferred in an accounting sub-culture would influence the extent of the information disclosed in accounting reports. The higher the degree of secrecy, the lower the extent of disclosure. 31 196 Socially related information would relate to such issues as health and safety, employee education and training, charitable donations, efforts to eliminate modern slavery, support of community projects and environmental performance. A more Feminine (less Masculine) society would tend to consider these issues to be more important. Hence, while Femininity might be associated with less financial disclosure, it is assumed to be associated with greater social and environmental disclosure and the demonstration of greater social and environmental accountability. International accounting CHAPTER 5 FIGURE 5.6 Gray’s hypothesised relationships between society values, accounting values and accounting practice Society values Uncertainty avoidance Individualism Power distance Masculinity Accounting values Accounting practice Professionalism Uniformity Authority and enforcement Conservatism Secrecy Measurement and disclosure Source: Based on H. H. E. Fechner & A. Kilgore (1994), ‘The influence of cultural factors on accounting practice’, International Journal of Accounting, 29, p. 269. One objective of Gray’s research was to explain how differences between countries in respect of their culture may either impede any moves towards international harmonisation of accounting standards or bring into question efforts to generate some form of harmonisation or standardisation. While some of the above material might appear a little confusing (perhaps not), it does represent quite an intellectual body of research, which is attempting to relate a fairly difficult-to-measure construct, culture, to differences in values of the accounting subculture, and ultimately differences in the systems of accounting employed. While we might not be able to remember all the hypothesised relationships described, what is important is that we appreciate how researchers have attempted to link cultural measures to accounting practice. Such research is particularly relevant to standard-setters such as the IASB. A number of other authors have also used Hofstede’s cultural dimensions.32 Zarzeski (1996) provides evidence that supports a view that entities located in countries classified as relatively more Individualistic and Masculine and relatively less in terms of Uncertainty Avoidance provide greater levels of disclosure. Zarzeski also considered issues associated with international profile and found that those entities with a relatively higher international profile tend to be less secretive than other entities. Further, entities from continental European countries, such as France and Germany, which have historically tended to rely more heavily on debt financing than, say, Anglo-American companies, have lower levels of disclosure than Anglo-American companies. In relation to the issue of secrecy, Zarzeski shows that local enterprises are more likely to disclose information commensurate with the secrecy of their culture than are international enterprises. In explaining this, she states (p. 20): The global market is just a different ‘culture’ than the one the firm faces at home. When a firm does business in the global market, it is operating in a different ‘culture’ and therefore may need to have different ‘practices’. Higher levels of financial disclosures may be necessary for international survival because disclosure of quality operations 32 Baydoun and Willett (1995, p. 72) identify a number of problems in testing the Hofstede–Gray theory. They emphasise that many accounting systems are imported from other countries with possibly different cultures. As they state: ‘Due to the interference in what would otherwise have been the natural evolution of financial information requirements there are no uncontaminated examples of modern accounting practices in developing countries. Consequently, great care has to be taken in using data from developing countries to draw inferences about relevance on the basis of the Hofstede–Gray framework.’ 197 Financial Accounting Theory should result in lower resource costs. When enterprises from more secretive countries perceive economic gain from increasing their financial disclosures, cultural borrowing may occur. The culture being borrowed will be a ‘global market culture,’ rather than a specific country culture. Perera (1989) considered both Hofstede’s cultural dimensions and Gray’s accounting subcultural value dimensions and used them to explain historical differences in the accounting practices adopted in continental European countries and Anglo-American countries. According to Perera (p. 51), many countries in continental Europe are characterised by relatively high levels of uncertainty avoidance, where rules or ‘social codes’ tend to shape behaviour, while the opposite applies in Anglo-American countries: The presence of these rules satisfied people’s emotional needs for order and predictability in society, and people feel uncomfortable in situations where there are no rules. Therefore, in general, one can expect more formalization and institutionalization of procedures in strong uncertainty avoidance societies than in weak uncertainty avoidance countries. There is a preference for the existence of individual professional judgement, the maintenance of professional self-regulation, and flexibility in accordance with the perceived circumstances of individual companies in the accounting sub-culture of Anglo-American countries, whereas there is a preference for compliance with prescriptive legal requirements and statutory control, the maintenance of uniform accounting practices between companies, and the consistent application of such practices over time in the accounting sub-cultures of Continental Europe. Also, there is more support in the latter group for a prudent and cautious approach to income measurement to cope with the uncertainty of future events and the confidentiality of the information by restricting disclosures to only those involved with the management and financing of the organization. These characteristics, in turn, tend to influence the degree of disclosure expected in the respective accounting systems or practices. For example, in France and West Germany, where the level of professionalism is relatively low and the preference for conservatism and secrecy is relatively high, the combined effect on the degree of disclosure will be negative. On the other hand, the collectivist or anti-individualist values of the society require business enterprises to be accountable to society by way of providing information. Therefore, it becomes necessary for the Government to intervene and prescribe certain disclosure requirements, including those in regard to social accounting. Furthermore, this situation is not likely to be rejected by the accounting profession, because there is a preference for compliance with prescriptive legal regulation and statutory control in the accounting sub-culture. By comparison, in the United States and U.K., although the relatively high level of professionalism and low level of preference for conservatism and secrecy tend to have a positive combined effect on the degree of disclosure in accounting practices, the individualistic values of the society are more concerned with the provision of information to shareholders or investors than those issues involving accountability to society at large. Baydoun and Willett (1995) used the Hofstede–Gray theory to investigate the use of the French United Accounting System (which was ranked lowly in terms of Professionalism and highly in terms of Uniformity as well as being considered quite conservative) in Lebanon. According to Baydoun and Willett, following World War I the Allied Supreme Council granted France a mandatory authority over Lebanon. Lebanon was a French colony until 1943 and French troops remained there until 1946. Strong trading relations between France and Lebanon 198 International accounting CHAPTER 5 continued to exist and in 1983 the French Government sponsored the transfer of the French Uniform Accounting System (UAS) to Lebanon. What was of interest was whether the French system was actually suited to the Lebanese cultural environment. Baydoun and Willett provided evidence to suggest that Lebanon and France ranked in a relatively similar manner in terms of Power Distance and Individualism. However, Lebanon was considered to rank lower in terms of Uncertainty Avoidance and higher in terms of Masculinity. On this basis (refer back to Table 5.1), Baydoun and Willett (p. 81) conclude that ‘it would appear that Lebanon’s requirements are for less Uniformity, Conservatism and Secrecy in financial reporting practices’.33 They further state (p. 87): Assuming that cultural relevance is or should be a factor in determining the form of financial statements, we would expect Lebanese financial statements to be less uniform across time and between entities, to contain more market value information and provide more items of disaggregated information. Normal publication dates should be relatively flexible and there should be less call for conservative valuation rules such as lower of cost and market. It would appear that these and other similar prescriptions cannot be tested directly at present. Since 1983 all Lebanese firms have been required to follow UAS and this system has not yet been modified to accommodate any cultural differences between France and Lebanon ... However, our analysis suggests that modifications along the lines described above either will or should take place in Lebanese accounting in the future. Chand and White (2007) explored various cultural attributes within Fijian society to determine whether the adoption of IFRS within the Fijian context made sense. Their view was that rules-based standards would be more appropriate than the principles-based standards that have been developed by the IASB. As they state (p. 616): Fiji is a society that is dominated by two ethnic groups – indigenous Fijians and IndoFijians. Both groups exhibit cultural characteristics of uncertainty avoidance and a preference for a society that adheres to rules as opposed to one that expects the individual to act appropriately by personal initiative and professional judgment (see Chand, 2005). Fijian society is also characterized by the presence of a strong power distance between leaders in all capacities and their constituents. A number of entities have been established in Fiji with a stated remit to foster the indigenous population’s participation in the economy. Educated and articulate principals who have the temerity to question financial reports are typically reminded that Fijian society does not tolerate such challenges. The adoption of IFRSs leads to principles-based financial reports that require the exercise of professional judgment and introduces ambiguity in the reporting process, thus clouding rather than enhancing accountability (Davie, 1999, 2000). Managers of such entities drawn from the Fijian elite caste, as many are, who are beyond the challenge by non-elites, may ‘request’ the accountant to exercise judgment in such a way that the entity reports a stronger financial position than economic reality. Cultural values would require a Fijian accountant to accede to the ‘request’. Rulebased standards would protect the accountant from such ‘requests’. In Fiji, rule-based standards may reduce the potential relevance of financial reports, but should improve their transparency and the confidence that principals will place in them. 33 In undertaking their work, Baydoun and Willett were, in a number of respects, critical of Gray’s work. For example, they state (p. 82) that ‘all of Gray’s accounting values are defined in terms of preferences for particular courses of action, rather than in terms of apparent attributes of financial statements, such as the qualitative characteristics described in the FASB’s conceptual framework project’. Also they state that Gray’s theory does not clearly indicate what forms of financial statements might be preferred. 199 Financial Accounting Theory Apart from using culture to explain differences in published financial reports, researchers have also applied culture to explain differences in how managers verbally communicate information about financial results (that is, how culture impacts the provision of a verbal ‘account’). Brochet, Miller, Naranjo and Yu (2019) used managers’ cultural background (based upon their ethnic background and using insights from Hofstede) to explain differences in how corporate executives communicate with capital market participants through the media of ‘earnings conference calls’, which is a conference (meeting) between the management of large organisations and stakeholders, such as analysts, investors and the news media, in which managers discuss the organisation’s financial results for a given financial period. The conference call usually follows the release of a report detailing the financial earnings of an organisation. Brochet et al. (2019, p. 58) state: We hypothesize that managers from cultures that are more individualistic disclose information in a more optimistic and self-referencing manner. The prediction is based on psychology literature findings that in independent cultures (typically Western) there is greater emphasis on influencing individuals through displays of optimism and selfconfidence. Consequently, studies find that people from individualistic cultures have a greater impulse to maximize positive and minimize negative affect than do those from collective cultures. In addition, self-attribution is more prevalent in cultures where independence is highly valued. In relation to their results, Brochet et al. (2019, p. 79) report: Managers from a more individualistic background use a more positive tone and more singular first-person pronouns relative to managers from a collectivist background. The results are specific to the Question & Answer portion of the conference calls, where individual managers’ cultural roots are more likely to have an effect. Religion A great deal of the culture-based research, particularly that based on the work of Hofstede and Gray, tends to lead to countries being grouped together in terms of both community and accounting subculture; this is perceived as providing insights into the appropriateness of the harmonisation/standardisation process and, particularly, in identifying limits therein. That is, a feature of the work of Gray is that it relies on indigenous characteristics which are confined within the boundaries of the countries under review. In subsequent work, Hamid, Craig and Clarke (1993) considered the influence of one cultural input or factor, religion, on accounting practices. As they indicate, religion transcends national boundaries. They looked at how Islamic cultures, which exist in numerous countries, had typically failed to embrace ‘Western’ accounting practices, and they reflected on how issues of religion had previously occupied minimal space in the accounting literature. They state (p. 134): The existing literature dealing with the interaction of business activity and Islam needs extending to capture the particular effects which compliance with Islamic beliefs have on the structure of business and finance within an Islamic framework. In particular, the incompatibility of many Western accounting practices with Islamic principles requires explanation. For jurisprudential Islamic law influences the conduct of businesses in a manner not accommodated automatically by Anglo-American accounting practice. And many Western accounting practices draw upon assumptions which conflict with the tenets of Islam ... There seems to be little understanding that, unlike the Western tradition, fundamental business ethics flow automatically from the practices of the religion, rather than from the codes (mainly of etiquette) devised and imposed upon members by professional associations. 200 International accounting CHAPTER 5 Hamid, Craig and Clarke point out that the Islamic tradition does have notions of stewardship, but to God rather than to suppliers of equity or debt capital. That is, Muslims are characterised as believing that they hold assets not for themselves but in trust for God. There are also other fundamental differences – for example, Islam precludes debt financing and prohibits the payment of interest, and this prohibition has significant implications for processes aimed at the international harmonisation of accounting standards, particularly: ... in-so-far as harmonisation is perceived necessary to entail implementation of many standard Western accounting procedures in which interest calculations are integral. Many past and present Western standards entail discounting procedures involving a time value of money concept, which is not admitted by Islam. (p. 144)34 Hence, Hamid, Craig and Clarke appear to provide a logical argument that religion can have a major impact on the accounting system chosen. Religion can potentially affect how people do business and how they make decisions. As is discussed in Chapter 7, the conceptual framework projects developed in countries such as the United States, Australia, Canada, the United Kingdom and New Zealand (which, interestingly, have all been grouped together by Hofstede), and by the IASB’s predecessor (the International Accounting Standards Committee, or IASC), are based on the underlying objective that financial report users require financial information as the basis for making rational economic decisions (and what is ‘rational’ may be culturally dependent). Such rational economic decisions also take into account the time value of money, which necessarily requires considerations of appropriate interest or discount rates. In some societies, such as Islamic states, this may not be a relevant objective. Further, any claims that particular frameworks of accounting are superior to others should only be made after considering the environments in which the frameworks are to be used. Having examined several theoretical perspectives that seek to explain international accounting differences in terms of broad cultural (including religious) influences, we now move on to explore five of the more concrete institutional factors that some theorists believe influence the shape of accounting practices in any nation at any point in time. As you will appreciate when reading the following sections, these institutional factors are interrelated, and they can be linked to the broader cultural influences just examined. A useful exercise to help develop your understanding of both the cultural factors and the institutional factors is for you to attempt, while reading the following sections, to associate (in a broad way) the institutional factors with cultural influences. Legal systems The legal systems operating in different countries can be divided into two broad categories: common law and Roman law systems. In common law systems, there have historically been relatively fewer prescriptive statutory laws. Instead, the body of law has been developed by judges applying both the limited amount of statutory law and the outcomes of previous judicial decisions to the facts of a specific case. Each judgement then becomes a legal precedent for future cases. Common law originated in England and spread to its former colonies (such as the United States, Canada, Australia and New Zealand). Conversely, in Roman law systems, parliamentary (statutory) law tends to be very detailed and covers most aspects of daily life. The implication of this for accounting is that in common law countries we would expect to find relatively few detailed accounting laws guiding accounting practices, and therefore historically the development of accounting practices would have been left much more to the professional judgement of accountants (and auditors). With Roman law systems, by contrast, we would expect to find a body of codified accounting laws prescribing in 34 Common law system A system where law is made by judges, based upon precedent, where legal judgements on current cases are made by reference to judgements made by judges on past cases of a similar nature. Roman law A term used to refer to a system of law where detailed laws are developed to apply to potentially all crimes and aspects of daily lives, and where little emphasis is to be placed on professional judgement. For example, notions of discounting are found in ‘Western’ accounting standards dealing with employee benefits, lease capitalisation, non-current provisions, impairment of assets and general insurers. 201 Financial Accounting Theory detail how each type of transaction or event should be treated in the accounts. In this type of system there was therefore much less need or scope for the use of professional judgement in preparing accounts or developing accounting practices. As Nobes and Parker (2010) explain, the common law system was developed in England after the Norman Conquest of 1066, whereas the Roman law system was developed in continental European countries and spread to the former colonies of Belgium, France, Germany, Italy, Portugal and Spain. Countries where the development of legal systems and practices were heavily influenced by England tend to have common law systems. Conversely, most continental European countries, along with countries whose legal systems were developed under the influence of these countries, tend to have Roman law systems. Such countries include most members of the EU (other than England, Wales and Ireland) and many countries in other parts of the world that were former colonies of continental European nations.35 Therefore, we would expect England, Wales, Ireland and (partially) Scotland historically to have had relatively few codified accounting laws, with the development of financial accounting practices being left to the professional judgement of accountants. In the EU, we would expect accounting practice to have historically been developed through detailed codified accounting laws (or legally recognised regulations) with relatively little input from professional accountants. The adoption of IFRS, which are often considered to be principles based, would have represented a significant change in practice for countries with Roman law systems relative to countries with common law systems. Business ownership and financing systems A second key institutional factor that researchers have demonstrated has historically had an impact on the shape of a nation’s accounting practices is the business ownership and financing system. Similarly to legal systems, this factor can be broadly divided into two distinct types – ‘outsider’ systems and ‘insider’ systems. In ‘outsider’ systems, external shareholders (that is, those who are not involved in the management of the company) are a significant source of finance for much business activity. As these external shareholders will not be involved in the detailed management of the company, and will therefore not have access to the company’s detailed management accounting information, they will need to be provided with separate financial accounting information to help them make their investment decisions. They may invest in the shares of a number of companies, and they need a basis on which to evaluate the performance of any company – for example, by comparing it to the performance of other companies. To help ensure an effective and efficient allocation of finance to different companies in this type of outsider-financed system, it is important for external investors (and potential investors) to be provided with financial accounting information that reflects the underlying economic performance of a business in a fair, balanced and unbiased manner. Thus, given the significance of outsider finance, financial accounting will have historically developed with a primary aim of providing this fair, balanced and unbiased information to external shareholders – a process that requires rather extensive use of professional judgement (Nobes, 1998), for example to handle regular developments or innovations in business practices that cannot easily be foreseen when writing accounting codes or legislation. Conversely, in ‘insider’ systems of finance, provision of finance by external shareholders is much less significant. Instead, there has been a dominance of family-owned businesses, and/or the dominant providers of long-term finance have historically been either banks or governments (Zysman, 1983). With family-owned businesses, the owners will tend to have access to the detailed internal management accounting information of the business, so 35 202 Nobes and Parker (2004) point out that a very small number of countries (such as Scotland, South Africa and Israel) have developed legal systems that incorporate aspects of both common law and Roman law. International accounting CHAPTER 5 there is no obvious need for financial statements to provide information to aid investment decision making by shareholders. In some countries (such as Germany) where banks have historically been the dominant source of long-term finance for large companies (rather than external shareholders), banks and companies have tended to develop long-term supportive relationships. These involve banks having a representative on the supervisory board of companies to whom they are major lenders, and these representatives are provided with the detailed management accounting information available to all members of the supervisory board. In the case of family-owned businesses, given that the predominant providers of finance are effectively ‘insiders’ to the business and have access to detailed management information, there will have been little pressure for financial accounting to have developed to provide information to aid external investment decisions (Nobes, 1998).36 The relationships between differences in sources of finance and how that flows on to the differences in financial accounting has also been explained by Lantto and Sahlstrom (2009), who state: Prior literature shows that in code-law countries, such as continental European countries, capital provided by the state, banks or families tends to be more important than in common law countries, such as those of North America where firms are mainly financed by a large number of private investors (e.g., La Porta et al., 1997). Therefore, whereas information asymmetry between capital providers and a firm is likely to be resolved in continental European countries by providing accounting information privately to the capital providers, in the North American countries it is likely to be resolved by providing high-quality public financial reporting. Nobes and Parker (2010) explain that, in systems where governments provide a significant amount of long-term business finance, government representatives will often become directors of the state-funded companies, and will thus have access to the inside management information. Thus, a characteristic shared by all countries in which insider systems of finance predominate is that the primary role of accounting has historically not been to provide fair, balanced and unbiased information to help outside investors make efficient and effective investment decisions. Financial accounting in these countries has developed to fulfil a different role than in outsider-financed countries. One such role, which is explored in the next section, is the provision of information to calculate taxation liabilities. Countries that have historically been dominated by insider systems of finance have tended also to be countries with Roman law systems, while outsider-financed countries usually have common law systems (La Porta et al., 1997). Thus, most continental European countries (a notable exception being the Netherlands, which has a Roman law system but a large amount of outsider finance) have historically relied on insider forms of finance, with the result that financial accounting in these nations did not develop to serve the needs of investment decisions in capital markets. Conversely, the United Kingdom and Ireland (and the United States, Australia and New Zealand among other non-European states) have relied to a much greater extent on outsider forms of finance, with a primary role of accounting historically being to service the information needs of capital markets with fair, balanced and unbiased information.37 As an example of empirical research linking financing systems with differences in accounting practices, Pratt and Behr (1987) compared the standard-setting processes adopted in the United States and Switzerland. Differences in the standards and processes adopted were explained by As such, the entities would not be considered to be reporting entities. The topic of ‘reporting entities’ is addressed in Chapter 7. Reporting entities produce general purpose financial statements for parties with a stake in the organisation and that are unable to command information to satisfy their specific information needs. 37 As demonstrated in the final chapter of this book, many critical accounting theorists strongly disagree that accounting information is fair, balanced or unbiased. 36 203 Financial Accounting Theory differences in ‘size, complexity, and diversity of capital transactions, the wide distribution of ownership, and the opportunistic nature of the capital market participants’. Chand and White (2007) consider the ownership and financing systems that are common in Fiji and argue that the recent adoption of IFRS in Fiji created a level of inefficiency not previously experienced. That is, they argue that there is an inappropriate match between IFRS and the financing systems inherent in Fiji. As they state (p. 615): The financial institutions and in particular the commercial banks dominate Fiji’s capital markets. It is on these institutions that almost all of Fiji’s domestically controlled business enterprises rely for financing. Two commercial banks control 75% of the banking market and exercise duopoly powers (Ministry of Finance, 1999). Many business enterprises therefore need to provide financial reports to their banks, the banks being their prime financiers. Banks in Fiji, as in other jurisdictions, are concerned with assessing the financial stability and security that can be offered by prospective borrowers and compliance with loan covenant agreements by established clients. They typically require their borrowers to adopt a conservative approach to asset valuation and gearing measures, inter alia, as a bonding exercise (Watts, 2003). Banks seek reports from their clients that conform to a particular framework and a set of rules that the banks themselves impose. The banks operating in a non-competitive environment are able to require clients to reconstruct their financial reports on terms determined by the banks in order both to secure and retain financing. The banks acquire the accounting information the way they need it, without having to lobby the regulator to set reporting standards that address those needs. Kanaenabogi (2003) provides evidence that banks in Fiji typically take a conservative view of asset valuations offered as security in assessing loan applications. Banks use asset valuations, which are determined by applying conservative assumptions, taking these as proxies for orderly liquidation values, where formal independent valuations have not been secured. Accounting values determined by applying Fiji’s current reporting regulations and IFRS are not accepted in assessing entities’ capacities to repay loans. Therefore, Kanaenabogi argues that complying with two sets of audited financial statements imposes an unnecessary financial burden on business enterprises. Consequently, the more conservative financial reporting models applied by France, Germany and Japan (Briston, 1978; Radebaugh and Gray, 2002) may be more appropriate for Fiji’s domestic economy than the IASB model. Before leaving the discussion of the impact of different financing systems on the shape of accounting practices, we should emphasise that, with the increasing scale of globalised businesses, multinational corporations based in any country are increasingly relying on financing from more than one nation. The funding needs of many companies in countries that have traditionally relied on insider forms of finance have grown beyond the funding capacity of the insider sources of finance, and several companies are now increasingly also relying on outsider finance, from shareholders in both their home country and other nations. Thus, the information requirements associated with outsider-financed systems are now becoming applicable to many large companies in continental European countries (Nobes and Parker, 2010). Taxation systems In countries with predominantly outsider systems of finance, financial accounting practices historically developed to provide a fair, balanced and unbiased representation of the underlying economic performance of a business to help improve the effectiveness of investment allocation decisions by external shareholders. Such a system requires that financial accounting reflects 204 International accounting CHAPTER 5 some sort of economic reality; for example, an organisation selects a depreciation method that most closely reflects the manner in which it uses its fixed assets. Conversely, in countries with largely insider systems of finance this pressure for financial reports to have developed to reflect fairly some form of underlying economic reality is not present. Rather, financial reports have developed for different purposes, and one important purpose is the calculation of tax (Nobes and Parker, 2010). In most continental European countries that have traditionally relied heavily on insider forms of finance, for a company to claim an allowance for tax, this allowance must be included in its financial reports. For example, if a company wishes to reduce its tax liability by taking advantage of the maximum permitted taxable depreciation allowances, it has to include the tax depreciation allowances in its financial reports. The tax depreciation allowances will be determined by taxation law, and will not necessarily bear any relationship to the amount of the non-current assets that have actually been used in any particular year. The financial accounting results will therefore be expected to be substantially affected and determined by the provisions of taxation law in many continental European countries that have historically relied on insider systems of finance. In outsider-financed systems, the tax accounts have historically been separated from the financial accounts. Thus, if a company wished to claim the maximum tax depreciation allowances permitted by taxation law in these countries, this would not affect the calculation of its reported profits in its financial statements. These financial statements can therefore include a fair depreciation charge reflecting the utilisation of assets without affecting the company’s ability to claim the maximum tax depreciation allowances in its tax accounts, and the provisions of taxation law have not therefore exerted much influence on the financial statements. Given that there has tended to be a high correlation between insider-financed systems and Roman law countries (La Porta et al., 1997), the detailed provisions of taxation law have effectively become a large part of the detailed accounting regulations in many continental European countries that have codified Roman law systems (with the notable exception of the Netherlands). Again, the adoption of IFRS in such countries represented a significant change to their traditional accounting practices. A further institutional factor that tended to differentiate between, and also reinforce the distinction between, Roman law insider-financed countries and common law outsider financefinanced systems is the strength of the accounting profession. Outsider-financed system Where longer-term funding comes from parties such as large numbers of shareholders who are not involved in the management of the organisation (they are ‘outsiders’). Insider-financed system Where organisations are predominantly family owned and where longerterm funding typically comes from banks or government. Strength of the accounting profession The strength of the accounting profession in any country has historically been determined by, and helped to reinforce, the influence on financial accounting systems of the institutional factors discussed above (Nobes and Parker, 2010). In a common law country, which has a predominantly outsider system of long-term finance and where tax law has had little influence on financial accounting, there will have been relatively few statutory laws determining the contents of financial statements. The primary purpose of these financial statements will have been to provide a fair, balanced and unbiased representation of the underlying economic performance of the business, and this will have required the exercise of professional judgement to cope with each different situation. Thus, in these countries, there will have historically been a demand for a large number of accountants who are able to apply professional judgement to determine the most suitable way of reflecting unique sets of transactions and events in financial accounting reports of companies. This need for accountants who are able to, and have scope to, exercise professional judgement has led to the development of large and strong accounting professions in countries such as the United Kingdom, Ireland, the United States, Canada, Australia and New Zealand. As seen in Chapter 4, strong accounting professions have been effective in lobbying governments to ensure that accounting regulatory systems give scope for the exercise of professional judgement, thus possibly reinforcing the strength and influence of the accounting profession. 205 Financial Accounting Theory Conversely, in Roman law countries that have largely insider systems of finance and where compliance with the details of tax laws exerts a substantial influence on the shape of financial accounts, there will have been little need or scope for the use of professional judgement when drawing up financial accounting statements. There has therefore been much less impetus for the development of accounting professions compared to outsider-financed common law systems. The accounting professions in many continental European countries have historically been smaller and weaker (in terms of influence) than their counterparts in the United Kingdom, Ireland, Australia or the United States. Nobes and Parker (2004) argue that these weaker accounting professions have had an impact in reinforcing accounting practices that require little exercise of professional judgement, because the effective implementation of flexible accounting practices requires a reasonably large accounting profession that is comfortable with (and has sufficient experience of) applying professional judgements to complex accounting issues. Accidents of history As indicated at the beginning of this section, accounting systems tend to be regarded as following either an Anglo-American model or a continental European model. The cultural and institutional differences discussed so far in this chapter support this view, with countries following the AngloAmerican model tending to have common law systems, outsider financing, little influence of taxation law on financial reporting and a strong accounting profession accustomed to exercising a considerable amount of professional judgement – with the opposite applying in countries following the continental European model. If we accept that these influences are significant in shaping a nation’s accounting practices, we should expect accounting practices in countries with Anglo-American systems to have historically been broadly similar. However, this is not consistent with the evidence presented in the first section of this chapter, when, for example, we saw that both the reported profits and the net assets of the multinational pharmaceutical company AstraZeneca were significantly different when calculated in accordance with UK accounting rules than when calculated in accordance with US rules. If the cultural and institutional influences examined so far in this chapter, that are broadly similar in the United Kingdom and the United States, are significant in shaping accounting practices, there must be an important additional influencing factor which varies between the United Kingdom and the United States. Nobes and Parker (2004) point to the importance of the additional factor of ‘accidents of history’, whose influence will be restricted to the accounting systems of the individual countries affected by the accidents. For example, following the Wall Street crash of 1929, the United States established securities exchange legislation aimed at investor protection, while there was no such development at the time in the United Kingdom. This legislation included certain accounting requirements, which have been delegated to private sector accounting standardsetting bodies and produced a detailed set of US accounting rules (as we would expect to see in a Roman law country). In contrast, following a series of high-profile accounting failures in the United Kingdom in the late 1980s, the United Kingdom established a more principles-based system of accounting regulation. As Unerman and O’Dwyer (2004) highlight, in the aftermath of accounting failures at Enron in 2001, it was claimed by many in the United Kingdom that the different regulatory systems would have prevented Enron using the creative accounting techniques in the United Kingdom that it followed in the United States. Going back to the case of AstraZeneca, studying the reconciliation provided in the financial reports between the results calculated using UK accounting rules and those calculated using US accounting rules, it is apparent that a substantial difference between the two sets of accounting regulations (in the case of this company) arises from differences between the US and the UK accounting treatment of mergers and acquisitions (including the calculation of goodwill). Different pressures in the United Kingdom (possibly including different 206 International accounting CHAPTER 5 lobbying efforts by interested parties in each country) resulted in UK and US accounting rules for mergers and acquisitions being somewhat different. Summarising this chapter so far, a number of reasons have been advanced to explain the accounting systems in place in different countries, including culture, religion (which is a subset of culture) and institutional factors (which we could also imagine would be influenced by culture). The discussion has by no means been exhaustive in identifying the many factors proposed to explain why historically there were international differences in accounting systems; nevertheless, the referenced research indicates that one general approach to financial accounting may suit one particular environment but not others. Therefore, it is probably somewhat naive to claim that there is one ‘best’ system of accounting. With this in mind, we can reflect on the claim by a former chairperson of the US Financial Accounting Standards Board, Dennis Beresford, that the US accounting and reporting system was regarded by many as ‘the most comprehensive and sophisticated system in the world’ (as quoted in Wyatt and Yospe, 1993). Perhaps in some countries (perhaps the majority), the US system would be considered to be sophisticated, but in others it might be considered to be quite irrelevant on cultural, religious or institutional grounds. Despite various factors that provide a logical rationale for international differences in accounting practices, there have been extensive efforts over several decades to reduce the differences between financial accounting systems in different countries. A great deal of this effort culminated in many diverse countries adopting IFRS. The material in this chapter has given the reader a good understanding of why accounting systems in different countries were dissimilar prior to efforts to standardise financial accounting. The reader might also have formed an opinion about whether the global standardisation of financial accounting is appropriate. What do you, the reader, think? Is it appropriate for diverse countries with different cultural attributes, different financing systems, different religions, different taxation systems, different histories and so forth to all adopt the same financial reporting standards? Why do I need to know some of the reasons that financial reporting might, in the absence of standardisation efforts, differ between different countries or cultures? As we have emphasised several times in this book, the numbers generated through the practice of financial accounting shape all of our lives to some extent. Stakeholder support for organisations, particularly large organisations, is often linked in some respect to their reported financial performance and financial position. For example, if we read or hear that a high-profile company has just reported record profits then that could influence how various stakeholders deal with an organisation. Given the importance that financial accounting numbers have within society, we should understand how those numbers are determined, and what factors shape the rules that have been applied (or perhaps not applied). By knowing some reasons why different cultures or countries might have different information demands or expectations, and by understanding that different countries will have different enforcement mechanisms, we can understand the obstacles that confront bodies such as the IASB in the quests for standardised financial reporting practice. As a result of reading the material in this chapter, we might logically question any claim that IFRS have created, or are likely to create, full standardisation in financial reporting internationally. Such insights are important, particularly if we ever have the role of comparing the financial performance of different organisations internationally (and as accounting researchers we might do this). By having the insights from this chapter, we will be aware of some reasons, or motivations, that might drive some organisations to depart from IFRS, and if needed, we would then be better placed to suggest safeguards to combat such incentives. 207 Financial Accounting Theory REFLECTION QUESTION 5.2 International standardisation of financial reporting information Question So, given what you have read in this chapter, do you think it is sensible or logical that people/stakeholders in different countries – such as Australia and China, for example – which have quite different cultures and regulations, be provided with the same financial accounting information? Solution As a result of reading the material in this chapter, you should understand that there seems to be some logic to the argument that it is inappropriate to provide people from all countries with the same types of financial information. People from different cultures seem to have different needs for information and in this chapter we have linked these differences back to particular cultural attributes. We are not all the same and therefore you should now be able to provide logical arguments and insights about why a ‘one-size-fits-all’ approach is perhaps rather simplistic and seems to ignore some important research. This would particularly be the case when it comes to reporting by smaller organisations that do not rely so much on global capital markets and whose stakeholders tend to be more local in orientation. However, as organisations get larger, they tend to move towards more of an ‘international culture’ and the arguments against standardisation do tend to decline to some extent. As Newson and Deegan (2002) argue, large multinational organisations make their disclosure decisions in response to global information demands and global cultural expectations, rather than the demands of citizens in the home country. Impacts of culture on issues beyond financial reporting LO5.4 In Chapter 8, we consider issues to do with executive remuneration. Applying theories known as Positive Accounting Theory and Agency Theory, we learn that researchers explain that management remuneration plans are put in place to align the interests of managers (who are assumed to be motivated by self-interest) with the interests of the providers of financial capital to the organisation (for example, shareholders and lenders). These theories point to the need to have various contractual agreements included within a manager’s remuneration plan (bonus plan) to encourage the manager to work in a way that does not only benefit them individually, but also the shareholders (owners) and the debt-holders. For example, managers might contractually be offered a bonus that is linked to accounting profits or to measures such as return on assets. An ‘efficient’ management remuneration plan is one that includes appropriate clauses to motivate and monitor the (self-interested) manager to work in a way that also benefits other stakeholders. However, and linking the material covered in this chapter, insights from other researchers applying other theories suggest that the development of management remuneration plans might also be influenced by cultural factors as well. That is, we should never assume that one theoretical perspective (for example, from Positive Accounting Theory, as referenced above) provides a full explanation for differences in a particular phenomenon. We can usefully see the world through different theoretical lenses. In this respect, a paper by Free, Yao, Kent and Xin (2021) applied the ‘culture scores’ developed by Hofstede (as discussed earlier in this chapter) to explain how culture also influences Chief Executive Officer (CEO) pay structures. They propose that national culture is associated with different perceptions of the value of money and ‘success’, and that different interpretations of value and success in different cultures are expected to change the extent to which CEO pay is linked to the financial performance of an organisation. In their study of management remuneration plans from a number of culturally diverse countries, Free et al. (2021) found that Power Distance and Uncertainty Avoidance dimensions (from Hofstede) are associated with a lower pay–performance link, while Individualism and Masculinity dimensions are associated with a high pay–performance link. They explain this on 208 International accounting CHAPTER 5 the basis that managers from countries with higher scores in Power Distance and Uncertainty Avoidance are accepting of less risk, while managers from countries with higher Individualism and Masculinity scores accept more risk. They also find that Long-Term Orientation dimension is associated with higher pay–performance sensitivity. Concluding comments about obstacles to the ongoing standardisation of financial accounting LO5.2 LO5.4 As discussed, one key obstacle to the establishment and maintenance of the international standardisation of accounting is the international cultural and institutional differences that caused financial accounting to vary in the first place. As argued earlier, if these causal factors continue to vary between countries, it is difficult to see how a single set of financial accounting rules, such as those published by the IASB, will be appropriate or suitable for all countries. That is, as financial accounting traditionally varied between different countries for reasons that could be theoretically explained (such as cultural, religious or institutional reasons), a key impediment to the continued standardisation of financial reporting is the fact that these good reasons for accounting differences arguably continue to exist. While many countries have either adopted IFRS or plan to adopt them in the near term, there is nothing that strictly stops them from abandoning IFRS should it become apparent that they are not very relevant to their countries’ financial accounting information needs. Of course, it would be costly and difficult for a country to abandon IFRS, but it is possible. As an example of the obstacle to maintaining standardisation efforts, Perera (1989, p. 52) considers the success of transferring accounting skills from Anglo-American countries to developing countries. He notes: ‘The skill[s] so transferred from Anglo-American countries may not work because they are culturally irrelevant or dysfunctional in the receiving countries’ context.’ Perera also argues that international financial reporting standards themselves are strongly influenced by Anglo-American accounting models and, as such, they tend to reflect the circumstances and patterns of thinking in a particular group of countries. He argues that these standards are likely to encounter problems of relevance in countries with different environments from those found in Anglo-American countries. Thus, for example, if the majority of German companies continue to rely on ‘insider’ forms of finance, and Germany continues to use a Roman law system, its previously used codified accounting regulations would probably be more appropriate for most German companies than the imposition of a form of the Anglo-American accounting system.38 Nobes and Parker (2010) suggest that in such circumstances it might be more appropriate to have a dual system, where all companies in each country are required to prepare financial reports in accordance with their historically developed domestic system, and companies that raise funds internationally can prepare an additional set of financial reports (probably only the consolidated or group accounts) in accordance with Anglo-American-style international accounting rules.39 A further obstacle to harmonisation, identified by Nobes and Parker (2010), is the lack in some countries of a developed accounting profession. Thus, in countries where strong accounting professions have not developed there are likely to be initial problems implementing international In a similar way, the imposition of a detailed codified accounting system would not be appropriate for Australia, the United Kingdom, the United States or New Zealand, for example, where the ‘outsider’ system of finance requires financial accounts to provide fair and balanced information reflecting some form of underlying economic reality. 39 In this regard, although companies in member states of the EU are required to follow accounting standards released by the IASB for the purposes of their consolidated financial reports, the requirement is restricted to companies listed on a stock exchange. 38 209 Financial Accounting Theory accounting regulations based on the Anglo-American professional judgement model (such as IFRS). Furthermore, some countries might have nationalistic difficulties in being seen to implement a system of international accounting standards that are regarded as being closely aligned to the Anglo-American systems. A final potential and significant obstacle to the ongoing standardisation of financial accounting is that, as seen in Chapters 3 and 4, accounting regulations can and do have economic consequences (Nobes and Parker, 2010). Across time, governments of individual countries may regret giving the control of a process – financial reporting standard-setting – that has real economic consequences, to an international body (the IASB) over which they have little influence. (Indeed, this was a concern in Australia, where the AASB’s role in developing accounting standards has effectively been transferred to the IASB, although the AASB provides input to the standards being developed by the IASB. It was also cited as a major concern in the United States and this ‘loss of control’ aspect is probably a key reason the United States did not adopt IFRS.) It was seen in Chapter 4 how this can impact on the process of international standardisation, in the recent difficulties experienced with the refusal of some EU countries to endorse fully the provisions of the revised IAS 39, partly because of the potential negative economic impact that these provisions might have on banks in their countries. STUDY TOOLS CHAPTER SUMMARY This chapter identified and considered historical differences in international financial reporting practices and looked at numerous reasons (generated from different theoretical perspectives) that have been advanced to explain why such differences arose (including differences in culture, religions as a subset of culture, legal systems, financing systems, taxation systems, the strength of the accounting profession and accidents of history). Much of the research into comparative international accounting questions whether it is appropriate to have one system of accounting that is adopted uniformly throughout the world (a long-term objective of the IASB). While many researchers question the relevance of ‘Western-style’ accounting standards for all countries, efforts by a number of international organisations are nevertheless continuing to encourage quite culturally disparate countries to adopt IFRS. This implies that the members of some international organisations are either unaware of the literature or, alternatively, choose to reject it as irrelevant. As efforts by a number of countries continue in relation to the domestic implementation of IFRS, it is to be expected that this debate will continue. In concluding the chapter, we can now make reference to Figure 5.7, which provides a summary of various factors that can influence the practice of financial accounting. As a result of reading the material in this chapter, you will be able to understand the rationale behind including the various potential influences in this diagram. While not represented in the diagram (so as to keep the diagram relatively simple), we can expect that there will be various interrelationships between some of the influences shown within the boxes. For example, the strength of the accounting profession will affect the level of monitoring and enforcement, and the culture and legal systems within a particular country would be expected to be related. 210 International accounting CHAPTER 5 FIGURE 5.7 Some factors that influence the practice of financial reporting Strength of the accounting profession Business ownership and financing system Accounting regulations History Culture Financial accounting practice Legal system Economic influences Level of monitoring and enforcement Religion Political influences ANSWERS TO THE OPENING QUESTIONS At the beginning of the chapter, we asked the following two questions. As a result of reading this chapter, you should be able to provide informed answers to these questions – ours are shown below. Since the start of 2005, financial reporting standards issued by the International Accounting Standards Board (IASB) have become the financial reporting standards that are applied within many countries. 1 Do you believe that all countries should adopt the same financial reporting standards – that is, do you think that a world-wide ‘one-size-fits-all’ approach to financial accounting and reporting is appropriate? If not, what might be some reasons against such international standardisation? As a result of reading this chapter, you have been exposed to a number of different arguments about why it is, and why it is not, appropriate that we have a ‘one-size-fits-all’ approach to financial reporting globally. Some of the arguments in favour of the standardisation of financial reporting are that it will enhance international comparability, and this will be good for investors wanting to invest internationally. Relatedly, this will also be good for the reporting organisations, as it has been argued that this will allow them to attract more financial capital from international investors and to attract the funds at a lower cost of capital. The mobility of financial accountants will also increase because of reporting standardisation. However, there are many arguments against standardisation. As we learned in this chapter, people from different countries have, through an analysis of different cultural attributes, been shown to have different information demands and expectations. Further, differences in legal systems, taxation systems, sources of finance and accounting and auditing expertise also all point to the potential inappropriateness of introducing one standardised set of financial reporting standards. Whether we individually accept arguments for or against the international standardisation of financial reporting will be influenced by how prepared we are to accept the arguments of the different researchers, such as those reported in this chapter. In Chapter 1 of this book, we discussed various factors to consider when evaluating the insights provided by different researchers and we emphasised 211 Financial Accounting Theory that such evaluation is necessary before we ultimately decide to accept the arguments provided by different researchers. 2 What are some of the advantages and disadvantages that arise as a result of a country adopting the financial reporting standards issued by the IASB? Linked to the above answer, some of the advantages relate (supposedly) to increased inflows of capital, lower costs of capital, elimination of costs that might be imposed if investors had to translate financial reports from one set of accounting standards to another, and the use of a better, more efficient set of financial reporting standards. The disadvantages are that the information generated as a result of applying IFRS may not meet the needs of local stakeholders. There is also quite an extensive reporting burden (cost) associated with implementing IFRS. The advantages and disadvantages will be linked to the organisation’s size as it is likely that larger, perhaps multinational, organisations are more likely to benefit from the adoption of a ‘one-sizefits-all’ approach to financial reporting relative to smaller organisations. QUESTIONS 5.1 5.2 5.3 5.4 5.5 5.6 In the context of financial accounting, what is harmonisation and/or standardisation? LO5.5 Global standardisation of accounting arguably requires the United States to adopt IFRS. Do you think it is likely that the United States will embrace IFRS in the near term, and what do you think are some of the factors that discouraged the country from adopting IFRS? LO5.1 LO5.6 LO5.7 Do you think that the Securities and Exchange Commission’s reluctance to support the adoption of IFRS for US organisations undermines the credibility of the IASB? Why? LO5.1 LO5.3 LO5.5 Identify some factors that might be expected to explain why different countries use different systems of financial accounting. LO5.4 Why would it matter if organisations calculate ‘profits’ differently as a result of applying financial reporting standards? LO5.1 LO5.4 LO5.7 Evaluate the following statement: If various countries adopted the same financial reporting rules, then if the same series of transactions and events occurred within different countries, there would be no differences between the results that would be reported in those different countries. LO5.5 5.7 5.8 5.9 5.10 5.11 5.12 5.13 5.14 212 Do you think that the standard-setting processes of the IASB are likely to be ‘captured’ by particular interest groups? LO5.1 Would cultures that rank more highly on Individualism be more or less inclined to support detailed rules for financial reporting, or would they prefer that many accounting-related decisions be left to professional judgement? LO5.4 Nobes and Stadler (2018) provide evidence that when IFRS are translated from English to local languages, errors are sometimes introduced. How might the introduction of such errors undermine the standardisation efforts of the IASB? LO5.1 LO5.2 With the cultural value of ‘Masculinity’ in mind, would you expect people within countries that rank higher, or lower, in terms of Masculinity to prefer the use of profit-related measures of performance that enable the financial performance of different organisations to be benchmarked against each other? LO5.4 Given what you have read in this chapter, would you expect the financial reporting practices in countries that have traditionally relied upon funding from banks and from government to be different to the reporting practices traditionally applied in countries that rely more upon funding received from large numbers of shareholders? LO5.4 Does the adoption of IFRS by different countries necessarily mean that the accounting procedures and practices they adopt will be consistent and comparable internationally? LO5.3 After considering the Hofstede–Gray model, briefly explain the hypothesised link between society values, accounting values and accounting practice. LO5.4 Any effort towards standardising accounting practices on an international basis implies a belief that a ‘one-size-fits-all’ approach is appropriate. Is this naive? LO5.3 LO5.4 International accounting CHAPTER 5 5.15 5.16 5.17 Continental European countries historically relied upon capital provided by state, banks or families whereas other countries, such as the United States, United Kingdom, Canada and Australia, have relied on receiving funding from a large number of external investors. How would this difference in funding sources impact the type of reporting undertaken and the expertise of the local accounting profession? LO5.4 While it is often argued that within particular countries there should be some association between various value systems and accounting systems, it is also argued (for example, by Baydoun and Willett, 1995) that over time many events would typically have occurred that confound this expected relationship. What type of events might confound the expected relationship? LO5.4 Baydoun and Willett (1995, p. 72) identify a number of problems in testing the Hofstede–Gray theory. They emphasise that many accounting systems are imported from other countries with possibly different cultures. As they state: Due to the interference in what would otherwise have been the natural evolution of financial information requirements, there are no uncontaminated examples of modern accounting practices in developing countries. Consequently, great care has to be taken in using data from developing countries to draw inferences about relevance on the basis of the Hofstede–Gray framework. Explain Baydoun and Willett’s point of view. Do you believe that they are correct? LO5.4 5.18 5.19 5.20 5.21 5.22 5.23 5.24 5.25 5.26 5.27 As noted in this chapter, Hamid, Craig and Clarke (1993) provide an argument that religion can have a major impact on the accounting system chosen by a particular country and that before ‘Western’ methods of accounting are exported to particular countries it must be determined whether particular religious beliefs will make the ‘Western’ accounting policies irrelevant. Explain their argument. LO5.4 Nobes (1998) suggests that for countries that have organisations that rely relatively heavily on equity markets, as opposed to other sources of finance, there will be a greater propensity for such organisations to make public disclosures of information. Evaluate this argument. LO5.4 In the early 1990s, the US Financial Accounting Standards Board’s chairperson Dennis Beresford claimed that the US accounting and reporting system was regarded by many as ‘the most comprehensive and sophisticated system in the world’. Evaluate this statement. How do you think its validity might have changed in the aftermath of accounting failures at Enron, WorldCom and Andersen in 2001–02? Do you think that the US system would be regarded as sophisticated in all cultural contexts? LO5.1 LO5.3 Do you think it is realistic to expect that there will eventually be an internationally uniform set of accounting standards? What factors would work for or against achieving and maintaining this aim? LO5.1 LO5.2 LO5.4 LO5.6 Prior to international actions to adopt IFRS, would you expect that large international companies domiciled in a particular country would have adopted different accounting policies from companies that operated only within the confines of that country? Explain your answer. LO5.4 Evaluate how reasonable it is to assume that the inflow of foreign investment into Australia would have been restricted if Australia, through the decision of the Financial Reporting Council, had not made the decision to adopt IFRS from 2005. LO5.1 LO5.2 LO5.6 Explain barriers to ongoing standardisation of financial accounting across all EU member states. Given these barriers, do you think that the EU has been naive in embracing the standardisation process for all member states? LO5.1 LO5.2 LO5.3 What are some perceived benefits that flow from the decision that a country will adopt IFRS? LO5.2 LO5.6 LO5.7 On the basis of actions to standardise accounting across countries, does it appear that organisations such as the AASB and the IASB are ignoring academic research that signals why we would expect to find international differences in financial accounting practices? LO5.4 LO5.6 It is often argued that the accounting standards of the FASB are rule-based, whereas the accounting standards issued by the IASB are principles-based. Rules-based standards by their nature can be quite complex, particularly if they seek to cover as many situations as possible. Do you think it would be easier to circumvent the requirements of rules-based or principles-based accounting standards? LO5.1 213 Financial Accounting Theory 5.28 Explain what Ball (2016, p. 556) means within the following quote: Competition among alternative economic systems, including financial reporting systems, is conducive to healthy innovation. History is replete with examples of one system learning from the institutional structure of a competing system, the most famous example in accounting being the near worldwide adoption of the Italian method of double entry bookkeeping….. In my view, adopting uniform worldwide standards invites risky centralisation and reduced innovation. LO5.2 5.29 5.30 5.31 5.32 5.33 A concern raised by Ball (2016) is that the reliance of IFRS on ‘fair values’ means that IFRS do not provide an efficient basis for debt contracting. What is the basis of this view? LO5.2 Is it appropriate for accounting standard-setting bodies to consider culture and religion when devising accounting regulations, particularly given that the output of financial reporting is expected to be objective and unbiased? Explain your view. LO5.4 LO5.6 What are some possible reasons for historical differences in accounting rules operating within Australia, the United States and the United Kingdom? LO5.4 LO5.7 Does the standardisation of financial reporting standards on a global basis necessarily equate with a standardisation in financial reporting practice? LO5.3 The website of the FASB has a section entitled ‘About the FASB’ (Financial Accounting Standards Board, n.d.), in which there is information about how accounting standards are developed. In part, it states: The Mission of the Financial Accounting Standards Board The collective mission of the FASB, the GASB, and the FAF is to establish and improve financial accounting and reporting standards to provide useful information to investors and other users of financial reports and educate stakeholders on how to most effectively understand and implement those standards. The FASB, the GASB, the FAF Trustees, and the FAF management contribute to the collective mission according to each one’s specific role: • The FASB and the GASB are charged with setting the highest-quality standards through a process that is robust, comprehensive, and inclusive. • The FAF management is responsible for providing strategic counsel and services that support the work of the standard-setting Boards. • The FAF Trustees are responsible for providing oversight and promoting an independent and effective standard-setting process. Standards-Setting Process The FASB accomplishes its mission through a comprehensive and independent process that encourages broad participation, objectively considers all stakeholder views, and is subject to oversight by the Financial Accounting Foundation’s Board of Trustees. The Rules of Procedure describe the FASB’s operating procedures, including the due process activities that are to be open to public participation or observation to provide transparency into the standardssetting process. In particular, the Rules of Procedure describe: • The organization in which the FASB operates • The FASB mission, how the mission is accomplished, and related principles that guide the Board’s standards-setting activities • The operating procedures of the FASB, including the responsibilities of the Chairman, the composition of the FASB technical staff, the role of advisory groups including the Emerging Issues Task Force, and public forums in our due process • Our various forms of communications, including the form and content of Accounting Standards Updates, Exposure Drafts, and Concepts Statements • Protocols for meetings of the FASB and voting requirements • Rules governing public announcements and the kinds of information made broadly available to the public. A high-level overview of the standards setting process as established by the Rules of Procedure follows. The nature and extent of the Board’s specific research and outreach activities will vary from project to project, depending on the nature and scope of the reporting issues involved. 214 International accounting CHAPTER 5 • The Board identifies financial reporting issues based on requests/recommendations from stakeholders or through other means. • The FASB decides whether to add a project to the technical agenda based on a staff-prepared analysis of the issues. • The Board deliberates at one or more public meetings the various reporting issues identified and analyzed by the staff. • The Board issues an Exposure Draft to solicit broad stakeholder input. (In some projects, the Board may issue a Discussion Paper to obtain input in the early stages of a project) • The Board holds a public roundtable meeting on the Exposure Draft, if necessary. • The staff analyzes comment letters, public roundtable discussion, and any other information obtained through due process activities. The Board redeliberates the proposed provisions, carefully considering the stakeholder input received, at one or more public meetings. • The Board issues an Accounting Standards Update describing amendments to the Accounting Standards Codification. Given the process involved in developing accounting standards, which involves asking constituents to make submissions on exposure drafts, do you think that accounting standards developed within the United States would be the same as accounting standards developed in another country? Provide an explanation for your answer. LO5.4 5.34 The IASC (1998, p. 50) stated that: many developing and newly industrialised countries are using International Accounting Standards as their national requirements, or as the basis for their national requirements. These countries have a growing need for relevant and reliable financial information to meet the requirements both of domestic users and of international providers of the capital that they need. Do you think that IAS/IFRS will provide ‘relevant and reliable information’ that meets the needs of all financial statement users in all countries? LO5.4 LO5.6 5.35 In considering the relevance of IFRS to developing countries, Chand and White (2007, p. 606) state: While the forces of globalisation and convergence are moving accounting practices towards a unified, or at least harmonised regulatory framework for financial reporting, this is unlikely to best serve the diverse interests of the disparate user groups of financial reports. Explain the reasons behind Chand and White’s claim. LO5.4 5.36 5.37 Latest evidence suggests that the United States will not adopt IFRS, at least in the near term. Why do you think the United States moved away from the commitment to adopt IFRS? LO5.1 LO5.6 Ball (2006, p. 17) makes the following comment: In sum, even a cursory review of the political and economic diversity among IFRS-adopting nations, and of their past and present financial reporting practices, makes the notion that uniform standards alone will produce uniform financial reporting seem naive. Explain the basis of Ball’s comments. 5.38 LO5.2 LO5.3 Irvine (2008, p. 127) makes the following comment: Global accounting technologies, including IFRS, provide developing nations with legitimacy. Similarly, emerging economies, if they wish to gain credence in global capital markets, need to adopt western accounting technologies. Explain the basis of Irvine’s comments. 5.39 5.40 LO5.2 LO5.6 The website of the FASB says that it considers the views of its constituents. Do you think that the financial information demands or expectations of ‘constituents’ in the United States would be different from the financial information demands or expectations of people in other countries? Why or why not? LO5.4 In continental European countries, prior to the adoption of IFRS, the domestic accounting rules were typically much more aligned with local taxation regulation than would be the case in countries like the United States, United Kingdom, Canada, Australia or New Zealand. Why do you think this would have been the case? LO5.3 LO5.4 215 Financial Accounting Theory 5.41 Paragraphs 2.42 and 2.43 of the IASB Conceptual Framework for Financial Reporting (IASB, 2022) state: 2.42: In applying the cost constraint, the Board assesses whether the benefits of reporting particular information are likely to justify the costs incurred to provide and use that information. When applying the cost constraint in developing a proposed Standard, the Board seeks information from providers of financial information, users, auditors, academics and others about the expected nature and quantity of the benefits and costs of that Standard. In most situations, assessments are based on a combination of quantitative and qualitative information. 2.43: Because of the inherent subjectivity, different individuals’ assessments of the costs and benefits of reporting particular items of financial information will vary. Therefore, the Board seeks to consider costs and benefits in relation to financial reporting generally, and not just in relation to individual reporting entities. That does not mean that assessments of costs and benefits always justify the same reporting requirements for all entities. Differences may be appropriate because of different sizes of entities, different ways of raising capital (publicly or privately), different users’ needs or other factors. Do you think that cost–benefit considerations will be different in different countries? If so, how would cost–benefit considerations be determined by a global accounting standard-setter such as the IASB? LO5.2 5.42 Ball (2006, p. 17) states: Under its constitution, the IASB is a standard setter and does not have an enforcement mechanism for its standards: it can cajole countries and companies to adopt IFRS in name, but it cannot require their enforcement in practice. It cannot penalise individual companies or countries that adopt its standards, but in which financial reporting practice is of low quality because managers, auditors and local regulators fail to fully implement the standards. Nor has it shown any interest in disallowing or even dissuading low-quality companies or countries from using its ‘brand name’. Individual countries remain primarily regulators of their own financial markets. EU member countries included. That exposes IFRS to the risk of adoption in name only. Evaluate Ball’s comments and provide an argument as to whether you agree or disagree with his view. LO5.1 LO5.4 5.43 Ball (2006, p. 22) provides the following statement: In the presence of local political and economic factors that exert substantial influence on local financial reporting practice, and in the absence of an effective worldwide enforcement mechanism, the very meaning of IFRS adoption and the implications of adoption are far from clear. In the enthusiasm of the current moment, the IFRS ‘brand name’ currently is riding high, and IFRS adoption is being perceived as a signal of quality. I am not sure how long that perception will last. Provide an argument as to whether you are inclined to agree or disagree with Ball’s scepticism about the future ‘value’ associated with embracing IFRS. LO5.1 LO5.4 5.44 The European Commission made the following statement in a press release issued in 2002: European Commission has welcomed the Council’s adoption, in a single reading, of the Regulation requiring listed companies, including banks and insurance companies, to prepare their consolidated accounts in accordance with International Accounting Standards (IAS) from 2005 onwards (see IP/01/200 and MEMO/01/40). The Regulation will help eliminate barriers to cross-border trading in securities by ensuring that company accounts throughout the EU are more reliable and transparent and that they can be more easily compared. This will in turn increase market efficiency and reduce the cost of raising capital for companies, ultimately improving competitiveness and helping boost growth. Evaluate the above statement. 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CHAPTER 6 MEASUREMENT ISSUES: ACCOUNTING FOR THE EFFECTS OF CHANGING PRICES AND MARKETS LEARNING OBJECTIVES On completing this chapter, readers should: LO6.1 LO6.2 LO6.3 LO6.4 understand what ‘measurement’ means, why it is a potentially controversial issue, and some of the factors that accounting standard-setters consider when prescribing one particular measurement approach in preference to another be aware of the various measurement approaches currently, and potentially, in use be aware of some particular limitations of historical cost accounting in terms of its ability to cope with various issues associated with changing prices and changing market conditions be aware of a number of alternative methods of asset valuation that have been developed to address problems associated with changing prices and market conditions, including fair value accounting LO6.5 be able to identify some of the strengths and weaknesses of the various alternative accounting methods and measurement approaches LO6.6 understand that the calculation of income under a particular method of accounting will depend on the perspective of capital maintenance that has been adopted LO6.7 be aware of the increasing use of fair value measurement in financial reporting standards, and understand some concerns about, and criticisms of, fair value measurements LO6.8 be aware of evidence about the demand for, and professional support of, alternative measurement approaches. 219 Financial Accounting Theory OPENING QUESTIONS Before reading this chapter, please consider how you would answer the following three questions. We will return to these questions at the end of the chapter, where we suggestModule 1 Questions / some answers. Various asset valuation approaches are typically utilised within a set of financial reports. Non-current assets acquired (or perhaps revalued) in different years can be added together to give a total monetary value, even though the various costs or valuations might provide little reflection of the current values of the respective assets. For example, pursuant to IAS 16 Property, Plant and Equipment, it is permissible for some classes of property, plant and equipment to be measured at cost, less accumulated depreciation and impairment losses, whereas another class of property, plant and equipment is allowed to be measured at fair value.1 The different measurements will then simply be added together to give a total monetary value for property, plant and equipment – with the total representing neither cost nor fair value. 1 Answers What are some of the criticisms that can be made in relation to the practice of accounting wherein assets that have been acquired or valued in different years are added together, without adjustment (as occurs with historical cost accounting), when the purchasing power of the dollar in those years was conceivably quite different? 2 What are some of the alternative methods of accounting (alternatives to historical cost accounting) that have been advanced to cope with the issue of changing prices and market conditions, and what acceptance have these alternatives received from the accounting profession and accounting researchers? 3 What are the perceived strengths and weaknesses of the alternatives to historical cost? Introduction Chapter 4 considered various theoretical explanations for why regulation might be put in place. Perspectives derived from public interest theory, capture theory and the economic interest theory of regulation did not attempt to explain what form of regulation was most optimal or efficient. Rather, by adopting certain theoretical assumptions about individual behaviour and motivations, the theories attempted to explain which parties were most likely to try to affect the regulatory process, and perhaps succeed in doing so. This chapter considers a number of normative theories of accounting. Based on particular judgements about the types of information people need (which could be different from what they think they want), the various normative theories provide prescriptions about how the process of financial accounting should be undertaken and, in particular, how assets (and liabilities) should be measured.2 The chapter also considers efforts of the International Accounting Standards Board (IASB) and Financial Accounting Standards Board (FASB) to develop appropriate measurement bases as part of the work that was undertaken to develop a revised conceptual framework for financial reporting. What we shall see is that fair value has become the preferred measurement base of the IASB, although there is also an acceptance that fair value is not appropriate in all cases. Across time, numerous normative theories of accounting have been developed by a number of well-respected academics, with these theories providing prescription in relation to measurement. However, these theories typically failed to be embraced by the accounting profession, or to 1 2 220 Throughout this chapter, where reference is made to an accounting standard, reference will be made to the International Accounting Standard/International Financial Reporting Standard. Positive theories, by contrast, attempt to explain and predict accounting practice without seeking to prescribe particular actions. Positive accounting theories are the subject of analysis in Chapters 8 and 9. Measurement issues: accounting for the effects of changing prices and markets CHAPTER 6 be mandated within financial reporting regulations. Relying in part on material introduced in Chapter 4, this chapter considers why some proposed methods of accounting are ultimately accepted by the profession and/or accounting standard-setters, while many are dismissed or rejected. We can question whether the rejection of a particular approach to financial reporting is related to the merit of the arguments (or lack thereof), or due to the political nature of the standardsetting process, wherein various vested interests and economic implications are considered. The chapter specifically considers various prescriptive theories of accounting (normative theories) that were advanced by various people on the basis that historical cost accounting, which was the dominant measurement basis for centuries, has too many shortcomings. These shortcomings become more apparent as the rate of price rises within the economy increases. As IAS 29 Financial Reporting in Hyperinflationary Economies (IASB 2022d, paragraph 2) states: In a hyperinflationary economy, reporting of operating results and financial position in the local currency without restatement is not useful. Money loses purchasing power at such a rate that comparison of amounts from transactions and other events that have occurred at different times, even within the same accounting period, is misleading. LO6.1 LO6.2 The process of measurement As we would appreciate through a study of financial accounting, different assets and liabilities are measured in different ways as a result of the application of different financial reporting standards. For example, inventory is required to be measured at the lower of cost and net realisable value (see IAS 2 Inventories), property, plant and equipment can be measured either at cost or fair value depending upon what election is made by management (see IAS 16 Property, Plant and Equipment), financial assets are generally to be measured at fair value (see IFRS 9 Financial Instruments), and many liabilities are to be measured at present value (see IAS 37 Provisions, Contingent Liabilities and Contingent Assets). This is referred to as a mixed measurement model of accounting wherein no one basis of measurement/valuation (for example, ‘fair value’, ‘present value’ or ‘historical cost’) is prescribed for all classes of assets and liabilities. Using a mixed measurement model provides flexibility for preparers of financial reports. For example, in measuring property, plant and equipment a preparer of financial reports applying IFRS might elect to use fair value to measure assets when an active market exists for the particular class of assets, and where market prices can be easily determined. However, for property plant and equipment that does not have an active market, such as might be the case for specialised machinery, the preparer might elect to utilise historical cost as the basis of measurement.3 Further, when markets become unstable (such as around the time of a severe financial crisis, such as the global financial crisis [GFC]), it might appear inappropriate to base the measurement of an asset on ‘fair value’ because of the uncertainties in the market and the low level of trading that might be occurring with respect to various classes of assets – all of which potentially leads to volatile prices. Therefore, different bases of measurement could be justifiable depending upon the attributes of ‘the market’ at a particular point in time. While there can be good reasons for having a mixed measurement model for accounting, some downsides of allowing a mixture of different measurement approaches include: • it potentially undermines the comparability of financial reports prepared by organisations that use different measurement bases • it leads to what is known as an ‘additivity problem’ wherein the sum of total assets will represent the summation of assets (and liabilities) measured on different bases 3 Fair value The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Present value The value of an item to be received or paid for in the future expressed in terms of its value today. Mixed measurement model of accounting An approach to accounting wherein a variety of measurement approaches are used to measure assets and liabilities. Active market A market in which transactions for the asset or liability take place with sufficient frequency and volume to provide pricing information on an ongoing basis. Historical cost Assets are recorded at the amount of cash or cash equivalents paid, or the fair value of the consideration given, to acquire them at the time of their acquisition. Liabilities are recorded at the amount of proceeds received in exchange for the obligation, or in some circumstances (for example, income taxes), at the amounts of cash or cash equivalents expected to be paid to satisfy the liability in the normal course of business. The use of historical cost or fair value for balance sheet purposes also has implications for the income statement. For example, under IFRS, the recognition of an increase in the fair value of a depreciable non-current asset will lead to an increase in ‘other comprehensive income’ in the year of revaluation but will also lead to increases in depreciation expenses, potential increases in impairment losses and ultimate reductions in the profit on sale. 221 Financial Accounting Theory • where choice is available, it allows for the possibility that managers will opportunistically select the measurement basis that best suits them (that is, the method that provides a preferred result). While we have now discussed measurement briefly, we have not defined it. For financial reporting purposes, measurement is the process of determining the monetary amounts at which the elements of the financial statements are to be recognised and carried in the balance sheet (statement of financial position) and income statement (statement of profit or loss and other comprehensive income). This involves the selection of the particular basis of measurement, or the ‘measurement basis’. As paragraphs 6.1 and 6.2 of the IASB Conceptual Framework for Financial Reporting (Conceptual Framework; IASB, 2022c) state: 6.1 Elements recognised in financial statements are quantified in monetary terms. This requires the selection of a measurement basis. A measurement basis is an identified feature – for example, historical cost, fair value or fulfilment value – of an item being measured. Applying a measurement basis to an asset or liability creates a measure for that asset or liability and for related income and expenses. 6.2 Consideration of the qualitative characteristics of useful financial information and of the cost constraint is likely to result in the selection of different measurement bases for different assets, liabilities, income and expenses. There is generally a sequence of events when recording transactions and events within financial accounts. These are represented in Figure 6.1. In terms of the steps to be undertaken: 1 The financial accountant initially has to consider and apply the respective definitions of the elements of financial accounting. These elements are assets, liabilities, equity, income and expenses (we explore these definitions and their associated recognition criteria in Chapter 7 when we discuss the IASB Conceptual Framework). FIGURE 6.1 A summary of some of the steps undertaken within the financial accounting process 222 STEP 1 Definition of an element of financial accounting Does the transaction or event seem to satisfy the definition of either an asset, liability, income, expense or equity item? STEP 2 Recognition criteria When should the particular transaction or event that satisfies one of the element definitions be recorded within the financial accounting system? STEP 3 Measurement What financial amount should be recorded for the respective transaction or event that satisfies the definition of an element? STEP 4 Disclosure and presentation Should the particular item be disclosed separately, and if so, how should the particular item be presented within the financial statement? Measurement issues: accounting for the effects of changing prices and markets CHAPTER 6 Once the financial accountant is satisfied that a transaction or event creates something that satisfies one of the element definitions, the financial accountant then needs to determine when to actually recognise the transactions or events; that is, they need to determine when to make adjustments to the respective financial accounts that comprise the assets, liabilities, income, expenses and equity of an organisation. 3 Once the financial accountant has determined that they will recognise a transaction or event, they then need to determine how to financially measure the respective transaction or events so that they know the monetary value to assign to the financial accounts. This is the focus of this chapter. 4 Finally, financial accountants then need to determine what to disclose and how to present the respective elements of accounting within the financial statements (and various financial reporting standards will provide guidance here). Measurement is obviously a very fundamental issue within financial accounting. Measurement allows us to attribute monetary amounts to the items that appear within financial reports. Without some form of measurement, we might just simply provide pages of descriptions of the various assets and liabilities that are controlled or payable by the organisation, and this would be very confusing. However, when financial reporting standard-setters prescribe some measurement approaches in preference to others then this can potentially be very controversial as it can have profound effects upon financial reports, and therefore also on agreements, or contracts, that utilise numbers from the financial statements. For example, organisations might be subject to borrowing agreements that only allow additional borrowing by the organisation if specified debt to asset ratios are not breached (and conversely, might require repayment of borrowed funds if the prescribed financial accounting ratios are breached – often referred to as a ‘technical default’ of a borrowing agreement), or perhaps there are requirements that the organisation’s reported profits (with various negotiated adjustments) covers interest expense by a specified number of times (referred to as an ‘interest coverage clause’). Also, management might be paid bonuses tied to some proportion of reported profits, or perhaps government provides funding to the organisation based on some measure of efficiency, such as its ‘return on assets’. What is being emphasised here – and something which is explored in greater depth in Chapter 8 – is that financial accounting numbers are used in many contractual agreements to which an organisation is party. Therefore, how assets and liabilities are measured can be a very political issue as it can have many cash flow implications for an organisation, and therefore for the wealth of many stakeholders. There are various bases of measurement that could be used, including: • historical cost, which will be based on prices paid in the past (and which perhaps are not reflective of current costs and therefore can suffer problems pertaining to ‘relevance’) • current costs, perhaps based on the cost to replace the item with an identical item (and replacement costs can be considered as an ‘entry price’) or on the basis of the amount that would be paid now to replace the future economic benefits expected to be generated by the item • fair value, which represents the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date • net realisable value, for example fair value less the costs of disposal, which can also be considered as an example of an ‘exit value’ • present value, which relies upon various subjective judgements such as expectations about future cash flows and their timing, as well as judgements associated with respect to selecting an appropriate discount rate. ‘Value-in-use’, which is considered when determining the ‘recoverable amount’ of an asset (see IAS 36), relies upon present values • deprival value, which would reflect the loss that would be incurred if an organisation was ‘deprived’ of the asset being measured. It would be determined as the lower of the replacement cost of the asset and its recoverable amount (with recoverable amount being the higher of the asset’s fair value less costs to sell and its value in use). 2 Measurement The assignment of a quantitative measure to a particular item. In financial accounting it results from the application of a measurement basis – such as historical cost or fair value – to an asset, liability and related income and expenses. 223 Financial Accounting Theory Why do I need to know about different measurement bases? Because financial reports use various measurement bases for assets and liabilities, we need to appreciate what the various measurement bases actually reflect so that we can understand what the monetary amounts reported within financial reports actually represent, thereby allowing us to more fully understand the contents of financial reports. Understanding the different measurement bases allows us to consider the likely relevance and representational faithfulness of alternative measures. As researchers, we would need to understand Why the different measurement bases together with their respective strengths and weaknesses so that we can potentially suggest improvements to current practice. Further, across time, there have been controversies and crises (such as the collapse of Enron, and the GFC) that have been linked to various measurement bases. To understand these controversies and how financial accounting might have contributed to the particular events, we need to know the differences between available, and potential, approaches to assets and liability measurement. REFLECTION QUESTION 6.1 The relationship between measurement and contractual compliance Question How can the selection of a particular measurement basis by an organisation impact on an accounting-based contractual agreement that it is party to, such as ‘debt to asset’ or ‘interest coverage’ debt covenant? Solution As we explain more fully in Chapter 8, most organisations – particularly, larger organisations – agree to certain accountingbased contractual agreements as part of the process of borrowing funds. Such contractual agreements allow them to borrow funds at a cost that is lower than would be the case without such agreements. For example, to satisfy the requirements of lenders, the managers of an organisation might agree to: • keeping the organisation’s reported debt to assets to less than 60 per cent • ensuring that the organisation’s profits covers the total interest expense by 5 times (this is typically referred to as an ‘interest coverage’ requirement). If the organisation breaches the above requirements, then under the terms of the agreement that has been negotiated, the lender might have a contractual right to insist on immediate repayment of the loaned funds. Now let us assume that at the end of the reporting period the organisation’s draft financial reports show total assets of $100 million and total liabilities of $62 million, total interest expenses of $2 million and profits of $12 million. Let us also assume that the organisation has land that cost $3 million 224 Reflection many years earlier and which is measured at historical cost, but which has a fair value of $8 million. Given the above numbers, we can see that at the present time the organisation is in technical default of the debt to asset covenant negotiated with the lender. The debt to asset ratio is 62 per cent when the organisation agreed to keep it below 60 per cent. The interest coverage requirement has not been breached. Because one of the covenants within the lending agreement has been breached, the organisation could, pursuant to the contract, be forced to pay back the borrowed funds. What can the organisation do to alleviate this problem? Before finalising its financial reports, it could potentially revalue the land to its fair value of $8 million. This would increase total assets to $105 million, meaning that the debt to asset ratio would fall to 59 per cent (62/105) and the organisation would no longer be in technical default. Of course, this assumes that the borrowing agreement permits the organisation to use revaluations for contractual purposes. Assuming that the contract allows such revaluations to fair value, a change in measurement basis from historical cost to fair value for a class of assets (land) has allowed the organisation to comply with a negotiated debt covenant, thereby avoiding either a costly renegotiation with the lenders or having to pay back borrowed funds. While this is a simplified example, it does provide an insight into how an asset measurement choice can have real cash flow consequences for an organisation, and therefore potentially for its shareholders and other stakeholders. Measurement issues: accounting for the effects of changing prices and markets CHAPTER 6 Determining how an asset or liability should be measured should ideally be linked to the perceived objectives of general purpose financial reporting – something that we explore more fully in Chapter 7. According to paragraph 1.2 of the IASB Conceptual Framework (IASB, 2022c), the objective of general purpose financial reporting is: to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions relating to providing resources to the entity. Those decisions involve decisions about: (a) buying, selling or holding equity and debt instruments; (b) providing or settling loans and other forms of credit; or (c) exercising rights to vote on, or otherwise influence, management’s actions that affect the use of the entity’s economic resources The balance of the Conceptual Framework is built on this objective. Parts a and b relate to the information needed to help users of financial statements assess the prospects for future net cash inflows to the entity and to inform their future investment or lending decisions (resource allocation decisions) with respect to the reporting entity. This is linked to the notion of ‘decision usefulness’. That is, investors and lenders are perceived by the IASB to find it useful to their resource allocation decisions to have information about an organisation’s financial performance and financial position. When the Conceptual Framework was revised and re-released in 2018, part c was added. This additional component relates to what is known as ‘stewardship’. The IASB’s use of the term ‘stewardship’ is consistent with the general understanding of that term, which means the careful and responsible management of something entrusted to one’s care. From an accounting perspective, ‘stewardship’ refers to the process wherein a manager demonstrates how they have used the resources that have been entrusted to them by others who generally are not directly involved in the management of the entity. That is, the demonstration of ‘stewardship’ requires those who are in control of, and who use resources (managers), to provide an ‘account’ of this control and use to those stakeholders to whom they are accountable (for example, shareholders). Traditionally, stewardship was seen as one of the key roles of historical cost accounting, and some researchers and practitioners questioned the usefulness of fair value measurements for assessing managements’ stewardship of the resources entrusted to them. Relatedly, Ijiri (1975) also noted that to assess the stewardship being demonstrated by managers, it is preferable to use information that is as ‘hard’ as possible, and he defines a hard measure as ‘one that is constructed in such a way that it is difficult for people to disagree’ (p. 36). Ijiri (1975) believed that historical cost – being a relatively ‘hard’ measure – was best for assessing stewardship. However, other researchers, such as Edwards and Bell (1961), note that measurements of current or market (fair) values also provide useful information in assessing management’s past purchasing and production decisions, and therefore also have applicability when assessing stewardship. Therefore, the most recent version of the IASB Conceptual Framework embraces two objectives for financial reporting, these being to provide information that is useful for the decisions being made by financial capital providers in terms of: 1 making decisions regarding the allocation of their economic resources 2 assessing the actions managers have taken with respect to the economic resources that have been entrusted to them. The reinstatement of the notion of stewardship follows its previous removal in 2010 when the IASB and the FASB were jointly developing a revised Conceptual Framework. The Conceptual Framework now notes that users need information to enable them to assess management’s stewardship so that they can hold them ‘to account’ for the resources entrusted to their care. Stewardship The acceptance of a responsibility to look after, or safeguard, the assets or entitlements of identified parties. Refers to the process whereby a manager demonstrates how they have used the resources that have been entrusted to them by others who generally are not directly involved in the management of the entity. 225 Financial Accounting Theory This is a broader perspective of accountability than was evident in the 2010 Conceptual Framework. Paragraph 1.22 now states: Information about how efficiently and effectively the reporting entity’s management has discharged its responsibilities to use the entity’s economic resources helps users to assess management’s stewardship of those resources. Such information is also useful for predicting how efficiently and effectively management will use the entity’s economic resources in future periods. Hence, it can be useful for assessing the entity’s prospects for future net cash inflows. (IASB, 2022c) Relevance Information that will make a difference to a decision maker. From a financial accounting perspective, relevant information will have predictive value, confirmatory value, or both. Representationally faithful Information is ‘representationally faithful’ if it is complete, neutral and free from error; it depicts what it claims to depict. Pelger (2016) provides some interesting insights into the previous decision by the IASB and FASB to remove stewardship from the 2010 version of the Conceptual Framework. As he notes, the decision to remove the reference to stewardship was somewhat surprising as stewardship historically was one of the main reasons for the existence of financial accounting and is still considered to shape accounting practices. Pelger (2016) also noted that it was overwhelmingly the US participants from the FASB who were strongly opposed to the retention of stewardship as an explicit part of the objective of general purpose financial reporting. The standard-setters from the United States thought the objective that needed to be focused upon was the information needs of external providers of financial capital – that is, a focus on ‘decision usefulness’. Because the IASB worked on the 2018 version – and subsequent versions – of the Conceptual Framework (without the FASB), the members of the IASB were able to reintroduce stewardship without the previous opposition from US participants. According to the IASB Conceptual Framework, to fulfil the requirement that information is ‘decision useful’, financial information should be both ‘relevant’ and ‘representationally faithful’ and allow financial statement readers to make informed resource allocation decisions (IASB, 2022c). The IASB’s ultimate selection of a particular measurement base will supposedly be tied to whether a particular measurement approach enables the above objective of general purpose financial reporting to be satisfied. The IASB previously identified three fundamental principles of measurement that flow from the objective of financial reporting and the qualitative characteristics of useful financial information as described in Chapters 1 and 3 of the Conceptual Framework. Figure 6.2 details the three principles. FIGURE 6.2 The IASB’s three fundamental principles of measurement Principle 1 The objective of measurement is to represent faithfully the most relevant information about the economic resources of the reporting entity, the claims against the entity, and how efficiently the entity's management and governing board have discharged their responsibilities to use the entity's resources. Principle 2 Although measurement generally starts with an item in the statement of financial position, the relevance of information provided by a particular measurement method also depends on how it affects the statement of profit or loss and other comprehensive income and if applicable, the statements of cash flows and of equity and the notes to the financial statements. Principle 3 The cost of a particular measurement must be justified by the benefits of that information to existing and potential investors, lenders, and other creditors of reporting that information. Source: Based on IASB (2013b), Staff Paper: Conceptual Framework Draft Discussion Paper: Measurement Principles (paragraph 5). 226 Measurement issues: accounting for the effects of changing prices and markets CHAPTER 6 Based on the increasing use of fair value in various newly released accounting standards (in preference to other measurement approaches, such as historical cost), it appears that the IASB considers that measuring many classes of assets at fair value will provide more relevant and representationally faithful information than measuring all assets at ‘cost’.4 However, as the objective of general purpose financial reporting also considers stewardship, it is not resolved whether fair value is relatively useful for assessing stewardship. There is some argument that historical cost provides a clearer perspective about what management has done with the funds that were entrusted to it. Demonstrating how funds have been used is a key component of stewardship. However, there is also a counterargument that in assessing the stewardship of management, interested parties would not only want to know about the original amounts spent by managers, but also about how monies spent have increased in value, and historical cost accounting might be deficient in this respect. Arguments regarding what measurement bases best serve ‘decision usefulness’ and ‘stewardship’ roles are therefore far from settled. Measurement bases utilised within financial reporting standards LO6.2 As already indicated, accounting standards issued by the IASB, and therefore used within many countries globally, use a variety of measurement bases. We have noted that this has been referred to as a mixed measurement model of accounting. While a mixed measurement model provides flexibility for organisations to select those accounting methods that most efficiently represent the underlying facts, it does make comparability between organisations difficult. It also provides managers with the ability to select accounting methods in a manner driven more by opportunism than a desire to produce representationally faithful accounts – something we explore more in Chapter 8. As an example of how comparability between organisations can be difficult, we can consider the measurement rules applicable to property, plant and equipment as reflected in IAS 16 Property, Plant and Equipment. These rules are reflected in Figure 6.3. As Figure 6.3 shows, when it comes to property, plant and equipment we effectively have a mixed measurement model available within the one accounting standard. When items are originally recognised (perhaps on the date of acquisition), they are to be measured at ‘cost’ (with the components of cost being described within the accounting standard). ‘Cost’ on the date of acquisition would often also be the same as fair value. As paragraph 4 of IASB (2013a) states: Most transactions that result in recognition of assets and liabilities involve unrelated parties that are not in financial distress or another form of duress. In such transactions the value of the consideration given is normally equal to the value of the consideration received, and that amount is presumed to be the fair value. Because in most cases, cost is the fair value of the consideration given or received, cost and fair value often are the same at the recognition date. However, the two will begin to diverge immediately, which is why many of the most contentious measurement issues relate to subsequent measurement. For property, plant and equipment, following initial recognition, the organisation then, in accordance with IAS 16, has a choice to use either the ‘cost model’ or the ‘revaluation model’. Where the revaluation model is chosen then the measurement basis to be employed subsequent to initial 4 The IASB Conceptual Framework for Financial Reporting is explored in depth in Chapter 7. As that chapter discusses, the two fundamental qualitative characteristics that useful financial information possesses are relevance and representational faithfulness – both of which are required before financial information can be considered to be useful. 227 Financial Accounting Theory FIGURE 6.3 Measurement rules for property, plant and equipment At time of initial acquisition Item to be measured at ‘cost’ Measurement subsequent to initial recognition or Cost model Revaluation model Yes After recognition as an asset, an item of property, plant and equipment shall be carried at its cost less any accumulated depreciation and any accumulated impairment losses. The fair value of items of plant and equipment is their market value determined by reference to quoted prices in active markets. Referred to as ‘mark-to-market’. Is market-based evidence available? No The entity will need to estimate fair value by using unobservable inputs within a valuation model. Referred to as ‘mark-to-model’. recognition is ‘fair value’. Hence, at this point we can see there are problems of comparability – some companies might use ‘cost’ and others ‘fair value’ and this will impact numbers such as ‘total assets’ and will also impact various income and expense items, such as depreciation expenses, impairment losses, and gain or loss on disposal of the item. Hence, difficulties will arise in comparing the financial position and financial performance of an organisation that uses the cost model with an organisation that uses the revaluation model. Further complicating matters, an individual organisation can use the cost model for some classes of property, plant and equipment, and the ‘revaluation model’ for other classes. This gives rise to the additivity problem – within a single reporting entity some classes of property, plant and equipment might be measured at cost while other classes might be measured at fair value, meaning that any total for property, plant and equipment provides a number that is neither based on cost or fair value, but a mixture of both. Whether such a total would be relevant or meaningful to many report readers is questionable. Also, as Figure 6.3 shows, when the ‘revaluation model’ is chosen, how fair value is determined will be dependent upon whether market-based evidence of prices is available. If there is an active market for the item, with many similar items being traded, then the market price can be fairly objectively determined. However, if an active market does not exist, then the accounting standard allows fair value to be determined by use of a valuation model, and this will require various judgments to be made. Hence, even when fair value is used as the basis of measurement, there can be a mixture of methods used to determine fair value. 228 Measurement issues: accounting for the effects of changing prices and markets CHAPTER 6 REFLECTION QUESTION 6.2 Revaluation of assets and the implications for reported profits Question Why will reported profits or losses change as a result of an upward revaluation of an asset, and if they do, so what? Solution To answer this question, let us consider an example. An organisation has an item of machinery with a cost of $10 million and accumulated depreciation of $1 million (therefore having a carrying amount of $9 million). It has an expected remaining useful life of nine years with no expected residual value at the end of its useful life. It is assessed as having a fair value of $15 million and will be revalued. Other comprehensive income As a result of revaluing the asset to its fair value, there will be an increase in the carrying amount of the asset by $6 million. This increment would be recorded, pursuant to IAS 16, as part of ‘other comprehensive income’ and not part of profits. Nevertheless, ‘comprehensive income’, which is the sum of ‘profit or loss’ and ‘other comprehensive income’, will increase by the $6 million. Depreciation expense Had the revaluation not occurred, depreciation would be $9m ÷ 9 = $1m. Following the revaluation, the depreciation expense will be $15m ÷ 9 = $1.67m. Therefore, the revaluation will cause a reduction in profits due to the higher depreciation expenses. Profit on sale If the revalued asset is sold one year after revaluation for $16 million, then the profit on sale will equal the sale price less the carrying amount of the asset which equals $16m– (15m– $1.67m) = $2.67m. Had no revaluation been made, the profit on sale would have been $16m – $8m = $8m. Therefore, as a result of the revaluation, the profit on sale of the asset is lower. Reflection So what? So, while the revaluation led to an increase in ‘total other comprehensive income’ in the year of revaluation, it led to a subsequent increase in depreciation expenses (thereby reducing reported profits) and a reduction in profit on sale (also reducing reported profits relative to using historical cost). However, following the upward revaluation, the reported assets would be higher, as would be equity. Pursuant to IFRS, ‘profit or loss’ and ‘total other comprehensive income’ shall be presented separately with the total being ‘comprehensive income for the period’. Many contractual agreements are tied to reported profits. For example, managers are often paid a bonus linked to profits, and managers frequently negotiate borrowing agreements that utilise measures of profits – such as interest coverage clauses (which require profit to exceed interest expenses by an agreed number of times). Therefore, there can potentially be adverse contractual implications associated with a revaluation, as revaluations tend to lead to a reduction in reported profits, and measures of profits are often used within accounting-based contracts. Lending agreements often have restrictions, such as debt to asset agreements which stipulate that debt is not to exceed a certain percentage of assets. An upward revaluation can tend to reduce the possibility of organisations breaching such restrictions. Therefore, from a contracting perspective, whether a revaluation is undertaken can have cash-flow implications for an organisation. Further, the market often has expectations about what the reported profits will be for an organisation. Managers also often make profit forecasts. With all this in mind, managers are sometimes motivated to change the timing of any possible asset revaluations, albeit there is a general principle that revaluations should be undertaken objectively, and once an organisation decides to use the ‘revaluation model’, revaluations are to be undertaken regularly. Factors to consider when choosing between alternative measurement bases LO6.1 The IASB and the FASB did, as part of their former joint initiative to develop a revised Conceptual Framework, identify a number of factors that need consideration before a preferred approach (or a number of approaches) to measurement is (are) selected. According to the website of the FASB (2021), five factors that might be considered in selecting from among alternative measurement bases are: 1 Value/flow weighting and separation. The relative importance to users of information about the current value of the asset or liability versus information about the cash flows generated by the item, as well as the ease and precision with which the flows can be separated from the value changes (an indication of relevance) 229 Financial Accounting Theory 2 Confidence level. The level of confidence that can be placed on alternative measurements as representations of the asset or liability being measured (an indication of faithful representation) 3 The measurement of similar items. Items of a similar nature should be measured in similar ways (an indication of comparability) 4 The measurement of items that generate cash flows together. Items that generate cash flows as a unit should be measured the same way (an indication of understandability) 5 Cost-benefit. An assessment of the ratio of the benefits that would be derived from alternative measurements to the costs of preparing those measurements (an indication of the primary limiting factor in financial reporting). As we can see from this list, there are a variety of issues that require consideration before standard-setters, such as the FASB or IASB, believe that they can favour particular measurement bases in preference to others. Some of these issues are quite complicated. The IASB and the FASB do not overwhelmingly favour one basis of measurement in preference to other alternatives due to a view that different measurement techniques will be appropriate in different circumstances. Limitations of historical cost accounting in times of rising prices LO6.3 LO6.4 LO6.5 LO6.6 Until recent decades, historical cost was the dominant method used to measure assets and liabilities for financial reporting purposes. That is, while fair value is currently the measurement method to be applied in many financial reporting standards, this requirement is a relatively recent phenomenon. For many years, historical cost was the major required method for measurement of assets and liabilities. Nevertheless, historical cost is still required, or allowed, in a number of current accounting standards. Where the historical cost basis of measurement is used, the assets and liabilities will be measured on the basis of the transactions that occurred in the past – hence the name ‘historical cost’. The IASB Conceptual Framework (IASB, 2022c) provides a useful definition of historical cost, this being: 6.4 Historical cost measures provide monetary information about assets, liabilities and related income and expenses, using information derived, at least in part, from the price of the transaction or other event that gave rise to them. Unlike current value, historical cost does not reflect changes in values, except to the extent that those changes relate to impairment of an asset or a liability becoming onerous (see paragraphs 6.7(c) and 6.8(b)). 6.5 The historical cost of an asset when it is acquired or created is the value of the costs incurred in acquiring or creating the asset, comprising the consideration paid to acquire or create the asset plus transaction costs. The historical cost of a liability when it is incurred or taken on is the value of the consideration received to incur or take on the liability minus transaction costs. Over time, criticisms of historical cost accounting have been raised by a number of notable scholars, particularly in relation to its inability to provide useful information in times of rising prices. That is, its ‘relevance’ was questioned. For example, criticisms were raised by Sweeney, MacNeal, Canning and Paton in the 1920s and 1930s. From the 1950s, the level of criticism increased, with notable academics (such as Chambers, Sterling, Edwards and Bell) prescribing 230 Measurement issues: accounting for the effects of changing prices and markets CHAPTER 6 different models of accounting that they considered provided more useful information than was available under conventional historical cost accounting. Such work continued through to the early 1980s, but declined thereafter as levels of inflation throughout the world began to drop. Subsequently, the debate changed to focus on the use of current market values – known as fair values (supposedly reflecting current market conditions at the end of the reporting period) – for valuing assets, rather than amending historic costs simply to take account of inflation.5 Across time, criticisms of historical cost appear to have been accepted by accounting regulators, at least on a piecemeal basis. In recent years, for example, various accounting standards have been released that require or permit the application of fair values when measuring assets. Historical cost accounting assumes that money holds a constant purchasing power. As Elliot (1986, p. 33) states: An implicit and troublesome assumption in the historical cost model is that the monetary unit is fixed and constant over time. However, there are three components of the modern economy that make this assumption less valid than it was at the time the model was developed.6 One component is specific price-level changes, occasioned by such things as technological advances and shifts in consumer preferences; the second component is general price-level changes (inflation); and the third component is the fluctuation in exchange rates for currencies. Thus, the book value of a company, as reported in its financial statements, only coincidentally reflects the current value of assets. Again, it is emphasised that under our current financial reporting standards, many assets can or must be measured at historical cost. (For example, inventory must be measured at cost – or net realisable value if it is lower – and property, plant and equipment can be valued at cost where an entity has adopted the ‘cost model’ for a class of property, plant and equipment pursuant to IAS 16.) Measures such as the lower of cost and net realisable value can perhaps be justified in terms of conservatism but are very difficult to justify in terms of decision usefulness. Why do I need to know about the limitations of historical cost? Financial accounting once relied almost entirely on the use of historical costs. To understand the history of financial accounting, we therefore need to understand what ‘historical cost’ represents. Historical costs are still used in relation to various assets and liabilities. Therefore, readers of financial statements need to understand what the associated numbers represent and what are the limitations inherent in such numbers. Further, while there has been an ongoing movement towards the use of fair values rather than historical costs, there has remained debate about whether fair value measurements are more relevant for stakeholders’ decision making relative to historical costs. 5 6 There has also been much debate about whether Why managers’ ‘stewardship’ over the resources that have been entrusted to them is best demonstrated through the use of historical costs or fair values. To understand this debate, we need to understand the strengths and limitations of historical costs and other bases of measurement, such as fair value. Also, if we work as researchers, regulators or teachers of financial accounting, we need to understand the strengths and weaknesses of alternative measurement approaches so that we are able to provide proper advice and guidance in relation to alternative approaches to measurement. For example, there is a great deal of debate about whether inventory measurement rules (which require inventory to be measured at the lower of cost and net realisable value pursuant to IAS 2) provide relevant information in situations where the market (fair) value of the inventory greatly exceeds its cost. As indicated in Chapter 3, the historical cost method of accounting was documented as early as 1494 by the Franciscan monk Pacioli in his famous work Summa de Arithmetica, Geometrica, Proportioni et Proportionalita. 231 Financial Accounting Theory While there was much criticism of historical cost accounting during the high-inflation periods of the 1970s and 1980s, there were also many people who supported historical cost accounting. The practice of financial accounting used today still utilises historical cost accounting. Hence, the accounting profession and reporting entities have tended to maintain at least partial support for the historical cost approach. The very fact that historical cost accounting has continued to be applied by business entities for certain items has been used by a number of academics to support its continued use (which in a sense is a form of accounting-Darwinism perspective – the view that those things that are most efficient and effective will survive over time). For example, Mautz (1973) states: Accounting is what it is today not so much because of the desire of accountants as because of the influence of businessmen. If those who make management and investment decisions had not found financial reports based on historical cost useful over the years, changes in accounting would long since have been made.7,8 It has been argued (for example, Chambers, 1966) that historical cost accounting information suffers from problems of irrelevance in times of rising prices. That is, it is questioned whether it is useful to be informed that something cost a particular amount many years ago when its current value (as perhaps reflected by its replacement cost, or current market value) might be considerably different. It has also been argued that there is a real problem of additivity. At issue is whether it is logical to add together assets acquired at cost in different periods when those assets were acquired with dollars of different purchasing power.9 Again, we need to remember that there are still many assets and liabilities measured at historical costs, so many of these concerns expressed decades ago are still pertinent today. In countries that have adopted IFRS, organisations are permitted to revalue their non-current assets. What often happens, however, is that different assets are revalued in different periods (with the local currency – for example, dollars or euros – having different purchasing power in each period), yet the revalued assets might all be added together, along with assets that have continued to be valued at cost, for the purposes of balance sheet (also known as the statement of financial position) disclosure.10 However, because something continues to be used does not mean that there is nothing else that might not be better. This is a common error made by proponents of decision usefulness studies. Such studies attempt to provide either support for, or rejection of, something on the basis that particular respondents or users indicated that it would, or would not, be useful for their particular purposes. Often there are things that might be more ‘useful’ – but they are unknown by the respondents. As Gray, Owen and Adams (1996, p. 75) state: ‘Decision usefulness purports to describe the central characteristics of accounting in general and financial statements in particular. To describe accounting as useful for decisions is no more illuminating than describing a screwdriver as being useful for digging a hole – it is better than nothing (and therefore “useful”) but hardly what one might ideally like for such a task.’ 8 Reflective of the lack of agreement in the area, Elliot (1986) adopts a contrary view. Still relying on metaphors associated with evolution, Elliot (p. 35) states: ‘There is growing evidence in the market place … that historical cost-basis information is of ever declining usefulness to the modern business world. The issue for the financial accounting profession is to move the accounting model toward greater relevance or face the fate of the dinosaur and the messenger pigeon.’ 9 Again, under existing accounting standards, assets such as property, plant and equipment can be measured at fair value or at cost. IAS 16 gives reporting entities the choice between applying the fair value model or the cost model to the different classes of property, plant and equipment. Hence, we are currently left with a situation where, even within a category of assets (for example, property, plant and equipment), some assets might be measured at cost while others might be measured at fair value. 10 In relation to property, plant and equipment, IAS 16 requires that where revaluations to fair value are undertaken, the revaluations must be made with sufficient regularity to ensure that the carrying amount of each asset in the class does not differ materially from its fair value at the end of the reporting period. Nevertheless, there will still be instances where some assets have not been revalued for three to five years but they will still be aggregated with assets that have been recently revalued. 7 232 Measurement issues: accounting for the effects of changing prices and markets CHAPTER 6 There is also an argument that methods of accounting that do not take account of changing prices, such as historical cost accounting, can tend to overstate profits in times of rising prices, and that distribution to shareholders of historical cost profits can actually lead to an erosion of operating capacity. For example, assume that a company commenced operations at the beginning of the year with $100 000 in inventory comprising 20 000 units at $5.00 each. If at the end of the reporting period all the inventory had been sold, there were assets (cash) of $120 000 and throughout the year there had been no contributions from owners, no borrowings and no distributions to owners, then profit under an historical cost system would be $20 000. If the entire profit of $20 000 was distributed to owners in the form of dividends, the financial capital would be the same as it was at the beginning of the year. Financial capital would remain intact.11 However, if prices had increased throughout the period, the actual operating capacity of the entity may not have remained intact. Let us assume that the company wishes to acquire another 20 000 units of inventory after it has paid $20 000 in dividends, but finds that the financial year-end replacement cost has increased to $5.40 per unit. The company will be able to acquire only 18 518 units with the $100 000 it still has available. By distributing its total historical cost profit of $20 000, with no adjustments being made for rising prices, the company’s ability to acquire goods and services has fallen from one period to the next. Some advocates of alternative approaches to accounting would prescribe that the profit of the period is more accurately recorded as $120 000 less 20 000 units at $5.40 per unit, which equals $12 000. That is, if $12 000 is distributed to owners in dividends, the company can still buy the same amount of inventory (20 000 units) as it had at the beginning of the period – its purchasing power remains intact.12 Despite the problems associated with measuring inventory at historical cost, organisations using IFRS are still required to measure their inventory at cost (or net realisable value if it is lower than cost) pursuant to IAS 2. In relation to the treatment of changing prices, we can usefully, and briefly, consider IAS 41 Agriculture. IAS 41 provides the measurement rules for biological assets (for example, for grapevines or cattle). The accounting standard requires that changes in the fair value of biological assets from period to period be treated as part of the period’s profit or loss. In the development of the accounting standard, there were arguments by some researchers (Roberts, Staunton and Hagan, 1995) that the increases in fair value associated with changing prices should be differentiated from changes in fair value that are due to physical changes (for example, changes in the size or number of the biological assets). The argument was that only the physical changes should be treated as part of profit or loss. Although IAS 41 treats the total change in fair value as part of income, it is interesting to note that IAS 41 ‘encourages’ disclosures that differentiate between changes in the fair values of the biological assets that are based upon price changes, and those based on physical changes. As paragraph 51 of IAS 41 (IASB, 2022a) states: The fair value less costs to sell of a biological asset can change due to both physical changes and price changes in the market. Separate disclosure of physical and price While it might be considered that measuring inventory at fair value would provide relevant information, IAS 2 Inventories prohibits the revaluation of inventory. Specifically, IAS 2 still requires inventory to be measured at the lower of cost and net realisable value. 12 In some countries, such as the United States, an inventory cost-flow assumption based on the last-in-firstout (LIFO) method can be adopted (this cost-flow assumption is not allowed under IAS 2). The effect of employing LIFO is that cost of goods sold will be determined on the basis of the latest cost, which in times of rising prices will be higher, thereby leading to a reduction in reported profits. This does provide some level of protection (although certainly not complete) against the possibility of eroding the real operating capacity of the organisation. 11 233 Financial Accounting Theory changes is useful in appraising current period performance and future prospects, particularly when there is a production cycle of more than one year. In such cases, an entity is encouraged to disclose, by group or otherwise, the amount of the change in fair value less costs to sell included in profit or loss due to physical changes and due to price changes. This information is generally less useful when the production cycle is less than one year (for example, when raising chickens or growing cereal crops). In relation to the above disclosure guidance, it is interesting to consider why the regulators considered that financial statement users would benefit from separate disclosure of price changes and physical changes in relation to agricultural assets when similar suggestions are not provided within other accounting standards relating to other categories of assets. This is somewhat inconsistent and not justifiable from a conceptual perspective. Returning to the use of historical cost in general, it has also been argued that historical cost accounting distorts the current year’s financial results by including in the current year’s income holding gains that actually accrued in previous periods.13 For example, some assets may have been acquired at a very low cost in a previous period (and perhaps in anticipation of future price increases pertaining to the assets), yet under historical cost accounting the gains attributable to such actions will only be recognised in the subsequent periods when the assets are ultimately sold. As an illustration, let us assume that a reporting entity acquired some land in 2019 for $1 000 000. Its fair value increased to $1 300 000 in 2023 and then $1 700 000 in 2026. A decision is made to sell the land in 2027 for its new fair value of $1 900 000. If the land had been measured at cost, the entire profit of $900 000 would be shown in the 2027 financial year even though the increase in fair value accrued throughout the previous eight years. Arguably, placing all the gain in the last year’s profits distorts the results of that financial period as well as the results of preceding periods. Another potential problem of historical cost accounting is that it can lead to a distortion of ‘return-on-asset’ measures. For example, consider an organisation that acquired some machinery for $1 million and returned a profit of $100 000. Such an organisation would have a return on asset of 10 per cent. If another organisation later acquired the same type of asset at $2 million (due to rising prices) and generated a profit of $150 000, then on the basis of return on assets the second organisation would appear less efficient, pursuant to historical cost accounting. There is a generally accepted view that dividends should be paid only from profits (and this is enshrined within the corporations laws of many countries). However, one central issue relates to how we measure ‘profits’. There are various definitions of profits. One famous definition, provided by Hicks (1946), is that profits (or ‘income’, as he referred to it) is the maximum amount that can be consumed during a period while still expecting to be as ‘well off’ at the end of the period as at the beginning of the period. Any consideration of ‘well-offness’ relies on a notion of capital maintenance – but which one? Different notions will provide different perspectives of profit. There are a number of perspectives of capital maintenance. One version of capital maintenance is based on maintaining financial capital intact, and this is the position taken in historical cost accounting. Under historical cost accounting, dividends should normally be paid only to the extent that the payment will not erode financial capital, as illustrated in the earlier example of a company needing to replace 20 000 units of inventory where $20 000 is distributed to owners in the form of dividends and no adjustment is made to take account of changes in prices and the related impact on the purchasing power of the entity. 13 234 Holding gains are those that arise while an asset is in the possession of the reporting entity. Measurement issues: accounting for the effects of changing prices and markets CHAPTER 6 Another perspective of capital maintenance is one that aims at maintaining purchasing power intact.14 Under this perspective, historical cost accounts are adjusted for changes in the purchasing power of the dollar (typically by use of the price index), which, in times of rising prices, will lead to a reduction in income relative to the income calculated under historical cost accounting. As an example, under general price level adjustment accounting (which is considered more fully later in the chapter), the historical cost of an item is adjusted by multiplying it by the chosen price index at the end of the current period, divided by the price index at the time the asset was acquired. For example, if some land, which was sold for $1 200 000, was initially acquired for $1 000 000 when the price index was 100, and the price index at the end of the current period is 118 (reflecting an increase in prices of 18 per cent), the adjusted cost would be $1 180 000. The adjusted profit on sale would be $20 000 (compared with an historical cost profit of $200 000).15 What should be realised is that under this approach to accounting where adjustments are made by way of a general price index, the value of $1 180 000 will not necessarily (except due to chance) reflect the current market value of the land. Various assets will be adjusted using the same general price index. Use of actual current values (as opposed to adjustments to historical cost using price indices) is made under another approach to accounting which seeks to provide a measure of profits which, if distributed, maintains physical operating capital intact. This approach to accounting (which could be referred to as current cost accounting) relies on the use of current values, which could be based on present values, entry prices (for example, replacement costs) or exit prices. Reflective of the attention that the impact of inflation was having on financial statements, Figure 6.4 is an article that appeared in The Australian in April 1975 (a period of high inflation of about 17 per cent and a time when debate in this area of accounting was widespread). In the discussion that follows, a number of different approaches to undertaking financial accounting in times of rising prices are considered. This discussion is by no means exhaustive but does give an insight into some of the models that have been prescribed by various accounting researchers.16 It also provides us with useful insights into many of the issues and suggestions that have been raised over the years, all of which had the intention of improving our system of financial reporting. By reading the following material, it allows us to place into context many of the judgements currently being made by the IASB and FASB in their work to determine appropriate bases of asset and liability measurement. Gray, Owen and Adams (1996, p. 74) also provide yet another concept of capital maintenance – one that includes ‘environmental capital’. They state, ‘it is quite a simple matter to demonstrate that company “income” contains a significant element of capital distribution – in this case “environmental capital”. An essential tenet of accounting is that income must allow for the maintenance of capital. Current organisational behaviour clearly does not maintain environmental capital and so overstates earnings. If diminution of environmental capital is factored into the income figure it seems likely that no company in the western world has actually made any kind of a profit for many years.’ This issue is considered further in Chapter 10. 15 Hence, if $20 000 is distributed as dividends, the entity would still be in a position to acquire the same land that it had at the beginning of the period (assuming that actual prices increased by the same amount as the particular price index used). 16 For example, we will not be considering one approach to determining income based on present values, which did not have wide support but would be consistent with Hicks’ income definition (and which might be considered as a true income approach). A present value approach would determine the discounted present value of the organisation’s assets and liabilities and use this as the basis for the financial statements. Under such an approach, the calculated value of assets will depend on various expectations, such as expectations about the cash flows the asset would return through its use in production (its value in use) or its current market value (value in exchange). Such an approach relies on many assumptions and judgements, including the determination of the appropriate discount rate. Under a present value approach to accounting, profit would be determined as the amount that could be withdrawn yet maintain the present value of the net assets intact from one period to the next. 14 235 Financial Accounting Theory FIGURE 6.4 An insight into some past professional initiatives in the area of accounting for changing prices . Call for inflated books Brian Mahoney With their capitalist ship slowly sinking from the weight of inflation, company directors and accountants are at last doing something about the problem. They are not exactly finding a way to overcome it, but they have decided on a way of recording the effects of inflation in company accounts. Members of the Institute of Chartered Accountants in Australia at the annual Victorian congress last weekend and a panel of directors at the Institute of Directors in Australia in Sydney on Wednesday called for the introduction of some form of accounting for inflation. At present there is a preliminary exposure draft of one such form of accounting – Changes in the Purchasing Power of Money– distributed by the Institute of Chartered Accountants and the Australian Society of Accountants. Under CPP, figures are adjusted by an index to a constant purchasing power. Another such draft of another form of inflation accounting– Replacement Cost– is expected within a few months and hopefully some decision will be made after that as to what form of accounting will be encouraged. RC accounting aims at showing the replacement value of non-monetary assets expected to be replaced, with consequential adjustments to profits. As the ICAA pointed out at its Victorian meeting, a company reporting a steady profit in times of 20 per cent inflation would show adjusted earnings actually 20 per cent lower under the new schemes. The present historical cost accounting, where companies compared different value dollars without converting them by any ‘inflation exchange rate’, has led some companies effectively to pay dividends out of capital. Over 200 directors at the institute’s seminar at the Wentworth Hotel, Sydney, were told until companies start to show the real effect of inflation on their earnings they could not hope to see any government moves similar to that of Finland where an index of inflation is declared each quarter. Mr R. N. H. Denton, an accountant with Irish, Young and Outhwaite, told them: ‘I prophesise that more and more companies will be seeking capital issues merely to maintain their level of operations. ‘This is in a capital market where confidence has been severely shaken and which is in doubt as to whether industry can now earn an adequate return to service capital in real terms. ‘To add to the problem, no recognition is given to our taxation policy to the effect that inflation exerts. The rate of 45 per cent, after a hopelessly inadequate reduction of 2.5 per cent, is really significantly higher on real earnings,’ he said. Source: Mahoney (1975). The use of this work has been licensed by Copyright Agency except as permitted by the Copyright Act, you must not re-use this work without the permission of the copyright owner or Copyright Agency. Current purchasing power accounting A method of preparing financial statements wherein adjustments are made to non-monetary assets – initially recorded at historical cost – to reflect changes in the value of money as reflected by changes in general price level indices. Gains and losses recognised will relate to the holding of net monetary assets. 236 LO6.2 LO6.4 LO6.5 Current purchasing power accounting (CPPA) A model of financial accounting known as current purchasing power accounting (CPPA, or, as it is also called, general purchasing power accounting, general price level accounting or constant dollar accounting) can be traced to the early works of such authors as Sweeney (1964, but originally published in 1936) and was subsequently favoured by a number of other researchers. CPPA has also, at various times, been supported by professional accounting bodies throughout the world (but more in the form of supplementary disclosures to accompany financial statements prepared under historical cost accounting principles). CPPA was developed on the basis of a view that, Measurement issues: accounting for the effects of changing prices and markets CHAPTER 6 in times of rising prices, if an entity were to distribute unadjusted profits based on historical costs the result could be a reduction in the real value of an entity – that is, in real terms the entity could risk distributing part of its capital. In considering the development of accounting for changing prices, the majority of research initially related to restating historical costs to account for changing prices by using historical cost accounts as the basis, but restating the accounts by use of particular price indices. The literature then tended to move towards current cost accounting (which is considered later in the chapter), which changed the basis of measurement to current values as opposed to restated historical values. Consistent with this trend, the accounting profession initially tended to favour price-level-adjusted accounts (using indices), but then tended to switch to current cost accounting, which required the entity to find the current values of the individual assets held by the reporting entity.17,18 CPPA, with its reliance on the use of indices, was generally accepted as being easier and less costly to apply than methods that rely on current valuations of particular assets.19 It was initially considered by some people that it would be too costly and perhaps unnecessary to attempt to find current values for all the individual assets. Rather than considering the price changes of specific goods and services, it was suggested on practical grounds that price indices be used. Calculating indices When applying general price level accounting, a price index must be applied. A price index is a weighted average of the current prices of goods and services relative to a weighted average of prices in a prior period, often referred to as a ‘base period’. Price indices may be broad or narrow – they may relate to changes in prices of particular assets within a particular industry (a specific price index) or they might be based on a broad cross-section of goods and services that are consumed (a general price index, such as the Consumer Price Index [CPI] in Australia and the United Kingdom). But which price indices should be used? Should we use changes in a general price index (for example, as reflected in Australia or the United Kingdom by the CPI) or should we use an index that is more closely tied to the acquisition of production-related resources? There is no clear answer. From the shareholders’ perspective, the CPI may more accurately reflect their buying pattern – but prices will not change by the same amount for shareholders in different locations. Further, not everybody will have the same consumption patterns as is assumed when constructing a particular index. The choice of an index can be very subjective. Where CPPA has been recommended by particular professional bodies, CPI-type indices have been suggested. Because CPPA relies on the use of price indices, it is useful to consider how such indices are constructed. To explain one common way that indices might be constructed, we can consider the following example which is consistent with how the Australian and UK CPI is determined. Let us assume that there are three types of commodities (A, B and C) that are consumed in the base year quantities and at the prices shown in Table 6.1. Price index A weighted average of the current prices of goods and services relative to a weighted average of prices in a prior period, often referred to as a ‘base period’. General price index A price index calculated for a generally consumed bundle of goods. An example would be a consumer price index. Current values could be based on entry or exit prices. As we will see, there was much debate as to which ‘current’ value was most appropriate. 18 The professional support for the use of replacement costs appeared to heighten around the time of the 1976 release of ASR 190 within the United States. 19 However, many questions can be raised with regard to what the restated value actually represents after being multiplied by an index such as the general rate of inflation. This confusion is reflected in studies that question the relevance of information restated for changes in purchasing power. 17 237 Financial Accounting Theory TABLE 6.1 Example of three types of commodities, with base prices and quantities consumed Commodity A Year Commodity B Commodity C Price ($) Quantity Price ($) Quantity Price ($) Quantity Base year (2026) 10.00 100 15.00 200 20.00 250 2027 12.00 15.50 21.20 From the data in Table 6.1, we can see that prices have increased. The price index in the base year is frequently given a value of 100 and it is also frequently assumed that consumption quantities (or proportions between the different commodities) thereafter remain the same, such that the price index at the end of year 2027 would be calculated as: (12.00 × 100) + (15.50 × 200) + (21.20 × 250) (10.00 × 100) + (15.00 × 200) + (20.00 × 250) = 106.67100 100 × Monetary assets Monetary assets are assets that remain fixed in terms of their monetary value, for example cash and claims to a specified amount of cash (such as accounts receivable and investments that are redeemable for a set amount of cash). These assets will not change their monetary value as a result of inflation. Non-monetary assets Can be defined as those assets whose monetary equivalents will change over time as a result of inflation, and would include such things as property, plant and equipment and inventory. Monetary liabilities Liabilities that remain fixed in terms of their monetary value and will not change their monetary value as a result of inflation. Most liabilities are monetary liabilities. Non-monetary liabilities Liabilities that require the transfer of goods or services in the future, the monetary value of which can change across time. Net monetary assets Are monetary assets less monetary liabilities. 238 From the above calculations, we can see that the prices within this particular ‘bundle’ of goods have been calculated as rising on average by 6.67 per cent from the year 2026 to the year 2027. The reciprocal of the price index represents the change in general purchasing power across the period. For example, if the index increased from 100 to 106.67, as in the above example, the purchasing power of the currency would be 93.75 per cent (100/106.67) of what it was previously. That is, the purchasing power of the currency has decreased. Performing current purchasing power adjustments When applying CPPA, all adjustments are done at the end of the period, with the adjustments being applied to accounts prepared under the historical cost convention. When considering changes in the value of assets as a result of changes in the purchasing power of money (due to inflation), it is necessary to consider monetary assets and non-monetary assets separately. Monetary assets are those assets that remain fixed in terms of their monetary value, for example cash and claims to a specified amount of cash (such as trade debtors and investments that are redeemable for a set amount of cash). These assets will not change their monetary value as a result of inflation. For example, if we are holding $10 in cash and there is rapid inflation, we will still be holding $10 in cash, but the asset’s purchasing power will have decreased over time. Non-monetary assets can be defined as those assets whose monetary equivalents will change over time as a result of inflation, and would include such things as property, plant and equipment and inventory. For example, inventory might cost $100 at the beginning of the year, but the same inventory could cost, say, $110 at the end of the year due to inflation. Relative to monetary assets, the purchasing power of non-monetary assets is assumed to remain constant even in the presence of inflation. Most liabilities are fixed in monetary terms (there is an obligation to pay a pre-specified amount of cash at a particular time in the future independent of the change in the purchasing power of the particular currency) and hence liabilities would typically be considered as monetary items – that is, as monetary liabilities. Non-monetary liabilities, on the other hand, although less common, would include obligations to transfer goods or services in the future, items that could change in terms of their monetary equivalents. Net monetary assets would be defined as monetary assets less monetary liabilities. In times of inflation, holders of monetary assets will lose in real terms as a result of holding the monetary assets, as the assets will have less purchasing power at the end of the period relative to what they had at the beginning of the period (and the greater the level of general price increases, the greater the purchasing power losses). Conversely, holders of monetary liabilities will gain, given that the Measurement issues: accounting for the effects of changing prices and markets CHAPTER 6 amount they have to repay at the end of the period will be worth less (in terms of purchasing power) than it was at the beginning of the period. Let us consider a simple example to demonstrate how gains and losses might be calculated on monetary items (and under CPPA, gains and losses will relate to net monetary assets rather than net non-monetary assets). Let us assume that Organisation A holds the assets and liabilities shown in Table 6.2 at the beginning of the financial year. TABLE 6.2 Assets and liabilities held by Organisation A at the beginning of the financial year $ Current Assets Cash 6 000 Inventory 9 000 15 000 Non-current Assets Land 10 000 Total Assets 25 000 Liabilities Bank loan 5 000 Owners’ Equity 20 000 Let us also assume that the general level of prices has increased 5 per cent since the beginning of the year and let us make a further simplifying assumption that the company did not trade during the year and that the same assets and liabilities were in place at the end of the year as at the beginning. Assuming that general prices, perhaps as reflected by changes in the CPI, have increased by 5 per cent, the CPI-adjusted values are given in Table 6.3. TABLE 6.3 CPI-adjusted values for Organisation A’s assets and liabilities at end of financial year Unadjusted $ Price adjustment factor $ Adjusted $ Current Assets Cash Inventory 6 000 9 000 6 000 0.05 9 450 15 450 15 000 Non-current Assets Land 10 000 Total Assets 25 000 25 950 Bank loan 5 000 5 000 Owners’ Equity 20 000 20 950 0.05 10 500 Liabilities Again, monetary items are not adjusted by the change in the particular price index because they will retain the same monetary value regardless of inflation. Under CPPA there is an assumption that the organisation has not gained or lost in terms of the purchasing power attributed to the non-monetary assets, but, rather, it will gain or lose in terms of purchasing power changes attributable to its holdings of the net monetary assets. In the above example, to be as ‘well off’ at the end of the period the entity would need $21 000 in net assets (which equals retained 239 Financial Accounting Theory earnings × 1.05 = $20 000 × 1.05) to have the same purchasing power as it had one year earlier (given the general increase in prices of 5 per cent). In terms of end-of-year dollars, in the above illustration the entity is $50 worse off in adjusted terms (it has net assets with an adjusted value of $20 950, which does not have the same purchasing power as $20 000 did at the beginning of the period). As indicated above, this $50 loss relates to the holdings of net monetary assets and not to the holding of non-monetary assets, and is calculated as the balance of cash, less the balance of the bank loan, multiplied by the general price level increase. That is, ($6000 − $5000) × 0.05. If the monetary liabilities had exceeded the monetary assets throughout the period, a purchasing power gain would have been recorded. If the amount of monetary assets held was the same as the amount of monetary liabilities held, no gains or losses would result. Again, it is stressed that under CPPA no change in the purchasing power of the entity is assumed to arise as a result of holding non-monetary assets. Under general price level accounting, non-monetary assets are restated to current purchasing power and no gain or loss is recognised. Purchasing power losses arise only as a result of holding net monetary assets. As noted at paragraph 7 of Provisional Statement of Standard Accounting Practice 7 (PSSAP 7), issued in the United Kingdom in 1974: Holders of non-monetary assets are assumed neither to gain nor to lose purchasing power by reason only of inflation as changes in the prices of these assets will tend to compensate for any changes in the purchasing power of the pound. An important issue to consider is how the purchasing power gains and losses should be treated for income purposes. Should they be treated as part of the period’s profit or loss, or should they be transferred directly to a reserve? Generally, where this method of accounting was recommended, it was advised that the gain or loss should be included in income. Such recommendations were found in the US Accounting Research Bulletin No. 6 (issued in 1961), in the Accounting Principles Board (APB) Statement No. 3 (issued in 1969 by the American Institute of Certified Public Accountants [AICPA]), in the Financial Accounting Standards Board’s (FASB) exposure draft entitled ‘Financial Reporting in Units of General Purchasing Power’, and within Provisional Statement of Accounting Practice No. 7 issued by the Accounting Standards Steering Committee (UK) in 1974. One main strength of CPPA is its ease of application. The method relies on data that would already be available under historical cost accounting and does not require the reporting entity to incur the cost or effort involved in collecting data about the current values of the various nonmonetary assets. CPI data would also be readily available. However, and as indicated previously, movements in the prices of goods and services included in a general price index might not be reflective of price movements involved in the goods and services in different industries. That is, different industries may be affected differently by inflation. Another possible limitation is that the information generated under CPPA might actually be confusing to users. They might consider that the adjusted amounts reflect the specific value of specific assets (and this is a criticism that can also be made of historical cost information). However, as the same index is used for all assets this will rarely be the case. Another potential limitation considered at the end of the chapter is that various studies (which have looked at such things as movements in share prices around the time of disclosure of CPPA information) have failed to find much support for the view that the data generated under CPPA are relevant for decision making (the information when released caused little if any share price reaction, and some researchers use such results to claim that the information has no relevance to shareholders). Following the initial acceptance of CPPA in some countries in the 1970s, there was a move towards methods of accounting that used actual current values rather than revised values being based on the application of indices. Support for CPPA declined. However, while support for CPPA has declined, and it is not used today, it is nevertheless useful for us to know some of the 240 Measurement issues: accounting for the effects of changing prices and markets CHAPTER 6 arguments that were raised in the past in support of CPPA. With the debates currently going on about ‘measurement’, it is useful to know some of the history of such debates, and some of the alternatives that have been suggested. Some of the arguments in support of CPPA may very well be raised again in the future if inflation ‘takes off’. In the next section, we consider approaches to accounting that relied upon current values, rather than amounts that were adjusted by way of indices. Again, this provides important insights that can also be used in evaluations of fair value accounting – something currently favoured by the IASB and FASB. LO6.2 LO6.4 LO6.5 LO6.6 Current cost accounting Current cost accounting (CCA) is one of the alternatives to historical cost accounting that tended to gain the most acceptance back in the times of high inflation. Notable advocates of the approach included Paton (1922) and Edwards and Bell (1961). Such authors decided to reject historical cost accounting and CPPA in favour of a method that considered actual valuations. As we will see, unlike historical cost accounting, CCA differentiates between profits from trading and those gains that result from holding an asset. Holding gains can be considered as realised or unrealised. If a financial capital maintenance perspective is adopted with respect to the recognition of income, then holding gains or losses will be treated as income. Alternatively, they can be treated as capital adjustments if a physical capital maintenance approach is adopted. Some versions of CCA, such as that proposed by Edwards and Bell, adopt a physical capital maintenance approach to income recognition. In this approach, which determines valuations on the basis of replacement costs,20 operating income represents realised revenues, less the replacement cost of the assets in question. It is considered that this generates a measure of income which represents the maximum amount that can be distributed, while maintaining operating capacity intact. For example, assume that an entity acquired 150 items of inventory at a cost of $10 each and sold 100 of the items for $15 each when the replacement cost to the entity had risen to $12 each. Assume also that the replacement cost of the 50 remaining items of inventory at year end was $14. Under the Edwards and Bell approach, the operating profit that would be available for dividends would be $300, which is 100 × ($15 – $12). There would be a realised holding gain on the goods that were sold, which would amount to 100 × ($12 – $10), or $200, and there would be an unrealised holding gain in relation to closing inventory of 50 × ($14 – $10), or $200. Neither the realised nor the unrealised holding gain would be considered to be available for dividend distribution.21 In undertaking CCA, adjustments are usually made at year end using the historical cost accounts as the basis of adjustments. If the Edwards and Bell approach to profit calculation is adopted, profit is derived after ensuring that the operating capacity of the organisation is maintained intact. Edwards and Bell believe that operating profit is best calculated by using replacement costs.22,23 As noted above, in calculating operating profit, gains that accrue from holding an asset (holding gains) are excluded and are not made available for dividends, although Current cost accounting A method of accounting that measures assets at their current cost and where profits from trading and gains from holding assets (holding gains) are separately disclosed. Holding gains Increases in the value of assets or reductions in the value of liabilities that arise as a result of holding assets or liabilities over time without transforming or modifying them. Financial capital maintenance perspective Under this perspective of capital maintenance, a profit is earned if the amount of net assets at the end of the reporting period exceeds the amount at the beginning of the year, excluding any contributions from, or distributions to, owners. Physical capital maintenance approach Under this perspective, a profit is earned only if the organisation’s productive or operating capacity at the end of the reporting period exceeds the capacity at the beginning of the period, excluding any contributions from, or distributions to, owners. We will also see later in this chapter that there are alternative approaches to current cost accounting that rely on exit (sales) prices. 21 Comparing this approach to profit calculations under historical cost accounting, we see that, if we add CCA operating profit of $300 and the realised holding gain of $200, this will give the same total as we would have calculated for profit under historical cost accounting. 22 In a sense, the Edwards and Bell approach represents a ‘true income’ approach to profit calculation. They believe that profit can only be correctly measured (that is, ‘be true’) after considering the various asset replacement costs. 23 Those who favour a method of profit calculation that requires a maintenance of financial capital (advocates of historical cost accounting) treat holding gains as income, while those who favour a maintenance of physical capital approach to income determination (such as Edwards and Bell) tend to exclude holding gains from income. A physical capital perspective was adopted by most countries in their professional releases pertaining to CCA. 20 241 Financial Accounting Theory they are included when calculating what is referred to as business profit. For example, if an entity acquired goods for $20 and sold them for $30, business profit would be $10, meaning that $10 could be distributed and still leave financial capital intact (this would be the approach taken in historical cost accounting). But if at the time the goods were sold their replacement cost to the entity was $23, then $3 would be considered a holding gain, and to maintain physical operating capacity only $7 could be distributed – current cost profit would be $7. No adjustment is made to sales revenue. This $7 distribution can be compared with what could be distributed under historical cost accounting. Because historical cost accounting adopts a financial capital maintenance approach, $10 could be distributed in dividends, thereby maintaining financial capital (but nevertheless causing an erosion in the operating ability of the organisation). In relation to non-current assets, for the purposes of determining current cost profit, depreciation is based on the replacement cost of the asset. For example, if an item of machinery was acquired in 2026 for $100 000 and had a projected life of 10 years and no salvage value, then, assuming the straight-line method of depreciation is used, its depreciation expense under historical cost accounting would be $10 000 per year. If at the end of 2027 its replacement cost had increased to $120 000, then under current cost accounting a further $2000 would be deducted to determine current cost profit. However, this $2000 would be treated as a realised cost saving (because historical cost profits would have been lower if the entity had not already acquired the asset) and would be recognised in business profit (it would be added back below profit), and the other $18 000 would be treated as an unrealised cost saving and would also be included in business profit. As with CPPA, no restatement of monetary assets is required, as they are already recorded in current dollars and hence in terms of end-of-period purchasing power dollars. Consistent with the CCA model prescribed by Edwards and Bell, all non-monetary assets have to be adjusted to their respective replacement costs. Unlike historical cost accounting, there is no need for inventory cost flow assumptions (such as last-in-first-out, first-in-first-out, weighted average). Business profit shows how the entity has gained in financial terms from the increase in cost of its resources – something typically ignored by historical cost accounting. Differentiating profit from holding gains and losses (both realised and unrealised) has been claimed to enhance the usefulness of the information being provided. Holding gains are deemed to be different from trading income as they are due to market-wide movements, most of which are beyond the control of management. Edwards and Bell (1961, p. 73) state: These two kinds of gains are often the result of quite different decisions. The business firm usually has considerable freedom in deciding what quantities of assets to hold over time at any or all stages of the production process and what quantity of assets to commit to the production process itself ... The difference between the forces motivating the business firm to make profit by one means rather than by another and the difference between the events on which the two methods of making profit depend require that the two kinds of gain be separated if the two types of decisions involved are to be meaningfully evaluated. As with CPPA, the CCA model described above has been identified as having a number of strengths and weaknesses. Some of the criticisms relate to its reliance on replacement values. The CCA model just described uses replacement values, but what is the rationale for replacement cost? Perhaps it is a reflection of the ‘real’ value of the particular asset. If people in the market are prepared to pay the replacement cost, and if we assume economic rationality, then the amount paid must be a reflection of the returns it is expected to generate. However, it might not be worth that amount (the replacement cost) to all organisations – some organisations might not elect to replace a given asset if they have an option. Further, past costs are sunk costs and if the entity were required to acquire new plant it might find it more efficient and less costly to acquire different 242 Measurement issues: accounting for the effects of changing prices and markets CHAPTER 6 types of assets. If it did buy it, this might reflect that it is actually worth much more. Further, replacement cost does not reflect what it would be worth if the organisation decided to sell it. As indicated previously, it has been argued that separating holding gains and losses from other results provides a better insight into management performance, as such gains and losses are due to impacts generated outside the organisation; however, this can be criticised on the basis that acquiring assets in advance of price movements might also be part of efficient operations. Another potential limitation of CCA is that it is often difficult to determine replacement costs. The approach also suffers from the criticism that allocating replacement cost via depreciation is still arbitrary, just as it is with historical cost accounting. An advantage of CCA is better comparability of various entities’ performance, as one entity’s profits are not higher simply because it bought assets years earlier and therefore would have generated lower depreciation under historical cost accounting. Chambers, an advocate of CCA based on exit values, was particularly critical of the Edwards and Bell model of accounting. He states (1995, p. 82) ‘In the context of judgement of the past and decision making for the future, the products of current value accounting of the Edwards and Bell variety are irrelevant and misleading’. Again, while CCA as described above is currently not in use, many of the issues raised are of relevance today in terms of the ongoing discussions being held by accounting standard-setters with respect to developing appropriate accounting measurement bases. For example, today there is still debate about whether replacement costs (entry prices) or fair values in market transactions (exit prices) should be the basis of asset valuation, and whether unrealised holding gains should be included in profit or loss or ‘other comprehensive income’ – issues which were debated decades ago when developing CCA. By knowing about past debates, we can more knowledgeably reflect on current discussions. The next section looks at an alternative accounting model prescribed by Chambers and a number of others – a model that relies on the use of exit values. Exit price accounting: the case of Chambers’ Continuously Contemporary Accounting LO6.2 LO6.4 LO6.5 LO6.6 Exit price accounting has been proposed by researchers such as MacNeal, Sterling and Chambers. It is a form of current cost accounting that is based on valuing assets at their net selling prices (exit prices) at the end of the reporting period and on the basis of orderly sales. Chambers coined the term ‘current cash equivalent’ to refer to the cash that an entity would expect to receive through the orderly sale of an asset, and he had the view that information about current cash equivalents was fundamental to effective decision making. He labelled his method of accounting Continuously Contemporary Accounting, or CoCoA. Although Chambers generated some much-cited research throughout the 1950s (such as Chambers, 1955) a great deal of his work culminated in 1966 with the publication of Accounting, Evaluation and Economic Behavior. This book stressed that the key information for economic decision making relates to capacity to adapt – a function of current cash equivalents. He considered that the balance sheet (statement of financial position) is the prime financial statement which should show the net selling prices of the entity’s as
