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                         Lecture 1
Textbook Reference:
Deegan, C. Australian Financial Accounting 5e, Chapter 2

Financial Accounting Defined
• Financial accounting is a process involving the collection and
  processing of financial information to meet the decision-making
  needs of parties external to the organisation
• Management accounting, in contrast, focuses on providing
  information for decision making by parties within the
   – is largely unregulated
• Financial accounting is heavily regulated, and a great deal of
  regulation changes each year
     Users’ Demand for General-Purpose
              Financial Reports
• Users include:
   – present and potential investors
   – shareholders
   – employees
   – lenders
   – suppliers and other trade creditors
   – customers
   – government and its agencies
   – the public

• Users lack the power to demand specific information to meet
  their needs – hence the need for ‘general purpose financial
     Users’ Demand for General-Purpose
              Financial Reports
• General-purpose financial reports
  – meet the information needs common to users who are
    unable to command the preparation of reports tailored to
    satisfy, specifically, all their information needs
  – Example: financial statements and supporting notes included
    within an annual report presented to shareholders at a
    company’s annual general meeting

• Special-purpose financial reports
   – designed to meet the needs of a specific group or to satisfy
     a specific purpose
   – Example: Bank demanding as part of a loan agreement that
     the borrowing entity provide information about projected
     cash flows
 Sources of external financial reporting
Bodies that formulate and/or enforce accounting regulations:
    In Australia
1. The Australian Securities and Investments Commission
2. The Australian Accounting Standards Board (AASB)
3. The Interpretations Agenda Committee
4. The Financial Reporting Council (FRC)
5. The Australian Stock Exchange (ASX)
    In Fiji
1. Fiji Institute of Accountants (FIA)
2. South Pacific Stock Exchange (SPSE)
3. Capital Markets Development Authority (CMDA)
            Conceptual Framework
• A coherent system of interrelated objectives and fundamentals
  that is expected to lead to consistent standards and that
  prescribes the nature, function and limits of financial accounting
  and reporting
• Central goal in establishing CF is general consensus on
   – scope and objectives of financial reporting
   – qualitative characteristics that financial information should
   – elements of financial reporting
• Provides guidance on key issues, such as objectives,
  qualitative characteristics, definitions and recognition criteria
• We need a conceptual framework of accounting before we start
  developing accounting standards
                 Conceptual Framework
It stipulates:

 Objectives of financial reporting

 Qualitative characteristics of useful information

 Users & their needs

 Elements of financial reporting
    Definition criteria
    Recognition criteria
  Benefits of a Conceptual Framework
• Accounting standards more consistent and logical, because
  they are developed from an orderly set of concepts. In the
  absence of a coherent theory, the development of accounting
  standards could be somewhat ad hoc.

• Increased international comparability of accounting standards

• Should result in the Boards (e.g. IASB, AASB) being more
  accountable for their decisions

• Enhanced process of communication between the Boards and

• More economical accounting standard development
Components of a Conceptual Framework
What are GPFRs and reporting entities?
SAC1—Definition of the Reporting Entity
• Defines general-purpose financial reports (GPFRs)
   – Financial reports intended to meet the information needs
     common to users who are unable to command the
     preparation of reports tailored to their specific needs

   – GPFRs to be produced by entities who have users who
     cannot command the preparation of specific information
      • Such entities are deemed to be ‘reporting entities’
      • An entity in respect of which it its reasonable to expect
        the existence of users who rely on the entity’s general
        purpose financial report for information that will be useful
        to them for making and evaluating decisions about the
        allocation of resources
                     Reporting entity
• If an entity is not deemed to be a ‘reporting entity’ it will not be
  required to produce GPFRs—and not necessarily be required
  to comply with all accounting standards

• Small proprietary companies are frequently not considered to
  be reporting entities—it is assumed that most people who
  require financial information about the entity will be in a position
  to specifically demand it

SAC2—Objective of GPFRs

• To provide relevant and reliable information to assist users to
  make and evaluate decisions about the allocation of scarce
  resources and to allow management and governing bodies to
  discharge their accountability
             Usefulness of GPFR’s
User Group       Areas of interest
Shareholders &   Profitability (ROI, ROE, EPS)
Investors        Dividends (Pay-out)
Lenders          Liquidity (Working Capital)
                 Financial Stability (Gearing)
Suppliers        Liquidity
Customers        Profitability (Gross Profit)
Employees        Profitability (Net Profit)
Regulators       Profitability (ROA)
                 Investment (Asset base)
General Public   Profitability & Tax?
                 Investment & Employment?
                 Debt & Equity?
    Qualitative characteristics of financial
•   Identifies the characteristics of financial information necessary
    to allow users to make and evaluate decisions about the
    allocation of scarce resources

•   Four principal characteristics of financial reporting identified in
    AASB Framework:
    1. understandability
    2. relevance
    3. reliability
    4. comparability
              Qualitative characteristics
•   Understandability
    – information is considered to be understandable if it is likely
      to be understood by users with some business & accounting
•   Relevance
    – if information influences decisions about the allocation of
      scarce resources
    – Information is relevant if it:
    • assists in making predictions about future situations (i.e.
      influences decision-making); or
    • helps to confirm past predictions
•   Reliability
    – faithfully represents the entity’s transactions and events
    – free from bias and undue error (neutrality)
    – verifiability
•   Comparability
    – Requires consistency of measurement & disclosure across
      time and across organisations
              Elements of accounting
• Five elements of accounting are defined in the AASB

   – Assets

   – Liabilities

   – Equity

   – Expenses

   – Income
   Definition and Recognition of Assets
• Definition of Asset (AASB Framework, par. 49)
   – a resource controlled by the entity as a result of past events
      and from which future economic benefits are expected to flow
      to the entity
• Three key characteristics of definition:
   1. There must be future economic benefits
   2. The reporting entity must control the future economic benefits
   3. The transaction or other event giving rise to the control must
      have occurred
• An asset is to be recognized in the financial statements if (AASB
  Framework. par. 83):
   – it is probable that any future economic benefit associated with
      the asset will flow to or from the entity; and
   – the item has a cost or value that can be measured with
Definition and Recognition of Liabilities
• Definition of Liabilities (AASB Framework, par. 49)
   – a present obligation of the entity arising from past events, the
      settlement of which is expected to result in an outflow from the
      entity of resources embodying economic benefits
• There are three main characteristics
   1. There must be a future disposition or sacrifice of economic
      benefits to other entities
   2. It must be a present obligation
   3. A past transaction or other event must have created the
• A liability is recognized in the balance sheet when it is probable
  that an outflow of resources embodying economic benefits will
  result from the settlement of a present obligation and the amount
  at which the settlement will take place can be measured reliably—
  AASB Framework (par. 91), consistent with asset recognition
• Where a liability cannot be reliably measured but is potentially
  material, the liability should be disclosed within the notes to the
  financial statements
Definition and Recognition of Revenues
• Definition of Revenues (AASB Framework, par. 70)
   – increases in economic benefits during the accounting period
     in the form of inflows or enhancements of assets or
     decreases of liabilities that result in increases in equity, other
     than those relating to contributions from equity participants
• Income can be recognized in the financial statements when
   – it is probable that the inflow or other enhancement or saving
     in outflows has occurred; and
   – the inflow or other enhancement or saving in outflows of
     economic benefits can be measured reliably
• Revenues’ and ‘gains’ distinguished in AASB Framework
   – revenue arises in the course of the ordinary activities of an
     entity and includes: sales, fees, interest, dividends, royalties,
     and rent
   – gains represent other items that meet the definition of
     income and might or might not arise in the ordinary activities
     of an entity, e.g. disposal of non-current assets
Definition and Recognition of Expenses
• Definition of Expenses (AASB Framework, par. 70):
   – decreases in economic benefits during the accounting period
     in the form of outflows or depletions of assets or incurrences
     of liabilities that result in decreases in equity, other than
     those relating to equity participants
• Expenses are recognized in the income statement when (AASB
  Framework, par. 94):
   – a decrease in future economic benefits related to a decrease
     in an asset or an increase in a liability has arisen that can be
     measured reliably

Definition of equity (AASB Framework, par. 49)
   – residual interest in the assets of the entity after deducting
     all of its liabilities
Critical review of conceptual frameworks
• Objective of GPFRs in SAC2 implies that reports should be
    primarily economic in focus
     – should social issues be ignored in the annual report?
• An individual's view of business responsibilities directly impacts
    on the perceptions of accountability
• Economic focus of GPFRs ignores transactions or events not
    resulting from market transactions or an exchange of property
• Ignores environmental externalities caused by business
• Financial statements included within reports reflect only
    financial performance and do not provide a means of assessing
    social performance
It has been argued that
• Conceptual frameworks simply codify existing practice
• Conceptual frameworks have been used as devices to
    legitimize the existence of the accounting profession
   Theories of Financial Accounting

Accounting theories typically either explain and predict accounting
 practice (positive theories), or they prescribe specific accounting
                    practice (normative theories)

                     Textbook Reference:
         Deegan, C. Australian Financial Accounting 5e
                          Chapter 3
     Positive Accounting Theory (PAT)
• A Positive Theory is a theory that explains and predicts a
  particular phenomenon

• PAT explains and predicts accounting practice

• It does not seek to prescribe particular actions

• Grounded in economic theory

• Focuses on the relationships between various individuals
  involved in providing resources to an organisation (agency
   – Owners (as suppliers of equity capital) and managers (as
     suppliers of managerial labour)
   – managers and debt providers                          continued
Agency theory
• Agency relationship
   – delegation of decision making from one party (the principal)
     to another party (the agent)

• Agency problem
   – delegation of authority can lead to loss of efficiency and
     increased costs

• Agency costs
   – costs that arise as a result of the agency relationship
   – Monitoring costs
   – Bonding costs
   – Residual loss

Assumptions of PAT
• All individual action is driven by self-interest (do we think this is
  a realistic assumption?)
• Individuals will act in an opportunistic manner to increase their
  wealth. It assumes managers will opportunistically select
  accounting methods to increase their own personal wealth
• Notions of loyalty and morality are not incorporated within the
• Organizations are a collection of self-interested individuals who
  agree to cooperate to the extent it is in their interest
PAT predictions
• Organizations will seek to put in place mechanisms
  to align the interests of managers of the firm (agents) with the
  interests of the owners (principals)
• Some of these mechanisms rely on the output of the accounting
   – for example, the owners might agree to pay the manager a
     bonus based on a specified percentage of profits        continued
Bonus schemes
• Remuneration based on the output of the accounting system
• Very common and their existence can be explained by PAT
• Bonuses might be based on:
   – profits of the firm
   – sales of the firm
   – return on assets
• May also be rewarded based on market price of shares

Accounting-based bonus schemes
• Any changes in the accounting methods used by the
  organization will affect the bonuses paid (e.g. as a result of a
  new accounting standard)
• Changing the bonuses paid impacts cash flows, and this in turn
  is predicted to impact the value of the organization
Incentives to manipulate accounting numbers
• Rewarding managers on the basis of accounting profits can induce
   them subsequently to manipulate the related accounting numbers
   to improve their apparent performance and thus the related
• Accounting profits might not always provide an unbiased measure
   of a firm’s performance – so also common to find the use of share-
   based reward structures, which in certain circumstances, might be
   deemed to be more efficient
Market-based bonus schemes
• Market prices are assumed to be influenced by expectations about
  the net present value of expected future cash flows
• Cash bonuses might be awarded on the basis of increases in
  share prices
• Shares or options to shares might also be provided
• Market prices reflect market-wide factors, not just those factors
  controlled by the manager
• Only senior management will be likely to be able to affect cash
  flows and hence securities prices                            continued
Role of auditor
• If managers’ remuneration is based on accounting numbers the
  auditor takes a monitoring role
• The auditor arbitrates on the reasonableness of the accounting
  methods adopted

Political costs
• Costs that particular groups external to the firm might be able to
  impose on the firm, such as costs associated with:
   – increased taxes
   – increased wage claims
   – product boycotts
   – decreased subsidies
• Organizations are affected by governments, trade unions,
  environmental lobby groups or particular consumer groups
           3 main hypotheses of PAT
• The bonus plan hypothesis is that managers of firms with
  bonus plans are more likely to use accounting methods that
  increase current period reported income

• The debt/equity hypothesis predicts that the higher the firm’s
  debt/equity ratio, the more likely managers use accounting
  methods that increase income

• The political cost hypothesis predicts that large firms rather
  than small firms are more likely to use accounting choices that
  reduce reported profits.
             Accounting policy selection
                  and disclosure
• To allow comparison between reporting entities
   – a summary of accounting policies must be presented in the
     notes to the financial report (IAS 1 Presentation of Financial
   – where an accounting policy has changed and the change
     has a material effect on results the notes must disclose the
     nature of, reason for, and financial effect of the change
     (IAS 1 Presentation of Financial Statements)
Accounting policy choice and ‘creative accounting’
• ‘Creative accounting’ refers to selecting accounting methods
  that provide the result desired by the preparers
• Also known as opportunistic
• Can be explained by PAT
• It is possible to be creative and still follow accounting standards
                   Criticisms of PAT
• Does not provide prescription so does not provide a means of
  improving accounting practice

• Not value-free but rather value-laden

• Underlying assumption of wealth maximization is simplistic

• Issues being addressed have not shown any significant

• Scientifically flawed
        Normative accounting theories
• Seeks to provide guidance in selecting accounting procedures
  that are most appropriate
• Prescribes what should be done

The Conceptual Framework is considered a normative theory
• seeks to identify the objective of GPFR
• seeks to provide recognition and measurement rules within a
  ‘coherent’ and ‘consistent’ framework
• identifies the qualitative characteristics financial information
  should possess
• makes recommendations that depart from current practice
Other normative theories
• Three main classifications
   1. current-cost accounting
   2. exit-price accounting
   3. deprival-value accounting
• These theories addressed issues associated with changing

Current-cost accounting
• Aim is to provide a calculation of income that, after adjusting for
  changing prices, can be withdrawn from the entity and still
  leave the physical capital (operating capacity) of the entity
   – referred to as true measure of income
• True income theories propose a single measurement basis for
  assets and a resultant single measure of income (profit)
Exit-price accounting
• Continuously Contemporary Accounting (CoCoA)

• Uses exit or selling prices to value the entity’s assets and
    – referred to as current cash equivalents

• Assumptions:
   – firms exist to increase the wealth of their owners
   – the ability to adapt to changing circumstances
   – capacity to adapt best reflected by the monetary value of the
     organizations assets, liabilities and equities at balance date,
     where the monetary value is based on the current exit or
     selling prices
Deprival-value accounting

• Deprival value represents the amount of loss that might be
  incurred by an entity if it were deprived of the use of an asset
  and the associated economic benefits

• This method considers:
   – the net selling price
   – the present value of future cash flows
   – an asset’s current replacement cost

• The deprival value is the lower of replacement cost and the
  greater of the net selling price and present value (value in use)
Systems-oriented theories

• These theories focus on the role of information and disclosure
  in the relationships between organizations, the State,
  individuals and groups

• The entity is assumed to be influenced by the society in which it
  operates and to have an influence on it

• Systems-based theories include:
   – stakeholder Theory
   – legitimacy Theory
   – institutional Theory
Stakeholder Theory
• Two branches
   1. Ethical (normative) branch
   2. Managerial (positive) branch

• Ethical (normative) branch
   – stakeholders are any group or individual who can affect or
     are affected by the achievement of the firm’s objectives

   – includes shareholders, employees, customers, lenders,
     suppliers, local charities, interest groups, government, etc.

   – all stakeholders have a right to be provided with information

   – because it prescribes how stakeholders should be treated
     (based on various ethical perspectives), it is a normative
• Managerial (positive) branch
  – seeks to explain and predict how an organization will react to
    demands of various stakeholders
  – relative power or importance of stakeholders considered
  – relative power and importance can change across time—
    associated with control of resources
  – the firm will take actions to ‘manage’ its relationships with

• Stakeholder Theory (either branch) does not prescribe what
  information should be disclosed, other than indicating that the
  provision of information can be useful for the continued
  operations of the entity

• Managerial branch
  – financial and social information is used to control conflicting
    demands of various stakeholder groups
Legitimacy Theory
• Organizations continually seek to ensure that they operate
  within the bounds and norms of society
• Organizations attempt to ensure their activities are perceived to
  be legitimate
• Bounds and norms change across time
• Based on a ‘social contract’ between society and the
• Where this social contract is perceived as being breached then
  the organization will take corrective action, and this action might
  include disclosure
• Organizations must appear to consider the rights of the public
  at large, not just investors
• To gain or maintain legitimacy, organizations might rely on
  disclosure within their annual report
Institutional Theory
• Explains why organisations within particular ‘fields’ tend to take
   on similar characteristics and form

• Much overlap with Legitimacy Theory and Stakeholder Theory

• Two main dimensions to the theory – isomorphism and

• Isomorphism – a constraining process that forces one unit in a
  population to resemble other units that face the same set of
  environmental conditions
   – coercive
   – mimetic
   – Normative

• Decoupling
   – actual practices can be very different from formally
     sanctioned and publicly pronounced processes and
    Theories explaining why regulation
              is introduced
• Just as there are theories to explain why particular accounting
  disclosures are made (PAT, Legitimacy Theory, Stakeholder
  Theory), or why particular organisational forms exist
  (institutional theory), there are also theories to explain why
  particular regulations (for example, accounting regulations) are
  developed. Such theories include:
   – Public interest theory
   – Capture theory
   – Economic interest group theory
Public interest theory
• Regulation put in place to benefit society as a whole rather than
  vested interests

• Regulatory body considered to represent the interests of the
  society in which it operates, rather than the private interests of
  the regulators

• Assumes that government is a neutral arbiter

Capture theory
• The regulated parties seeks to take charge (capture) the

• They seek to ensure rules subsequently released are
  advantageous to the parties subject to regulation
Economic interest group theory (Private Interest Theory)
• Assumes that groups will form to protect particular economic
• Different groups are often in conflict with each other and will
  lobby government to put in place legislation that will
  economically benefit them (at the expense of others)
• No notion of public interest inherent in the theory
• Regulators (and all other individuals) deemed to be motivated
  by self-interest
• The regulator is not a neutral arbiter but is also seen as an
  interest group
• Regulator is motivated to ensure re-election or maintenance of
  its position of power or privilege within the community
• Regulation serves the private interests of politically effective
• Those groups with insufficient power will not be able to lobby
  effectively for regulation to protect their own interests
• No single accounting theory is universally accepted

• Positive Theory of Accounting
   – seeks to explain and predict accounting-related phenomena

   – e.g. study of capital market’s reaction to particular
     accounting policies, what motivates managers to select a
     given method of accounting, reasons for the existence of
     particular accounting-based contracts

   – relies upon a fundamental assumption that individual action
     can be predicted on the basis that all action is driven by a
     desire to maximise wealth (a perspective often criticised by
     other researchers)
Normative theories of accounting

   – prescribe how accounting should be practised

   – argue typically that a central role of accounting theory is to
     provide prescription—inform about optimal accounting
     approaches and why a particular approach is considered

   – examples: Conceptual Framework Project, current-cost
     accounting, exit-price accounting and deprival-value
Systems-based theories

• Include Stakeholder Theory, Legitimacy Theory, and
  Institutional Theory
   – see organisation as firmly embedded within a broader social
   – organisation is considered to be affected by, and to affect,
     the society in which it operates
   – accounting disclosures and particular organisational forms
     are seen as a way to manage relations with particular
     groups outside the organisation— organisational activities
     and accounting disclosures are considered to be reactive to
     community pressures—how a firm operates and what it
     reports must be determined upon consideration of various
     stakeholder expectations
Theories that seek to explain how regulation is developed
• Some theories suggest that regulation is introduced to serve
  the public interest by regulators who work for the public good

• Other theories of regulation assume that the development of
  regulation is driven by considerations of self-interest

• Overall, the selection of one theory over another will depend on
  the views and expectations of the researcher in question

• No one theory of accounting can be described as a ‘best’
  theory—however, different theoretical perspectives can at
  various times provide valuable insights in accounting issues


Lecture 1
        Tutorial Questions for Week 2

Deegan, C. Australian Financial Accounting 5e

Chapter 2
Review Questions: 1, 2, 6, 9, 10, 11, 22

Chapter 3
Review Questions: 2, 9, 10(a), 14, 19, 21, 27

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