Solution Manual for Financial Accounting Theory 5th Edition by Craig Deegan

Chapter 1: Introduction to financial accounting theory Solutions 1.1

Broadly speaking, a positive theory seeks to explain and/or predict particular phenomena whereas a normative theory seeks to prescribe what should be done in particular circumstances based on particular assumptions made by the researcher.

In relation to accounting, the assumptions adopted within a normative theory might relate to assumptions made by the researchers about what information people need to make informed decisions, or what is the central objective, or role, of accounting.

Positive theories are typically evaluated by considering how well the explanations or predictions relate to actual observations. That is, how well the explanations or predictions are supported by available empirical evidence. The predictions are usually based upon assumptions about what motivates human behaviour. For example, there might be a maintained assumption within a positive theory of accounting that all people are motivated by self-interest linked to maximisation of personal wealth.

Normative theories, by contrast, are not (or should not be) evaluated on the basis of their correspondence with observations of real-world phenomena. For example, a researcher may develop a theory that prescribes a particular approach to asset measurement. The theory should not be considered as invalid if people currently do not adopt the prescribed approach to asset measurement. Normative theories provide prescriptions, not predictions.

1.2

If we developed a theory to explain how a financial statement preparer’s cultural background influences how they prepare financial statements then, as we are attempting to ‘explain’ particular practice (and not evaluate it relative to some normative criteria), we have developed a positive theory. Such a theory would then be evaluated in terms of how well its predictions (perhaps based on particular cultural attributes of a given population) correlate with the predicted accounting practices (for example, we might have predicted that people from a ‘conservative’ society or culture are more likely to adopt historical cost accounting rather than 1

utilising valuations based on fair values). In developing such a theory, we are not attempting to prescribe what accounting methods should be used – which contrasts our research with normative research.

1.3

A conceptual framework, such as the International Accounting Standards Board (IASB) Conceptual Framework for Financial Reporting, provides some fundamental assumptions about the role of general purpose financial reporting and the attributes that financial information should possess for it to be useful in assisting the resource allocation decisions of financial statement readers. As indicated in this chapter, the United States’ Financial Accounting Standards Board (FASB) defined a conceptual framework as ‘a coherent system of interrelated objectives and fundamentals that can lead to consistent standards’.

Since conceptual frameworks provide perspectives about such issues as: the qualitative characteristics that financial information should possess; the identification of the types of entities that should produce general purpose financial reports; the way in which the elements of financial accounting should be defined and recognised, and so forth (note the emphasis on ‘should’), the conceptual frameworks – in providing prescription – are considered to be normative in nature.

Positive research, on the other hand, might simply attempt to describe or predict the behaviour of those people in charge of producing general purpose financial reports, or the behaviour of financial report readers.

1.4

Arguably, Peter Costello has a hunch, rather than a theory. The Oxford English Dictionary defines a theory as ‘a scheme or system of ideas or statements held as an explanation or account of a group of facts or phenomena’. Theories would not generally be considered to be ad hoc in nature, and should be based on systematic and coherent reasoning. It is not obvious that Peter Costello’s ideas match with our views of what constitutes a theory.

1.5

Prescriptions are clearly not the same thing as predictions. If, for example, a researcher is prescribing a particular approach to accounting (that is, he or she is being ‘normative’ in nature) that does not mean when we look at actual accounting practice we will find that the prescribed method is being used. In fact, the reason why the researcher developed a particular normative theory (a theory that 2

prescribes what should be done) could well be driven by the researcher’s observation of the inadequate practices currently being employed. For instance, Raymond Chambers developed a theory of accounting (labelled Continuously Contemporary Accounting) which prescribes that assets should be valued on the basis of exit (market) values. He did this on the basis of the perceived limitations of historical cost accounting. The fact that almost all reporting entities used historical cost at the time does not of itself invalidate Chambers’ theory.

1.6

A hypothesis might provide a prediction that indicates that a particular outcome will occur if something else happens or exists. The predicted outcome would be the dependent variable and the things that might or might not happen or exist would be the independent variables.

If the available evidence indicates that the predictions made – typically based upon some theory – continue not to be supported by the data, then this would potentially be grounds for rejecting the theory. However, we would need to be careful that we are collecting the appropriate data (being careful that it is not biased in some manner) and that the data that we are collecting actually reflects the respective dependent or independent variables emanating from the theory.

So, just because a hypothesis is not supported does not invalidate a theory. Perhaps the data does not properly capture the variables or constructs that are part of the theory. Further, for some theories that relate to human behaviour, we might be prepared for hypotheses to be rejected (even when the data is deemed appropriate and reflective of the variables identified within the theory) from time to time as theories of human behaviours cannot necessarily be expected to always provide perfect predictions or explanation of behaviour. However, if the hypotheses continuously fail to be supported in different settings and with different data sets then we might start to question the merit of the theory.

1.7

If the conceptual framework for financial reporting (which is an example of a normative theory) is based upon, or built upon, a particular assumption then, before we are prepared to accept the prescriptions provided by the framework, we would need to satisfy ourselves that we accept the central assumption. If we reject the central assumption, then no matter how logically developed the theory might be we will reject its prescriptions.

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Within the IASB Conceptual Framework for Financial Reporting it is stated (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.

Therefore, if we rejected the above belief about the objective of general purpose financial reporting then we would probably reject the contents of most of the conceptual framework given that it has been developed from the perspective of this underlying objective. For example, if we believed that general purpose financial reporting should provide information about the financial impacts an organisation has on a broad group of stakeholders beyond those that hold, or intend to hold, a financial interest (that is, we take a broader accountability-based perspective rather than one that focuses on providing information to parties involved in resource allocation decisions) then we would question the prescriptions provided by the framework.

1.8

Yes, we can reject a theory even though we believe that it is very logical. For example, if we were to adopt an assumption that capital markets are efficient and that individuals are motivated by self-interest tied to wealth maximisation (two very important assumptions made in much economics literature), then that might lead us to make particular prescriptions about what information organisations should produce. However, if we reject these assumptions (perhaps we consider that markets are not efficient, and that human behaviour is not based upon selfinterest) then we might consider that the prescriptions provided by the theory are unsound – and potentially even damaging to particular groups within society – even though we might nevertheless believe that the theory is coherent and logically developed.

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1.9

As explained in this chapter, theory that is developed through induction is developed as a result of undertaking a series of observations of particular events, and on the basis of these observations, a theory is developed. Early theories of accounting (for example, in the 1960s) were often developed by observing what accountants were actually doing in practice. This led to the formulation of certain conventions and doctrines of accounting which were considered to be theories. As we discussed however, developing theory on the basis of observation typically does not allow us to address the issue of what would be the most appropriate behaviour in particular circumstances (and determining ‘appropriate behaviour’ will in turn be influenced by particular assumptions or value judgements made by the researcher). That is, it does not encourage us to evaluate what the accountants are doing.

By contrast, developing theory on the basis of deduction does not rely upon observation. Rather, it relies upon the use of logic to develop arguments and related theory. Some theories developed through deduction – such as positive accounting theories which are developed and then used to predict particular behaviour – can be tested (but not initially developed) through subsequent observation. Other theories developed through deduction – such as Chambers’ theory of accounting (Continuously Contemporary Accounting) – should not be evaluated through subsequent observation as he was prescribing a particular approach to accounting that was in stark contrast to what accountants were doing at the time.

1.10

When researchers use a number of theories to explore particular research questions, this is generally referred to as the application of theoretical triangulation. The term indicates that we are looking at solving or addressing a particular research 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.

Some of the advantages of using theoretical triangulation include that it allows us to consider different insights and to see phenomena through different lenses and 5

therefore potentially enables us to have a more complete understanding of a particular phenomenon than is possible through applying a single theory. Single theories can potentially provide quite restricted perspectives about an underlying reality.

A significant disadvantage of using multiple theories to address a particular research question is that the practice can cause some confusion for researchers and readers particularly where the theories being used have vastly different assumptions about what motivates human behaviour, or have different assumptions about, for example, the role of accounting, or about the meaning and breadth of accountability that managers should embrace.

1.11

Some interesting answers should be given here. Some students might argue it is a total waste of time. The perspective adopted by the author of your textbook, and many other accounting academics, however, is that the outputs of the accounting system are used in many decisions throughout society and hence it is important to consider how particular accounting methods, or changes thereto, will impact various groups. If we only considered how to calculate accounting numbers, without considering their impacts, then we would be only getting a fraction of the total ‘story’. People involved in accounting logically need to have some perspective about how people will react to different accounting numbers or forms of disclosure; accounting theories can provide us with such insight. Apart from considering how accounting numbers might impact different groups, people involved in accounting should arguably understand the different factors which might have influenced accounting standard-setters when they developed particular requirements. They should also be aware of research that suggests improvements to current practices (with such information perhaps being derived from different normative theories of accounting).

As you will see throughout the textbook, there are various perspectives about why organisations might adopt particular accounting methods. If we are ultimately involved in reading financial statements, then understanding the possible motivations of those in charge of preparing the financial statements will be useful.

For example, some theories suggest that managers will want to use those accounting methods that provide the greatest benefits to themselves personally 6

(from Positive Accounting Theory). Other theoretical perspectives suggest that a reporting entity will be motivated to provide information primarily to powerful stakeholders (from Stakeholder Theory), or that the managers of reporting entities provide information to legitimise the entity’s ongoing existence (from Legitimacy Theory). Chapter 13 of the book provides a perspective (a critical perspective) that suggests that financial accounting is a mechanism to further the interests of those people who currently have wealth, and to undermine the interests of those without wealth. As this brief discussion shows, there are numerous views about the implications of accounting, and the factors which cause managers to select one accounting method in preference to another. Such insights might be useful when interpreting particular accounting disclosures. If we do not read about accounting theory, then these valuable insights might not be available to us. Any critical thinking about accounting, and its role and impacts within society, requires theory.

1.12 A research question is a question that a particular research project seeks to answer.

The research question should be clear and specific so that readers know, and the researcher remembers to focus upon, what the research is trying to answer. Without clear research questions, a research project can tend to lose focus. When reading research one of the first things many readers do is to look for a clearly defined research question.

We would expect some form of correspondence between the research questions being posed and the theory being applied. That is, the research question will be linked to, or influenced by, the theory used within the research. For example, a researcher applying Positive Accounting Theory (a theory which was developed to explain and predict financial accounting practices) might explore a research question such as ‘if a new financial reporting standard is released which increases expenses then will managers tend to oppose the standard?’ Such a question links to the theory in question.

By contrast, many other accounting researchers, who do not embrace Positive Accounting Thery, might not be interested in such a research question. For example, in Chapter 13 we will explore the work of a body of researchers known as ‘critical accounting researchers’. Many of these researchers are inspired by the works of philosophers such as Marx. The sort of research question they might ask would be 7

‘will the introduction of a particular accounting approach further undermine the interests of workers within particular industries?’ Such a question resonates with the philosophical issues that critical accounting theory addresses.

1.13 It can be argued that before we can seek to improve the practice of financial accounting, we need to know which methods of accounting are currently being used. Research which describes what is currently being done as well as describing the generally accepted conventions is therefore useful to the overall process of improving financial accounting.

What might not be constructive, however, is where theories are developed through observing current practice and these observations/theories are then used to prescribe what all other people should do. Just because most people are doing something does not necessarily mean that it is the best or most efficient thing to do. As the chapter emphasises, studying what is does not mean the same thing as studying what should be. As Gray, Owen and Maunders (1987, p. 66) indicate, an approach to developing theories on the basis of observing what is ‘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’.

As the chapter explains, research that provides prescription on the basis of what is already being done does not tend to be very controversial (for example, the work of Grady, 1965) and will not tend to generate opposition from the accounting profession. But again, assuming that what is being done is the best approach (perhaps on the basis that only the ‘fittest’ survive) is not really logical.

1.14 Undertaking research based on observing actual practice provides an understanding of what is being done, although a key point here is: what we actually observe to be happening, and what we record, might be influenced by our own values and biases that we have prior to undertaking the research. This means that researchers with different ‘views of the world’ (perhaps they work from quite different research paradigms) might actually see things differently; ask different questions and record different events than would other researchers. Inductive researchers need to be careful that their own biases do not overly influence the data they are collecting if they are attempting to develop a theory based on actual practice.

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With the above in mind, we might nevertheless argue that it is important to understand current practice and therefore inductive research provides an important basis for subsequently providing suggestions for improvement to practice.

However, if we restrict our research to describing what currently occurs, this does not allow us to evaluate the practice or to prescribe improvements. For example, just because most accountants do things in a certain way – which would be identified by inductive research – this does not in itself mean that it is the best way to do things.

1.15 This answer is very much related to the answers given for questions 1.13 and 1.14.

Just because the majority of accountants do something, this does not necessarily mean there is not a better, unknown approach (unless we start adopting all sorts of assumptions about the high level of efficiency of accountants in determining what methods best reflect the underlying performance and position of particular entities).

The other point that must be appreciated is that the longer the time that particular accounting methods have been used then arguably the greater will be the resistance of accountants to change. Accounting practices can effectively become ‘institutionalised’ across time, despite the possibility that the practices are no longer the most efficient way to do something.

A change in accounting methods means that accountants and users of financial statements need to retrain and, realistically, there may be some opposition to this.

Also, there could be many contractual arrangements in place that use accounting numbers (for example, borrowing agreements with banks or accounting-based bonus schemes negotiated with employees) and hence there could be all sorts of social and economic consequences if the accounting rules, and hence, the ultimate accounting numbers, change.

There is also an argument by some researchers, identified as critical theorists (covered in Chapter 13 of the textbook), that financial accounting practices tend to provide results that favour people with control over capital at the expense of those without capital. These ‘powerful’ people will tend to argue against reform

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if it appears that new rules will favour those who have traditionally had limited wealth.

1.16 History indicates that in situations where researchers have prescribed significant departures from existing financial accounting practices, such prescriptions have often been met with a great deal of opposition from the accounting profession and other representatives of the business community. There are many possible reasons for this. Perhaps it is not made clear that the newly prescribed methods are any better than what is currently being used (and we can reflect about whose perspective should be taken when considering the costs and benefits of new methods of accounting). Since there would be many contractual agreements between different parties that rely upon financial accounting numbers (for example, between an organisation and its lenders, employees or government), changing accounting measurement systems might lead to real costs being imposed on particular parties.

For many years accounting regulators have considered the economic consequences of particular proposals prior to efforts to put such accounting proposals in place. If it is considered that a change in accounting rules might lead to significant economic (and social) consequences, then the proposal might be abandoned even though it might arguably provide the best reflection of the financial performance or position of a reporting entity. However, an issue that should be taken into account when considering the economic consequences of proposed accounting methods is whether existing accounting rules are appropriate and/or whether the existing rules unfairly advantage some parties at the expense of others.

Another issue that might explain why some accounting proposals are promoted by an accounting standard-setter, while others are not, is the level of constituency support for the proposals. Throughout the world, the ongoing existence of many accounting standard-setting bodies has historically relied on support from the public. History shows that when the standard-setting bodies’ constituency are critical of the standard-setting body then in certain situations the particular body has been disbanded and replaced by another group (obviously this does not always happen). Hence, whether a particular accounting proposal is promoted by a standard-setting body might be dependent upon whether the proposals are acceptable to the standard-setter’s constituency.

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A further issue that is raised in Chapter 13 of the book relates to the views of ‘critical theorists’. They argue that the rules which exist in financial accounting act to maintain the vested interests of people with wealth and to undermine the interests of other people (the work of some critical accounting theorists is informed by the works of philosophers such as Karl Marx). For example, financial accounting emphasises the positive attributes of increased income and profits (which ultimately go to the owners of capital) but highlights the negative implications of rising costs – including payments made to employees. Critical theorists would argue that standard-setters would be more likely to support particular accounting proposals to the extent that the proposals support existing social structures (which in turn support the social positions of professionals, such as accountants).

1.17 For financial reports to be ‘neutral’ and ‘representationally’ faithful then, arguably, they would be constructed from the application of a set of financial reporting standards which have themselves been developed by way of a process that is neutral and which has involved the assessment of each proposed rule on the basis of whether it improves the output of the financial accounting process (perhaps in terms of qualitative characteristics, such as those identified in the IASB Conceptual Framework for Financial Reporting).

In many countries, financial reporting standards were developed through a political process. This might have involved the development of a draft standard which is then circulated (perhaps more than once) to interested parties who in turn, make submissions to the accounting standard-setting body. Quite often these submissions come from large corporations that have the necessary funding to have people who specialise in activities such as making submissions to standard-setting authorities. The standard-setting body will then consider the merit of the various arguments before developing the final financial reporting standards. Because it is often the case that the views of people in different countries will be different (which in turn might be related to issues such as cultural differences, as Chapter 7 of this book explains) financial reporting standards developed within a particular nation will typically be different to the standards developed in other countries to cover the same issue. As Chapter 5 discusses, the choice by many countries to standardise local accounting standards with International Financial Reporting 11

Standards (IFRS) tends to ignore how cultural differences influence the types of accounting information demanded by different cultures.

Once we accept that accounting standard-setting is a political process (with standard-setters themselves possibly being concerned that they have constituency support) then it is hard to accept that accounting standards themselves can be neutral and objective documents. If we accept this position, we might then find it difficult to accept that accounting reports developed in accordance with these accounting standards can themselves be neutral and representationally faithful.

1.18 This is clearly a matter of opinion. There are many people (such as Howieson, 1996, from whom this quote is taken) who consider that the role of an academic is to provide guidance as to what practitioners should be doing – because practitioners do not typically have the time to do the research that improves practice in the same way as academics (with academics typically having their salaries paid by way of community-based taxes). Positive accounting theorists (particularly those that apply Positive Accounting Theory) are typically reluctant to provide prescription (that is, to use the ‘should’ word) and this has, in turn, been the cause of much criticism of this theory (for example, by researchers such as Sterling and Chambers).

Positive theory is theory that describes and/or predicts particular phenomena and does not tend to prescribe particular activities. Researchers such as Watts and Zimmerman (central figures in the development of Positive Accounting Theory) considered that ‘good, scientific’ research was research which was free of the researchers’ own values and biases and that, by restricting one’s attention to describing and predicting, one was not taking the value-based step of saying what people should do. As we would appreciate however, no research can be value free (for example, Positive Accounting theorists accept the theoretical economicsbased assumption that all people are self-interested wealth maximisers – accepting such an assumption is obviously a value judgement).

While positive accounting theorists might not elect to provide prescription, their research, which provides information about the possible implications of particular accounting approaches and the potential motivations that drive managers to select 12

particular accounting methods, could provide the resources and knowledge that others might use to develop prescription. Hence, positive theory can arguably provide benefits to ‘the community’, just as normative theory can.

1.19 The two branches of ‘decision usefulness’ theories are the decision-makers emphasis and the decision-models emphasis.

The decision-makers approach relies upon finding out what types of information particular groups seek. The information might be found out by means such as the use of questionnaires or interviews. Once the information demands or needs are discovered, these form the basis for prescriptions about what information should be provided to the groups in question. As is explained in this chapter, developing prescriptions based upon what information individuals say they want or need ignores the fact that there might be other types or forms of information that are ‘better’. As an illustration of the potential logical flaws in this approach we can consider the following, perhaps somewhat extreme, illustration. Assume that a group of people were asked to give an opinion about what is the most useful implement for digging a hole. Assuming they have been exposed to spoons but not to shovels, then they may indicate that spoons are the most useful implement to use to dig a hole. If a prescription follows that spoons should be provided to all people, then we can see that this is perhaps not in the benefit of potential ‘diggers’.

The decision model’s emphasis relies upon the researcher’s own perceptions about what information is necessary for efficient decision making and these perceptions are used to develop prescriptions about what information should be disclosed. This form of research does not rely upon finding out what information users actually want, and it typically assumes that all stakeholders have identical information needs. In situations where people are unfamiliar with the form of information being prescribed, it is assumed that they can be taught how to use it. An example of this branch of research might be Chambers’ Continuously Contemporary Accounting.

In his theory Chambers prescribes that the most useful information for financial statement users is information about the net market values of a reporting entity’s assets.

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1.20 Kuhn (1962) proposes that knowledge develops through a process of revolution rather than evolution. New theories replace old theories as a result of researchers questioning the existing theories. The view is that once theories are in place they will continuously be scrutinised and cannot be expected to maintain a position of dominance indefinitely. When theories are under maintained attack they are considered as being brought into crisis. The view is that when a theory is brought into question (in crisis) another theory might be advanced as superior and this theory may then become the one that is more generally accepted. As a result of critical analysis this theory may in turn be brought into crisis, and so forth. Because of new arguments and insights, it is also possible that ‘old’ theories will re-emerge.

Kuhn’s perspective appears to imply that particular theories can ‘overthrow’ others (at least temporarily). However, within the accounting discipline it is not at all clear that a particular theory has ever been successful in overthrowing all others.

Nevertheless, Positive Accounting Theory certainly did displace many normative theories in many accounting schools throughout the world in the 1980s (but they in turn seemed to be displaced as the dominant theory throughout the 1990s – but arguably by a number of other theories rather than just one theory).

In discussing how some theories displace others, Kuhn parallels the experience as being similar to ‘religious conversion’. Certainly, when we think of how some researchers defend their theoretical perspectives against all others we can perhaps liken some of them to religious zealots.

1.21

This chapter provided a number of definitions of a paradigm. 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.

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An important point to emphasise from the above definition is that one’s own values will impact the research paradigm they elect to embrace. Kuhn (1962) also provided a definition of a paradigm. He stated that ‘a paradigm can be defined as an approach to knowledge advancement that adopts particular theoretical assumptions, research goals and research methods’.

In terms of whether researchers would typically embrace more than one paradigm when doing research, the general answer would be no (although there are some limited exceptions to this). As we have already indicated, the paradigm a researcher embraces is impacted in large part by their own values and beliefs, hence often researchers would feel uncomfortable embracing more than one paradigm (perhaps it is like embracing more than one religion). For example, if I strongly disagreed with a perspective that all individual action is driven by self-interest then I would not feel comfortable embracing a paradigm – such as Positive Accounting Theory or Agency Theory – that embraces as a core assumption the view from neo-classical economics that individuals are principally motivated by self-interest. Similarly, if I believed that it is inappropriate to treat all organisations as being homogeneous (that is, as being the same) then I would adopt a research paradigm that perhaps relied upon in-depth case study research, rather than large scale research undertaken by way of mail-out questionnaires, or research that utilised secondary data, such as details of share-price movements of many companies.

1.22

There is a difference between financial accounting theory and financial accounting research. Financial accounting theory provides a basis for undertaking a great deal of financial accounting research. For example, the theory provides us with insights on what factors to investigate, what evidence to collect, and how and where we should collect the data.

Different theories can lead to very different research being undertaken. For example, advocates of Positive Accounting Theory will often undertake large-scale research that seeks to provide results that can be generalised across various situational contexts. By contrast, advocates of various critical theories (discussed in Chapter 13) would not undertake such research and would not necessarily seek to provide generalisable predictions.

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Financial accounting research can lead to the development of new theory, or the refinement or acceptance of existing theories. That is, research can precede the development of theory, and then subsequently, theory can guide research.

Not all research requires theory. For example, we might want to initially find out what methods of accounting are being used by different organisations. This would be called descriptive research and would not necessarily be theory-based.

1.23 Arguably, accounting research cannot really be considered to be value-free. Many value judgements must be made in the research process. For example, selecting a theory to use from among competing alternatives can be based on a value judgement. We might dismiss a theory because in our view its assumptions about what motivates human behaviour do not tie in with our own views. Also, determining what is important or interesting enough to research in the first place can be a value judgement. What I think is worthwhile research might be dismissed by others as a waste of time.

1.24 There could be various reasons why particular theories might have widespread acceptance within a particular research community.

Perhaps the assumptions inherent within the theory fit well with the philosophical beliefs of the researchers within that community. Also, perhaps the theory generates research questions that are considered important by people within a particular research community. For example, a particular community might have a fascination with explaining accounting practice, or in understanding which accounting-based disclosures are likely to impact share prices and therefore investors’ wealth. Other research communities, by contrast, might focus on broader ethical issues and therefore have limited interest in, or respect for, theories that fixate on the interests of owners and managers.

Another reason is that high profile researchers use a particular theory. Because of their prestige and position, other researchers might uncritically simply decide to ‘follow the leader’. Linked to this possible reason, editors of particular research journals, where researchers want to publish, might also have a clear preference for

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particular theories. This tendency tends to inhibit the advancement of knowledge.

Further, if particular researchers who favour particular paradigms are known to have been appointed as assessors on (or have been able to capture) particular research assessment exercises, then researchers in particular universities might be encouraged to adopt similar paradigms in order to increase the chance of receiving a higher ranking.

So, although theories should be selected on their merit, there can be many other reasons – sometimes political – which coerce people into using particular theories.

1.25 Value judgements have a great deal to do with what theory a researcher might elect to use to explain or predict particular phenomena, or to provide prescription. To demonstrate this, we can consider the alternative theories accounting researchers might use to explain why companies elect to voluntarily produce information about their social and environmental performance. If I believed that corporate managers are motivated by self-interest, then I would embrace an economics-based theory – such as Positive Accounting Theory – that has self-interest (tied to wealth maximisation) as one of the fundamental assumptions about what drives human behaviour. These people would have a predisposition towards believing that all human activity – including the disclosure of social and environmental information – is undertaken to the extent that the activity can somehow be related back to positively impacting the managers’ wealth.

By contrast, if I was a researcher who embraced a vision of sustainable development – which requires people of current generations to sacrifice current consumption to the extent it is in the interests of future generations – then I would reject Positive Accounting Theory as self-interest and sustainable development are to a great extent, mutually exclusive. Such a researcher would embrace another theoretical perspective (perhaps such as legitimacy theory or stakeholder theory, which we discuss in Chapter 8). It is interesting to note that almost no researchers in the area of social and environmental accounting embrace Positive Accounting Theory.

1.26 Central to this question is the issue of whether a theory can ever be proved. There are different views on this. The falsificationists, initially led by Karl Popper, would typically argue that theories cannot be proved regardless of the amount of evidence 17

collected to support a theory. Theories are deemed to be developed through trial and error and at a particular time a theory might appear to provide the best explanation for a particular event among the theories available at a point in time – but there is always the possibility that a new or refined theory might ultimately provide better explanations or predictions.

In accounting we are dealing with human behaviour, so from a logical perspective we would not expect to have a theory that provided perfect explanations or predictions in all cases – hence we would be cautious about saying our data ‘proved’ a theory. Indeed, when some researchers say that they have ‘proved’ particular theories, or have proved the existence of particular relationships, this often effectively signals a degree of naivety that is held by the researchers in that they appear to be ignorant of alternative plausible explanations for particular phenomena. There is always likely to be somebody who acts differently to the majority. We are safer in saying that our evidence ‘supports’ a theory.

1.27 The answer to this question follows on from the answer to Question 1.26. If we accept the views provided by falsificationists, then we should be careful not to say we have ‘proved’ a theory. It is much safer to say that the findings we have generated ‘support’ a particular theory. There is always the chance that a ‘better’ theory can be subsequently developed, or that a future observation might not be consistent with our theory.

1.28 Many researchers do believe that we first need theory, as the chosen theory then informs the research questions, the hypotheses to be developed (if any), and the research methods to be applied.

While it is generally accepted that it is less risky for researchers if they start with a predetermined theory, some researchers do nevertheless collect data first and then seek to have theory evolve from an analysis of the data. That is, when developing grounded theory, the researcher does not commence with a theory. 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 18

with an area of study and, as part of the research process, allow research constructs and theory to emerge from the data.

1.29 Whether we think a particular theory is a ‘good theory’ or not will often be very much a subjective assessment (although a poorly developed theory should be rejected by all researchers). Some criteria that we might use to evaluate a theory as appropriate for our own use (and a number of these criteria overlap) include the following (and although the question has asked for five criteria we have provided more): •

Is the theory logical? That is, do the arguments logically flow given the central assumptions that have been made? The chapter suggests that one way to test this is to break the theory up into its key premises and then depict the theory by way of a ‘syllogism’. The argument will be logical to the extent that if the premises upon which the theory or argument is based are true, then the conclusion will be true. When considering the logic of the argument we must be careful to consider whether our acceptance of an argument has been influenced by any emotive or colourful language that has been used (or by any of the other ‘dishonest tricks in argument’ identified on page 27 of your textbook).

•

Are the underlying assumptions adopted within the theory realistic? This point ties in with the above point. If the assumptions appear to conflict with how we see the world, or are overly simplistic, then we might tend to reject a theory. While a theoretical argument might logically follow (in syllogism form, or otherwise), if the assumptions on which the argument is based are ‘outlandish’ then we might reject the theory.

•

Is it consistent with our own values? This also ties in with the above point. Whilst a theory might be ‘sound’ and logical, we nevertheless need to determine whether we are happy with the various assumptions it makes, or whether it addresses, or generates, research questions that we think are interesting and worthwhile pursuing.

•

Does the theory tie in well with our own perspectives of what ‘theory’ should achieve? For example, if we think that theory should be capable of generating generalisable predictions, then does the theory in question do this?

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•

Whether we accept a particular theory might also be dependent upon whether it appears to be superior to existing theories in terms of explaining particular phenomena (if we are applying positive theories).

•

Was the theory developed by well respected researchers? This will provide some comfort; however we must remember that everybody will get it ‘wrong’ at some stage.

•

Is the theory widely applied and supported by other people within the ‘research community’? Again, whilst this is comforting, particularly if many research studies have generated results that support the theory, it needs to be remembered that just because a lot of people are doing something does not necessarily mean it is the ‘best’ way to do something.

•

Is the theory parsimonious? That is, compared to other theories that provide similar insights, is our theory more ‘straight-forward’, or simpler to understand?

•

Is the theory falsifiable? That is, according to some researchers (the ‘falsificationists’), a ‘good theory’ is one that can produce predictions that have the potential to be disproved.

•

Also, at a pragmatic level, if we use one theory in preference to another, will this impact the possibility of getting the research published? (While it could be argued that such considerations of ‘publishability’ should not be relevant, and they certainly deviate from the issue of whether we evaluate a theory as being ‘sound’, in practice promotion within an academic career is typically based on issues such as number of publications, and hence such concerns can be very real. Further, it is generally accepted that it is easier to get research published if it follows existing theories, rather than relying upon a newly developed theory.

1.30 A good theory, according to the falsificationists, should generate predictions or hypotheses that are of such a nature that they can be rejected should evidence be provided that is not supportive of the theory’s predictions or hypotheses.

Knowledge is deemed to advance as a result of continual refinement of theories.

Lack of empirical support for theories, through rejection of predictions or hypotheses that emanate from the theory, encourage refinement of existing theories.

Therefore, failure to find support for a theory is not deemed to be a ‘bad’ outcome.

Researchers are expected to continually look for evidence which challenges or disproves a theory.

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1.31 In terms of what differentiates grounded theories from other theories, a grounded theory emerges from the data. With research that relates to grounded theory, the research is used to generate the theory, rather than the normal situation where the theory drives the research in terms of the questions to be asked, and the data to be collected. When grounded theory is applied, ideas, concepts and, ultimately, a theory ‘emerge’ from the data’.

1.32 The role of data collection in the research work of a ‘grounded researcher’ is that the data is analysed to develop a theory, rather than the reverse situation where data is used to test a predetermined theory? Grounded theory is developed by immersing oneself in data. Grounded theory seeks to make sense or give meaning to the data that is collected and to attribute some structure to that data.

A ‘grounded researcher’ would not tend to believe that the results generated within one research setting can always be generalised to other settings. Grounded researchers tend to believe that data should not be studied without careful consideration being given to the context within which that data was collected. They would also tend to believe that the social world often changes with the result that meanings attributed to the data by the research subjects are also time dependent.

Therefore, extrapolating the results of the research to different settings and different time periods would not typically be something that a grounded researcher would do.

1.33 In considering whether a theory is sound, there would be various factors to consider.

For example, if it’s a positive theory, does the theory appear logical and have its predictions or explanations been supported by various empirical investigations. In terms of whether the theory – whether it be normative or positive – is logical we might want to break the theory down into a series of premises and a conclusion.

That is, we might want to compose a syllogism (as discussed within the Chapter).

Of interest would be whether the premises inherent within the theory lead to a logical conclusion. Also, if the premises are based upon ‘real world’ observations, do they seem to be true? We would also want to see whether we are prepared to accept the assumptions made within the theory – are they realistic or consistent with our own values? For example, it might make particular assumptions about what motivates people, what the role of organisations in society is, how markets react to 21

information, and so forth. If we do not accept such assumptions as valid, then we might reject the theory.

In relation to a normative theory of accounting, we would also need to determine whether the prescriptions flowing from the theory seem logically derived (see above). We would also need to determine whether we are prepared to accept the assumptions made within the theory about the perceived role attributed to accounting. For example, if the theory has central assumptions that users use particular information in a particular way, and we do not agree with the assumption, then we might reject the theory.

1.34

This is an interesting issue. If we are trying to get others to accept our theory, or point of view, then of course we should try to gain their acceptance by showing them the logic of our argument. However, in the process of trying to convince others it is difficult not to use some form of emotive or colourful language – indeed, converting or convincing others might be assisted by such tactics. What we must be vigilant about is whether our own acceptance of particular perspectives is based on logic, or has been impacted by the use of language.

While some people might argue that academic research must be written in an objective, emotionless manner, such material can be particularly difficult to read.

Without some obvious emotion on the part of the author we can find it difficult to maintain an interest. Hence, there is possibly some trade-off between being objective and being emotive. For many of us that read numerous research articles it is sometimes pleasing to see how excited somebody is about the research they are undertaking. Objective, non-emotive writing cannot signal such excitement.

1.35

The IASB Conceptual Framework for Financial Reporting and International Financial Reporting Standards (IFRS) are normative documents in the sense that they tell us how we should do general purpose financial reporting. The Conceptual Framework is considered to represent a normative theory of accounting which is based on various key assumptions about such things as the objective of general purpose financial reporting, the users of general purpose financial reports, the knowledge of accounting expected to be possessed by users of general purpose

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financial reports, the required qualitative requirements that financial accounting information should possess, and so forth.

Whilst these documents are normative in nature, they are backed by a deal of research that is positive in nature. For example, bodies such as the IASB review and even fund research that looks at how various stakeholders react to accounting information. They also consider research that investigates what motivates organisations to provide particular information, or adopt particular accounting methods, in preference to others. Such research is positive in nature. Bodies such as the IASB will also draw on normative research which has been generated by researchers who prescribe the benefits of certain approaches to accounting (for example, relating to measurement issues) relative to other approaches.

Therefore, their work involves and utilises research that is of both a positive and normative nature. Their final outputs – conceptual framework requirements and financial reporting standards – are normative in nature.

1.36 It is generally accepted that theories cannot be ‘proved’. They are often developed to explain a particular phenomenon (positive theory) and will rely upon a number of simplifying assumptions to make them ‘workable’ (some of the ‘best’ theories are often considered to be the simplest theories – such theories would be considered as parsimonious). When considering the development of theories to explain human behaviour (for example, the behaviour of accountants or the behaviour of users of financial statements) a number of assumptions must be made about how people act, how they are motivated, and so on. Arguably, people are all different and their behaviours cannot be predicted with total accuracy. Further, people will not always be consistent in how they act. If we attempted to develop a theory to predict behaviour with near-perfect accuracy then the development of the theory would take forever and really could probably never achieve its goal. Hence, theorists make simplifying assumptions, and the ultimate theory will therefore be a simplifying abstraction of reality. Nevertheless, they will provide us with a basis of understanding certain phenomena.

1.37 A positivist would often tend to believe in an objective world. That is, many positive researchers – such as researchers that apply Positive Accounting Theory or Agency 23

Theory – believe that there is an objective reality in which we all see things effectively the same. This means that they believe that observations made in some research settings can be combined with observations from other research settings to generate large pools of data that can then be tested through the application of various statistical techniques. The results of the testing are then typically used to explain or predict what might happen in contexts beyond those within which the data was collected. This can be contrasted with some other researchers, such as grounded researchers, who tend to believe that data from particular research settings will have different meanings to different people, and therefore generalisable predictions or explanations should not be made or developed.

Because of their beliefs about the existence of an ‘objective world’ in which we all tend to see things the same, and react in the same manner, positive researchers will tend to believe that their results can be generalisable (subject to some testing about whether there were any biases in the data collection processes).

1.38 It would be good. As the Chapter explains, a parsimonious explanation is one that applies the most logically economic explanation to explain a particular phenomenon of interest to the researcher.

Generally speaking, a simple explanation of something is preferred to a complicated explanation, and the same applies to theories. Some of us would be familiar with people who undertake research that uses many independent variables to try to explain why a particular phenomenon occurs. For example, to explain why a company might voluntarily adopt a particular accounting method the researcher might consider a multitude of many different factors. If another researcher also provides an explanation of the particular accounting choice, but he or she only identifies a small number of important factors that seem to influence the choice, then this theory would be preferred to the extent it appears to provide similar predictive accuracy. Where possible, we should always try to ‘keep it simple’. A simple explanation will be understood by more people and is more likely to be used by more people.

1.39 A hypothesis can be defined as a proposition, typically derived from theory, which can be tested for causality or association using empirical data.

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Not all research will provide testable hypotheses. For example, normative research which prescribes what organisations should do would typically not involve the development of hypotheses about what organisations actually do. Hypotheses often act to provide predictions that can then be empirically tested. For much normative research there is not an intention to explain or predict current practice, hence the development of empirically testable hypotheses would not necessarily be appropriate. Nevertheless, normative research has the potential to provide valuable insights into improving the practice of accounting.

While hypotheses are often developed within positive research that utilises large amounts of observations (for example, thousands of observations of movements in share prices), for researchers who seek to develop ‘rich insights’ from case study research (which might involve the detailed investigation of the practices adopted in only one or more organisations), it is generally accepted that the use of hypotheses is not appropriate. Further, if a researcher adopts a view (or research paradigm) that suggests that all organisations and individuals are fundamentally different, then such a researcher would not tend to develop hypotheses to test across a broad range of individuals or organisations. By contrast, a researcher who adopts an assumption that all individuals are fundamentally the same (for example, they are all motivated by self-interest tied to wealth maximisation) might be inclined to develop hypotheses for testing across different samples of the population.

What is being emphasised here is that the absence of empirically testable hypotheses does not necessarily negate the value of particular research.

1.40 We would probably not reject a theory as ‘insignificant and useless’ on the basis that a particular study failed to provide support for the theory. Since theories, by necessity, are ‘abstractions of reality’ they cannot be expected to generate predictions that will always hold. Theories about human behaviour (such as the behaviour of accountants) rely upon a number of assumptions about human behaviour. These assumptions will not necessarily always reflect actual behaviour.

Hence, we would generally not be inclined to abandon a theory because a particular research project generated results that did not support the theory. Also, it is possible that the results failed to support the theory because there were problems with how 25

the underlying data was gathered and analysed, or how the theoretical variables were defined.

Obviously, if a theory continued to be unsupported by many studies then we might ultimately question its relevance.

1.41 Of importance is how the sample was selected. Usually, to generalise the results of a particular sample to a larger population the sample must be representative of that larger population. This will normally require that the sample was of a reasonable size and that the selection process was of a random nature, such that each item in a population has an equivalent chance of being selected. If a sample is not randomly selected, then any efforts at generalising will commonly be criticised.

When selecting a sample, it is also important that the items in the ‘population’ have similar attributes (which in itself is the essence of a ‘population’). Some researchers from more of an ‘interpretive’ perspective question whether different organisations are actually that similar. They consider that because of differences in personalities, social and organisational structures and cultures, institutional influences, and so on, then large scale research (which relies on sampling) is inappropriate because it is not valid to generalise across organisations, that in essence, are very different.

Researchers working within an ‘interpretive paradigm’ generally do small-scale, indepth research.

1.42 When referring to ‘herding’ they are referring to the fact that it is common that researchers in a particular discipline tend to adopt theories that are used by many other people within that discipline. That is, it is not uncommon for many researchers to adopt particular theories because the majority of people researching the particular topic also adopt or use the theory – what some people might call as ‘running with the herd’. Whilst this is not necessarily a bad or wrong thing to do, just because the majority of people might be applying the theory does not mean it is necessarily the best theory available to fulfil whatever aims or objectives the researcher is hoping to achieve. Adopting something because ‘everybody else does it’ can also potentially be considered as intellectually lazy. Embracing a theory should be based on an assessment that it is the best available theory (and in the chapter we have identified a number of factors to consider when evaluating a theory).

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In terms of some of the advantages associated with using a commonly used theory, one benefit would be that it will save time for the researcher. If a logical and coherent theory has already been developed, then we do not have to replicate the work that others have already done to develop the theory. Also, if a theory has become accepted within a paradigm and is used by leaders in the field (who would also conceivably act as journal paper reviewers and editors), the less resistant path to publication is deemed to be one that embraces the apparently accepted theory of the day. Generating publications is a key performance requirement of university researchers.

The disadvantage in using theories that many others are using is that our contribution to the literature would not be as significant as it would be if we were responsible for developing a theory. Whilst it is generally considered a risky exercise to develop new theory (for example, it might be relatively more difficult to get the work published compared with research which applies accepted theories) if the work is published, despite the hurdles, it will tend to command high citation rates. Also, if we simply use theories that everybody else is using then we will never potentially be considered as a ‘leader’ within our field.

1.43 What the diagram is attempting to emphasise is that there are many interdependencies between various factors, or decisions, made in the process of undertaking research. For example, our own values and expectations will influence how we ‘see the world’. How we see the world will influence the sort of research questions we think are interesting or worthwhile pursuing. How we see the world also influences the theories we elect to use. For example, if we do not want to accept the assumption that all individual action is driven by wealth-maximising selfinterest then we would reject many economic theories.

There is a relationship between the theory we use and the research questions we will seek to answer. For example, if we are embracing Positive Accounting Theory then we might try to answer questions about why a company elected to use one method of depreciation in preference to another. But Positive Accounting Theory would not generate questions about whether a particular depreciation method is

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influenced by cultural or ethical considerations. Different theories generate different questions.

While the choice of theory influences the type of research questions addressed, it will also influence the research methods to be employed. For example, if our theory incorporates an assumption that all people act in the same manner (for example, they are all motivated by self-interest as is the case in many economic theories) then large-scale sampling and statistical testing might be appropriate. However, if we adopt a theory that assumes that individual behaviour is influenced by many different factors then we might not undertake large scale testing (such as mailing our questionnaires to thousands of individuals).

The assumptions we make about individuals, organisations, and so forth not only influence the research methods we apply but also the degree of generalisability we believe is associated with our findings. For example, if our theory suggests that different cultural aspects influence how people use accounting information then it would be inappropriate to generalise the results derived from people within a given culture to people in a different culture.

As emphasised in the chapter, different research paradigms embrace different philosophies, values, assumptions, research goals, and research methods.

1.44 Absolutely yes! In developing accounting standards there will be many questions, such as: •

What will be the effect of the related information on different stakeholder groups?

•

Will the new rules incorporated within the proposed accounting standard provide more benefits to some groups relative to others?

•

Will organisations be likely to oppose the requirements, and why?

•

Does the proposed accounting standard provide the best approach for accounting for the particular transaction or event?

•

What are the costs and benefits of the proposed accounting requirements?

•

Is the accounting standard applicable across all countries?

To answer questions such as those provided above requires knowledge of various theories of accounting.

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Chapter 2: Accountability and its link to responsibility and accounting Solutions

2.1

As pages 48 and 49 of the textbook indicate, a useful definition of ‘accountability’ is provided by Gray, Adams and Owen (2014, p. 50), this being: The duty to provide an account or reckoning of those actions for which one is held responsible.

Gray, Adams and Owen (2014) also emphasise that accountability involves two key responsibilities or duties: 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.

We can also consider the following definitions of accountability: 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. Source: Barton (2006), p. 257.

Accountability is acknowledging, assuming responsibility for and being transparent about the impacts of your policies, decisions, actions, products and associated performance. Source: AccountAbility (2008), p. 6.

[Accountability is] 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. Source: BusinessDictionary (2017).

What is apparent in most definitions of accountability is that the definitions link an organisation’s responsibilities (and there can be a range of responsibilities actually embraced) with the related obligation to provide information – that is, to provide an ‘account’ – about an organisation’s performance and its adherence to the expectations of certain others.

2.2

Different managers will – at some level – have differences in opinion about the accountability of an organisation. The differences in opinion might be small, or large.

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Views about organisational responsibilities and associated accountabilities are linked to personal opinion, and personal values.

Accepting that there is a linkage between perceptions of responsibilities and accountabilities (see Figure 2.3 on page 48) means that differences in opinions about accountabilities can be traced back to differences in opinions about organisational responsibilities with respect to ‘to whom’, and ‘for what’ aspects of performance an organisation and its managers are responsible.

Figure 2.4 on page 56 identifies several factors that might influence managers’ perceptions of organisational accountability, and these include factors such as gender, professional experience and affiliations, religion, culture, sporting affiliations, and the types of education received. There is a great deal of literature available that explores how such factors influence the accountability embraced, and the reporting practices employed, at different organisations.

2.3

Different managers might have different perceptions of organisational responsibilities because of various factors. Reference should be made to Figure 2.4 on page 56 which identifies some factors that might explain why managers might have different views about organisational responsibilities and accountabilities. We must remember that any differences in opinion about responsibilities in turn lead to differences in opinion about organisational accountabilities, which in turn influences organisational ‘accounting practices’.

Students should review Figure 2.4 and consider how each of the factors identified might influence the responsibilities managers embrace. For example, if we consider responsibilities for animal welfare then we might consider how religion and culture influences views about how animals might be used by humans, and how they should be treated by humans. This would also then flow to judgements about accountabilities for animal welfare.

2.4

Arguably, it makes no sense to study the practice of ‘accounting’ without considering the issue of organisational accountability. Our views about organisational accountability – which are influenced by our views about organisational responsibilities – directly influence our views about what ‘accounts’ should be produced. To make 30

sense of accounting practices, we need to understand the context in which the accounting is practised.

For example, if managers do not believe they have any responsibility and related accountability in respect of climate change, then they will not be likely to provide any accounts in relation to their climate-related emissions, targets, and related governance policies. By contrast, in an organisation that embraces a responsibility and related accountability for climate change, we would expect to find some form of climatechange related accounting being practised.

Therefore, students of ‘accounting’ should – at the commencement of an ‘accounting education‘ – spend time considering different views about accountability so that they can then understand why certain forms of accounting might be employed.

Accounting courses, or accounting textbooks, which commence by firstly addressing financial accounting (balance sheets, income statements, statements of cash flows) – which many unfortunately do without any attention to ‘accountability’ – seem to be assuming (albeit, as an unstated assumption) that the only accountability of managers is in relation to financial performance for the benefits of owners and other providers of financial capital 2.5

Page 52 of Chapter 2 defined a stakeholder 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.

As we can see above, there are two limbs to this definition of stakeholders. Firstly (the first limb), there are those who ‘can affect’ the organisation. These stakeholders are often considered to be the ‘powerful ones’ and often managers will take actions to manage or even manipulate these powerful stakeholders on whom the organisation depends. These stakeholders might be providing valuable resources to the organisation and that is what gives them some degree of power over the organisation.

The second limb in the above definition refers to those stakeholders that are ‘affected by’ the organisation. These stakeholders might have limited power over the organisation 31

but nevertheless are impacted by its operations. Whether managers will consider such (less powerful) stakeholders’ needs and expectations will be influenced by the social responsibilities and related accountabilities the managers decide to embrace.

The stakeholders of an organisation could include owners or investors, loan providers, direct employees, workers across the supply chain, customers, suppliers, government, local communities, future generations, animals used across the organisation’s supply chain, and the ‘environment’.

If managers define their stakeholders broadly, and if they believe they have a responsibility to provide information to stakeholders about how those stakeholders are influenced/impacted by the organisation then the nature of the ‘accounting’ undertaken will tend to be broad in nature. By contrast, if managers were to embrace a narrow view that an organisation was only responsible for its financial performance and that the responsibility for such performance was restricted simply to a narrow group of stakeholders such as owners (shareholders) and loan providers (creditors), then such an organisation might decide to only produce financial accounts, and those accounts would only be distributed to owners and creditors. This would be considered a very restricted, or narrow, view of accountability.

2.6

A stakeholder could also be the environment, animals, or future generations. Animals, for example, as a group might not be able to directly impact an organisation, but they might be affected by an organisation’s operations. The same could be said for ‘future generations’. Of course, not all managers will consider these to be stakeholders of the organisation.

2.7

Stakeholder engagement refers, somewhat obviously, to a practice wherein stakeholders are ‘engaged’. This means that some form of communication and dialogue is established with identified stakeholders to determine what their needs and expectations might be.

For some stakeholders – such as the ‘environment’ or animals – there is a need to engage with what are often referred to as ‘surrogate stakeholders’. Surrogate

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stakeholders are groups who give a ‘voice’ to stakeholders who are unable or unwilling to provide their views but who nevertheless might be impacted by the operations of an organisation/ industry. For example, there will be environment-based non-government organisations (NGOs) who lobby on behalf of the environment, and there will be animal welfare NGOs who lobby on behalf of animals.

2.8

In determining what aspects of organisational performance an organisation should be accountable for, the manager needs to engage different stakeholder groups (or their surrogates) to determine what aspects of the organisation’s performance those stakeholders believe the organisation should take a responsibility for. Once this responsibility is accepted, then it is the obligation for the organisation and its managers to then provide an account to those stakeholders about how this responsibility has been acted upon.

2.9

Yes, stakeholder engagement is an important part of the corporate governance policies of an organisation. It is generally accepted that for an organisation to be successful it needs to consider the expectations of its stakeholders. Failure to consider the expectations of stakeholders, which could lead to the organisation operating in a way that is not in accordance with stakeholder expectations, could result in stakeholders withholding resources from the organisation which could detrimentally affect the operations of the organisation.

From a broader ethical perspective, regardless of the power of particular stakeholder groups, the organisation and its managers should respect the views and needs of stakeholders. Some form of engagement makes this possible. In this regard, organisations often perform what are referred to as ‘social audits’ wherein they engage with particular stakeholders to determine the stakeholders’ expectation of the organisation and whether the stakeholders believe that the organisation has been operating in a way that satisfies the stakeholders’ perspectives about the organisation’s responsibilities. The results of social audits are often made publicly available and can act as bases for operational improvements.

2.10

For practical reasons, it will not be possible for an organisation to attend to the needs of all stakeholders. Some prioritisation is necessary.

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From an ethical perspective, the views and expectations of those stakeholders most affected by the organisation’s operations should be considered and acted upon. Such stakeholders should also be provided with accounts that document how the organisation has performed in relation to those expectations.

From a ‘managerial perspective’ it is often the case that those stakeholders with the most power to influence the operations of the organisation (with this power perhaps linked to the resources they control, and which are required by the organisation) will have their needs and expectations met. That is, the needs of powerful stakeholders are often prioritised. However, managers need to make sure that the rights of all impacted stakeholders are respected, otherwise there can be negative implications for the reputation of the organisation, and this can ultimately flow through to its financial performance 2.11

As indicated on page 69, 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 reflected in this definition, 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.

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 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 carbon-related emissions. Conversely, an organisation that does not accept responsibility for mitigating its contribution to climate change will be relatively unlikely to have such governance policies.

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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.

2.12

Yes, systems of corporate governance and accounting practices are likely to be related.

If managers believe they have a responsibility for certain aspects of performance, then they are likely to put in place policies and procedures to ensure that those responsibilities are performed and that the related actions and outcomes are reported, monitored and controlled. That is, where governance policies are in place, it is also important that appropriate monitoring systems exist to ensure that the policies are actually being followed. Having a policy in place without effective monitoring and enforcement mechanisms can render policies relatively useless.

Therefore, we could expect that the managers’ perspectives of responsibilities and associated accountabilities will not only influence what governance policies are established, but will also influence what accounting practices are put in place.

‘Accounting’ and corporate governance are very much related.

2.13

It is a fact that the accounting programs in some universities differ in terms of the amount of the courses that are devoted to addressing social and environmental performance. Some universities spend little time focusing on social and environmental issues. Rather, they tend to focus on various aspects of financial performance.

In explaining the reason for this different focus, it is likely that the programs that focus relatively highly on issues to do with financial performance have lecturers who tend to prioritise the interests of financial stakeholders rather than broader stakeholders. Such lecturers are likely not to spend time focusing on broader issues to do with organisational responsibilities and associated accountabilities.

Students should be encouraged to reflect on different subjects/units they have taken and what perspective of responsibility and accountability appeared to be embraced by the lecturers involved.

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2.14

As page 58 notes, 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.

The surrogate stakeholder – who is often a social or environmental non-government organisation (NGO) – works on behalf of other stakeholders who are either unable to voice their own expectations and concerns (for example, the environment or future generations), or do not have the power to make their voice heard (for example workers within factories in developing countries who produce goods for large multinational companies).

As an example of a surrogate stakeholder, we can refer to a labour rights organisation/NGO which perhaps has the power to enforce the rights of workers within factories located within developing countries. The workers themselves might have no power to force employers to provide safe work environments or to demonstrate proper accountability. So, they need the help of the NGO to project their rights. We return to the issue of surrogate accountability in Chapter 9.

2.15

The materiality determination process is the process of determining what to disclose/ report to stakeholders, and what not to disclose. That is, the materiality determination process (also referred to by other titles such as ‘materiality assessment process’) is an important process that organisations undertake to determine what particular items of information to publicly report. It involves various forms of engagement with stakeholders and a prioritisation of particular stakeholders’ information demands.

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 can 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 that the managers have employed, the disclosure about the processes should enable readers to better understand the context 36

for why some information is reported and other information is not. This should increase the understandability of the report.

2.16

It is important for researchers to explore the factors that motivate managers to make particular disclosures. Such insights will be of use to various stakeholders, such as the users of corporate reports, and also to people with a responsibility for regulating disclosures.

From a users’/ readers’ perspective, before they read particular disclosures, it is useful to try to understand why the disclosures were made in the first place. That is, what were the managers’ motivations for disclosing particular information?

This is particularly the case when it comes to unregulated disclosures – such as many corporate disclosures made with respect to social and environmental performance. For example, since the choice by managers to produce social and environmental performance information is often voluntary, it is important that users are provided with some insights into why managers have decided to report, as the answer to this question could impact whether users of this information should be relying upon it when making decisions. That is, it will impact whether we should believe the information being disclosed is reliable.

For example, if evidence shows that managers are reporting simply to enhance their organisation’s reputation/legitimacy/profitability – as much research shows (and this is discussed in Chapter 9) – then readers of the information might be wise to question the objectivity (representational faithfulness) of the information. This in turn might increase the need for an independent review/ audit of the information before it is relied upon.

By contrast, if research shows that organisations with particular attributes predominantly seem to be objective when making their disclosures, and that they seem to respect the rights of people to be informed about the various impacts of the organisation, then users might be better placed to rely upon the organisation’s disclosures, particularly those made voluntarily. Researchers might be able to discover

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attributes of organisations that provide an indication that an organisation does respect the rights of stakeholders to be informed about organisational performance.

Research about the motivations of managers to report will also be of relevance to disclosure/ accounting regulators. For example, if research shows that managers make disclosures to simply win support or to increase profitability then this might signal to regulators the need to regulate such disclosures rather than leaving it to the discretion of managers. In the social and environmental accounting literature, for example, much research has shown that social and environmental disclosures are used as a means to bolster corporate legitimacy. This is an important finding and increases the veracity of arguments supporting the need to regulate such disclosures.

It is important that we do not naively believe everything managers report. Research into managers’ motivations for reporting can provide guidance for readers in terms of when they perhaps should be relatively sceptical about the disclosures being made by managers.

In practice, there will be a range of motivations that could be driving managers to make disclosures which could incorporate various ethical and managerial reasonings.

2.17

As Chapter 2 notes, the four-step accountability model addresses the following issues in a sequential manner: •

Why report?

•

To whom to report?

•

What to report?

•

How to report?

The answers to the ‘to whom’, ‘what’, and ‘how’ questions ultimately can be linked back to the answer to the ‘why report’ question which is the first step in our four-step accountability model. That is, the answer to this ‘why report?’ question then influences the following three steps, which are the ‘to whom to report?’, the ‘what to report?’ and the ‘how to report?’ steps.

For example, if an organisation’s reporting is motivated exclusively by managerial reasoning and strategising (for example, it is primarily focused on increasing the wealth 38

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.

Conversely, reporting motivated by ethical/moral reasoning will seek to address the information needs of a broader range of stakeholders. Specifically, a broader ethical approach to reporting would direct the reports 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’ ‘right to know’.

Once we have answers to ‘why report?’ (Step 1) and ‘to whom to report?’ (Step 2, as just discussed above) we can then answer the ‘what to report?’ (Step 3) question. For example, if we have decided that the targeted recipients of the information are shareholders, then we might decide that the most relevant information is information about the financial performance and financial position of the organisation.

Once we have addressed the first three steps of our four-step accountability model we can then determine how and where the information is best reported. For example, if we have arrived at the decision that investors are our targeted audience, and we believe that financial reports are what they want/need, then we might produce financial statements and make them available on the organisation’s website. We would reasonably assume that all investors would have access to the internet.

2.18

The answer to this question is also addressed by the answer to Question 2.16. As we have noted, stakeholders who have an interest in the reports being prepared by managers ideally will have an insight into what motivated managers to prepare particular reports.

For example, if they think that managers are simply reporting to enhance the organisation’s reputation or legitimacy, then they might be right in questioning the reliability of the information being presented.

Conversely, if it appears managers are reporting because they believe they have a moral responsibility to do so, then stakeholders might be right to consider the disclosures as 39

being relatively reliable (relative to disclosures made by managers who are just disclosing information for the purposes of advancing the organisation’s, and therefore their own, interests).

2.19

The point being made here is that although we can likely use the four-step accountability model in most situations, and therefore the same four broad ‘steps’ in explaining or prescribing the reporting process, 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.

For example, there will always be a reason why managers have decided to report. It would not have simply been a random happening. For example, some managers might be reporting because of a belief in the need to demonstrate full accountability.

Alternatively, some managers might decide to report because of the financial benefits it will likely bring to the organisation and/or to themselves. That is, there could be different reasons, and these can be referred to as departure points.

For example, if we depart from an ethical accountability focus and instead decide to report solely because of perceived business benefits, then this will move us down a different path in terms of Step 2 – where we decided ‘to whom’ to report. Rather than reporting to impacted stakeholders, we might report to those stakeholders with power to impact the financial performance of the organisation.

As Chapter 2 states, if a judgement (grounded in certain ‘values’) is made from a neoclassical 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 would be prioritised (the ‘what to report?’ question), and the information would be provided in financial reports

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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 that 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.

2.20

This question should actually be referring to Figure 2.3 and not Figure 2.1. In terms of Figure 2.3, the argument is that our perceptions of organisational responsibilities will influence our views about what the organisation should be accountable for. In turn, our views about what we should be accountable for will then influence the ‘accounts’ we prepare, and therefore the ‘accounting’ that we practise.

For example, if we do (do not) believe we have a responsibility for workers across our supply chains then we will (will not) embrace an accountability for how those workers are treated, and we will (will not) provide accounts that provide information about what we have done to ensure the fair treatment of workers.

2.21

If the managers of an organisation are primarily focused on satisfying the information needs of powerful stakeholders, then the managers would directly engage those stakeholders to determine their information needs and expectations. They would tend to disregard the needs of other less powerful stakeholders. For example, managers 41

might decide to only provide information that is demanded by financial capital providers and to disregard the information needs or expectations of various interest groups within society. In such an instance, the disclosures would be used as a means to manage, or perhaps manipulate, the powerful stakeholders.

Organisations that only provide information to powerful stakeholders, and which ignore the information needs of other stakeholders would not be deemed to be demonstrating a high level of accountability. A high level of accountability would be demonstrated when disclosures are being objectively made to a cross section of stakeholders who are impacted by the operations of the organisation.

2.22

Expectations about the responsibilities and accountabilities of organisations change across time and this has direct implications for the types of accounts being produced, and therefore, for the practice of ‘accounting’.

For example, a number of decades ago there was little attention from the community directed towards issues associated with the treatment of workers within supply chains.

This has changed however, and now people expect an organisation to report information about how it ensures that workers employed across supply chains are properly treated.

The same sorts of comments can also possibly be made about issues relating to climate change and animal welfare.

Changes in the way markets are organised (for example, greater globalisation and greater outsourcing) and in how members of society interact (for example, evolving social media and an increasing reliance on cashless transactions) will also lead to changes in how accounting is undertaken.

Because perceptions of organisational responsibilities will change across time, the aspects of performance that managers will be accountable for will also change.

Accounting practices need to evolve to meet these changes. Evidence shows how ‘accounting’ has greatly changed over the past few decades with issues such as modern slavery and climate change now being accounted for in ways that were never previously undertaken.

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2.23

Should we ever be asked to help a client prepare a sustainability report it is necessary that we clearly understand why they are wanting to prepare one – which is the first step in the four-step accountability model (the ‘why step’). The reason why a potential client is wanting to produce a sustainability report will then have direct implications for determining which stakeholders to consider (Step 2) as part of the reporting process.

For example, if a client is only wanting to report because of potential financial benefits, then we might only engage those stakeholders who have the ability to impact financial performance.

Conversely, if the client is wanting to produce a sustainability report because the client wants to be accountable for its significant social and environmental impacts then we might extend the range of stakeholders to be considered to those who are most impacted – regardless of whether such stakeholders have any ability to influence the performance of the organisation.

As the chapter emphasises, once we then engage the stakeholders we can then, and only then, address the next steps in terms of what to report (Step 3), and how to report (Step 4).

2.24

In the absence of steps to standardise reporting practices internationally, we would expect accounting practices to be different in different countries.

As Figure 2.4 indicates, there will be various reasons why perceptions of responsibilities and accountabilities will be different in different countries, and these difference will then flow through to differences in accounting practices.

For example, factors such as religion, culture, type and place of education, and professional associations have all been found to impact views about responsibilities and accountabilities. Different countries will differ with respect to these factors, and therefore we expect international differences in accounting (which in turn is an argument against a one-size-fits-all approach to accounting).

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For example, Chapter 5 will explore in more depth how 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. 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).

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Chapter 3: The financial reporting environment Solutions 3.1

Accounting standard-setters do not specifically address the expected accounting knowledge of financial statement readers but there is an expectation that the readers of general-purpose financial reports have a ‘reasonable knowledge’ of business and economics. Specifically, the IASB Conceptual Framework for Financial Reporting states 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’. Hence, there appears to be an implied expectation that financial statements are not tailored to meet the needs of people who have not, in some way, studied financial accounting. Students should be encouraged to consider whether this expectation is in itself ‘reasonable’.

3.2

As Chapter 2 states, there is an expectation held by accounting standard-setters that users of financial statements have a reasonably sound knowledge of business and economic activities. For example, within the IASB Conceptual Framework for Financial Reporting reference is made to users who ‘have a reasonable knowledge of business and economic activities and who review and analyse the information diligently’. Within the United States Conceptual Framework Project, reference was made to the ‘informed reader’.

Hence, a view has been adopted by the regulators that users of financial statements should have a certain level of knowledge of business, and by inference, of financial accounting, so when financial reporting standards are being developed, this level of knowledge is assumed. In defence of this position, we could probably argue that if such an assumption was not made then the development of financial reporting standards would be much more difficult and time consuming given that the standard-setters would need to consider how uninformed users might react to the particular standards. The position adopted is consistent with other professions which also typically assume a certain level of expertise when developing guidance for their profession’s members (however, we need to be careful with justifications like this – just because others do a certain thing does not mean it is the ‘right’ thing).

If users of financial reports find it necessary, there are many experts who would be 45

available to provide advice on how particular numbers were derived. Indeed, the IASB Conceptual Framework states that ‘at times, even well-informed and diligent users may need to seek the aid of an advisor to understand information about complex economic phenomena’. Of course, such advice will generally be at a cost which does raise the issue that it can be costly for some individuals to gain an understanding about the operations of organisations that perhaps have an impact on their ongoing existence. Hence, while there is arguably a ‘right-to-know’, for people without any financial accounting knowledge, this right can only be exercised at some cost.

3.3

In making this judgement, students should consider the various articles that frequently appear in newspapers and various discussions that occur on television and radio in relation to an organisation’s profits. Rarely is any mention made of the accounting methods used, even though the profits ultimately reported are directly a product of the many decisions that would have been made regarding how particular items should be accounted for (if possible, direct reference should be made to a number of articles which discuss organisations’ reported profits).

Hence, it does appear as if profits are often held out as some form of ‘hard’, objective measure of organisational performance.

In considering why the media might behave in this manner, one possibility is that those responsible for writing the stories are ignorant that financial accounting relies upon a great deal of professional judgement, and they might believe that every decision made by accountants is clearly mapped out by a comprehensive system of rules. Alternatively, the writers might consider that people simply do not want to be ‘bogged down’ in the fine detail. As another possibility, the accounting profession, through such vehicles as conceptual frameworks, may have successfully cultivated an impression (with the people in the media, and others) that the practice of accounting is objective, and the output of the accounting system is highly comparable between different entities – meaning that one organisation’s profits can appropriately be compared to another.

The implications of this approach to reporting profits in the media is that one entity’s performance as represented by its profit might simply be compared to another, and that the entity with the higher reported profit might be considered to 46

be more successful, and therefore to represent a better investment. Its management might also be considered in a more favourable light than the management of the entity with the lower reported profits. Implications such as this, however, assume that readers and media listeners do not appreciate that profits are directly related to the various financial accounting choices made. Advocates of an efficient market perspective might, however, argue that as long as the information about financial accounting method selection is made public somewhere, such as in the annual report, then the market (for example, the capital market) on average, will be able to understand how the adoption of particular accounting methods affected reported profits and hence the market will not simply fixate on the final numbers reported.

There are differences in opinion about the efficiency of markets, such as the capital market.

A further point that could be raised in relation to this question is that financial accounting ‘profits’ are not a comprehensive measure of organisational performance, given that accounting profits typically disregard many of the social and environmental implications of a reporting entity.

3.4

It would be unrealistic and somewhat naïve to believe that all accountants will be objective and free from bias when preparing financial statements. Financial accounting numbers are used in many agreements (such as management compensation agreements and debt covenants negotiated with lenders), and financial accounting numbers – such as profits – are often used as a basis for arguing that organisations could pay more in wages, could drop the price of their goods and services, and so forth. Hence, given the very real role of financial accounting numbers within society there will be various pressures on the financial accountant in respect of those numbers, and not all accountants will be able to resist pressure to alter the financial accounting numbers.

Also, in answering this question, we cannot ignore the evidence of creative accounting that has been exposed in past years, including that related to various high profile corporate failures in which creative accounting was later detected.

In considering whether accountants will always be objective, our expectations will also be influenced by our views about what drives individual behaviour. For 47

example, if we were to adopt an economic perspective in which we believe all people are driven by self-interest tied to wealth maximisation then we might have little difficulty accepting that accountants will not be objective in undertaking their role, particularly to the extent that a lack of objectivity might lead to personal gain.

3.5

Creative accounting can be defined as an approach to accounting wherein objectivity is not employed, 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.

There can be a number of reasons why creative accounting might be employed.

Perhaps it might be undertaken to hide some fraud. It might also be undertaken because the organisation might have negotiated various contractual arrangements with various stakeholders. For example, the organisation might have borrowed funds from certain lenders, and as part of the lending agreement the organisation might have signed a contract that included various covenants that use financial accounting numbers and which have the aim of reducing the risks of the lenders.

This also would have reduced the costs that the organisation would have paid for the finance. In this regard, the organisation might have agreed to restrict its total level of debt by means of a stipulation that its debt to asset ratio is not to exceed a pre-specified upper limit (often referred to as a debt to asset covenant), or it might have agreed to maintain a certain interest coverage ratio, for example, that its profits (perhaps before interest and taxes) was to exceed/cover interest expense by a minimum number of times.

When an organisation has agreed to certain accounting-based debt covenants, then a failure to comply with these covenants/restrictions means that the organisation would enter what is commonly referred to as ‘technical default’. Being in technical default can be costly for an organisation and can potentially lead to the company being discontinued. To avoid this, the accountant might be encouraged to ‘creatively’ increase reported income and assets, both actions of which would lead to a reduced probability of technical default (to the extent that the creativity remained undetected).

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Also, organisations often pay key people within an organisation rewards that are tied to the performance of the organisation. These management bonuses might pay a bonus based on reported profits, return on assets, or perhaps sales. Such bonus schemes are common. When people’s bonuses, and therefore wealth, are linked to accounting numbers there will be pressures on the accountant to be ‘creative’ with the accounting numbers.

The above discussion has been far from exhaustive. There can be many reasons why creative accounting can occur. Not all accountants will respond to the various pressures to be ‘creative’, but to believe that accountants are always objective (and never ‘creative’), would be very naïve.

3.6

Some of the arguments in favour of regulating the practice of financial accounting are provided in the text and 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’ approach may argue that the 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 upon some unregulated disclosures.

• Those who demand information can often do this as a result of power over scarce resources. Parties with limited power (limited resources) will generally be unable to secure information about an organisation, even though that organisation may impact upon 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.

• Regulation helps provide confidence to investors in capital markets, and it is often considered that such confidence is important to societies.

There was also a view that major adverse events such as the Great Depression, and more recently, collapses such as Enron, WorldCom, HIH and Lehman 49

Brothers were due to the fact that financial information being provided about particular entities was misleading and did not enable readers to be aware of impending problems. Whether a ‘better’ system of accounting could have reduced the likelihood of events such as the Great Depression or unexpected corporate collapses is however, a highly debatable point.

3.7

Developing accounting regulation based upon a survey of what most accountants currently do will not necessarily lead to best possible practice given that just because most accountants do something, this logically does not necessarily mean that it is the most appropriate, or best way, to do something.

If people do not know there are better practices available, then they may be inclined to follow commonly used, but potentially sub-optimal, practices. People typically need to be shown that there are better practices available before they change what they do. They need education.

Accounting researchers, and their use of theory, have a role in identifying potential improvements in existing accounting practice. What is necessary is that there is some form of critical examination of current practices, with this critical analysis potentially being linked to some underlying theory.

3.8

Special purpose financial reports are financial reports that meet the specific information needs of a specifically identified, and potentially narrow group of stakeholders. They 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. Special purpose financial reports do not need to comply with the requirements embodied within financial reporting standards or the conceptual framework.

General purpose financial reports, by contrast, are reports that are expected to comply with financial reporting standards and conceptual framework prescriptions.

They meet the information needs common to users who are unable to command the preparation of reports tailored specifically to satisfy all their information needs.

General purpose financial reports are subject to high levels of regulation because 50

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. Such regulation is also considered to help bolster confidence in capital markets.

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.

3.9

Management accounting focuses on providing information for decision making for parties who work within an organisation (that is, for internal as opposed to external users) and it is largely unregulated. That is, management accounts can effectively be compiled in whatever manner the managers believe best serves their specific purposes and needs. Whereas most countries have a multitude of financial reporting standards that are 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.

They can effectively access what information they need, and in the form they want.

It is the information rights of outsiders who have funds invested in an organisation, but who only have access to general purpose financial reports, and who are not involved in the day-to-day management of an entity, that must be protected.

3.10 Financial accounting measures such as ‘profits’ ignore many social and environmental externalities. For example, if an organisation releases huge amounts of carbon dioxide into the air, or releases pollutants into waterways, then unless some fines or taxes are imposed, no expenses will be recognised and there will be

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no direct impact upon profits. Therefore, we must appreciate that performance measures such as ‘profits’ are incomplete measures of performance.

In Chapter 10 we will more fully explore the reasons why generally accepted financial accounting practices (with adherence to financial reporting standards and conceptual framework requirements) ignore the social and environmental externalities being generated by organisations. As we will learn, factors such as the application of the entity principle, the way we define the elements of financial reporting (in particular the way we define assets and expenses and the related reliance on ‘control’), and the need to consider issues such as measurability and probability all act to exclude many social and environmental costs from being recognised by the financial accountant.

3.11

No, it is not appropriate. Financial reporting standards change regularly across time with the effect being, that for a given set of transactions and events, different ‘profits’ can be calculated in different time periods because of the different rules.

That is, a change in profit from one period to the next might simply be because a new financial accounting method has been released.

Therefore, any research that investigates changes in profits across time (perhaps the research uses ‘profits’ as the dependent variable and tries to explain how profit has changed as a result of various initiatives or factors) must make some adjustments to offset the effects of changing financial accounting methods.

3.12

Arguments in favour of eliminating regulation are often referred to as ‘freemarket’ arguments. Advocates of a ‘free-market’ approach typically base their arguments on an assumption that markets (such as capital markets, labour markets and product markets) are efficient and that the markets will provide various incentives and penalties to ensure that managers, on average, do as the market expects. For example, if the capital market expects an entity’s managers to provide information and the managers elect not to, then the market might penalise the entity by charging a higher price for funds advanced to the entity (to compensate the investors for the higher risk that they face as a result of having limited access to information to enable them to monitor their investment). Further, it is also believed by some people that the absence of information probably implies that the 52

reporting entity has bad news that it has elected not to disclose (it is a ‘lemon’).

The textbook also identifies a number of other arguments that have been advanced to support a ‘free-market’ approach to providing accounting information. These 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 it has use. This will, it is assumed, lead to an optimal supply of information by entities.

• Because users of financial information typically do not bear its cost of production, regulation will lead to oversupply of information (at cost to the producing firms) as users will tend to overstate the need for the information.

• Regulation typically restricts the accounting methods that can be used. This means that some organisations will be prohibited from using accounting methods that management believe best reflect their particular performance and position. This is considered to impact the efficiency with which the firm can inform the markets about their operations. This will have implications for the costs involved when a firm needs to attract investment capital. This perspective is very critical of the globalised ‘one-size-fits-all’ approach to accounting standards wherein the IASB is now responsible for developing accounting standards that are to be used by organisations operating within different industries and within different countries throughout the world (students should be encouraged to consider whether, for example, an accounting standard on inventory (IAS 2) is equally relevant for a motor vehicle manufacturer in China and a food producer in Australia.)

3.13

There are various theories available to describe what motivates regulators to introduce new legislation. There is the public interest theory of regulation, which proposes that 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’. Therefore, under this theoretical view, regulators are motivated by the ‘public interest’ when introducing new legislation.

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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 selfinterested and will introduce regulations more likely to lead to their re-election or reappointment. In deciding on a particular regulation, they will consider the impacts on key voters, or other decision makers, 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. Therefore, this theoretical perspective assumes that the actions of legislators, as with all other people, are driven by self-interest rather than some consideration of the ‘public interest’.

3.14

As the separation between the ownership and management of an organisation increases, this generally leads to an increase in the demand for accounting regulation. As separation increases, parties with a financial interest in an organisation will have less direct knowledge of the operation of the organisation.

They will then become dependent upon financial information being generated by the organisation. To help ensure that appropriate information is being provided to the external parties, regulation will be introduced to help ensure that generally accepted financial accounting principles are being used in the preparation of the information, and to assist external parties to make assessments of one organisation’s financial position and performance relative to another organisation (the attribute of comparability).

Of course, the above argument is a ‘pro-regulation’ argument. As this chapter has demonstrated however, researchers that embrace an anti-regulation stance would not favour the introduction of regulation irrespective of changes in the degree of separation between management and ownership. Such researchers would argue that there are ‘market-based’ incentives for organisations to provide sufficient

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reliable information and that failure to produce such information will lead to market-based penalties being imposed upon the organisation.

3.15

Developing rules based upon observing what accountants are actually doing in practice is referred to as an ‘inductive approach’ to research (that is, research based on observing particular phenomena). Some criticisms of this approach to developing accounting rules and theory are that in studying ‘what is’ there is an implied assumption that just because most people do something then somehow it must be the ‘best’ thing to do. This is not necessarily the case. Further, it will not necessarily lead to improvements in practice as there is no direct action undertaken to evaluate the practice. As 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.

As indicated in the textbook, if we are not exposed to new ideas, we might use commonly used approaches which are not necessarily the most efficient approaches. For example, if we have only ever been exposed to people who use a screwdriver to dig a hole then we might think this is the best thing available – yet there could be something better …. A shovel!!

3.16

Pursuant to capture theory, while regulation might initially be introduced in the public interest, the regulatory mechanisms are often subsequently captured by those groups that are subject to the regulation. The regulated parties seek to capture the regulatory process so that they can then act to ensure that any subsequent regulations do not disadvantage them. This chapter referred to the work of Walker (1987) who provided evidence that the Australian accounting profession was able to capture the government-controlled accounting standardsetter (at the time, the standard-setter was known as the Accounting Standards Review Board). Across various industries there has been historical evidence of related regulatory bodies being captured by vested industry interests.

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3.17

This is an interesting question in the sense that it emphasises that one’s view of the world influences whether one is prepared to accept a particular theoretical perspective.

If we reject the view that individual behaviour can be explained in terms of selfinterested, wealth-maximising behaviour then we would reject private economic interest theories of regulation. If we were trying to explain the regulatory process then we would search for an alternative theory that was more in accordance with our views (unless advocates of the private economic interest theory of regulation are able to convince us that their assumption is reasonable) about individual behaviour; alternatively, we might attempt to develop our own theory (however, most researchers rely on existing theories).

Whatever theories and assumptions we adopt we must remember that perspectives about how humans behave cannot be expected to hold in all situations. While there might be a great deal of anecdotal evidence that some regulators behave as if in their own self-interest, hopefully there is also evidence that many regulators also act in the public interest. Students should be encouraged to consider their own assumptions about what motivates regulators and therefore, what theories best correspond with their own views.

3.18

This is an interesting and topical question. Climate change is accepted (by most people) as being one of the greatest threats (if not, the greatest threat) to the future of mankind and other inhabitants of the planet (other key problems confronting the planet would include population growth).

Quests towards ecologically sustainable development, which incorporate actions to reduce ongoing contributions to climate change, necessarily put the interests of future generations above current quests to maximise our own wealth and selfinterest.

However, if we accept the basic tenets of the private interest theory of regulation then we would probably reject a view that regulators would put the interests of the planet and that of future generations above their own. They would only put in

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place mechanisms to reduce climate change if such actions were believed to be directly beneficial to them.

Since business corporations have a great deal of power within society, and because their views and support could have direct implications for the reappointment of the regulators, the opposition of business organisations might further reduce the likelihood that ‘tough’ regulation, with associated costs, would be put in place to combat climate change. For evidence of this we can consider the actions currently being undertaken by various governments to combat climate change. To many people it would appear that government actions throughout the world (or, more to the point, government inactions) are restricted by concerns not to damage relations with business associations and because of the economic impacts such actions might take (many people consider that governments worldwide are not being active enough in addressing climate change because making policies that restrict consumption of various products, and increasing the costs of carbon intensive activities, will not be popular with many people within the community and this will lead to a loss of electoral support).

Arguably (and of course this is a value-laden belief), economics-based theories, which at their core adopt assumptions that self-interest (tied to wealth maximisation) drive the actions of individuals, do not provide great hope for real efforts to address ongoing ecological problems.

3.19

In general, the role of financial reporting in European countries was different from the role of financial reporting in countries such as the United States, the United Kingdom, Australia, or Canada. A possible reason for this was due to the differences in sources of funds. In European countries there was not, until recent decades, large scale reliance on funding from capital markets. Rather, funding typically came from a limited number of investors, or from a limited number of debt providers. Because there was only a limited number of relatively powerful investors and lenders within the European context these parties were able to specifically require the organisation to provide the information they required to specifically meet their information needs. There was not such a need to regulate to protect the interests of these parties, and there was typically not a requirement for investors or lenders to rely upon general purpose financial reports.

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By contrast, within countries such as the United Kingdom and the United States there was more evidence of companies attracting capital from a large number of investors, many of whom were separated from the management of the company, and who did not individually have the power to command information tailored to meet their specific information needs. These parties tended to rely upon general purpose financial reports for their information. Regulation relating to general purpose financial reports – including financial reporting standards – was particularly relevant to satisfying their needs for information.

The implications of this were that the release of accounting standards was a much earlier phenomenon in countries that relied upon funding from external sources (such as the United Kingdom and the United States), compared to those European countries which relied upon a limited number of parties that were generally able to require the organisation to meet their specific information needs.

However, with increasing globalisation of business and capital markets, the role of financial reporting undertaken by large companies in all European countries is now more 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.

3.20

If we embraced the central tenets of either capture theory or the private interest theory of regulation then we would probably accept that ‘objective’ accounting standards (which favour no particular group) would only be developed if their creation coincided with furthering the interests of the standard-setters. This can be contrasted to the perspective we would adopt if we believed accounting standards were developed in the public interest, as would be suggested by public interest theory. However even under public interest theory, ‘objective’ accounting standards would only be developed if the overall benefits to society exceed any associated costs. Any consideration of costs and benefits also acts to undermine the objectivity of the accounting standard-setting process (cost benefit calculations inevitably include an element of subjectivity).

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Hence, regardless of the theoretical basis adopted, we might question whether accounting standards will always be developed that ‘fairly present information about the financial position and performance of a reporting entity’.

3.21 Accounting standard-setters throughout the world typically consider the economic and social implications that could potentially arise if particular accounting rules were put in place. That is, while a particular method of accounting might be considered to provide the most accurate and efficient reflection of a reporting entity’s financial position and performance (and of course, this in itself will be based on views about what are the most appropriate ways to measure and recognise elements of accounting – and there is much debate here), if it is considered that the proposed method might lead to unacceptable economic or social hardship for some members of the community, inclusive of the reporting entity, then the method may not be introduced even though it was otherwise considered to be the best method available.

Consideration of the costs and benefits of new accounting rules requires a great deal of judgement and various costs and benefits have to be traded off against one another (and depending upon who is doing the analysis some costs and benefits might be included, or ignored, when doing the analysis). Consideration of costs and benefits can be very subjective.

Many different parties will make lobbying submissions to the standard-setters in which they indicate how they will be impacted by the proposed requirements. Not all people will be satisfied by the outcome of the standard-setting process, with some believing that their case was not appropriately considered, and as a result, believing that they bear a disproportionate amount of the costs relating to the new requirements. If accounting standards were developed in a ‘neutral’ manner, then rules might be put in place on the basis of their theoretical merit and not as a result of considering the costs and benefits that might follow.

By considering various costs and benefits as part of the process of developing accounting standards, the final result will be that the accounting standards themselves will be an outcome of various cost/benefit trade-offs and political considerations. The standards will be different to those that would be developed 59

solely on the basis of providing the most objective picture of the organisation’s performance and position (and, of course, there will be differences of opinion as to what is an ‘objective picture’). It could therefore be argued that given the process involved in developing accounting standards, in which various cost/ benefit decisions are made and in which various lobbying submissions are considered, then the standards themselves are not developed in an objective manner. Without objectively developed accounting standards it is questionable whether financial reports developed in accordance with the standards can themselves be objective.

3.22

Free-market advocates would argue that if the users of financial accounting information are not required to pay for the information, then they will tend to overstate their demands and needs for information in an effort to encourage regulators to mandate additional disclosures. The free-market advocates believe this creates unnecessary costs for organisations as they will end up producing information that people would not demand if they knew they would have to pay for it. Free-market advocates argue that accounting information should be treated like other goods, and forces of supply and demand should be left to operate freely to determine the optimum amount of information to supply.

3.23

This is an argument that would be proposed by people who are opposed to regulation and who would prefer that organisations and their managers be free to select the accounting methods that best reflect the underlying operations of the entity. It is an anti-regulation argument.

The basis of the argument is that organisations have various market-based incentives to provide information that best reflects the financial performance and financial position of the reporting entity. There is a view that the more efficiently an organisation can provide accounting information, the less the perceived risk of investing in an organisation. That is, there will be incentives for managers within organisations to select those financial reporting methods which best reflect the underlying financial performance and position of the entity (often referred to as the ‘efficiency perspective’).

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Regulators might decide to restrict the financial reporting methods available to an organisation. (Perhaps the regulators release a financial reporting standard that prohibits various financial accounting methods; for example, they might release a standard that requires all entities to expense research expenditure as it is incurred – even those entities that have undertaken research that will lead to significant economic benefits.) If this is the case, then the argument is that the reporting entity will no longer be able to select the most appropriate (or ‘efficient’) financial accounting methods, and hence the financial accounting information will not best reflect the financial performance or position of the entity.

If the information does not best reflect the underlying transactions, then users would not be able to monitor the entity as well as they might otherwise have been, and this in itself will increase the perceived risk of investing in the entity. This in turn will lead to higher costs for the entity to attract funds.

While the above arguments (which are based on an efficiency perspective) argue against restricting the financial accounting methods that reporting entities can use, it should be appreciated that from an ‘opportunistic perspective’ there is a counter view. If we believe that managers might be opportunistic, then it might be preferable to restrict the available accounting options, as this will go some way towards restricting the propensity of managers to be ‘creative’ rather than objective when selecting accounting methods.

3.24 The basis of Hines’ (1989) arguments is that the accounting profession develops conceptual frameworks (which identify qualitative characteristics such as objectivity) primarily to provide benefits to themselves as a profession and that conceptual frameworks are ‘devices’ used to ensure the ongoing existence of the accounting profession by boosting the profession’s public standing. Conceptual frameworks are considered to represent a means of increasing the ability of a profession to self-regulate, thereby counteracting the possibility that government intervention will occur. Hines (1991, p. 328) argues that ‘since the objectivity assumption is the central premise of our society … a fundamental form of social power accrues to those who are able to trade on the objectivity assumption.

Legitimacy is achieved by tapping into this central proposition because accounts generated around this proposition are perceived as normal’.

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If we are to accept Hines’ argument, then notions of ‘objectivity’ are nothing more than a façade. Hines also suggests that when accounting professions are in crisis (with threats of government intervention) this appears to be the very time that they undertake projects associated with developing conceptual frameworks.

3.25

The accounting standard-setting process is a political process in which constituents typically provide various submissions during the period in which accounting standards are developed (and for some accounting standards this period has been as long as a number of years). Depending upon the force of the argument, some arguments will have more effect on the regulators than others.

Further, standard-setters have publicly stated (in vehicles such as conceptual frameworks) that they consider the economic and social implications of potential requirements as part of the process of developing new standards. Once the potential costs and benefits to various constituents are considered and weighted, which necessarily requires much judgement about the nature and relevance of the costs, and once the views of various constituents are taken into account, it is indeed difficult to believe that the ultimate accounting standards have been developed in a manner that can be considered objective. (As we have seen in this chapter, there are a number of theories of regulation which suggest that regulators are driven by issues associated with their reappointment, rather than the public interest.) If accounting standards are developed on a basis that is less than objective, then the financial statements themselves can arguably not be considered as objective either (even though objectivity is promoted in various conceptual framework projects).

3.26

The argument is, that in developing financial reporting standards it is important and perhaps appropriate to consider the costs that might be imposed on some parties if the standards are put in place. That is, there may be some unacceptable economic consequences that might result from implementing the standards (at issue here is from whose perspective are the economic consequences deemed to be unacceptable – it would generally be considered that it is from the standardsetters’ perspective). However, once we start considering the costs and benefits that might result (and the recognition and weighting of the respective costs and benefits would arguably be different depending upon whose perspective is 62

adopted) rather than the merit of the standards themselves, we really cannot argue that the standards have been developed in an unbiased manner.

3.27

Hines challenges the view that financial accounting provides an account of the performance of an entity that is a faithful representation and objective. Rather than objectively recording a snap-shot of an underlying reality, accountants actually create a reality. She believes that accountants are actually responsible for determining which factors should be recognised in the accounting process and which should be ignored. If accountants identify and record particular phenomena, then the phenomena effectively become real. If accountants ignore particular issues (for example, the great majority of accountants ignore the social and environmental externalities caused by a business), then these issues are not highlighted and are therefore not, apparently, of any relevance. The practice of accounting identifies those issues for which the firm will be accountable – which issues are relevant. If managers do not want to be accountable for particular aspects of an entity’s performance, then perhaps the best strategy is not to record information about those aspects. If information about those aspects is not recorded, monitored and subsequently reported, then perhaps nobody will consider the particular aspects to have any relevance, and managers will not have any associated accountability.

There is also a view that accounting numbers can themselves generate consequences. If a company elects to use a particular accounting method, which leads to it recording a substantial loss, then this loss might cause panic and a rush by investors to withdraw their funds, even though the firm might have been able to trade out of difficulties. Had different methods been used, which perhaps painted a rosier picture, there might not have been such an adverse reaction. The accounting numbers themselves, which are based on many assumptions, led to actual outcomes that were very real for investors, customers, employees and others. If accounting used other performance indicators, apart from profits (such as contributions to the local communities or to employees) then stakeholder reactions might be different.

3.28

There can be many examples provided here, and therefore a comprehensive answer is not possible.

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One example might be the release internationally of IAS 38 Intangible Assets.

This standard requires, amongst other things, that all research must be expensed as incurred. This can be contrasted with the requirements previously in place within, for example, Australia. Within Australia, prior to the adoption of IFRS in 2005, reporting entities were allowed to capitalise research expenditure (subject to certain tests for deferral). The new requirement to immediately expense research expenditure would arguably have caused some entities to defer or even cancel some research activity. We are never to know whether such deferred or cancelled research might have led to some important ‘break-throughs’ that might have provided significant social benefits. Therefore, the adoption of IAS 38 in various countries might have had real social implications.

As another example we can consider the efforts of the IASB and FASB to develop a new accounting standard on leasing. This new accounting standard – which has proved to be very ‘political’ in nature in terms of the number of submissions being made by various vested interests (all of which have contributed to years of delay in issuing a final standard) was argued to have led to a reduction in the use of leasing of various assets. The reduction in leasing would obviously have direct cash flow consequences for various organisations. Requiring many leases to be recorded in the statement of financial position (many of which were previously excluded from recognition) would also have implications for many organisations in terms of potentially defaulting on various debt covenants – and this will also create various economic consequences.

3.29

This chapter has provided several reasons why accountants might be considered to be powerful individuals. These reasons include the following: • Consistent with the views of Hines, accountants can select which items or events should be captured by the accounting system, and this in turn impacts the extent of accountability managers have.

• Support for a company is often related to the performance of the company from an accounting perspective. Hence, if the accountant uses particular methods that mean that a profit is reported then this may have positive consequences for a company relative to a situation where a loss is reported.

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• Many contracts exist (for example, management bonus plans, debt contracts) which rely upon the output of the accounting process. Such contracts have direct cash-flow consequences for people both inside and outside the organisation and the cash-flows can be directly impacted by the accounting methods which have been chosen.

• If the accountant uses accounting methods which lead to a reported loss, this reported loss might be used as a justification for reducing the number of employees, support for community-based projects, and so forth.

• Consistent with the views of Gray (1992), for people to be able to make informed decisions and have ‘power’ to create change, they need information.

The accountant often plays a part in determining how much information is to be released to the organisation’s stakeholders.

• Organisations that are profitable are often considered to be ‘good’ organisations worthy of support. They are considered to be legitimate – hence the accountant, through financial accounting, can have the effect of making a firm appear legitimate and thus it will attract community support.

3.30

If an organisation is required to publicly disclose information about a particular aspect of its performance, then various stakeholders will have knowledge about that aspect of the organisation’s performance and will act accordingly.

Conversely, if no information is publicly available about particular aspects of an organisation’s performance, then people will not be sufficiently informed to take action in support of, or against, an organisation. In a sense, they would not have ‘power’ to create change.

Of course, some theorists might argue that if ‘the market’ requires such information and the organisation does not supply the information, then ‘the market’ will penalise the organisation. But such market-based arguments ignore the actions and expectations of many ‘non-financial’ stakeholders – unless the market believes they have the power to influence the financial position or performance of the reporting entity.

In relation to this question, we can consider the financial accounting treatment of greenhouse gas emissions. Traditionally, the release of carbon gases into the environment has not been accounted for in financial accounting terms (unless 65

particular fines were imposed). This has meant that many carbon-intensive firms have shown massive profits at the same time as they were making real negative contributions to climate change (of course, these views would be challenged by ‘climate-change sceptics’). Arguably, this is why relatively few efforts have been undertaken by corporations to reduce carbon emissions.

However, had the accounting profession developed an approach to account for carbon emissions and to place a cost thereon, then this would have had the very visible impact of reducing reported profits – and this would have been very visible.

Reduced profits would have had the implications of reducing dividends. Those with a financial stake in the organisations would have then had a very good reason to encourage organisations to reduce their impacts on climate change – the impacts that financial accounting would be making ‘real’.

Given the above comments, a somewhat provocative question to pose to the students would be: is the accounting profession in part responsible for climate change? Some interesting and diverse views should follow.

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Chapter 4: The regulation of financial accounting Solutions 4.1

The Oxford Dictionary defines regulation in terms of a ‘prescribed rule’ or ‘authoritative direction’. This 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, when we are discussing regulations relating to financial accounting, we are discussing rules that have been developed by an independent authoritative body that has been given the power to govern how we are to prepare financial statements, and the actions of the authoritative body will have the effect of restricting the accounting options that would otherwise be available to an organisation. The regulation would also be expected to incorporate a basis for monitoring and enforcing compliance with the specific regulatory requirements.

4.2

Supporters of reducing regulation often use the argument that accounting information is like any other good and that the forces of supply and demand should be allowed to operate so that the optimal amount of accounting information is produced. These advocates of the ‘free-market’ approach also argue that markets, such as the capital market, the market for managers and the market for corporate takeovers, operate efficiently and will impose penalties on managers who do not elect to provide unbiased information about an organisation’s financial performance and position.

Opinions based on a contracting perspective are also used to support arguments for reduced regulation. The argument is that all individuals will act in their own self-interest and will take actions to maximise their own wealth. Further, it is assumed that people will expect others to behave in this manner. If investors or creditors are considering advancing funds to an organisation then, if the managers agree to provide financial information on a periodic nature (probably subject to an audit by an independent third party), the outside parties will be able to monitor the actions of the (self-interested) managers and will be prepared to advance funds to 67

the entity at a lower cost. Managers will have incentives to provide information, as failure to do so might mean that no funds can be attracted or, if they can, only at high cost. Hence, in the absence of regulation there will be private incentives to produce accounting information. Further, managers are assumed to be able to best determine what methods of financial accounting best reflect the financial performance of their entity, rather than leaving it to regulators to impose particular methods which in certain cases may be unsuitable.

There is also the ‘lemons’ argument which suggests that in the absence of regulation, managers will still be motivated to provide financial information or else the organisation will be assumed to be a ‘lemon’.

In considering the logic of the above arguments, we can consider a number of issues, including the following: • Accounting information has a characteristic similar to a ‘free good’ and it is generally accepted that market mechanisms do not operate efficiently in relation to free goods.

• An acceptance of market efficiency and the notion that it will lead to optimal amounts of information being produced, suggests that managers are somehow able to determine the marginal costs and marginal benefits associated with disclosing particular items of information. It is arguable whether most managers have this degree of sophistication.

• There is evidence to suggest that markets display characteristics which indicate that they are not always efficient. Further, market-based arguments are based around ‘on average’ outcomes. That is, while market mechanisms cannot be expected to control the behaviour of all people (such as managers) at all times, on average they will provide a disciplining mechanism. On average arguments, however, ignore the possibility that in the absence of regulation, some people may lose their life savings.

• There are arguments that in the absence of regulation only those parties with sufficient power (perhaps as a result of controlling scarce resources) will be able to obtain the information they demand. Such arguments suggest that issues associated with rights-to-know are ignored and in the absence of regulation, affected individuals will have no access to information.

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• The ‘market for lemons’ argument assumes that if you do not disclose particular information then the market will penalise you. This assumes that the market somehow knew you had information to disclose.

• Contractual arguments in favour of producing information to reduce agency costs, seem to be more applicable in the presence of small numbers of contracting parties, but as the number of parties with an interest in the organisation increases, the view that various contracts (with associated information production requirements) can be coordinated becomes, perhaps, quite unrealistic.

4.3

The basis of the ‘lemons’ argument is that if an entity elects not to disclose particular information, and perhaps its competitors are making disclosures, then the non-disclosing entity must have something to hide. In such respects it must have bad news which it would prefer people not to know about. It is a lemon.

If we accept this perspective that no news will be considered as meaning that the organisation is hiding bad news, then stakeholders will react negatively to companies that do not make disclosures when some disclosure was expected (this reaction might be in the form of capital market participants paying lower amounts for the securities of the organisation).

The ‘market for lemons’ perspective is assumed to provide an incentive for managers to release information, even in the absence of any regulation that requires disclosure, as failure to disclose will have implications for the organisation, and if we assume that various contractual arrangements are in place, also for the managers’ own wealth. Of course, whether we actually believe that the market will penalise non-disclosers is a matter of opinion. Is the market really expected to be so efficient that it becomes aware of potentially bad news about some (perhaps unexpected) issue which has not been disclosed? What do the students think about this?

4.4

As we know from reading this chapter, when financial reporting standards are being developed the accounting standard-setters will typically call for submissions from ‘interested parties’. Since these submissions will be taken into consideration when developing financial reporting standards, these submissions have the 69

potential to influence the accounting standard that is ultimately released (and the influence of the submission will perhaps be driven by the perceived credibility of the arguments being made within the submission). Introducing public debate into the accounting standard-setting process can have the effect of reducing the neutrality or objectivity of the final standards.

Also, accounting standard-setters consider the costs and benefits of potential regulations before they are introduced. Considerations of costs and benefits are subjective exercises. If a potential accounting standard is perceived as likely to create significant economic or social impacts, then the standard-setters might decide against introducing the new or revised standard despite the fact that they believe it otherwise represents ‘best practice’. This could mean that an existing accounting standard is retained even though it is deemed inferior to the proposed accounting standard and despite the fact that the existing accounting standard may in itself cause potential economic and social impacts that could be challenged.

If we were to accept the economic interest group theory of regulation which provides a perspective that regulators, like all individuals, will be driven by selfinterest, then we might also question any belief that accounting standard-setters will develop accounting standards in an unbiased manner. Pursuant to this theory, accounting standard-setters would develop accounting standards that most benefit their own interests (perhaps because the accounting standard favours a group that has influence over the reappointment of the regulator).

4.5

There are many pressures on accounting standard-setters which have the potential to impact the potential neutrality of accounting standards and the potential independence of the standard-setter. For example, accounting standard-setters consider perceived costs and benefits of proposed accounting standards as part of the accounting standard development process. Considerations of costs and benefits are subjective activities. Further, the (subjective) cost benefit calculations might lead to the rejection of a proposed standard despite the fact that it might otherwise represent ‘best practice’. This might be the case even if the standardsetters are attempting to act in the public interest (as suggested by public interest theory).

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Also, the standard-setting process typically involves interested parties making submissions. This introduces a political component into the accounting standardsetting process which again has the potential to threaten the objectivity or neutrality of any final accounting standard.

Related to the above point, if parties are able to make submissions as part of the standard-setting process then, consistent with the economic interest group theory of regulation, accounting standard-setters may elect to develop the accounting standards in a way that satisfies the concerns of those stakeholders which are of most importance to the standard-setters (perhaps the stakeholders have the ability to influence the re-election of the standard-setter, or are able to provide some other financial benefits).

Hence with various considerations in mind we can perhaps question whether the IASB (or any other accounting standard-setter) can realistically develop ‘neutral standards’. Also, whether we believe the standards they develop will be developed in the ‘public interest’ will be influenced by our view of what motivates regulators.

As we have seen, some theories of regulation assume that regulators will act in the public interest whereas other theories assume that everybody is motivated by their own self-interest, including regulators.

4.6

A ‘public good’ is a good which, after it is first made available, can be used by others without them paying for it, and which can be passed on to others that also do not pay for its use. Public goods, or free goods as they are often called, are traditionally considered as goods which are not scarce, and which do not have a price.

Relying upon market-based arguments to ensure that optimal amounts of a good are produced assumes that all users pay for the good. If free riders exist (people who use but who do not pay), then the quantity of a good will be under-produced relative to what would be produced if all that used the good did pay for its use. It is possible that users of a public good would pay for it if required, but if a good is public in nature, then there is no need to pay for it. Advocates of accounting regulation use this argument to suggest that optimal amounts of information will not be produced if we are to rely upon market-based mechanisms alone.

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4.7

The argument is that market forces do not operate effectively for goods that have ‘free’ or ‘public’ characteristics. Only the initial consumer might pay for the good however, and once available, others can use it at no cost. (For example, once information is released to one party, the information may spread quickly to others.

Consider the role of investment analysts – they might quickly disseminate the information to their clients.) With this in mind, the producers of the good might only receive payment from the first consumer. The first consumer, however, might be reluctant to pay a high price for the good given the knowledge that subsequent users will not pay (if it is truly ‘public’). Hence, producers will have limited incentive to produce the good given that consumers, on average, will not pay. Optimal amounts of the good (and determining this is problematic) will not be produced as market mechanisms break down. If all people paid however, then such mechanisms might not break down.

Regulation is often introduced when there is an undersupply of a resource. This is more likely to occur for goods with ‘public’ characteristics.

4.8

An accounting standards overload is in existence when there is a multitude of accounting standards in place which provide only limited benefits to financial statements users, but nevertheless generate considerable reporting costs for the reporting entities. At issue is: how could such a situation occur?

According to advocates of a ‘free-market’ approach, accounting standard-setters will react to calls from constituents demanding that organisations release more information. Certain parties (for example, investment analysts) will make calls for additional information because they will not directly have to pay for the preparation of the information, yet they can use the information in the various investment decisions they are required to make. Further, the parties calling for the information will overstate their need for the information. Many economists argue that the regulation of free goods (and accounting information is considered to have ‘free good’ characteristics) leads to an overproduction of those goods with non-users effectively subsidising the consumers of the goods.

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4.9

Again, as with many of the issues raised in this chapter, and in other chapters, whether equity or fairness issues justify the introduction of regulation is a matter of opinion. Advocates of a ‘free-market’ approach would argue that in relation to business entities there are many mechanisms that will result in penalties for organisations and managers that do not operate as expected. For example, the capital market, the market for managers, the market for corporate takeovers, the market for ‘lemons’, privately negotiated contractual arrangements and so on, all provide disciplining mechanisms which penalise managers for not operating in accordance with expectations, including not providing accounting information which would normally be expected. However, whether these markets actually work depends upon one’s view about their efficiency, and also from whose perspective they are efficient (for example, are they efficient from an investors’ perspective alone and if so, is this enough?).

Even if we accept that markets are efficient (and many people do not accept this), the mechanisms provided above can only be expected to work, at best, ‘on average’. While organisations and their managers might be penalised in the long run, in the short run many people might have lost considerable amounts of their wealth. To protect these people, who are ignored by ‘on average’ arguments, many people argue that regulation is necessary. And as stated above, many of the mechanisms referred to by advocates of the free-market perspective tend to protect people with capital, but not others.

There are some researchers who argue that a lack of regulation can lead to public benefits. That is, a freely operating market generates benefits across society as markets provide ‘protection’ for market participants. For example, Milton Friedman (1962, p. 82) states:

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.

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4.10 The ‘invisible hand’ is the label given to a mechanism – which cannot directly be observed – that guides resources to uses that are most efficient for all people associated with particular markets. The assumptions inherent in the concept of the invisible hand are that, 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. Under this perspective, the introduction of regulation tends to distort the efficient functioning of markets, and such advocates of the ‘invisible hand’ believe that freely operating market mechanisms will protect people participating in market transactions.

Advocates of the ‘invisible hand’ also often use the supporting arguments relating to what is known as the ‘trickle-down effect’, or ‘trickle-down theory’. 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 ‘trickledown 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.

4.11

This chapter has described several reasons that have been proposed by certain researchers (‘free market proponents’ that oppose regulation) to support a view that even in the absence of regulation, organisations will provide optimal amounts of accounting information.

There will be private economics-based incentives for organisations to produce information. For example: • It is assumed that managers like all individuals, will operate the organisation for their own benefit and this is expected by shareholders and debt-holders (free market proponents hold a maintained assumption that all individuals are motivated by self-interest and hence everyone expects everybody else to act in a self-interested manner).

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• To maximise their own rewards, it will be in the interests of management to enter contracts with shareholders and debt-holders to constrain managers’ actions (these contracts will act to constrain the actions of management and to align the interests of managers with those of the owners of the organisation).

• Many of these contracts will be based on financial accounting information (for example, paying the manager a bonus based on accounting profits).

• Organisations not producing information will be penalised by higher costs of capital.

• There is also a view that organisations are best placed to determine what information should be produced. The introduction of accounting standards creates inefficiencies by imposing a ‘one-size-fits-all’ approach on external reporting. Imposing regulation restricting the available set of accounting methods decreases the efficiency of contracting (for example, the organisation might have developed what it considers is the best way to reflect managers performance, but an accounting standard may disallow the use of this accounting technique).

There are also anti-regulation arguments based on the operation of efficient managerial labour markets. Pursuant to the ‘market for managers’ arguments: • It is believed that the managers’ previous performance impacts on remuneration they can command in future.

• In the absence of accounting regulation, it is assumed that managers are encouraged to adopt strategies to maximise value of firm (provides favourable view of own performance).

• Such strategies include providing optimal amounts of accounting information.

There are also anti-regulation arguments based on threats of corporation takeovers. ‘Free market’ proponents argue that: • Underperforming organisations will ultimately be taken over by another entity with the existing management team subsequently being replaced (because ‘the market’ is deemed to be efficient it will identify organisations that are underperforming because of poor managers).

• Therefore, managers are motivated to maximise firm value.

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• Information is produced to minimise the cost of capital thereby increasing firm value.

Yet another argument against the introduction of accounting regulation is the ‘market for lemons argument’. The basis of this argument is that: • No information is viewed in the same light as bad information.

• The market may make the assessment that silence implies the organisation has bad news to disclose.

• Therefore, managers will be motivated to disclose both good and bad news .

As we can see from the broad discussion above, proponents of the free market (anti-regulation) approach to providing accounting information have a number of arguments to counter any calls for regulation. However, as the chapter demonstrates, there are many other researchers who would reject the above arguments and would argue that regulation is required for a multitude of reasons including a belief that markets are not efficient and that less powerful stakeholders will not always be protected by freely operating market mechanisms.

4.12

The answer to this, as with most questions in the textbook, depends on the theoretical perspective we adopt. If we adopt the theoretical economics-based assumption that managers will act in their own self-interest, then we would predict that there will also be a contractual demand to have financial statements audited by an external and credible third party. Such an activity will increase the perceived reliability 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. 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 requirements to do so (Morris, 1984). As Cooper and Keim (1983, p. 199) indicate, however, to be an effective strategy ‘the auditor must be perceived to be truly independent in the accounting methods employed and the statements’ prescribed content must be sufficiently well-defined’.

4.13

As this chapter explained, it is common for business organisations to suggest that the introduction of disclosure-based legislation would ‘stifle’ any form of innovation in 76

reporting, particularly in areas that are new or do not have mandatory frameworks for reporting (such as social and environmental reporting).

We can challenge the view that introducing mandatory reporting requirements would stifle innovation. Regulation would simply establish a minimum level of disclosure which organisations could elect to exceed.

This chapter has indicated that it is common for business organisations to oppose the introduction of various forms of legislation which limit the actions they might otherwise undertake. As it is also common for business leaders to argue that if society expects corporations to undertake particular actions, inclusive of reporting, then corporations will undertake these actions because failure to do so will impose costs on the organisation. This is often referred to as ‘enlightened selfinterest’. 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.

4.14

The view is that if people believe a process is regulated, even though they might not understand the regulation, they are more likely to have confidence in it. While this is a simplistic argument it does have intrinsic appeal. Such confidence might rely on a perspective that regulators act in the interests of the public. We know from reading this chapter that this is not a view shared by all accounting researchers. Some argue that regulation is only put in place if it is in the interests of the regulators (perhaps it will lead to their re-election). Others argue that regulation is put in place to protect the favoured positions of those with capital.

The quote from Cooper and Keim also suggests that if the financial system is regulated then the resulting increased community confidence will lead to a reduced cost of capital for all firms. This is an interesting view and perhaps we could speculate whether and how, we might collect evidence to support such an assertion. Certainly, regulators throughout the world often highlight the need for public confidence in capital markets and they often use this as a basis for introducing more regulation. Arguably, we might expect some regulators to have more credibility than others and hence there might be differences in community reactions depending upon who introduces the regulation. Also, different 77

regulations will obviously be more effective than others and it is conceivable that the community, on average, will take this into account.

Advocates of a ‘free-market’ approach would probably disagree with Cooper and Keim’s view. They would argue that regulation might impose unnecessary costs on many organisations and that this would have adverse consequences for a firm’s costs in attracting capital. Further, regulation may preclude the use of particular accounting methods even though particular firms had chosen to use such methods because they were the methods best able to reflect the performance of the entity – that is, such methods were effective in providing a measure of firm performance.

If ‘second-best’ accounting methods must be used, then this will increase the agency costs of the organisation, and hence the cost of capital.

4.15 Advocates of a ‘free market’ approach argue that in the absence of regulation there will still be private incentives for firms to produce accounting information, with the requirement to produce accounting information often included within various contractual arrangements in which the party is involved. This perspective is based on Agency Theory which asserts that when principals (owners) appoint agents (managers) to perform duties on their behalf there will (naturally) be conflicts of interest (assuming self-interest) and to resolve these conflicts, contractual agreements will be put in place. Accounting is considered to play a key role in allowing principals to monitor the efforts of agents.

For example, to motivate managers to work in the interests of owners the managers might be offered a percentage of profits. This would require the managers to produce financial accounting reports (which could be audited by an independent party). Similarly, it is argued that when organisations borrow funds, the managers will agree to provide information to the debtholders to enable the debtholders to monitor the ongoing security of the advanced funds. This contractual agreement is expected to mean that the organisation can attract the funds at a cost below what would be required if the managers did not agree to provide information on a periodic basis.

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While in theory, contractual mechanisms might work when there are a small number of contractual parties, Scott (1997) argues, that in the presence of a large number of parties, the argument tends to break down. As he states (p. 332):

Unfortunately, while direct contracting for information 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 seems feasible only when there are a few parties involved.

What should also be appreciated is that the contractual arrangements referred to above relate to contractual agreements (and the associated information requirements) between the organisation and parties that hold resources which the organisation requires (for example, labour or debt capital). Such a perspective tends to ignore the information requirements of other parties that might be influenced by an organisation (perhaps they live nearby) but who do not have resources that the organisation needs (that is, the contractual perspective ignores issues associated with right-to-know).

4.16

Arguments which rely on the market for managers assume that the managerial labour market is an efficiently operating market in which a manager’s previous performance will impact the salaries they can demand in future periods, either from their current employer or elsewhere.

With such a market, managers will have an incentive to maximise the value of the organisation, because actions which prove subsequently to be successful will become known by ‘the market’. Because providing information to the various parties with which the firm contracts will be beneficial for the firm in terms of 79

maximising its value, managers will have an incentive to provide information, even in the absence of regulation.

The ‘market for managers’ argument is frequently used as a basis for an argument against regulating financial accounting disclosures. However, we must remember that such an argument is heavily reliant on its assumption about efficiency in the market for managers. Many people argue that such markets often show signs of inefficiency. The ‘market for managers’ argument also tends to break down if managers are approaching retirement, in which case they will not be demanding any future payments from the market for managers.

4.17

The ‘market for corporate takeovers’ argument works on the assumption that an under-performing organisation will be taken over by another entity that will subsequently replace the existing management team. That is, ‘the market’ will be aware of the current potential the organisation has – potential which is not being utilised by the existing management team.

With a perceived threat of takeover, it is predicted (by free market advocates) that managers would be motivated to maximise firm value and thereby to minimise the likelihood that outsiders could seize control of the organisation at low cost. The ‘market for corporate takeovers’ argument assumes that information will be produced to minimise the organisation’s cost of capital and thereby increase the value of the organisation.

The above arguments assume that management will know the marginal costs and benefits involved in producing accounting information and in accordance with economic theories about the production of other goods, management will provide information to the point where the marginal cost equals the marginal benefit thereby maximising the value of the organisation and, as a result, making the organisation more expensive for anybody seeking to acquire it. Whilst the disclosure of financial accounting information will be to the interests of shareholders, it will also be in the interests of managers – there will be an alignment of interests.

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4.18

Proponents of a free market argue that managers will have market-based incentives to disclose credible information and the disclosure of this information will be beneficial to the interests of shareholders (for example, through reducing the cost of capital of the organisation thereby increasing profits), and will also be beneficial to the interests of managers (for example, through such mechanisms as the ‘market for managers’). Disclosure will be made until such time as the marginal cost of the additional disclosure equals the marginal benefit.

Whilst in theory this might be logical (given assumptions about efficiencies of markets, and so on), 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 perhaps somewhat unrealistic. Further, cost/benefit calculations tend to be very subjective exercises.

Do the students think that the ‘average manager’ would really know how to calculate the costs and benefits of particular disclosures if such assessments were required to determine whether particular disclosures would be made (for example, in an unregulated environment)? Certainly, the free market advocates would seem to believe that the ‘average manager’ has such expertise.

4.19

(a)

Public interest theory would probably provide the best explanation for the existence of laws which prohibit insider trading. Insider trading is considered by many to be unfair and to provide benefits to those people with access to particular (inside) information at the expense of people without such information.

Laws against insider trading are often justified on the basis of the ‘level playing field argument’, that is, that all capital market participants should have access to the same information, or else inequities are introduced. If insider trading was allowed to exist, then many people believe that the confidence of people about the functioning and fairness of the market would be eroded and this would have implications for the economy. A lack of confidence in the market would be deemed not to be in the public interest.

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(b)

Advocates of a free-market (anti-regulation) perspective would question whether issues of fairness should be put before issues of market efficiency.

Advocates of the ‘free market’ often reject issues of fairness or equity as irrelevant and instead place their confidence in markets – mechanisms that somehow (as if guided by an invisible hand) function to the overall benefit of all. What do the students think in relation to this issue?

In the case of insider trading, an anti-regulation perspective would suggest that various market-based mechanisms would act to ‘punish’ parties found responsible for insider trading. They might also argue that laws against insider trading focus too much on equity issues at the expense of issues of efficiency. Allowing insider trading would encourage managers to seek additional information which ultimately would become available to others (albeit, after the managers have made personal gains from using the information).

4.20 This is very much a matter of opinion. If we embrace a perspective that all people are driven by self-interest, then we would tend to reject the argument that anybody would necessarily do anything in ‘the public interest’. By contrast, if we embrace a ‘public interest theory’ of regulation then we might believe that members of the IASB would consider the public interest when voting in favour of, or against, particular proposals.

4.21 A well-functioning court system is an important aspect of a free market approach to financial reporting. One of the arguments against regulating financial accounting is that financial accounting-based contracts can provide a mechanism to align the interests of various stakeholders, thereby meaning that regulation is not required.

However, self-interested parties might elect not to comply with certain contractual requirements, and this can undermine the efficiency associated with the use of contractual arrangements.

One mechanism to encourage compliance with negotiated arrangements is a well functioning legal system – that is, well functioning law courts. That is, courts can be used as impartial arbiters to provide solutions between market participants and 82

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.

4.22

(a)

In the public interest theory of regulation, the regulators are assumed to act in the interests of the public and will only introduce regulation if the benefits to the public are believed to be greater than the costs. Regulation is not introduced to support particular vested interests and the regulators are not assumed to be driven by their own self-interest.

(b)

Advocates of capture theory also typically assume that regulation is also initially introduced with the public’s best interests in mind. However, once regulation is introduced, the parties that had been subjected to the regulation tend to be able to capture the regulatory process. The regulated parties typically do this for their own benefit. Hence, while it is assumed that the regulators might act in the public interest, it is typically assumed that those subjected to regulation act in their own self-interest. We can debate whether it is consistent to believe that some people act in their own self-interest whereas others (for example, the regulators) do not.

(c)

Economic interest theories of regulation assume that everybody acts in their own self-interest, including regulators and those people that are regulated (perhaps not an overly pleasant view of human nature).

Regulators will only propose and support regulation which leads to favourable outcomes for themselves, perhaps in terms of their re-election.

This perspective does assume that all people have similar motivations (in contrast to capture theory).

Students should be encouraged to consider which perspective of regulators matches best with their own views.

4.23

Given the material provided within this chapter, we should understand that there could be a variety of reasons why managers will make lobbying submissions to 83

the IASB. Some of the reasons might be linked to advancing the self-interest of those making the lobbying submissions (that is, linked to opportunistic motivations), while other reasons might be linked to concerns the lobbying parties have about how new accounting methods might undermine the efficiency with which organisations report their results.

From a self-interest (opportunistic) perspective, it is possible that organisations already have various financial accounting-based contractual agreements in place.

For example, they might have borrowed funds and agreed to a debt-to-assets covenant being put in place (for example, they might have agreed that total debt shall not exceed 60 per cent of total assets and they have agreed to this covenant because it will enable them to attract funds at a lower cost). If there is a new accounting standard being proposed that loosens the constraints associated with such a covenant (perhaps the standard will increase assets or decrease liabilities) then perhaps managers might lobby for the standard because it provides them with greater safety in terms of reducing the risks associated with potentially breaching the debt covenant. Conversely, they might oppose standards that decrease assets or increase reported liabilities because of the perceived economic consequences that the standard would have for the organisation, and therefore for the managers.

From an efficiency perspective, another reason for lobbying could be that managers believe they are best placed to select the financial accounting methods that most efficiently reflect the financial performance and financial position of their organisation, and that any efforts by the IASB to restrict the available set of accounting methods will act to limit the ability of managers to most effectively and efficiently report financial performance and position. This argument would suggest that managers would tend to lobby against the introduction of any restriction on the financial accounting methods they currently use.

The point to be made by this discussion is that there could be a variety of reasons why management might lobby. They might lobby because of concerns about their own self-interest, or they might lobby because of a real desire to improve organisational reporting practices. It is not always easy to differentiate the two.

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It should be noted that the IASB typically makes publicly available the lobbying submissions made by interested parties, and these submissions are a source of data for many accounting researchers.

4.24 Whether we believe that regulators will or will not be driven by their own selfinterest when designing and implementing regulations is really a subjective issue and ultimately a matter of personal opinion. As we have seen in Chapter 4, one theory, Public Interest Theory, assumes that regulations are put in place for the public interest. Economic interest theories, however, assume that all people are driven by self-interest (including regulators) and that the only reason that regulators will support particular regulations is that the introduction of the regulations will provide benefits to the regulators.

As we should appreciate, theories are abstractions of reality. To assume that all regulators act in the public interest (as indicated by public interest theory) or, alternatively, that all regulators always place their own self-interest above the interests of others (as indicated by private economic interest theories of regulation) would be rather naïve. They are simply assumptions. Realistically, we could expect that some regulators will be more public interest oriented than others (and vice-versa), or that on different issues, specific regulators may take various positions on the self-interest-public-interest spectrum.

4.25

Questions such as this really depend upon how efficiently we believe various information networks operate. If regulators’ actions and the implications of those actions are to be perfectly known by the regulators’ constituents, then knowing this the regulators will be driven to make decisions which lead to outcomes which are desired by the constituents. All would be known. However, such notions of information efficiency will seldom hold and therefore it is difficult to see how it is in the public interest for regulators to be driven by their own self-interest.

A further issue in relation to this question is which stakeholders are ultimately able to influence the reappointment or re-election of the regulator. If the regulator can freely function in their own self-interest, perhaps consistent with private economic interest theories of regulation, the regulator will only consider the demands or needs of those parties with the power to influence the regulator’s wealth (perhaps 85

a group who control a large block of votes). Those individuals without the necessary power will have their interests ignored.

4.26

The students will provide different answers to this question depending upon the financial reporting standard they select. As an example of how a newly released or revised accounting standard might have negative economic and social consequences, we can consider the accounting standard AASB 138 Intangible Assets, which was initially released within Australia in July 2004. This is the equivalent of IAS 38. This standard covers various intangible assets. We will specifically consider its treatment of research and development.

Under the new accounting standard, all research must be written off as incurred.

Under the previous accounting standard within Australia (AASB 1011), research was allowed to be carried forward to the extent that the future economic benefits were expected ‘beyond reasonable doubt’. The implications of the new accounting standard were that reporting entities that had incurred expenditure on research that was expected, beyond reasonable doubt, to generate economic benefits were required to expense the expenditure. The expenditure would be treated the same as expenditure on research which was not believed likely to lead to future economic benefits. This rather conservative accounting treatment therefore does not allow us to differentiate between entities with valuable research, and those without (hence, from an ‘efficiency perspective’ the merit of the accounting standard can be questioned). Every entity is treated the same, including both the successful and unsuccessful researchers.

As a result of the new accounting standard, managers will now know that any research they undertake will, at least at the outset, have a negative effect on profits.

For entities that are suffering poor profitability there might now be a view that it might be preferable to defer research until subsequent periods when profits are higher and therefore, they are better able to absorb the expenditure. The reduced expenditure – brought about by the conservative treatment now required by the accounting standard – will have obvious economic effects. Suppliers of the research-related supplies, services and so forth will receive less funds. If it is expected that the research would lead to advances in particular technologies that benefit people, then the deferral of the research will have social implications.

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Apart from entities with poor profitability, entities with senior managers approaching retirement might also undergo a reduction in expenditure on research (assuming managers are motivated by self-interest). For example, if a manager was on a profit-sharing scheme and if that manager was about to retire then he or she might elect to curtail research expenditure because any positive effects might not arise for many years, whereas the impacts the expenditure will have on profits will be immediate. A retiring manager will not share in the subsequent benefits the research will generate (unless they own shares or share options) and hence they would reduce the entity’s research expenditure.

As a more recent example, we can consider the efforts of the IASB to develop a new standard on accounting for leases. This financial reporting standard – IFRS 16 Leases – was in development for almost a decade before it became effective for reporting periods ending on or after 1 January 2019. IFRS 16 required the capitalisation of many more leased assets and lease liabilities than the pre-existing requirements. IFRS 16 therefore had implications for ratios such as debt to asset ratios, and debt to equity ratios. Such ratios are typically used in debt covenants negotiated between firms and their lenders. IFRS 16 also requires greater expenses to be recognised in the early years of the lease relative to the former standard (due to higher interest expenses), and this impacted earnings-based debt covenants, such as interest coverage clauses. Given the effects on debt covenants, a number of organisations suffered a ‘technical default’ of various debt contracts, and this had economic consequences for such organisations. Because of the changed requirements in relation to accounting for leases, this had implications for the number and amount of assets than entities were prepared to lease. A reduction in the total number of leases being entered by organisations throughout the economy could create various adverse social and economic implications. It is arguably because of the various economic implications that might flow from the new financial reporting standard that the standard attracted much discussion and submissions on various exposure drafts, and why it took so many years to be finalised.

4.27

If we accept the economic interest theories of regulation, then whether we believe a particular group is able to secure favourable legislation will be dependent upon 87

whether we assess that introducing such legislation will be in the interests of the regulators. Economic interest theories of regulation assume that regulation will only be introduced if it is in the interests of the regulators. Hence if a group wants to have favourable legislation introduced then, accepting this perspective of the world, they will need to demonstrate that they have resources that can be used by the regulators or perhaps that they control a block of votes that can help ensure the re-election or re-appointment of the regulators. Those people or groups without the resources or votes sought by the regulator are deemed to have little or no voice in the regulatory process (such a perspective would emphasise the need for interest groups to organise themselves as large cohesive groups of members with sufficient resources and votes to enable them to be heard).

We can perhaps debate whether our own views of politicians are consistent with the economic interest theory of regulation. Do we think that politicians would place their own private interests above the public interest?

4.28

In many countries throughout the world, financial reporting standards have traditionally been developed following a particular due process in which draft standards are developed and then released for public comment before final standards are developed. This process is also adopted by the International Accounting Standards Board (IASB – the body responsible for developing the financial reporting standards that are now used in many countries. During the time in which comments are sought, written submissions will generally be made. It is generally accepted that the more that the proposed standard represents a departure from existing generally accepted accounting practice, the more submissions are likely. For example, consider the development of the new standard on accounting for leases – IFRS 16. This standard had major impacts on financial statements for those organisations with a relatively large volume of leased assets, and it attracted a relatively large amount of submissions.

Since the standard-setters consider the contents of the various submissions when finalising the standard, the process is considered to be political – different people provide an opinion in an attempt to influence the development of the standard.

Some opinions are likely to have more impact than others. Because the financial reporting standards used in many countries are developed in this manner, and 88

because the views of the people in different countries can be expected to be different (due to such things as ‘cultural differences’, an issue investigated in Chapter 5) we might consequently expect there to be international differences in financial reporting standards. Such differences which have traditionally existed are now greatly diminished as more countries adopt the standards released by the IASB, rather than having standards developed by their own domestic standardsetting body.

If a standard-setter did not behave in a political manner (that is, if it did not take account of the views of its constituents) there is some likelihood that the standardsetter may not be able to maintain its legitimacy and hence may be forced out of existence.

4.29

This is an argument to support the introduction of legislation in relation to accounting information. The argument is that market forces of supply and demand cannot be expected to function properly in relation to ‘free goods’, or as they are also described, ‘public goods’. Public goods, which would include information, can initially be acquired at a cost, but can then be passed on to other users who will not then necessarily pay for them – these people would be referred to as ‘freeriders’.

In the presence of ‘free-riders’, market forces cannot operate, and true demand will be understated, the consequence being that regulation is needed in order to provide optimal levels of information.

4.30 Neutrality and objectivity would imply that accounting reports are generated without consideration being given to the social and economic effects that the reports will create. However, if the rules upon which the accounting reports are generated have been developed via a political process in which various constituents’ views are considered (and many compromises and trade-offs are made between various constituents and between various costs and benefits) then it is difficult to consider that accounting reports can be neutral and objective. If accounting standard-setters rely upon public support to survive (as the evidence seems to indicate) they cannot simply develop accounting standards on the basis that they are the best available from a theoretical perspective.

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4.31

This is clearly a matter of opinion (the inclusion of ‘should’ in the question signals that some value judgement is necessary). The standard-setter might consider that the method of accounting will enable financial statements to provide the ‘best’ reflection of the financial position and performance of the reporting entity and might decide to ignore the economic consequences that could follow. But this would appear to be a naïve approach and ignores the accepted position that standard-setters rely upon constituent support (perhaps, particularly from those people or groups that are powerful) to ensure their survival. Traditionally, conceptual framework documents throughout the world have specifically noted that social and economic consequences will be considered when accounting standards are developed.

If constituents have different views about the merits or otherwise of particular proposals, then we can speculate on how the standard-setters might decide in favour of one position over and above another. In this chapter we considered various theories of regulation. If we accept the view provided by public interest theories of regulation, then the standard-setters will select the method that provides the greatest overall public benefit. If the needs of financial statement users outweigh those of the preparers, then some costs will be imposed on preparers.

If an economic interest theory of regulation is accepted, then perhaps the standardsetters will opt to support the party with the most power to help to ensure the standard-setter’s survival. If there is widespread community support for a particular method of accounting, then perhaps the interests of the preparers will be ‘sacrificed’ in the interests of the public. Conversely, if the preparers represent a powerful lobby group, then perhaps their interests will be primarily considered.

Hence, what the standard-setter will do is not clear. What it should do is a matter of opinion. Perhaps we can argue from a normative position that they should promote a standard because it represents the best way of recording transactions, regardless of the potential social and economic consequences (but as we noted above, this may be a naïve position). If we are concerned about the survival of the

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standard-setter, then we might argue that they should firstly consider the interests of the powerful constituents.

One issue that perhaps warrants some consideration when determining what should be done is to consider the current rules in place and whether they appear to currently advantage some parties (perhaps due to past lobbying efforts) at the expense of other parties. It is not clear that considerations of economic consequences by standard-setters consider whether existing arrangements are currently equitable.

4.32

Across time, evidence shows that people holding senior positions in corporate regulators have subsequently been offered jobs by corporations that they previously acted to regulate. Evidence also shows that regulatory bodies have offered jobs to people who held senior roles in organisations the regulator used to regulate. Such job offers would be of concern to many people who believe in the insights provided by Capture Theory.

For example, if somebody acting as a regulator is potentially able to secure well paid employment in an organisation that was subject to the regulation, then it is possible that the regulator will provide favourable regulation in order to increase the chances of subsequent well-paid job offers. Also, if a regulatory body offers a job to somebody who formerly worked in the regulated industry, then it is possible that the appointed person will be favourably disposed towards their former industry (perhaps because of ongoing professional and personal affiliations), thereby undermining the objectivity of subsequent regulation.

In both these instances, the regulatory authorities might 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 would raise concerns for people who believe that regulation should be developed in the public interest.

4.33

(a)

If we embraced the public interest theory of regulation then we would tend to believe that the regulator introduced the requirement because on balance, it provided greater social benefits than related costs. That is, there was a net benefit to society (even though some parties might gain, and 91

some parties might lose). As we indicated in the chapter, however, the determination of costs and benefits of regulation tends to be a rather subjective exercise. The public interest theory of regulation does not give consideration to the implications the decision may have for the livelihood of the regulator (that is, it would ignore the fact that industry bodies with significant electoral power might be opposing the legislation).

(b)

By contrast, if we embraced the economic interest group theory of regulation then we would argue that the regulator like all individuals, is driven by self-interest and the enactment of the legislation must be perceived by the regulator as being beneficial to their own interests. For example, perhaps powerful labour unions with power to affect the reelection of the regulator demanded the introduction of the legislation.

4.34

Different theories can be used to explain why the EU adopted a ‘watered down’ version of IAS 39 rather than the full standard. Which theory we elect to embrace will be based on our own assumptions about what motivates individuals – and specifically in this case – what motivates regulators.

If we were to adopt a ‘public interest theory of regulation’ then we might argue that the EU believed that adopting the watered-down version of the standard was better than the possible alternative wherein there might have been broad noncompliance with the full version of IAS 39, and such non-compliance might have unduly impacted the confidence various stakeholders had in European capital markets and this in itself might have had widespread social and economic effects – none of which might be in the public interest.

If however, we adopted an ‘economic interest theory of regulation’ – which embraces an assumption that everybody, inclusive of regulators, is driven by selfinterest – then we might argue that representatives on the EU perhaps believed that their ongoing employment with the EU was in part dependent upon corporate support and hence it was necessary for them to take into account the demands of the powerful corporate stakeholder group. Also, corporations financially support the administrative operations of the EU and if the EU decided not to adopt a watered-down version of the standard there might have been some fear that 92

funding levels would be cut. Hence, it might have been in the interests of those people working at the EU that they support a watered-down version of the standard, despite the fact that there was no evidence to support a view that this was in the broader social interest.

If we were to adopt capture theory then we would look at the decision makers within the EU to see if linkages could be made with various corporations, such that they lobbied for standards that were consistent with the wishes of the corporations.

4.35

As the newspaper article indicates, President Jacques Chirac supported the opposition to the requirements of the standard (IAS 39) even though experts were saying the changes that would be brought about through the adoption of the standard were necessary in an endeavour to curtail accounting practices adopted at organisations like Enron.

Although students are required to adopt the ‘most appropriate theory’ to explain the actions of Chirac, it must be emphasised to them that the theory they select will be driven by their own values and expectations about what motivates politicians like Chirac.

If the students believe that politicians are likely to act in the public interest and are not driven by their own self-interest, then they might adopt public interest theory to explain Chirac’s actions. They might argue that Chirac considered that the standard might cause financial instability in France, and that such instability was not in the interests of the broader society.

If, however, the students believe that politicians’ actions are driven by their own self-interest then they might embrace the private economic interest group theory of regulation. In this case there might be a perception that Chirac’s continued presidency required the support of the business sector and the best way to maintain that support was to lobby for the changes that the business sector wanted. In this way the lobbying activity was effectively being swapped for votes.

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4.36

Again, as emphasised in other questions, the theories we choose to explain particular behaviour will be impacted by our own beliefs about what motivates human behaviour. We should also emphasise that theories are abstractions of reality and hence whatever theory we choose to use, it will not provide a comprehensive explanation of human behaviour.

Another point that should be made is that if we believe all individuals are motivated in the same way, then we would adopt a similar theoretical orientation to explain everybody’s behaviour. For example, if we believed that all behaviour is best explained by people fixating on their own self-interest (perhaps in quests to maximise their own wealth) then we would use the private economic interest group theory of regulation to explain the actions of Tweedie and Ruth Picker and we would assume that those responsible for the lobbying in both the banks and the insurance companies were also making the submissions because their preferred accounting standards would lead to positive wealth implications for themselves.

That said, we will now consider each part of the question in turn:

(a)

If we consider the stance that Tweedie is taking, it does look unpopular with most parties. If we were to embrace a public interest theory of regulation then we might believe that Tweedie considers that the world would in general, be better off if all countries adopted, without change, the standards being released by the IASB. An alternative perspective, however, and one tied to considerations of self-interest (and therefore aligned with the private economic interest group theory of regulation) would be that the legitimacy of the IASB as an international accounting standard-setter would be eroded if countries started introducing changes to IFRS before approving them for local use. This could, at an extreme, lead to the demise in the position of the IASB as the global standard-setter and this could have implications for the employment of people such as David Tweedie.

(b)

Again, if we reject a view that people are primarily motivated by their own self-interest, then we might assume that the banks believe that too many negative effects will occur throughout the economy if the IASB standards were adopted without change. Perhaps the banks believe that the rules within 94

the standards do not allow the banks to most efficiently provide information about their financial position and performance. Alternatively, if we embrace a view that the managers within the banks are driven by their own selfinterest, then perhaps they are lobbying against the standards because adoption of the standards will have negative implications for their private wealth. (As one example, perhaps the managers are on profit sharing schemes. If the new standards required significant impairment losses to be recognised, then this will reduce profits and the related share of profits they would receive in absolute terms.) Also, perhaps they prefer to retain the flexibility they previously had in how certain things, such as derivatives, were to be accounted for so that they have the ability to be ‘creative’ with their accounting policies should the need subsequently arise.

(c)

The same arguments provided in part (b) could be applied to insurance companies. In the newspaper article it is stated that the insurance companies worried about the volatile profits that might arise if they had to measure investment assets at market value (which will go up and down across time). There could be ‘legitimate’ reasons why the insurance companies are worried about volatile profits – perhaps they believe that investors and other stakeholders will not understand the basis of the volatility and as a result will act inappropriately. Alternatively, perhaps they are worried about the personal effects the changes in profits might create (perhaps to their own bonuses, reputation and so forth).

(d)

There could be an argument that Picker’s actions are consistent with a view that she has been captured by business interests. Apart from working on the AASB, Ruth Picker also had extensive links with the accounting profession (she has a background of being a partner in a large international accounting firm). Accountants work for business and provide services to support business; hence, it might be construed that she would use her position on the AASB to also support business – a view that business interests have effectively captured the AASB. Alternatively, Picker might be acting in the belief that there are flaws with the international financial reporting standards and that it would be preferable for changes to be made before they are adopted within Australia. What is being emphasised again 95

is that the lens through which we choose to see human behaviour (that is, the theoretical perspective we embrace) will be impacted by our own perceptions about what drives people to act in particular ways.

4.37

The view here is that something that is developed in the ‘public interest’ is difficult to criticise. Therefore, if politicians or regulators want to get widespread support for their actions then it is somewhat predictable that they will use the ‘public interest’ argument to gain support for what they are doing. Whether they are motivated by the ‘public interest’ will not always be obvious. ‘Left-leaning politicians’ – the term used in the quote – is a term often used to describe politicians that oppose freely operating market forces and who favour regulation to support the interests of people who have less financial wealth. Indeed, their voter-base (those who vote for them) will typically include relatively more people from lower socio-economic groups than the voters of more ‘right-wing’ politicians. From a ‘self-interest perspective’ it would be important for ‘leftleaning politicians’ to be seen to be supporting regulation that controls capital markets, takes control of industries away from powerful private interests, and provides social benefits to those people with less financial wealth – otherwise they might not be reappointed. If we accept that all individuals are driven by selfinterest (the assumption of private economic interest group theories of regulation) then all politicians will support those policies and regulations that are most popular with the voters that traditionally support them.

4.38

As with most issues, there are many diverse opinions. There are some people who still doubt the existence of climate change (despite the mounting scientific evidence). There are also some people who maintain an anti-regulation approach in response to climate change and who argue that the market is the best place to create change. However, a counter argument is that, to date, ‘the market’ has not addressed the issue (indeed, there is an argument that unregulated market forces are an underlying cause of climate change) and that is why the absence of regulation has led to the environmental problems we now have. Perhaps ‘selfinterest’ left to run rampant has caused many of our problems?

The economics-based theories discussed in this chapter (often adopted by free market advocates) arguably do not provide great hope for addressing climate 96

change. These theories embrace self-interest as a central assumption. But, quests towards sustainable ecological development require people, and organisations, to consider the interests of future generations, rather than simply their own wealth, when making investment and consumption decisions. In this regard we can consider a frequently used definition of sustainable development, this being: … development that meets the needs of the present world without compromising the ability of future generations to meet their own needs (World Commission of Environment and Development, 1987)

Related to the above point, a further and perhaps somewhat controversial point (which should stimulate discussion amongst the students) is whether university economics and finance schools should continue to teach students that ‘self-interest’ best describes what motivates the action of people in society. Does such teaching further perpetuate the use of self-interest as the basis of making decisions? Does it encourage graduates to apply self-interest, rather than broader social goals, when they are confronted with alternatives? An interesting issue to debate!

Doctrines such as public interest theories perhaps provide more hope that people will do the ‘right thing’ regarding the environment and future generations, but whether the assumptions underlying public interest theory are realistic is another issue to consider. Many discussions about the current state of the planet and the likelihood that these problems can be solved involve considerations of the underlying factors that drive human behaviour and that drive the actions of politicians. This chapter provides some insights into such discussions.

4.39

(a)

From a public interest theory perspective the government would introduce the legislation if they believe that the projected benefits to society exceed the projected costs. Determining costs and benefits is a subjective exercise and the assessment necessarily means some parties might benefit whilst others may bear more costs from introduction of the legislation. It is a balancing act.

(b)

Capture theory would suggest that ultimately it will be the regulated party that captures the regulatory process to ensure that any subsequent 97

regulation best serves its own interests. Since the disclosure will have particular implications for organisations that generate various significant environmental and social impacts (for example, the mining, chemical, transport and timber industries), then perhaps particular industry associations will take actions to ensure they can impact the regulations (perhaps through securing the support of people on the regulatory body or perhaps through gaining membership of the body).

(c)

As we know, the economic interest group theory of regulation proposes that all people, including politicians and regulators are driven by selfinterest. Therefore, from this perspective, the disclosure regulation would only be supported by the regulators if somehow the regulation provided benefits to them. Because large organisations can tend to have high levels of political power (perhaps through financial support of the regulator or related government, or through potential control over a large number of votes) we might question whether ‘strong’ legislation would be enacted that negatively impacts large corporations.

In this chapter we discussed a government inquiry into corporate social reporting.

In 2005 the Australian Government established through its Parliamentary Joint Committee on Corporations and Financial Services (PJCCFS) an Inquiry into Corporate Responsibility. Deegan and Shelly (2013) undertook an analysis of the submissions that were made to the Inquiry and found that business corporations and related associations (and it was mainly large corporations that made submissions) overwhelming favoured an anti-regulation (‘free market’) approach whereby corporations should be left to voluntarily determine their social responsibilities and associated accountabilities – the view being that markets will ultimately penalise organisations with poor social and environmental records.

At the completion of the Government Inquiry the government decided against introducing

any

regulation

to

specifically

identify

corporate

social

responsibilities. In justifying the conclusion in the Final Report of the Inquiry that there was no need to introduce additional legislation, the Committee itself made specific reference to the benefits of allowing ‘enlightened self-interest’ to dictate behaviour in stating (PJCCFS, 2006, p. xiv): 98

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 (free market) approach – driven perhaps by many of the ‘free market’ arguments provided in this chapter. Whether this position best favoured the politicians’ own self-interest (in accordance with the economic interest group theory of regulation) is something for debate.

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Chapter 5: International accounting Solutions 5.1 Harmonisation in relation to financial accounting refers to efforts to make the accounting standards being released by different countries as similar as possible and to remove all fundamental differences. Standardisation is typically construed as meaning that the accounting standards released by different countries will be identical. In recent times the two terms have been used synonymously – although arguably, this is incorrect.

Initially within Australia and from about 1995, the AASB established a process to harmonise Australian accounting standards with the standards being released by the IASC (which was later replaced by the IASB). Since the Australian standards were being ‘harmonised’ there were still a number of differences between the Australian standards and their international counterparts. As Policy Statement 6: International Harmonisation Policy (issued in April 1996 by the Australian Accounting Standards Board) noted in paragraph 1.2, ‘in this context 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’.

However, in 2002 following a directive from the Financial Reporting Council, Australia was required to thereafter adopt the accounting standards being issued by the IASB.

Harmonisation and standardisation were two goals of the IASC, and subsequently, the IASB (which as noted above, replaced the IASC). According to the IASC (1998), they established some short- and long-term aims (p. 8), including the following:

(a)

IASC’s short-term aim should be for national accounting standards and International Accounting Standards to converge around high-quality solutions (that is, to be harmonised); and

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(b)

IASC’s aim in the longer term should be global uniformity (that is, standardisation) – a single set of high-quality accounting standards for all listed and economically significant business enterprises around the world.

It is not possible to forecast how long this will take, as different countries are likely to converge with uniform global standards at different rates.

5.2

One notable exception to the global adoption of IFRS is the United States. Given that the US represents the world’s major capital market, the non-involvement of the US represents a significant limitation in the global acceptance of IFRS. Over two decades ago, the US appeared very strong in its resolve not to adopt IFRS, believing that its own ‘rules-based’ standards were superior to the more ‘principles-based’ standards of the IASB. However, this resolve to retain their own standards (and to reject IFRS) appeared to diminish around 2001/2002 with various ‘accounting scandals’ involving organisations such as Enron. The US Financial Accounting Standards Board (FASB) then worked for a number of years with the IASB to eliminate differences between the standards released by both bodies. Work was also initiated to jointly develop a revised Conceptual Framework. Much joint work between the IASB and the FASB was undertaken, but then concerns raised within the US led to the Securities Exchange Commission (SEC) in the US distancing itself from the aim to ultimately adopt IFRS within the US. After 2010, joint efforts between the FASB and IASB towards developing one global set of financial reporting standards that would also be used within the US were abandoned.

Some of the concerns that caused the FASB to move away from the aim of ultimately endorsing IFRS for US companies included the potential lack of independence of the IFRS Foundation – which oversees the IASB – from organisations such as the Big 4 accounting firms. These big accounting firms provide a significant amount of funding to the IFRS Foundation, and therefore to the IASB, and this led to concerns about the actual, or perceived, lack of independence of the IASB from these private interests (the view being that the Big 4 could capture the standards-setting process). The SEC noted that changes in the governance of the IFRS Foundation were required before further consideration could be given towards the US adopting IFRS. Another significant concern was that many countries make changes to IFRS at the local level before endorsing them 101

for national use, thereby undermining any claimed consistency in the way IFRS were being applied internationally.

Evidence would seem to indicate that, in the near term, the US will not embrace IFRS.

5.3

This is an interesting issue. Given the goal of the IASB is to develop one set of financial reporting standards for use internationally, the decision by the United States not to endorse IFRS does undermine the ability of the IASB to achieve this goal. Given the centrality of this goal, this does arguably undermine the credibility of the IASB. The US is a significant capital market, and it is likely that many countries embraced IFRS because of a belief that the US would ultimately adopt IFRS, which for about a decade leading up until about 2010 seemed likely. It needs also to be noted that many countries chose to adopt IFRS in the period in which the FASB and IASB were working to converge their standards.

Whether the failure of the IASB to converge its standards with those of the FASB will lead to countries moving away from IFRS will become evident in future years.

5.4

Chapter 5 has provided a number of factors which have been suggested to explain why different countries would use different systems of accounting if their standards were developed domestically. These include the following: •

It is argued that as countries became more ‘wealthy’ they tended to develop their own accounting standards (which can be costly). Less-developed countries typically adopted the accounting standards issued by the IASC/IASB (which may or may not actually be relevant to the information needs of the local people).

•

It has been argued that the nature of the domestic business ownership and financing systems can influence the accounting methods being used within a country. For example, in countries which have companies that rely relatively more on equity capital (funds from many ‘outsiders’) there will be a tendency to provide greater disclosures than in countries with companies that rely relatively more on debt capital.

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•

It has been argued that the colonial inheritance or history of a company will impact the accounting methods employed.

•

Invasion is another factor that can affect accounting practices. A country invaded by another may have a particular method of accounting imposed upon it.

•

A commonly mentioned reason for international differences in accounting is tied to the broad notion of ‘cultural difference’. Culture itself could be expected to influence other things (some already discussed above) such as legal systems, tax systems and how businesses are formed and financed, which will in turn influence the types of information demanded.

•

Sources of aid or finance might also influence the accounting methods used. For example, an international funding organisation (such as the World Bank) might require that particular accounting rules be used as a condition of providing funds to a country.

•

Religion, which is obviously linked to culture, has also been found to provide explanations for differences in accounting methods. Because religion can extend across national boundaries, religion has been used to explain why some different countries show similarities in accounting methods.

•

Other factors to explain differences in accounting systems have included different taxation systems, the relative strength of the accounting profession, and accidents of history.

Although the above reasons have been provided to justify or explain international differences in accounting procedures, the global push by the IASB for all countries to adopt the same accounting standards tends to disregard these reasons why accounting might, or indeed should, be different in different countries. It would appear that parties supporting the IASB initiatives believe that the benefits from global uniformity (for example, enhanced capital flows, increased efficiency for multinationals and so forth) outweigh individual differences in the needs and demands for financial information.

5.5

There could be various reasons why it might matter if organisations calculate profits differently as a result of applying different financial reporting standards. The reasons would tend to be more important for larger organisations that attract 103

investments on an international basis. For example, 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. If an international investor must 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 must 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.

5.6

It is naïve to believe that if different countries were to adopt the same financial reporting rules, and if the same series of transactions and events occurred within different countries, then there would be no differences between the results that would be reported in those different countries.

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As the Chapter discusses, there will be international differences in how financial reporting standards will be interpreted and implemented in different countries and this will lead to differences in reported results. For example, while a standard might require property, plant and equipment to be depreciated over its useful life, there might be tendencies, or biases in different countries to apply particular depreciation methods in preference to others.

As we also know, various professional judgements are required throughout the financial reporting process and these will be influenced by various factors, such as ‘culture’ as well as the contracting, financing, and legal environment of the respective country. Further, the level of education and professionalism of financial accountants will differ internationally, and this will impact how financial reporting standards are interpreted and implemented.

Different countries will also likely have differences in how financial reporting practices are monitored and enforced. The audit professions in different countries have different levels of expertise and professionalism. Further, the extent to which different national regulators will enforce the application of financial reporting standards will differ across countries.

5.7

Whether the IASB is able to be captured by particular interest groups will, in part, be influenced by the governance policies it has in place to restrict such capture.

Because of the importance of financial reporting, it would be naïve to believe that different vested interests would not, at different points in time, attempt to capture various processes within the IASB. Advocates of Capture Theory and economic interest theories of regulation would argue that the IASB will inevitably be captured by interest groups that are affected by the standards being released by the IASB.

As Chapter 5 discusses, one of the reasons proffered as to why the SEC had concerns about the US adopting IFRS was due to the funding arrangement the IFRS Foundation had in place, wherein a significant amount of the funding requirements of the IASB were met by the Big 4 accounting firms. The view was this might enable the Big 4 firms to potentially capture the IASB.

105

In Chapters 4 and 5 we have discussed the evidence produced by several accounting researchers which suggested there was some possibility that the IASB had, at different points in time, been subject to some level of capture.

5.8

According to Gray (1988) – who applied some of the insights provide by Hofstede – cultures that rank more highly in terms of individualism will be less inclined to support detailed rules for financial reporting. Cultures that are more individualistic will favour the use of professional judgement relative to the creation of detailed rules.

5.9

Nobes and Stadler (2018) argue that inappropriate translation of IFRS into local languages undermines efforts to standardise financial reporting practices internationally. Effectively, if there are errors in translation, this means that different countries are using different accounting standards.

5.10

People within countries that rank higher in terms of masculinity will prefer the use of profit-related measures of performance that enable the financial performance of different organisations to be benchmarked against each other. Masculine communities would be deemed to be more concerned with issues such as ranking the performance of one entity against another. By contrast, femininity is assumed to be associated with greater social and environmental disclosure and the demonstration of greater social and environmental accountability.

5.11

The evidence indicates that the financial reporting practices in countries that have traditionally relied upon funding from banks and from government will be different to the reporting practices traditionally applied in countries that rely more upon funding received from large numbers of shareholders.

Where funding mainly had traditionally come from banks and government, these stakeholders would generally have had the power to demand what information they want, and as a result, there will not be a highly developed framework for general purpose financial reporting.

By contrast, where funding has traditionally been sourced from capital markets, there will be a high degree of separation between management and ownership and 106

investors will be dependent upon general purpose financial reports to inform their respective resource allocation decisions. In such environments there would have been a greater reliance on conceptual frameworks and detailed financial reporting standards.

5.12

There is a difference between adopting IFRS and adopting standardised accounting practices. There are a number of reasons why the standardisation of financial reporting standards will not necessarily lead to standardisation in financial reporting practice. Some of the reasons include the following: •

In many countries tax-driven accounting choices will flow through to financial statements compiled pursuant to IFRS. Taxation rules vary between countries.

•

Differences in the economic and political forces operating within a country will have implications for various decisions and judgements made throughout the accounting process. Local economic and political forces may influence how managers, auditors, courts, regulators and other parties influence the implementation of accounting standards.

•

Different countries will have varying levels of expertise in applying IFRS.

•

Since the IASB has no ability to enforce the application of its accounting standards in countries that have made the decision to adopt IFRS, regulatory bodies in particular countries may take the decision to modify a particular IFRS before it is released. 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 diminishes the international comparability of financial reports.

Given the above points we might question the belief that the global adoption of IFRS will lead to consistency in international financial reporting practices.

Realistically, there will continue to be international differences in financial reporting practice despite the efforts of the IASB.

5.13

Firstly, society values are deemed to represent a system of values collectively held by all members of a particular society, values which in turn affect an individual’s 107

behaviour. Accounting values can be considered to be the values of a particular ‘subculture’ of that society. Different subcultures within a particular society are expected to have some common characteristics. According to Gray (1988), it is necessary to identify the mechanism by which values at the societal level are linked to values at the subcultural level, as it is the latter values which are likely to influence directly the development of accounting systems in practice.

For example, Gray considered the four cultural value dimensions developed by Hofstede (Hofstede’s cultural values included the dimensions of individualism versus collectivism; large versus small power distance; strong versus weak uncertainty avoidance; masculinity versus femininity) and then related them to values that he expected were in place within the accounting subculture (professionalism versus statutory control; uniformity versus flexibility; conservatism versus optimism; secrecy versus transparency). The hypothesised relation between the societal values and accounting values is summarised in Table 5.1 within Chapter 5.

The accounting subculture values could then be used to explain international differences in accounting practices. The relationship between society values, accounting values and accounting practice is summarised in Figure 5.6 within Chapter 5.

5.14

Moves towards standardisation do imply a belief that a globalised one-size-fits-all approach is appropriate. This chapter has referred to the work of different researchers who have shown that, in the absence of standardisation efforts by bodies such as the IASB, we can expect international differences in financial reporting standards and financial reporting practice. These differences can potentially be explained by international differences in culture, religion and business ownership and financing systems. The view provided by a good deal of the research indicates that underlying differences in how people think and how they conduct their business in turn impacts the information they require (which seems a reasonable proposition). A number of researchers have explicitly questioned the relevance of ‘Western-style’ standards to the needs of people within developing countries, or the relevance of ‘Anglo-American’ standards in ‘continental European’ countries.

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As we know, the standard-setting process in many countries is a political process (or perhaps ‘was’, given that domestic standard-setters have in many cases been replaced by the IASB) in which the standard-setters invite submissions from constituents as part of the due process of developing financial reporting standards.

The submissions are considered to influence the contents of the final standards.

When developed in this manner financial reporting standards developed in one country tended to be different from standards developed in other countries. For many years such differences were accepted as being reasonable – however, such differences no longer appear to be considered as ‘reasonable’ (particularly to parties such as the IASB).

If we accept that people in different countries have different values and consequently different information needs, then it is perhaps somewhat naïve to expect that one system of financial accounting will meet the needs of all people within all countries. Nevertheless, work towards international standardisation is ongoing and is being primarily driven by the IASB.

5.15

In those situations where the major sources of funds come from banks, governments, or families as was historically the case in Continental European countries, then those parties with a financial interest in the organisation were typically able to obtain the specific information they needed about the financial position and financial performance of the respective organisations. They would rely upon special purpose financial reports for information rather than general purpose financial reports. This would mean that there was less need to have expertise in developing or implementing accounting standards, the implication of which was that these countries did not develop accounting standards as early as countries such as the United States, the United Kingdom, Canada, or Australia.

Also, the development of the accounting profession in Continental European countries was not as robust as in the other settings.

By contrast, in countries such as the United States, United Kingdom, Canada and Australia there was a greater separation of ownership and management and a greater reliance on capital markets as the basis of raising capital. Because of the separation of ownership and management, and because of the multitude of people 109

with an interest in organisations, there was a need to produce general purpose financial reports and the need for an accounting profession that could develop financial reports in a manner that was objective and in conformance with generally accepted accounting principles. This led to the compilation of reporting principles and conventions and ultimately the development of financial reporting standards that would enable investors in capital markets to compare and contrast actual and potential investments in different organisations.

Across time, the size of organisations throughout the world has increased and this has meant that there has been a consequent increase in the use of capital markets as a source of raising capital throughout the world, and a consequent increase in the necessity for general purpose financial reports. This has direct implications for the development of the accounting profession and financial reporting standards.

5.16

If developed in isolation it is to be expected that the accounting system developed in one country would be different to an accounting system developed in another country. In part, this would be due to differences in culture which in turn have implications for how people might make decisions and what information they would need to make decisions.

However, countries are not isolated, and various ‘external’ factors will conceivably influence how they undertake their accounting. For example, to borrow funds from monetary agencies like the World Bank there might be a requirement that the borrowing party (for example, the government) be required to adopt particular financial accounting methods when showing how the funds have been used. Local accountants will be required to learn particular accounting rules and these accountants might in turn use these rules elsewhere. Countries might be colonised or invaded by other countries which in turn bring their own methods of accounting with them. While the ‘invaders’ might subsequently leave, the accounting methods they have put in place might have become generally accepted, even though they do not necessarily meet the information needs of the population.

In periods when a country is developing economically, foreign institutions might provide accounting ‘assistance’. For example, scholarships might be offered to 110

intelligent students to do their accounting education in a more developed country and the students could then take that knowledge back home with them (even though the particular methods they have learned might not fit the needs of the local people). Professional accounting bodies might assist the developing country in implementing particular accounting standards or those that have been developed by the IASB. Multinational companies can also influence local accounting practice if they require local accountants to adopt accounting rules developed in the multinational company’s parent country.

Hence, when we seek to relate the culture of a particular country to the accounting methods being used (or perhaps being used prior to recent global standardisation efforts) we must appreciate that culture alone cannot be expected to explain the differences, given that many outside factors (some described above) may have influenced the accounting methods currently (or formerly) in place. In a sense, the research samples have been ‘contaminated’.

5.17

Firstly, it should be stressed that with the recent moves by the IASB (and formerly the IASC) to promote international standardisation of financial accounting, any testing of the Hofstede-Gray theory needs to utilise details of financial accounting practices in place prior to the recent influence of the IASC and IASB.

In considering the argument of Baydoun and Willett, the argument is that while the theoretical argument about the relationship between societal values, accounting values and accounting practice as developed by the Hofstede-Gray analysis might indeed be logical, it is very difficult to empirically support the propositions. To assume that cultural differences can explain previous international differences in accounting practices is perhaps somewhat simplistic as it ignores the fact that many external events might have militated against finding this theoretical relationship (with such events including the influences of colonisation, invasion, financial assistance from particular agencies that require certain accounting methods to be used, assistance by international accounting bodies and the establishment of offices by multi-national companies).

5.18

The argument is that different religious beliefs (which are considered to transcend national boundaries) would conceivably influence how people do business, how 111

they make decisions and, as a related issue, the information they need to make the decisions.

Hamid, Craig and Clarke (1993) specifically contrast Islamic beliefs with ‘Western’ beliefs. They note how notions of stewardship, often used to explain Western accounting practice, are not relevant to the Islamic faith as resources are deemed to be held in trust for God, rather than providers of debt and equity capital.

Within the Islamic faith, notions of interest returns are also not relevant (there is a general prohibition of interest on debt). A number of Western accounting standards specifically consider issues associated with present values (for example, with respect to accounting for leases or accounting for liability provisions). These standards are not applicable to faiths such as the Islamic religion. Also, various conceptual framework projects developed in countries such as the United States, United Kingdom, Australia and Canada, as well as the revised conceptual framework being jointly developed by the IASB and FASB (that is, in part of the ‘West’) discuss the objective of financial reporting in terms of assisting with ‘rational economic decision making’. Such decisions, which take into account the time (present) value of money with associated consideration of interest rates, would be irrelevant within Islamic states.

Some religions also emphasise the importance of ‘community obligations’ rather than the individual’s self-interest. Many ‘Western’ accounting methods can be explained in terms of Gray’s accounting subculture values, which in turn rely upon Hofstede’s cultural values, such as Individualism versus Collectivism. Since Western cultural values (such as scoring highly on the dimension of Individualism) might not relate well to certain religious views, the work of researchers such as Gray would also suggest the potential irrelevance of some Western accounting methods to more ‘community-concerned’ religions.

5.19

The basis of the argument is that if funds are provided by people acquiring equity in the entity, then this equity will generally be held by a large number of diverse individuals, many without any real ability or power to influence the activities of the entity or to demand information to satisfy their individual information needs.

Hence such shareholders, without the ability to make the entity satisfy their information demands, will need to be provided with general purpose financial 112

reports (perhaps as required by accounting standards) which will provide information to satisfy most of their respective needs. The provision of public information will also provide information to prospective shareholders. Without such information, people would conceivably be less inclined to seek an ownership interest in an organisation.

If an organisation relies primarily upon debt capital, then it is generally the case that the debt capital has been provided by a relatively small number of investors.

These debt providers will be able to specifically demand the information they require, and this information can be prepared and provided to the debt providers on a private basis. Further, if an organisation is going to seek debt funds from a prospective lender, then the organisation can directly provide the lender with the information that is required.

5.20

The statement that the US accounting and reporting system is regarded as the most comprehensive and sophisticated system in the world is a very US-centric view.

It really depends upon who is giving the opinion and what types and forms of information they typically require. While from a ‘Western’ perspective there might be some individuals who consider the US system to be comprehensive and sophisticated (and also some people who do not and who will criticise western accounting systems generally), from the perspective of some developing countries, or countries that do not have similar cultural or religious systems as the US (which in turn can influence how people do business, finance their business, make decisions, as well as influencing the information they demand or need), the US system of accounting might be perceived as very naïve. In many situations, systems of accounting such as that used in the US may be of limited use and may not correspond with the information needs of the local communities. As Chapter 5 explains, views that a ‘one-size-fits-all’ accounting system can be developed and then globally applied appear to be quite naïve. In relation to events such as Enron, WorldCom and so forth, it would be reasonable to assume that such events did undermine a view that the US accounting methods were highly sophisticated.

Indeed, in the light of Enron, various changes have been made to required financial accounting practices and there has been a move to change US financial reporting standards from having a rules-based focus towards having a more principles-based focus.

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5.21

Chapter 5 has provided a number of reasons why it might actually be inappropriate to have a single standardised system of accounting. A standardised system of accounting assumes that the types of decisions being made (as an example, rational economic resource allocation decisions) by people in all countries are the same and therefore the information needs are also the same. The chapter has shown that various factors, such as differences in culture, business ownership and financing systems, religion and so forth (there will obviously be some interrelationships between these factors) will impact the information demands of the people within particular communities. The implication is that it is perhaps somewhat unrealistic to expect uniformity in accounting practices across all countries – unless of course we assume some convergence in cultures (or alternatively, unless we assume that the research which indicates that differences in culture, religion and so on explain differences in accounting is flawed in some way). Obviously, those organisations that are pushing for standardisation in financial reporting across the world (for example, the IASB) do not consider that different people, of different cultures and religions, require different information.

It also needs to be stressed that worldwide adoption of particular accounting standards (such as IFRS) does not necessarily mean they will be applied uniformly across all countries, meaning that some diversity in accounting practices will still be expected.

On a more pragmatic basis, there is great doubt mounting as to whether the US will ultimately commit to adopting IFRS. That is, despite earlier indications that the ‘Convergence Project’ between the IASB and FASB will ultimately lead to the US adopting IFRS, this now appears unlikely and this obviously has direct implications for the existence of an internationally uniform set of accounting standards.

5.22

Consistent with the work of Zarzeski (1996) – referred to in Chapter 5 – we would expect a difference in the accounting policies adopted by large international companies and those adopted by smaller companies that operate solely within the country. The smaller companies would tend to tailor their accounting policies to the needs and expectations of local people, with this demand being influenced by 114

local values, norms and expectations. Conversely, larger companies operating on an international scale would tend to embrace more universal or international accounting methods that are in demand by people internationally. Local expectations would be less relevant.

In a sense, the EU adopted the above position. Even though member states of the EU have adopted standards released by the IASB, this is only for companies that are listed on a stock exchange, and only for their consolidated financial statements.

Listed companies are more likely to be international in nature than unlisted companies.

5.23

If Australia has developed financial reporting standards that are unique in some nature, then this might be because the information demands of Australians are different to those of people elsewhere. This difference in information demands might be greater when comparing some countries relative to others. The unique nature of Australian financial reporting standards has obviously been eliminated as a result of the 2002 decision by the Financial Reporting Council that Australia shall adopt accounting standards issued by the IASB.

Arguing that capital inflows into Australia will increase if we have financial reporting standards that are the same as those adopted elsewhere assumes that potential international investors are unable or unprepared to make adjustments to remove the effects of rules that are unique to Australia. It is not clear that is a realistic assumption. However, to the extent that agencies such as the International Organization of Securities Commissions (IOSCO) restrict companies from listing on foreign exchanges unless they comply with IFRS, then this will have real implications for capital inflows.

In considering this issue we can consider the decision made by the US Securities and Exchange Commission in late 2007 whereby they permitted 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 generally accepted accounting principles (GAAP) as used in the United States. That is, foreign companies within the US can lodge their reports in

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the US even though the reports have not been prepared in accordance with US accounting standards and do not provide reconciliation to US GAAP.

Hence, effectively there are two types of financial statements being lodged within the US (as is the case in many other countries). Foreign companies can lodge their reports within the US 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, then does that question the need for all countries to adopt IFRS? That is, does the US position of supporting dual reporting systems undermine the view of the FRC in Australia who argued back in 2002 that if Australia retained its own financial reporting standards (which were fundamentally similar to IFRS) then this would be damaging to Australian capital markets? This is an interesting issue to debate.

5.24. The EU is obviously made up a number of countries that have underlying cultural, religious, financing, taxation and other differences. Whether these differences provide barriers to standardisation is clearly a matter of opinion. The IASB would not appear to believe that the barriers are significant (although it does need to be emphasised that the application of the IASB standards is commonly restricted to listed entities in the respective countries with such companies being larger and more international in orientation). The success of the standardisation process relies upon other countries also embracing the move towards one set of standards.

Harmonising with IASB standards would be a fairly useless endeavour if other countries do not do the same thing (and as in Australia there was some expectation from the EU that if EU member states did not adopt international accounting standards, then this will negatively impact the inflow of foreign investment capital. Whether this is actually true has not really been supported by any research).

Whether the EU’s decision to adopt the financial reporting standards released by the IASB will actually lead to benefits to the EU community is not something that we can predict with any certainty. As Chapter 5 has demonstrated, there are many researchers who believe that there are too many obstacles to standardisation and further, that in many communities standardisation is potentially harmful. Because the member states of the EU typically had followed a continental European system 116

of accounting rather than the Anglo-American model embraced by the IASB, the change in accounting practice was quite significant in some countries. Also, because the systems of finance and taxation of many EU countries continue to be different, we can only speculate on the continued viability of all EU states embracing standards released by the IASB.

5.25

Chapter 5 has identified some of the perceived advantages that will arise from the decision to adopt financial reporting standards released by the IASB. These perceived advantages (which have not necessarily been empirically supported) include the following: • International investors are better able to understand the financial performance and position of local companies.

• Tied to the above point, there is an expectation that standardisation will facilitate greater capital inflows.

• Also tied to the above point, standardisation will make it easier for local companies to list on foreign securities exchanges.

• Companies listed on several securities exchanges would only need to produce one set of financial statements, and this will have implications for cost savings.

• The accounting and auditing staff employed by international organisations will be better able to move to other member companies and this will have implications for the efficient operations of an entity.

• There will be cost savings in the accounting standard-setting function. Rather than individual companies duplicating the efforts of others, the majority of functions of the standard-setting process will be centralised at the IASB.

5.26

Bodies such as the IASB are either ignoring the literature which suggests that there is a need for different countries to adopt different accounting approaches (due to issues such as differences in culture, religion, financing systems and so forth), or they believe that the advantages that accrue as a result of standardisation outweigh the need to consider cultural, religious and other differences. However, while the global push for standardisation does seem to ignore much of the accounting literature pertaining to culture and so forth, it should be noted that in many countries (such as EU member states) only the listed companies are required

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to embrace the financial reporting standards issued by the IASB. Smaller companies can tailor their disclosures to local needs.

What also needs to be appreciated is that whilst various countries may, at facevalue, adopt IFRS, different cultural and political factors may mean that the various standards are applied or enforced in a variety of ways across the various IFRS-adopting countries. That is, we can still anticipate international differences in accounting practice and many of the factors identified in Chapter 5 might be useful in explaining the international variations in practice. To assume that all IFRS-adopting countries will adopt standardised approaches to applying and enforcing IFRS would be a very naïve position to adopt.

5.27

In basic terms, rules-based accounting standards tend to be relatively lengthier 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 for financial reporting. Principlesbased accounting standards require the exercise of greater levels of professional judgement relative to rules-based accounting standards. Accounting standards released by the FASB have generally been considered to be more rules-based than accounting standards issued by the IASB (which are considered to be principlesbased).

Whether it is easier to circumvent the requirements of rules-based or principlesbased standards is an interesting issue. Historically the FASB and SEC considered that rules-based standards provided more reliable information. However, this resolve to retain their own rules-based standards (and to reject IFRS which are more principles-based) appeared to diminish around 2001/2002 with various ‘accounting scandals’ involving organisations such as Enron. According to Veron (2007):

In February 2002, a Senate Committee investigating the Enron debacle heard the testimony of IASB Chairman David Tweedie who explicitly criticised the 118

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

Principles-based accounting standards do not provide detailed rules for a variety of circumstances but rather are developed to provide general guidance that can be applied across a variety of circumstances. That is, they provide rules for broad application. By contrast, if numerous detailed rules are developed to cover a variety of circumstances (rules-based standards) then it is probable that standardsetters would not have considered all situations and therefore there will be an absence of general principles for particular unexpected transactions or events.

This then provides financial statement preparers with some flexibility which may sometimes be used in an opportunistic manner. On balance we can probably argue that rules-based standards are more easily circumvented but there will be some people who argue to the contrary.

5.28

The view being proposed is that standardisation inevitably leads to a reduction in innovation. If all countries were effectively committed to applying one standardised approach to financial reporting, then there will be limited incentive to develop innovative reporting approaches, and with the reduced incentive to be innovative, the likelihood of discovering and implementing improved reporting practices will fall. Conversely, if all countries were responsible for developing their own reporting standards, then with the increased effort going on, the likelihood of knowledge advancement would increase.

5.29

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. The basis for this view is that the use of ‘fair values’ requires greater professional judgement (relative to, say, historical cost), and potentially allows for the introduction of a higher level of ‘creative accounting’. For countries with less active markets, the use of fair values becomes even more problematic. Ball’s argument is that the use of accounting-based contractual arrangements has been shown to reduce the agency costs confronting organisations. However, the effectiveness of

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accounting-based debt contracts tends to be higher when management has less ability to be opportunistic when measuring assets and liabilities. He believes that fair values increase the ability of managers to be opportunistic, thereby undermining the effectiveness of financial accounting-based contracting.

5.30

This is an interesting issue that should spark some debate. At issue is ‘objective and unbiased’ from whose view? Would the determination that some accounting information is objective and unbiased by a person in the IASB’s office in London be the same as a judgement made by somebody in Tehran? Students should be encouraged to discuss this point. Arguably, objectivity and perspectives of bias are not culturally independent hence, whether something is deemed to be objective and unbiased is dependent upon the cultural context in which that judgement is made.

5.31

Chapter 5 has provided numerous reasons for the differences in accounting rules that might operate between the three countries. For example, the extent of economic development within a country; the nature of the domestic business ownership and financing systems; the colonial inheritance or history of a company; cultural difference; sources of finance; religion; different taxation systems; the relative strength of the accounting profession; and accidents of history. Arguably these differences are fairly limited within this sample of companies relative to some other countries – for example, some Middle Eastern countries. As a result, we could argue that the differences between the accounting methods used in the United Kingdom, Australia and the United States are relatively minimal relative to the methods used in some other countries.

5.32

There are a number of reasons why the international standardisation of financial reporting standards will not necessarily lead to international standardisation of financial reporting practice. For example, the adoption of particular tax options could flow through to the financial statements. Given that taxation rules differ across countries this will contribute to international differences in accounting practices. Different countries will also be subject to different economic and political influences. As Ball (2006, p. 15) states:

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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.

Another cause for differences in financial reporting practice relates to the inability of the IASB to ensure that particular countries do not modify IFRS before they are released for issue. Any modifications will have implications for international differences in accounting practice.

Different countries will also have accounting professions of differing skills and professionalism. This will flow through to how they apply accounting standards such as IFRS. Different countries also have different enforcement programs, the implication being that countries with low levels of enforcement will tend to have greater variations in how IFRS are applied. As Ball (2006) discusses, 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 IFRSadopting countries? Probably not.

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 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, 121

Poland, Portugal, Slovenia, Slovakia, Finland, Sweden and the UK. It is well known that uniform EU economic rules in general are not implemented evenly.

5.33

We would probably not expect that accounting standards developed within the US would be the same as accounting standards developed within other countries (any more than we might expect the laws developed in different countries to be the same). Chapter 5 discussed various factors which influence the values and expectations of people within a particular population (such as differences in business structures, religions, culture, political systems and so forth) and these differences would flow through to expectations regarding what should be incorporated within accounting standards.

As the question indicates, the staff of the FASB will initially be responsible for development of an exposure draft. Their particular education, political affiliations and experience (and expectations) will be incorporated within the draft standards.

The exposure draft will then be subject to submissions from local constituents before the FASB staff develops a draft of the final accounting standard which is then subject to a vote by members of the FASB. As we can see, the process is very political, with interested constituents making submissions which will then be evaluated by FASB staff before a final draft is developed for review. It would be highly likely that if the same process was undertaken in a different country, then the expectations and pressures would be quite different and the final standard would be different – perhaps greatly different. The greater the differences in factors such as cultures, religions, social and political pressures, and so forth, the greater would be the likely differences in any final accounting standard.

Issues such as those raised above question whether it is appropriate that accounting standards developed by bodies such as the IASB or FASB can really be expected to have relevance to other countries throughout the world.

5.34

As Chapter 5 has demonstrated, there is much research indicating that factors such as religion and culture influence how people do business, how they make decisions, and as a result, the information they require. The approach to providing developing countries, of different cultures, with the same body of standards assumes that a globalised ‘one-size-fits-all’ approach to accounting standard122

setting will work. As numerous researchers referred to in Chapter 5 have indicated, such a tactic can be quite naïve and perhaps quite dysfunctional.

Relevance and reliability can realistically only be determined by considering the specific needs of a particular community. What is relevant to those standardsetters involved in developing International Accounting Standards (often from developed Western countries) might not be relevant to others. Hence, it is far from clear that IAS/IFRS will provide relevant and reliable information to financial statement readers in all countries.

5.35

Developing countries are subject to different pressures and have different business and political systems so it is questionable whether their information demands and expectations would be the same as those of individuals within developed countries. Since IFRS are developed predominantly by people from developed countries, it is unlikely that the financial reporting standards would incorporate demands and expectations of people from developing countries. 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).

Chand and White (2007) explored various cultural attributes within Fijian society (a society within a developing country) 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):

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Fiji is a society that is dominated by two ethnic groups – indigenous Fijians and Indo-Fijians. 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).

Chand and White (2007) consider the ownership and financing systems that are common in Fiji and argue that the 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 and in many other developing countries. As they state (2007, 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 … Accounting values determined by applying Fiji’s current reporting regulations and IFRS are not accepted in assessing entities’ capacities to repay loans …

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

5.36

There are numerous reasons that could explain why the United States has not elected to adopt IFRS.

It has been noted in the chapter that there have been concerns raised within the United States about the governance structures of the IASB, with many of the concerns relating to the independence of the IASB and its apparent reliance of funding on Big 4 accounting firms. An obvious concern is that the IASB might become effectively captured by groups that are actually required to follow the standards being released by the IASB. Some efforts have been undertaken by the IASB to address this concern.

Another obvious reason that has delayed the adoption of IFRS by the US has been the extent of difference between many of the accounting standards issued by the IASB and the FASB. Indeed, this is the reason that the ‘Convergence Project’ between the IASB and the FASB was established so that the standards 124

of both standard-setters could be as similar as possible before the United States finally elected to adopt IFRS.

Another concern that has been raised within the US is the lack of enforcement of IFRS in various countries said to be ‘applying IFRS’. As we would know, the IASB has no powers to enforce the application of IFRS in countries that have said that they have adopted IFRS. Rather, the enforcement of IFRS is the responsibility of local regulators. Evidence suggests that the level of enforcement in many countries is minimal or non-existent and this impairs the value associated with having globalised accounting standards. The ‘brand name’ of IFRS is tarnished by examples of countries failing to properly enforce IFRS.

A further issue has been the extent of changes being made to IFRS at the local level. For example, IAS 39 and IFRS 9 were modified before being applied in Europe (because of pressure from various constituents including some local major banks). Another example is provided by Malaysia where certain industries were relieved of the requirement to comply with IAS 41 Agriculture.

Again, this has implications for the perceived benefits that could flow from having a uniform set of accounting standards for world-wide use.

As with most national standard-setters, there would also be the ongoing concerns about losing control of the standard-setting process to the IASB in London. This would always be a consideration before a country decides to adopt IFRS.

As Chapter 5 has also emphasised, there would be some unique attributes of the United States (some differences might be tied to cultural factors, or marketbased differences) which brings into question whether a one-size-fits-all approach to standard-setting is applicable to the United States.

As we can see from the brief discussion above, there can be many reasons to explain why the United States did not adopt IFRS.

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5.37

The IASB has promoted a position that if countries throughout the world adopt IFRS then the outcome will be that capital markets will be more efficient and comparable information will be available on a global basis. Such a perspective assumes that standardised principles leads to standardised practice. Ball (2006) would suggest this is a rather simplistic assumption and he promotes a view that accounting standards would be applied consistently only if there were common political, regulatory and social environments and only when the same professional and monitoring standards are applied. This is unlikely to be the case on an international basis.

5.38

There is a certain quality and reputation attached to the financial reporting standards developed by the IASB. They are commonly construed as being developed through a logical and rigorous process that involves many knowledgeable experts and high levels of research. Therefore, countries that adopt IFRS are adopting what might be construed as being high quality standards and this might then lead to a perception that the country’s financial accounting practices are also high quality – but as previous questions (and Chapter 5) suggest, in reality this might not be the case. Whilst Irvine might be correct that developing countries might gain credibility in global capital markets if they adopt ‘western accounting technologies’ (which may or may not be appropriate to local needs), the adoption of IFRS should not be considered to be the same thing as applying accounting practices equivalent to many western reporting entities. Financial reporting standards will not necessarily be applied consistently throughout the world. As 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.

If a ‘symbol of legitimacy’ – such as IFRS – can be acquired at low cost, then some countries with low 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 levels of

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accounting proficiency and who put in place appropriate implementation, monitoring and enforcement mechanisms. As Ball (2006, p. 23) further 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’?

5.39

If we accept much of the research discussed in Chapter 5 then we would be inclined to believe that information demands and expectations in different countries (or cultures) will be different. Gray has shown how different cultural values or attributes (from the work of Hofstede) flow through to the values of accountants and the readers of financial statements thereby explaining why we would expect to find differences in accounting practices adopted across different cultures. Gray (1988) also hypothesised that cultural attributes will flow through to the enforcement of accounting systems.

Therefore, we would not expect that the views provided by constituents within the US would necessarily be equivalent to the information demands and expectations of people in other countries, just as we would not expect the lobbying efforts made to the IASB (often made by large multinational organisations) would reflect the views of the ‘average person’ from each country that has adopted IFRS.

5.40

As explained in the chapter, in some countries – particularly parts of Europe – it is a requirement that a given expense be included within the financial statements provided to owners and other outside parties before it is also allowed as a tax deduction. This will create obvious incentives for organisations to use the same method of accounting in financial reporting as they do for taxation purposes.

By contrast, in many other countries (such as Australia, United Kingdom, United States and Canada), the choice of one method of financial accounting for taxation purposes does not mean that the same method has to also be used in the general purpose financial reports. That is, the tax deduction will be provided despite the fact that the same amount might not be shown as an expense in the general purpose

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financial reports. This will lead to deferred tax assets and deferred tax liabilities being recognised.

The other point is that in many continental European countries there were traditionally few external users dependent upon general purpose financial reports.

This was because the major sources of capital either came from the government, banks, or family members and these stakeholders were able to obtain the specific information they required by way of special purpose financial reports. Such users probably did not worry whether reported expenses were based on taxation rules (as opposed to generally accepted accounting principles which are appropriate for general purpose financial reports).

5.41

Any cost-benefit calculation is necessarily subjective. Judgements must be made about what costs and benefits to consider (and from whose perspective those costs and benefits arise) and how and what costs to attribute to the various factors. Even within a particular country we would expect to find (and we often do find) much debate about the appropriate costs and benefits to consider. However, once we start to think about different cultures, religions, social systems, local needs, and so forth then the obvious subjectivity of any cost-benefit calculations magnifies.

As the chapter has explained, different cultures have different expectations about the role of professional judgement, the needs for transparency, the need to be conservative, and so forth. Hence, given what we have read in Chapter 5 (and assuming that the researchers’ arguments seem reasonable) then it really does seem that cost benefit calculations made by bodies such as the FASB or the IASB might have little relevance in some other countries.

5.42

Obviously, whether we agree with Ball’s sentiments is a matter of opinion and arguably tied to the perceived logic of argument provided by Ball, as well as a number of other researchers quoted in the chapter (many of which also appear to share Ball’s views).

We know that the IASB has no enforcement powers, meaning that whilst a particular country might adopt IFRS in name, that does not necessarily mean the IFRS will be applied in a manner expected by the IASB. Enforcement will be in the hands of local authorities in each jurisdiction in which IFRS have been 128

adopted. In some countries the level of enforcement is either very low, or entirely non-existent. It also means that particular countries may modify IFRS before they are released to local constituents. In many countries it is also possible that there simply are not enough well-trained accountants to apply the various requirements embodied within IFRS – many such requirements being rather complicated. 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.

Therefore, whilst the adoption of IFRS might be construed as a signal that a country has improved its quality of reporting, this might not necessarily be the case. Countries might elect to adopt IFRS because such actions bring a perceived level of legitimacy to a country’s financial reporting despite any limitations in the level of application or enforcement of the standards. If capital markets are efficient, as many researchers argue, then perhaps the level of credibility assigned to financial statements released in some countries might be lower than others (impacting relevant risk rates). But such expectations do not seem to match the overall mission of the IASB which (according to its website as accessed in mid 2009) is:

to develop, in the public interest, a single set of high quality, understandable and international financial reporting standards (IFRSs) for general purpose financial statements.

It is possibly questionable whether it is in the ‘public interest’ for different countries to highlight that their reporting entities have adopted IFRS when in fact the entities may not be adhering to the spirit of the standards. This is a good point for the students to debate.

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5.43

This is an interesting point. Certainly, there does seem to be a great deal of variation in how IFRS are being applied in different countries. Whilst some countries could elect to embrace IFRS because of the perceived legitimacy attached to such a ‘brand name’, the value of this ‘brand name’ will ultimately diminish if a number of countries release low quality financial statements under the label of IFRS. This is consistent with the argument of Ball (2006).

In the end it really comes down to individual jurisdictions. Whilst IFRS might provide a useful foundation for general purpose financial reporting (although there will be some researchers who question this), it is a matter of how these financial reporting standards are applied, monitored and enforced which matters. Capital markets will need to differentiate between reports being prepared and audited in particular jurisdictions relative to others (indeed, capital markets have probably been doing this for some time). Just as it would be naïve to believe that all countries that adopt IFRS will apply them equally, it would be naïve to expect that investors will not differentiate between financial statements generated in some countries relative to others.

5.44

To some extent this statement by the European Commission is a naïve statement.

Since different member states of the EU adopt IFRS this will not ‘ensure that company accounts throughout the EU are more reliable and transparent and that they can be more easily compared’. The enforcement (including monitoring) of compliance with IFRS remains a national matter within the EU. Not all EU countries will adopt the same standards of monitoring and enforcement so it is very difficult to believe that all financial statements being produced across various EU countries will be of equivalent standard. This is consistent with the views of Ball (2006, p. 16) who questions:

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?

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So, our view might be that financial statements prepared in a number of EU countries will not be more reliable and comparable just because the EU has embraced IFRS. Indeed, we might go so far as to say that the actions of the EU could lead to misleading financial statements if such financial statements are said to have been prepared in accordance with IFRS when the application and enforcement of the accounting standards falls short of the standards expected by the IASB – which has an inability to enforce its standards across the various jurisdictions.

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Chapter 6: Measurement issues: accounting for the effects of changing prices and markets

Solutions 6.1

According to paragraph 4.54 of the IASB Conceptual Framework for Financial Reporting, from an accounting perspective: 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 and income statement. This involves the selection of the particular basis of measurement.

Measurement allows us to attribute numbers to the items that appear in financial reports. That is, applying a measurement basis to an asset or liability creates a measure for that asset or liability, and ultimately for related income and expenses.

6.2

From a financial reporting perspective, prescribing particular approaches to measurement can be controversial, as how we measure particular assets and liabilities (which in turn has implications for income and expenses) can have profound effects upon financial statements, 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 if specified debt to asset ratios are not breached (and conversely, might require repayment of borrowed funds if the prescribed 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 is that financial accounting numbers are used in many agreements that an organisation is party to. Therefore, how items are 132

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.

6.3

Historical cost accounting assumes that the purchasing power of the currency remains constant across time. Related to this, it is assumed that the value of assets acquired in different time periods can simply be added together to give an indication of their value at a particular point in time.

6.4

In a time of rising prices, historical cost accounting can cause the following outcomes: •

If prices of different assets acquired in different periods are simply added together then the total figure can be quite meaningless, like adding together different currencies. The final figure will generally understate the current fair value of the assets.

•

Tied to the above point, if assets are understated then this will in turn mean that the net book value of the entity (assets less liabilities) is understated.

This could perhaps lead to the owners selling an entity for less than it is actually worth (although clearly the owners should consider other information about the value of the organisation before determining how much to sell it for).

•

Following on from the above points, historical costs information lacks relevance in times of rising prices (Chambers).

•

When historical cost accounting is used, depreciation and cost of goods sold are based on historical costs which means that profits are effectively overstated in times of rising prices (because expenses calculated through depreciation are understated). Dividends in turn can be paid out of profits, meaning that the actual operating capacity of the firm might be eroded because too much has been distributed to the owners and not enough has been retained to replace certain assets whose replacement costs have increased.

•

Historical cost accounting distorts the current year’s operating results because it includes in current year income holding gains that might have accrued over a number of periods. For example, if an asset such as land is acquired for $1 000 000 and increases in fair value by $100 000 each year 133

(and assuming no revaluations are undertaken), then if it is sold in year 5 for $1 500 000, a $500 000 gain will be shown wholly in year 5. No gain will be shown in any other year. Given this aspect of historical cost accounting, management might elect to sell certain assets in certain years simply to offset losses that might otherwise be reported.

6.5

According to the website of the FASB (as accessed January 2023), 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)

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 the above list, there are a variety of issues that require consideration before the FASB or IASB believes that it can favour particular measurement bases in preference to others. Some of these issues are quite complicated.

The IASB and the FASB do not favour one basis of measurement in preference to other alternatives due to a view that different measurement techniques will be appropriate in different circumstances. This would be of concern to researchers, 134

such as Chambers, who believed that all assets should be measured on the same basis, which in itself would address problems associated with ‘additivity’.

6.6

The answer to this question depends upon whether we assume that managers are motivated by efficiency considerations or whether we assume that they are motivated by opportunistic considerations.

From an efficiency perspective, managers might consider that historical cost provides a more objective measure of the value of an item, and this is preferable in terms of demonstrating proper stewardship over the resources contributed to an organisation. They might also consider that other bases of measurement – such as fair values – provide less relevant or reliable information. For example, perhaps they operate in an industry that has high volatility in asset values and they may consider that if assets were measured on the basis of fluctuating market values, then this might create confusion in the minds of the financial statement readers.

From an opportunistic perspective managers might prefer to retain the use of historical cost accounting as it can allow them to manipulate profit by determining when to sell an asset that has appreciated in value – with such appreciation not being acknowledged for financial reporting purposes until the asset is ultimately sold. The accumulated gain will be fully recognised in the period of the sale. Also, historical cost accounting can lead to higher profits (due to such factors as lower depreciation given that depreciation will be based on the original cost of an asset which could be significantly lower than its current marker value). This attribute of historical cost might be particularly attractive to managers who are paid a bonus tied to reported profits.

6.7

The lower of cost and net realisable value rule as applied to accounting for inventory is very conservative. Conservative accounting methods tend to understate net assets and profits relative to less conservative accounting methods.

Conservative accounting methods are preferred by some users of financial statements as they tend to restrict the ability of management to exercise their own judgement in terms of measurement, the view being that such judgement might at times be based on opportunistic motivations, rather than on objective reasoning.

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By contrast, it is generally considered in documents such as the IASB Conceptual Framework for Financial Reporting that users of financial statements are predominantly interested in determining whether they should invest in, or lend funds to a reporting entity. To determine this, they need information that is ‘useful’ for their decisions. Arguably, information based on current values is more ‘relevant’ that historical cost (although it might not be as ‘reliable’).

There will be a trade-off between allowing management the ability to use judgement to determine current (fair) values, or to restrict their ability to use their own judgement (as would be the case if historical cost was used). There will be advantages and disadvantages to users from either approach.

6.8

This is an interesting perspective and one that we are often exposed to in respect of a variety of issues. The belief is that if something was not useful then it would not still be used. However, just because something is used does not mean that there might not be something more useful, unless of course it is assumed that those people making the decisions, such as ‘businesspeople’, somehow know about all the alternatives and have by some efficient mechanisms (or by divine intervention) been able to determine that the current practices are the most efficient. The quote from Gray, Owen and Adams (1996, p. 75), as provided in footnote 7 of the chapter, encapsulates this concern:

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.

6.9

Yes, there should be a relationship between the measurement method that is prescribed for assets and the objective of general purpose financial reporting.

According to paragraph 1.2 of the IASB Conceptual Framework for Financial Reporting, 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

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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.

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).

According to the IASB Conceptual Framework for Financial Reporting, to fulfil the requirement that information is ‘decision useful’, and fulfil its stewardshiprelated requirements, financial information should be both ‘relevant’ and ‘representationally faithful’ and allow financial statement readers to make informed resource allocation decisions. 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 has identified three fundamental principles of 137

measurement that flow from the objective of financial reporting. As IASB (paragraph 5, 2013b) states:

The following three fundamental principles of measurement are derived from the objectives of financial reporting and the qualitative characteristics of useful financial information as described in Chapters 1 and 3 of the Conceptual Framework.

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 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.

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’. 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 138

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.

6.10

The additivity problem relates to the logic of adding together the costs of different items if the currency in question has been changing across time in terms of its purchasing power. For example, Chambers argues that historical cost accounting has an additivity problem because if we add together the costs of assets acquired in different periods then the combined amount is quite misleading. The total figure does not actually reflect the value of anything. However, if assets are recorded in a currency with the same purchasing power, such as in terms of the fair value as at reporting date, then the combined number does mean something. The numbers can logically be added together, and the combined number represents the fair value of the assets as at reporting date.

6.11

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. However, 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).

6.12

Fair value is 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.

6.13

The IASB’s financial reporting standard on fair value measurement – IFRS 13 Fair Value Measurement – establishes a ‘fair value hierarchy’ to be applied when selecting a particular approach to determining fair values. It represents a hierarchy or ‘ranking’ in respect of determining which approaches to fair value 139

measurement should be prioritised when preparing general purpose financial reports. The approaches to determining fair value are assigned to one of three ‘Levels’. IFRS 13 requires the highest attainable level of inputs must be used by preparers of general-purpose financial statements to establish the fair value of an asset or liability. As paragraph 72 of IFRS 13 states:

The fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities (Level 1 inputs) and the lowest priority to unobservable inputs (Level 3 inputs).

Levels 1 and 2 in the hierarchy can be referred to as mark-to-market situations, with the highest level, Level 1, being quoted prices (unadjusted) in active markets for identical assets or liabilities that the entity can access at the measurement date.

Level 1 inputs are generally considered to be subject to less potential for manipulation. Level 2 are directly observable inputs other than Level 1 market prices and could include market prices for similar assets or liabilities, or market prices for identical assets but that are observed in less active markets. Level 3 inputs – which rank last in the hierarchy are mark-to-model situations where observable inputs are not available and risk-adjusted valuation models need to be used instead to determine a fair value.

6.14

This is an interesting question as there are differences of opinion on this. From a definitional perspective, the answer would be yes. The IASB Conceptual Framework (paragraph 4.68) defines income as:

increases in assets, or decreases in liabilities, that result in increases in equity, other than those relating to contributions from holders of equity claims.

So, applying the above definition, an increase in the fair value of an asset increases assets (obviously) and does not represent a contribution from owners, so it therefore fits the above definition of income. However, if historical cost accounting is applied, then no recognition will be made of an increase in fair value, and no income would be recognised. By contrast, if fair value measurements are being used, then there will be an increase in assets and an increase in equity, and pursuant to IFRS 16 Property, Plant and Equipment, this would be treated as an 140

item of ‘other comprehensive income’ and would not be included within profit or loss. Nevertheless, it is still considered to be ‘income’, albeit that it would not be included within profit or loss (unless it reverses a previous diminution in fair value), and would generally not be available for the payment of dividends.

However, at issue in this question is ‘should’ the increase in the fair value of an asset be included within income. As Chapter 6 discusses, some accounting researchers believe that holding gains should not be included within income (they would be adopting an approach which focuses on maintaining physical operating capacity). By contrast, other researchers (for example, Chambers) include increases in fair values as part of income. The debate is not settled, and students should be encouraged to provide their own views.

6.15

For information to be useful for decision making, it needs to be both relevant and representationally faithful. Good decisions cannot be made on the basis of a faithful representation of irrelevant transactions or events. Nor can good decisions be made on the basis of unfaithful representations of relevant transactions and events. So, it is effectively a balancing act where we need to consider both.

There has been some research, which we have referred to within this chapter that suggests that fair values are not relevant in some circumstances, or that certain stakeholder groups – such as analysts – consider fair values less relevant relative to historical costs. For example, Ronen (2008) argues that exit values – and fair value is based on an exit value – might not be reflective of the value of the asset to an organisation that intends to hold an asset for the purpose of generating cash flows across time. In such an instance, fair value simply represents the opportunity cost forgone by not selling the asset.

In terms of representational faithfulness, while Level 1 fair values might be deemed to be relatively reliable, Level 2 measurements rely upon professional judgement, thereby potentially undermining representational faithfulness. Further, Level 3 valuations have been claimed by many researchers to be a means by which managers can, and at times do, manipulate financial statements.

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Therefore, the point to this question is that the use of fair values and other measurements – such as historical costs – have various strengths and weaknesses in terms of relevance and representational faithfulness, and it is a matter of balancing one against the other – which can be a difficult balancing act.

6.16

Adding together assets that have been measured using different measurement principles is effectively like adding apples and oranges. For example, assume that we bought three parcels of land which are still owned by the entity. Land A was bought in 2003 at a cost of $1.2 million and currently has a fair value of $9.0 million. Land B was bought in 2013 at a cost of $4.1 million and currently has a fair value of $8.0 million. Finally, Land C was acquired in 2022 for $7.6 million and now has a fair value of $8.5 million.

As we can see from the above, Land A which was acquired in 2003 is actually the most valuable land now, but using historical cost it would be measured much lower than Land B and Land C. As we can also see, the historical cost of the three parcels of land is $12.9 but has a total fair value of $25.5 million. What does the $12.9 million actually represent? It does represent the historical cost of the land that has been acquired but it represents the addition of assets that were acquired in different times when the value of the dollar was quite different. Adding together dollars with different purchasing power is effectively like adding apples and oranges together. It is doubtful whether reporting these items of land at a total amount of $12.9 million provides information that is ‘decision useful’.

6.17

The financial capital maintenance approach adopted within historical cost requires that dividends should only be distributed to the extent that financial capital is not eroded by the dividends. For example, assume that an entity started the year with $200 in assets and $50 in liabilities (that is, net assets or owners’ equity of $150 which we also will assume was contributed by the owners). Also assume that at the end of the year the net assets had increased by $100 to $250 and that no additional capital contributions had been made by the owners throughout the year.

To maintain financial capital intact (the approach to capital maintenance adopted within historical cost accounting), $100 can be distributed as dividends. The financial capital maintenance approach adopted within historical cost accounting ignores the fact that the replacement costs of many assets could have changed 142

during the year and that while the financial capital has remained intact, if the entity was required to replace certain assets it may not be able to. That is, its real operating capacity may have decreased. Within historical cost accounting, realised holding gains or losses are treated as part of income. This can be contrasted with other methods of accounting, such as current cost accounting, which treats holding gains as capital adjustments rather than treating them all as part of distributable income.

Under a physical capital maintenance approach to determining income the reporting entity calculates how much income can be distributed yet allow it to retain sufficient funds to replace current assets as required. Under methods of accounting, such as current cost accounting, a measure of profit is determined that represents the maximum amount that can be distributed while maintaining the operating capital intact. Holding gains are not generally considered to be available for dividend distribution.

6.18

(a)

Current purchasing power accounting (CPPA) separately considers monetary items and non-monetary items. Monetary items are those assets and liabilities that remain fixed in terms of their monetary value regardless of changes in the purchasing power of money (the majority of liabilities would be monetary items). Conversely, the monetary equivalent of nonmonetary items will be expected to change over time as a result of factors such as inflation. Under current purchasing power accounting, gains and losses are deemed to relate to the holding of monetary items (typically a loss if monetary assets exceeds monetary liabilities, otherwise a gain), but do not arise from holding non-monetary items. Further, in undertaking current purchasing power accounting adjustments are made to the carrying amount (book value) of non-monetary items, generally by way of a general price index. The carrying value of monetary items, however, is not adjusted. Hence, from this brief description we can see that CPPA treats monetary and non-monetary items differently and hence they must be considered separately.

(b)

The view is that if an entity holds a monetary asset (such as cash) and if there is a general decrease in the purchasing power of money (for example, 143

because of inflation), then that cash will buy less – it will suffer from a purchasing power loss. With non-monetary assets it is assumed that the assets will retain their equivalent purchasing power. For example, if an entity holds land that cost $10 000 and inflation has been recorded at 5 per cent then the adjusted value of the land might be shown as $10 500 and if this land was sold then it is assumed that the cash received would have the same purchasing power. Although the monetary equivalent of the land has increased, no gain or loss would be recognised. By comparison, $10 in cash held now is still worth $10 in cash 2 years later, but its purchasing power would have declined and this reduction in purchasing power would be recognised in determining the entity’s financial performance.

6.19

There are a number of arguments against using replacement costs for the purposes of valuing assets. These can include the following: •

Some organisations might not elect to replace a particular asset given the chance it might be more efficient and less costly to acquire a different type of asset.

•

It might be very difficult to determine replacement costs for some assets, particularly those that have unique characteristics.

•

Chambers was particularly critical of replacement costs because he considered that they did not provide a good reflection of what the assets could actually be sold for – he considered that information about the current cash equivalents of the entity’s resources was fundamental to effective decision making and that methods of accounting that use other bases of valuation, such as replacement costs, will generate information that is irrelevant and misleading.

6.20

Under Continuously Contemporary Accounting (CoCoA), the profits associated with selling inventory would be recorded at the time the inventory was purchased with the amount being the difference between the expected retail prices, net of related expenses, and the cost to the entity. This can be contrasted to historical cost accounting wherein profits related to a sale would be deferred until such time as the sale had occurred.

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6.21

Holding gains relate to the increases in the monetary values of assets being held by an entity. The gains can be considered as realised or unrealised. A gain would be realised to the extent that the asset has been sold or used by the firm. Under some methods of current cost accounting (such as that proposed by Edwards and Bell which adopts a physical capital maintenance approach) a measure of operating profit is calculated which excludes realised and unrealised holding gains. It is considered that dividends should only be paid out of operating profits.

Under current cost accounting of the Edwards and Bell variety, realised and unrealised holding gains must be differentiated. Realised gains are added to current cost operating profits to reconcile current cost profit to historical cost accounting profit. Unrealised holding gains are then added to historical cost accounting profit to give a measure which is known as business profit (business profit would be the amount that could be distributed if a financial capital, as opposed to a physical capital maintenance, approach was adopted). Business profit shows how the entity has gained in financial terms from the increase in the cost of its resources – something typically ignored by historical cost accounting.

6.22

Under a financial capital maintenance approach to financial accounting, the gains that accrue from holding an asset can be distributed to shareholders to the extent that financial capital remains intact. No account is taken of changes in the purchasing power of the dollar, or the fact that the cost of the assets of the entity (upon which depreciation might be based) has increased.

Under a physical capital maintenance approach, holding gains would only be distributable to the extent that it does not erode the physical operating ability of an entity. Similarly, an approach to financial accounting which seeks to keep the purchasing power of the entity intact would only permit the payment of dividends to the extent that the purchasing power of the entity is not eroded relative to what it was at the beginning of the period.

Arguably a physical capital maintenance approach, or a constant purchasing power approach, provides a more logical approach to dividend distribution than simply allowing the distribution of all holding gains. If historical cost accounting was employed and if the organisation elected to distribute all holding gains, then the organisation could realistically find that it is unable to operate at the same level 145

as it could at the beginning of the period because it will be unable to replace the depreciable assets when they are fully depreciated, or the inventory when it has been sold.

6.23

Some strengths of historical cost accounting would include the following: •

Information generated by the historical cost accounting system seems to be demanded by the market whereas various studies have indicated that price level adjusted information is not in great demand.

•

It is a generally accepted accounting system, hence maintaining its use will not lead to drastic changes in accounting practice, which in turn could cause a variety of social and economic consequences.

•

People are used to preparing and reading historical cost accounting reports, hence there is no need to re-educate them about the strengths and limitations of historical cost accounting.

Some weaknesses of historical cost accounting would include the following: •

The assumption that the purchasing power of the dollar remains constant is simplistic and flawed.

•

Information generated through historical cost accounting suffers from the ‘additivity problem’ – it is argued that it makes little sense to add together the costs of assets acquired in different time periods.

•

Historical cost accounting relies upon arbitrary cost allocations (for example, in relation to depreciation) which may have little correspondence to the actual changes in an asset’s values.

•

Historical cost accounting can lead to an overstatement of profits in times of rising prices and this overstatement can cause a reduction in the operating capacity of the entity because an excess amount of dividends might be distributed (because historical cost accounting relies upon a financial capital maintenance perspective).

•

Historical cost accounting data is of limited relevance to current decisions.

•

Historical cost accounting assists an organisation to manipulate its profits given that the decision to dispose of a non-current asset can directly lead

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to the recognition of gains on disposal, even though those gains actually related to prior periods. The decision to sell an asset might be made in an effort to offset other losses that will be recorded.

6.24

To answer this question we need to firstly define what we mean by ‘representationally faithful’. According to paragraph 2.13 of the IASB Conceptual Framework for Financial Reporting:

To be a perfectly faithful representation, a depiction would have three characteristics. It would be complete, neutral and free from error. Of course, perfection is seldom, if ever, achievable. The Board’s objective is to maximise those qualities to the extent possible.

It would appear that valuations based on fair value will be more ‘representationally faithful’ when they are based on quoted prices in active markets. Such valuations would tend to be more objective and relatively less based on individual judgement. Indeed, where fair value is to be used, this is the IASB’s preferred basis for determining fair value. In this regard the IASB’s (and FASB’s) accounting standard on fair value measurement establishes a ‘fair value hierarchy’ in which the highest attainable level of inputs must be used to establish the fair value of an asset or liability. As paragraph 72 of IFRS 13 states:

To increase consistency and comparability in fair value measurements and related disclosures, this IFRS establishes a fair value hierarchy that categorises into three levels (see paragraphs 76–90) the inputs to valuation techniques used to measure fair value. The fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities (Level 1 inputs) and the lowest priority to unobservable inputs (Level 3 inputs).

Levels 1 and 2 in the hierarchy can be referred to as mark-to-market situations, with the highest level, Level 1, being (paragraph 76 of IFRS 13):

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Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the entity can access at the measurement date.

Level 2 are directly observable inputs other than Level 1 market prices (Level 2 inputs could include market prices for similar assets or liabilities, or market prices for identical assets but that are observed in less active markets). As paragraph 81 of IFRS 13 states:

Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly.

Level 3 inputs are mark-to-model situations where observable inputs are not available and risk-adjusted valuation models need to be used instead. Level 3 inputs are unobservable inputs for the asset or liability. Paragraph 87 of IFRS 13 states:

Unobservable inputs shall be used to measure fair value to the extent that relevant observable inputs are not available, thereby allowing for situations in which there is little, if any, market activity for the asset or liability at the measurement date. However, the fair value measurement objective remains the same, i.e. an exit price at the measurement date from the perspective of a market participant that holds the asset or owes the liability. Therefore, unobservable inputs shall reflect the assumptions that market participants would use when pricing the asset or liability, including assumptions about risk.

So, in summary, if fair value is to be used it would generally be accepted that Level 1 inputs to the valuation process would be more representationally faithful that Level 2 or Level 3.

6.25

Some strengths of current purchasing power accounting would include: •

Current purchasing power accounting is relatively simple and inexpensive to apply and does not require collecting data about replacement costs or 148

market values. Information about movements in general price indices would be easily available.

•

Relative to historical cost accounting, it can reduce the possibility of paying excessive dividends, which in turn could reduce the operating capacity of an entity.

Some weaknesses of current purchasing power accounting would include: •

It was not generally favoured by the business or professional community and hence any attempts to put it in place could be thwarted.

•

Tied to the above point, various studies showed that there was not a great deal of demand for price-adjusted information.

•

People are used to preparing and reading historical cost accounting reports supplemented with fair value measurements, hence there would be a need to re-educate them about the strengths and limitations of current purchasing power accounting – this might be costly.

•

It assumes one price index applies to all assets – this is a very simplistic assumption.

•

Because one price index is generally applied to all assets, the adjusted values of the assets may show little correspondence with their actual values (whether this be in terms of replacement or market values).

•

Tied to the above point, the reported values may cause some confusion – report users may think that the values represent current values.

•

It still relies upon arbitrary cost allocations, for example, in the form of depreciation.

6.26

Some strengths of current cost accounting would include: •

Relative to historical cost accounting, it can reduce the possibility of paying excessive dividends which could otherwise reduce the operating capacity of an entity.

•

If all assets are valued at replacement cost, then logically they can be added together, which solves the ‘additivity’ problem.

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•

Allows for a separation of holding gains and losses from other results and therefore provides a better insight into management performance.

Some weaknesses of current cost accounting would include: •

It is questionable whether replacement costs are reflective of the value of the assets to the particular organisation. Perhaps the organisation, if given the option, would acquire alternative types of assets.

•

Replacement costs do not provide an indication of the asset’s current value if the entity decides to sell.

•

It will not always be easy to determine replacement costs – for specialised assets the values can be very subjective.

•

Implementing current cost accounting requires the entity to go to the expense of collecting information about replacement costs.

•

There is not much evidence to support a view that people actually demanded such information.

•

People are used to preparing and reading historical cost accounting reports, supplemented with fair value measurements, hence there would be a need to re-educate them about the strengths and limitations of current cost accounting – this might be costly.

•

It still requires reliance upon arbitrary cost allocations, for example, through depreciation.

6.27

Some strengths of Continuously Contemporary Accounting would include: •

CoCoA provides information about an entity’s capacity to adapt.

Chambers considers such information crucial for effective decision making.

•

It solves the ‘additivity’ problem – there is a common basis of valuation (net- market values) so it makes logical sense to add the various asset values together.

•

There is no need for arbitrary cost allocations through depreciation.

Some weaknesses of Continuously Contemporary Accounting would include: 150

•

Not all assets will have a readily determined market price – hence a deal of subjectivity will be involved.

•

Some assets can generate income within a particular entity but have little or no value to anybody else (for example, the case of the blast furnace).

The ‘value in use’ of such assets is ignored.

•

It values assets on the basis of the separate disposal of the respective assets.

The implication of this is that assets which cannot be separately sold are deemed to have no value – for example, goodwill. This attribute of CoCoA has attracted a great deal of criticism.

•

CoCoA did not have widespread acceptance within the business community and hence there would be numerous obstacles to its implementation.

•

Because CoCoA would represent a radical departure from current methods of accounting, its adoption could cause major social and economic implications.

•

People are used to preparing and reading historical cost accounting reports, supplemented with fair value measurements, hence there would be a need to re-educate them about the strengths and limitations of CoCoA – this might be costly.

•

If an entity does not expect to sell an asset, it is questionable whether the selling price is really that relevant.

•

Tied to the above point, valuing all assets on the basis of selling prices has been criticised if it is considered that the entity is a going concern.

•

Determining the market price of unique assets introduces a degree of subjectivity into the accounting process.

6.28

Chambers believed that the most relevant information for decision making is information about the current cash equivalents of the entity’s resources. To determine the strategies that an organisation can implement at a point in time it was necessary in Chambers’ view to know the current cash equivalents. According to Chambers other valuation approaches (for example, those based on historical costs or replacement costs) were irrelevant to decision making and could actually be misleading.

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While Chambers was a vocal advocate of valuations based on market values it must be appreciated that his method of accounting was not embraced by the accounting professions or by business entities. This in itself indicates that many other people did not agree with Chambers. As noted within the chapter, there are a number of potential problems associated with valuing items on the basis of their net-market values. For example, not all assets will have a readily available market price, and further, some assets might not have a market outside an organisation yet they can generate economic benefits when used within an organisation.

Chambers’ preferred approach to accounting would indicate that assets which cannot be sold separately have no value – to many people this in itself would be misleading. As another example, the accounting profession treats goodwill as an asset. Chambers would argue that goodwill is not an asset – hence there is another difference of opinion. Whether something is irrelevant and misleading is really a function of a number of considerations, including perceptions about the role of accounting and the related information needs of financial statement readers.

Different people will have different perceptions about what is relevant and what is not.

6.29

Edwards opposes the use of exit prices to value all assets on the basis that an entity, operating as a going concern, would not be expected to dispose of all of its assets at a point in time. Further, if an entity is expanding, then the notion that they would dispose of all of their assets is even more questionable.

Edwards, an advocate of using replacement costs, suggests that in some circumstances the use of exit values might be appropriate when they are less than the replacement costs of an asset ‘and the firm has taken a definite decision not to replace the asset or even the function it performs’. As we can see, Edwards’ approach to valuation admits the possibility that a consideration of management’s intention at a point in time might influence a decision as to how an asset will be valued. This in itself could introduce some problems as allowing such considerations to influence asset valuation could introduce issues associated with biases and manipulations. A change in intention would lead to a change in valuation – we can imagine that Chambers would oppose such a possibility. Also,

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if some assets are valued at replacement costs and others at exit prices then we again will encounter problems associated with ‘additivity’.

6.30

This is an interesting issue. Certainly, historical cost accounting has been the subject of many critical attacks over the years by many notable scholars – yet it has in large part held its position of dominance (although accounting standards being released in recent years are increasingly requiring the use of fair values).

Possible reasons could include: •

The arguments against historical cost accounting were simply not convincing.

•

Users of historical accounting information considered the information to be suitable for their decision-making purposes and did not seek change.

•

Various studies of users’ demands for alternative valuations approaches have tended to show that the alternatives have not appeared to generate significant demand.

•

Preparers of financial statements were reluctant to change. There could be many reasons for this. Perhaps they considered that the information they were preparing was superior to alternative forms of information and that it was useful to the financial statement readers. As another alternative, perhaps they had a number of accounting-based contractual arrangements in place with various parties such as lenders, and changing accounting methods might have had negative implications for these agreements, and for the value of the organisation.

•

Tied to the above point, major shifts in how financial accounting valuations are undertaken could have major economic and social implications for many different people and this in itself might have meant that the adoption of alternative forms of accounting were unlikely.

•

Because historical cost accounting is generally accepted, and because it would take time to learn new methods of valuation, there might be a general reluctance to change.

•

Within historical cost accounting, holding gains on assets are not recognised until the time an asset is sold. As such, management might plan to sell particular non-current assets at times when it is suitable to them to record the gains (for example, when other significant losses have occurred, 153

and they want to offset the losses). Historical cost accounting gives the management a degree of discretion in terms of when they recognise gains and management might maintain their support for historical cost because they fear losing such discretion. However, it should be appreciated that across time this level of discretion is being eroded as more accounting standards are being released which require the use of fair values for particular assets.

Of course, there could be many other reasons why historical cost accounting has maintained its position. However, it should be appreciated that in many countries reporting entities can revalue their assets above cost. Further, in some countries particular industries are required to value their assets other than in accordance with historical cost accounting. For example, in Australia, Accounting Standards require reporting entities in the general insurance industry to value certain assets at net-market value. Superannuation funds are also required to value their assets on the basis of net-market values. Other specific assets, such as investments and agricultural assets, are now also required to be valued at fair values. Hence, there is a gradual shift away from historical cost – but nevertheless many assets can still be recorded on an historical cost basis.

6.31

There could be many reasons why organisations lobbied in support of methods of accounting such as CCA and CPPA. These reasons could include: •

The organisations might have been ignorant of the studies relating to user demands for CCA/CPPA information or, alternatively, they might simply have thought that the studies were wrong, and that people would use such information.

•

Perhaps the organisations in support of CCA/CPPA information believed that if people did not currently demand such information the reason might have been that they were unfamiliar with it and that once it was made available, they would see the benefits of its use.

•

They considered that historical cost information was misleading.

•

Organisations might have supported the alternative valuation approaches because of political benefits the approaches might have generated. For example, if the methods led to a reduction in reported profits, then this 154

reduction in reported profits might provide some justification to argue for reductions in corporate tax rates.

•

Following on from the above point, if an entity reports lower profits, then this might reduce the degree of political scrutiny aimed at the organisation.

Managers of politically sensitive firms (perhaps because they are considered to be monopolistic) might have seen particular benefits in the introduction of methods of accounting that produce reduced reported profits.

6.32

In terms of why many recently released accounting standards have embraced fair values rather than historical costs, there could be numerous reasons – as this chapter has demonstrated. The chapter, as well as previous chapters, has discussed various reasons why the accounting standard-setters might put in place particular requirements ranging from self-interest arguments to public interest arguments.

Adopting a public interest argument, it is very conceivable that the regulators believed that measurements based on fair values are much more relevant to the decisions of financial statement users than measurements or valuations based on historical costs.

However, while accounting standards have gradually created a movement away from historical costs towards fair values, this has happened at a time when conceptual frameworks have not really addressed the measurement issue. In a sense, underlying concepts are being changed gradually through the vehicle of accounting standards (and some would argue, by ‘stealth’), rather than in ‘one hit’ via a major change to our conceptual framework. Arguably, an agreement on changes to conceptual frameworks in terms of the incorporation of measurement issues (and the related debate) should have preceded the general shift in measurement bases used in accounting standards. The chapter has discussed a number of reasons why standard-setters might have decided not to address measurement issues with conceptual framework projects. Certainly, the measurement issue has appeared to be a major stumbling block in the development of conceptual frameworks.

6.33

Had general price level accounting been implemented then this would generally have led to a reduction in the profits of organisations in times of rising prices 155

(inflation). According to Watts and Zimmerman (1978), accounting profits are typically used within political processes as an excuse for putting in place mechanisms to transfer wealth away from particular organisations. For example, a labour union may push for additional wages for its members and justify the push by referring to the high corporate profits. As another example, various stakeholders may lobby government to raise taxes or reduce protection in industries appearing to be making excessive profits. What is being emphasised here is that reported profits are being used as a justification for the attempted wealth transfers. A reduction in profits would lead to a reduction in the justification for action – or so the theory goes.

According to Watts and Zimmerman, large firms are particularly prone to wealth transfers in the political process. Therefore, such firms will at times, prefer to adopt accounting methods that lead to a reduction in reported profits – such as general price level accounting. Watts and Zimmerman (1978) found that, in general, large firms lobbied in favour of GPLA.

6.34

A quantity or measure that tends to increase when the overall economy is growing, or decreases when the economy is declining, is classified as being procyclical.

During the sub-prime banking crisis it was claimed by many (especially banks themselves) that accounting requirements – as reflected in various accounting standards – that require reporting entities to measure many of their assets at fair value – actually exacerbated the financial crisis (Laux and Leuz, 2009; Power, 2010). That is, fair values are procyclical. It is argued that when markets for financial assets (such as shares, bonds and derivatives) are booming, the value of these assets held by banks, and shown at fair value within their statements of financial position, will similarly rise significantly above their historical cost – thus increasing the reported net assets and capital and reserves of the bank. As banking regulations usually set bank lending limits in terms of a proportion (or multiple) of capital and reserves, this increase in the reported fair value of the assets of a bank will enable a bank to lend more. Some of this additional lending will fuel further demand in the markets for financial assets – thus further increasing the market values/prices of these assets held by banks and further increasing their reported capital and reserves. This, it is argued, will enable banks to lend even 156

more and thus will help to create an upward spiral in financial assets prices, and bank lending, that becomes increasingly disconnected from the underlying real economic values of the assets in these markets (Laux and Leuz, 2009).

Conversely, it has been argued by many at the time of the sub-prime banking crisis that when markets for financial assets are in free-fall (as they were at times during the crisis), fair value accounting exacerbates a downward spiral of asset prices and bank lending that is equally unreflective of (and significantly overstates) decreases in real underlying economic values (Laux and Leuz, 2009). The basis of this viewpoint is that requirements to mark-to-market financial assets held by banks may lead to a rapid erosion in the capital and reserves shown in the banks’ statements of financial position. This will reduce their lending limits (where these are tied to their reported levels of capital and reserves) and will both reduce bank lending (thus reducing demand in financial markets, putting further downward pressure on the asset prices in these markets) and possibly require the banks to sell some of the financial assets they hold to release liquidity. This will put further downward pressure on the asset prices, leading to a downward price spiral as these reduced prices further reduce the reported net assets of the banks.

Views such as these emphasise the key role that financial accounting plays within the broader society – with proponents of the above view emphasising that the choice of a financial accounting measurement approach such as fair value can, according to them, have widespread negative economic and social implications for society.

Although these impacts of fair value accounting were widely articulated at the time of the sub-prime banking crisis, Laux and Leuz (2009) argue many of these claimed empirical effects were not caused by fair value accounting, so the volatility and procyclicality case against fair value accounting is not as clear cut as the above arguments indicate. Laux and Leuz (2009, p. 827) indicate that while there are some legitimate concerns about the impact of fair values:

the concern about the downward spiral is most pronounced for FVA [fair value accounting] in its pure form but it does not apply in the same way to FVA as stipulated by US GAAP or IFRS. Both standards 157

allow for deviations from market prices under certain circumstances (e.g., prices from fire sales). Thus, it is not clear that the standards themselves are the source of the problem.

The basis of this argument is that both IFRS and US GAAP permit fair values to be determined using data other than direct market observations in many circumstances. These are referred to as Level 2 and Level 3 in the fair value measurement hierarchy. In situations where markets are demonstrably not providing values based on orderly transactions, or are for any other reason not operating efficiently (for example due to illiquidity in the markets), then rather than using Level 1 fair value measurements (directly observed market prices for identical assets), then Level 2 mark-to-market or Level 3 mark-to-model valuations should be used. Laux and Leuz (2009) explain that during the subprime banking crisis, many banks moved to using Level 2 and 3 valuations rather than Level 1 valuations for many financial assets, and also took advantage of provisions to allow some assets to be reclassified from fair value to historical cost categories in special circumstances, thus acting as a ‘damper’ reducing the speed (or acceleration) of any procyclical effects. They also argue that any failure to provide fair values in financial statements during economic downturns could in itself cause markets to overreact and/or misprice company shares:

it is also possible that market reactions are even more extreme if current market prices or fair-value estimates are not disclosed to the market. We are not aware of any empirical evidence that investors would be calmer under historical cost accounting. Investors are not naïve; they know about the problems, e.g., in the subprime-loan market, and hence will draw inferences even in the absence of fairvalue disclosures (and in that case might assume the worst). Thus, lack of transparency could make matters worse. Furthermore, even if investors were to react more calmly under historical cost accounting, this may come at the price of delaying and increasing the underlying problems (e.g., excessive subprime lending). (Laux and Leuz, 2009, p. 828)

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Therefore, we can see that there are different opinions about whether the use of fair value accounting should be reduced on the basis of procyclicality arguments.

6.35

IASB’s (and FASB’s) accounting standard on fair value measurement establishes a ‘fair value hierarchy’ in which the highest attainable level of inputs must be used to establish the fair value of an asset or liability. As paragraph 72 of IFRS 13 states: To increase consistency and comparability in fair value measurements and related disclosures, this IFRS establishes a fair value hierarchy that categorises into three levels (see paragraphs 76–90) the inputs to valuation techniques used to measure fair value. The fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities (Level 1 inputs) and the lowest priority to unobservable inputs (Level 3 inputs).

Levels 1 and 2 in the hierarchy can be referred to as mark-to-market situations, with the highest level, Level 1, being (paragraph 76 of IFRS 13): Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the entity can access at the measurement date.

Level 2 are directly observable inputs other than Level 1 market prices (Level 2 inputs could include market prices for similar assets or liabilities, or market prices for identical assets but that are observed in less active markets). As paragraph 81 states:

Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly.

Level 3 inputs are mark-to-model situations where observable inputs are not available and risk-adjusted valuation models need to be used instead. Level 3 inputs are unobservable inputs for the asset or liability. Paragraph 87 of IFRS 13 states:

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Unobservable inputs shall be used to measure fair value to the extent that relevant observable inputs are not available, thereby allowing for situations in which there is little, if any, market activity for the asset or liability at the measurement date. However, the fair value measurement objective remains the same, i.e. an exit price at the measurement date from the perspective of a market participant that holds the asset or owes the liability. Therefore, unobservable inputs shall reflect the assumptions that market participants would use when pricing the asset or liability, including assumptions about risk.

It would generally be considered that fair values based on Level 1 inputs would be more reliable, or representationally faithful, than fair values based on Level 2 or Level 3 inputs.

6.36

The underlying argument is that the use of fair value contributed to crises such as the collapse of Enron, and that the use of fair values needed to be carefully questioned.

In terms of which view we support, this is really a matter of opinion based upon what we think motivates standard-setters.

If we were to believe that all people act in their own self-interest – including regulators and standard-setters (that is, we reject a public interest theory of regulation) – then we might be inclined to believe that the standard-setters might have covered up the problems of fair value accounting. They might have done this because highlighting the problems might have undermined the legitimacy of their efforts to make fair values more widely used within financial reporting.

Undermining the legitimacy of their efforts would have had implications for the standard-setting bodies and potentially for the positions and reputations of those on the Boards.

Because members of standard-setting organisations are expected to have significant expertise in the related areas, it is difficult to believe the other argument that that these knowledgeable people did not know about the limitations of fair

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values. However, why it took several more years to introduce the fair value hierarchy (Levels 1 to 3) is far from clear.

6.37

This is another question where our response is a matter of opinion. As we know, useful information should be both relevant and representationally faithful. Good decisions cannot be made on the basis of a faithful representation of irrelevant transactions or events. Nor can good decisions be made on the basis of unfaithful representations of relevant transactions and events. So, it is effectively a balancing act where we need to consider both.

The use of fair values does mean that adjustments are made to financial statements in situations where there has been no transaction. This provides managers with the potential to manipulate financial statements. This ability to manipulate financial statements can be curtailed to some extent if there is a strong accounting and auditing profession in place together with strong systems of monitoring and enforcement. By contrast, if there are weak monitoring and enforcement mechanisms, then fair value accounting can be used relatively more opportunistically, particularly if we assume – as Ball would assume – that people are driven by self-interest. However, in an environment with poorly qualified financial accountants and auditors, and weak monitoring and enforcement mechanisms, then all approaches to financial accounting – not just those that relate to fair value accounting – would be questionable in their application. Therefore, Ball’s arguments would tend to bring into question the use of all methods of financial accounting in such environments, and not just fair value accounting.

Ball would also be right to question the use of fair value accounting in markets where assets are not greatly traded. There could be an over-reliance on Level 3 valuations which are known to have problems of reliability, with such problems being amplified in the presence of poor monitoring and enforcement.

Ball’s arguments are compelling, but nevertheless the use of fair value accounting continues in those environments that concern Ball.

6.38

This is a very interesting view and does reinforce the fact that accounting is both a technical and a social practice.

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We have seen in the past that large unfavourable changes in asset and liability measurements have been linked to major corporate and market collapses, and this in turn has created great social problems. We know that companies do negotiate various contracts – such as borrowing contracts – that use financial accounting numbers in covenants (debt covenants). If asset measurements fall (or liability measurements rise) significantly, then many companies can go into a situation of ‘technical default’ on their borrowing agreements and this can lead to widespread corporate collapses and the various social costs that follow.

So, it is potentially possible that if assets with values of this magnitude were suddenly subject to significant downward adjustments, then any initial fair value reductions could lead to even greater downward adjustments, reflecting what we have referred to within the chapter as ‘procyclical effects’. Again, financial accounting would be implicated – by some commentators – as being at least partially responsible for major negative economic and social events.

6.39

Standard setters should consider such findings. However, they also need to consider the quality of the research that was undertaken as well as other research that has been undertaken, some of which might contradict such findings. One, or just a few, research publications that question particular accounting approaches are unlikely to evoke a reaction from standard-setters. But as the body of research increases that is critical of particular approaches, then we could expect standardsetters to be more likely to react. Arguably, the work of financial accounting researchers should ultimately impact the standard-setting process.

Standard-setters need to consider a number of issues, including what they believe is the objective of general purpose financial reporting; the audience of general purpose financial reporting; and the qualitative characteristics that useful financial information possesses (which are addresses with the Conceptual Framework) before considering the relevance of particular research results.

How we think standard-setters will react to particular research will also be impacted by our view about what motivates standard-setters. For example, we

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might believe that they act in the public interest, or we might believe that they act in their own self-interest.

6.40

There is no model answer provided to this question. Rather, the intention is to stimulate critical debate. Students should consider the logic of the argument provided by the authors, as well as consider the authors’ apparent ‘political leanings’. Ideally, the answer should provide some linkage to a particular theory of regulation and in doing so, identify what the authors seem to believe motivates financial reporting standard-setters. Do the students have a different view about what they believe motivates standard-setters?

Students should also consider the language used by the authors. Do they think it is overly emotive or colourful, and if so, might this be a tactic applied by the authors to garner support for their arguments, or to distract attention from a potentially dubious argument? As we noted in Chapter 1, when reading documents written to support particular ideas or theories, we must 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.

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Chapter 7: Normative theories of accounting – the case of conceptual framework projects Solutions

7.1

A conceptual framework for financial reporting can be considered to be a normative theory of accounting. A conceptual framework makes prescriptions in regard to what the objectives of accounting are, what qualitative characteristics general purpose financial information should possess, how the elements of general purpose financial reporting should be defined and when they should be recognised, and how the elements of accounting should be measured.

Within the United States, the conceptual framework has been defined as ‘a coherent system of interrelated objectives and fundamentals that is expected to lead to consistent standards’. It is further stated that the conceptual framework ‘prescribes the nature, function and limits of financial accounting and reporting’ (Statement of Financial Accounting Concepts No. 1: Objectives of Financial Reporting by Business Enterprises, 1978).

In May 2008, an exposure draft entitled Exposure Draft of an Improved Conceptual Framework for Financial Reporting was released jointly by the IASB and FASB and, according to the exposure draft, the conceptual framework is:

a coherent system of concepts that flow from an objective. The objective of financial reporting is the foundation of the framework. The other concepts provide guidance on identifying the boundaries of financial reporting; selecting the transactions, other events and circumstances to be represented; how they should be recognised and measured (or disclosed); and how they should be summarised and communicated in financial reports.

As this definition indicates, the objective of financial reporting is the fundamental building block for the conceptual frameworks being developed by the IASB and the FASB. Hence, if particular individuals or parties disagreed with the objective identified by the IASB and the FASB, they would most likely disagree with the 164

various prescriptions provided within the revised conceptual framework.

7.2

The view often promoted by various advocates of conceptual framework projects is that it is difficult and perhaps illogical to develop systems of financial reporting if we do not initially agree on important issues such as what general purpose financial reporting is, what the objective of a general purpose financial reporting system is and in relation to this, what the qualitative characteristics of the information generated from that system should be. Further, to make the system consistent we need to agree on how we define, recognise and measure the elements of that system. The view taken is that there are a number of building blocks involved in developing a logical system of financial reporting and that a conceptual framework develops such building blocks in a logical order. For example, we initially need some consensus on the definition of general purpose financial reporting and of a reporting entity, before we can consider the objective of financial reporting. Once we have considered the objective of financial reporting, we can then consider defining the qualitative characteristics of financial reporting, as well as how to define the elements of financial reporting and so forth.

Without some consensus on issues such as those mentioned above, it is likely that the development of rules of financial reporting (assuming that we need rules) will be undertaken in a rather piecemeal manner with limited consistency between the various rules (which raises another issue: do we need consistency?). This inconsistency appeared to be the case in many countries prior to the development of conceptual frameworks. There was a great deal of inconsistency between the various standards in terms of definitions (often implied) of the elements of accounting, as well as inconsistencies in determining when the elements should be recognised and how they should be measured. With a conceptual framework, the financial reporting standards are expected to be more consistent.

Across time, the accounting profession attracted a great deal of criticism for the lack of agreement on key issues – so from a ‘legitimacy’ perspective, the profession probably needed a conceptual framework.

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7.3

The IASB Conceptual Framework is developed by the IASB. The IASB – which is a standard-setting body – has no power to enforce its financial reporting standards (IFRS), or its Conceptual Framework. Rather, it is up to regulators within countries to mandate – for example, within their respective corporations’ laws – the requirements for particular organisational forms to comply with IFRS.

In many countries, companies are required to comply with IFRS in order to satisfy national reporting requirements. In the event of a particular transaction or event not being addressed by an IFRS, there is often a requirement that companies then apply the guidance within the Conceptual Framework when determining how to account for the transaction or event.

7.4

The IASB Conceptual Framework is considered a normative theory because – based upon various judgements about the objective and users of general purpose financial reports – it prescribes how general purpose financial reporting should be undertaken. A positive theory, by contrast would explain and/or predict financial reporting practices.

7.5

A conceptual framework provides guidance at a much broader level than a financial reporting standard. The IASB Conceptual Framework provides general guidance about such issues as the objective of financial reports, which entities should produce general purpose financial reports, the qualitative characteristics that useful financial information will possess, how the elements of financial accounting (assets, liabilities, equity, income and expenses) should be defined, and when they should be recognised.

By contrast, financial reporting standards have a much narrower focus and tend to provide guidance on how particular types of transactions, or how particular assets and liabilities, should be accounted for. For example, different financial reporting standards will provide guidance on how to account for inventory (IAS 2), property, plant and equipment (IAS 16), biological assets (IAS 41), or employee entitlements (IAS 19). Such detailed consideration of particular assets or liabilities is not provided in a conceptual framework.

Effectively, a central role of financial reporting standards is to apply the concepts 166

included within a conceptual framework to specific transactions and events.

7.6

As Chapter 6 has discussed, because Australia adopted financial reporting standards issued by the IASB (and its predecessor, the IASC) and because those accounting standards were developed from the IASB Conceptual Framework, it would have been somewhat inconsistent to retain the Australian Conceptual Framework which was used to develop the superseded Australian standards.

Hence the decision to adopt standards issued by the IASB effectively meant we also had to adopt the IASB Framework.

7.7

Hines would seem to argue that the accounting profession and accounting standard-setters gain relatively more from the establishment of conceptual frameworks. The rationale for her argument is that the very existence of a conceptual framework based on notions such as ‘representational faithfulness’, objectivity, neutrality and so forth brings legitimacy and a form of professional status to a group that embraces it. Also, credibility attaches to a group of individuals who are able to construct a logically developed framework which appears to guide their actions.

Of course, we can expect financial statement readers to also gain from the establishment of a logically constructed conceptual framework – but such gains or advantages were not the focus of Hines’ interesting insights.

7.8

Some of the advantages that have been advanced in relation to conceptual frameworks of accounting include: •

Accounting standards developed by applying the contents of a conceptual framework should be consistent and logical.

•

Because many countries have adopted the IASB Conceptual Framework there should be greater international compatibility between various countries’ accounting practices, and this should lead to greater consistency and comparability between international financial reports (which some people have argued is important for flows of foreign investment capital).

•

Because conceptual frameworks provide the fundamentals of an accounting system, standard-setters should be more accountable for their 167

decisions. If they deviate from key issues addressed in a conceptual framework this should be clear and some explanation would be necessary.

•

Conceptual frameworks provide a means of communicating key concepts to financial report preparers and users, as well as providing guidance to reporting entities when no specific standards address a particular issue.

•

Because issues such as the objective of financial reporting, recognition criteria (and so on) have been determined when developing a conceptual framework, then accounting standard-setters will be subject to less political pressure when developing new standards.

•

Because standard-setters will have consensus on many key issues, the development of accounting standards should be more economical. There will be no need to go back to the ‘drawing board’ on many fundamental issues.

While not directly asked within Question 7.8, some of the disadvantages that have been associated with conceptual frameworks of accounting include: •

Conceptual frameworks are costly to develop.

•

The development of conceptual frameworks is subject to political interference – some people (for example, Hines) argue that conceptual frameworks are no more than residue of a political process.

•

Tied to the above point, when conceptual frameworks have attempted to consider issues in which there is much underlying disagreement (for example, measurement issues), they have tended to lose progress.

•

Following on from the above point, conceptual frameworks have tended not to tackle difficult issues.

•

Conceptual frameworks focus on economic (financial) performance alone.

As such, they tend to ignore other aspects of performance (for example, the social and environmental performance of a reporting entity). Further, by focusing on financial performance alone and by giving it prominence, conceptual frameworks tend to deflect attention away from other important areas of corporate performance.

•

They represent a codification of existing practice and do not provide ideal methods of accounting.

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•

They only act to provide a means of legitimising a profession under threat.

Whether we accept or reject the above advantages or disadvantages of conceptual frameworks will really be based on our own personal opinions and beliefs.

7.9

Neutrality and representational faithfulness have been proposed as important qualitative attributes of financial information. However, there are a number of issues that can be raised to question whether financial information can really be considered as neutral and representationally faithful. These include: •

Those responsible for accounting (accountants) are responsible for determining what issues need to be accounted for and those that do not.

This relies upon a great deal of judgement. If something is not separately identified and accounted for then it might be deemed unimportant.

Attention will tend to be directed towards those attributes of performance that are identified and measured. Identifying what is important is a subjective process.

•

The recognition criteria for the elements of financial reporting rely upon a consideration of probabilities, for example, the probability that an item of expenditure will generate future economic benefits. The determination of probabilities can be quite subjective.

•

When financial reporting standards are developed, accounting standardsetters consider the potential economic and social consequences that might result if the standard is issued. Once standard-setters allow such considerations to influence their standard-setting activities it is questionable whether the standards are developed in an objective manner.

If the financial reporting standards are not developed in an objective manner, then it is also questionable whether the accounting reports which are developed in accordance with those standards can be objective.

•

Related to the above point, the process involved in the development of financial reporting standards can be considered to be a political process given that constituents are encouraged to provide a lobbying submission during the process of developing accounting standards. A political process is not generally considered to be an objective process. To some extent, the

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ongoing existence of standard-setting bodies is reliant upon constituent support.

•

Some accounting researchers use various economic theories to explain what motivates managers to support one accounting method in preference to another. Proponents of Positive Accounting Theory assume that individual self-interest motivates the selection of accounting methods within a firm. Self-interest and objectivity are mutually exclusive.

7.10

The answer to this question is also partly reflected in the answer given to Question 7.9. The ‘due process’ involved in developing a conceptual framework and financial reporting standards requires the IASB (and FASB) to release exposure drafts and to actively seek the comments and opinions of diverse stakeholder groups. Bodies such as the IASB are also required to consider the costs and benefits associated with proposed financial reporting requirements.

Once a regulator or a standard-setter starts taking into account potential costs and benefits as well as various stakeholder opinions then the whole process becomes political in nature and judgements must be made about the validity of particular viewpoints over and above others, as well as about the importance of various costs and benefits to various constituents. It is very difficult to consider a process can ever be neutral and free from bias when it invites people in society to lobby for or against different accounting prescriptions, or requires the standard-setter to trade off the various costs and benefits that might be imposed on a variety of financial statement preparers and users. The final standards or conceptual framework components will inevitably be a ‘negotiated outcome’ given the way in which different constituents are invited to make submissions on proposed requirements, as well as being invited to various ‘round table’ discussions held as part of the process of developing new requirements.

Arguably, if accounting requirements are to be ‘representationally faithful’, neutral and free from bias then they should be developed on the basis of a logical foundation of beliefs (which might be included with a conceptual framework) and then be implemented no matter how unpopular they might be – but such an approach would ignore the real and obvious possibility that standard-setters who

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release unpopular requirements might ultimately find that their very existence is threatened.

Given the way in which financial reporting standards and the conceptual framework are developed, and the political nature of the development process, it is therefore difficult to argue that the resulting information that is generated from these ‘negotiated’ requirements can in itself be considered neutral and free from bias. The whole process of financial reporting is inherently political in nature – something that would probably surprise many non-accountants who might believe that financial accounting practices generate a fully objective perspective of an organisation’s performance.

7.11

As Chapter 7 explains, there are different approaches that can be applied to determining income and expenses, and therefore profits. Two such approaches are commonly referred to as the asset/liability approach and the revenue/expense approach.

The asset/liability approach links profit to changes that have occurred in the assets and liabilities of the reporting entity (after adjusting for the effects of certain transactions such as capital contributions or withdrawals), whereas the revenue/expense approach tends to rely on concepts such as the matching principle, which is very much focused on actual transactions and gives limited consideration to changes in the values of assets and liabilities.

The IASB Conceptual Framework adopts the asset/liability approach. Within this framework the definitions of elements of financial statements start with definitions of assets and liabilities. The definitions of all other elements flow from these definitions. In relation to the ‘asset and liability view’ of profit determination, the FASB and IASB (2005, pp. 7, 8) state:

In both [FASB and IASB] frameworks, the definitions of the elements are consistent with an ‘asset and liability view,’ in which income is a measure of the increase in the net resources of the enterprise during a period, defined primarily in terms of increases in assets and decreases in liabilities. That definition of income is grounded in a theory prevalent in economics: that an 171

entity’s income can be objectively determined from the change in its wealth plus what is consumed during a period (Hicks, 1946, pp. 178–179). That view is carried out in definitions of liabilities, equity, and income that are based on the definition of assets, that is, that give ‘conceptual primacy’ to assets. That view is contrasted with a ‘revenue and expense view,’ in which income is the difference between outputs from and inputs to the enterprise’s earning activities during a period, defined primarily in terms of revenues (appropriately recognised) and expenses (either appropriately matched to them or systematically and rationally allocated to reporting periods in a way that avoids distortion of income) … Some recent critics advocate a shift back to the revenue and expense view. However, in a recent study about principlebased standards, mandated by the 2002 Sarbanes-Oxley legislation, the US Securities and Exchange Commission said the following:

… the revenue/expense view is inappropriate for use in standard-setting – particularly in an objectives-oriented regime … Historical experience suggests that the asset/liability approach most appropriately anchors the standard-setting process by providing the strongest conceptual mapping to the underlying economic reality (page 30). … the FASB should maintain the asset/liability view in continuing its move to an objectives-oriented standard-setting regime (page 42).

7.12

Given that equity represents a residual interest in the assets of an entity, the amount disclosed as equity will correspond with the difference between the amounts assigned to assets and liabilities. As such, the criteria for the recognition of assets and liabilities, in turn, directly govern the recognition of equity.

Therefore, there is no need for a separate recognition criterion for equity.

7.13

Both relevance and faithful representation are considered in the IASB Conceptual Framework as ‘fundamental qualitative characteristics’ that financial information should possess. If something is not considered to be relevant (that is, if it is not likely to influence decisions about the allocation of scarce resources) then one view is that the item does not really need to be disclosed, perhaps regardless of whether it is representationally faithful or not.

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However, if something is considered to be relevant to financial statement readers, which obviously is a matter of judgement, then people are considered likely to act on the information. It would be important that the information faithfully represents the underlying transaction or event to which it relates (which implies it is free from bias and undue error).

Hence, we could perhaps argue that representational faithfulness is particularly important if an item is considered relevant; however, if it is not considered to be relevant then it probably does not matter whether the item is representationally faithful or not given that people might not be expected to act on it in either case.

Therefore, logically, we might argue that the initial characteristic to consider is whether the information is likely to be relevant. Does this sound logical? By contrast to this argument, it would appear that the IASB proposes that both attributes must be considered at the same time. As Paragraph 2.20 of the IASB Conceptual Framework states:

Information must be both relevant and provide a faithful representation of what it purports to represent if it is to be useful. Neither a faithful representation of an irrelevant phenomenon nor an unfaithful representation of a relevant phenomenon helps users make good decisions.

7.14

Accountability is an interesting concept and arguably one that should be carefully covered within any ‘accounting’ education.

Accountability is a complex and abstract term that is difficult to precisely define because it has many possible connotations. The Oxford English Dictionary defines it as:

The quality of being accountable; liability to account for and answer for one’s conduct, performance of duties, etc. (in modern use often with regard to parliamentary, corporate, or financial liability to the public, shareholders, etc.); responsibility.

Bovens (2007) defines accountability as a relationship between an actor and a forum, in which the actor has an obligation to explain and to justify his/her 173

conduct, and the forum can raise questions and pass judgement, while the actor may face any consequences that might result from this process.

Gray et al. (1996) developed an accountability model that explains how organisations should deal with stakeholders and proposes that since a firm’s activities affect the well-being of a wide range of stakeholders, the firm is morally responsible, and therefore accountable, to these stakeholders. In more practical terms Gray et al. (1997, p. 334) provide a broader notion of accountability:

Accountability is concerned with the relationships between groups, individuals, organisations and the rights to information that such relationships entail. Simply stated, accountability is the duty to provide an account of the actions for which one is held responsible. The nature of the relationships – and the attendant rights to information – are contextually determined by the society in which the relationship occurs.

From this definition, we can see that accountability involves two responsibilities or duties, namely: 1

to undertake certain actions (or to refrain from taking actions) in accordance with the expectations of a group of stakeholders; and

2

7.15

to provide a reckoning or account of those actions to the stakeholders.

There is a direct relation between perceptions of corporate accountability and corporate reporting. From the perspective of corporate managers, different perspectives will be held about their accountability in terms of ‘for what’ and ‘to whom’ they are accountable, and this will impact the nature of reporting undertaken.

In terms of considerations about ‘for what’ an organisation is responsible, some managers might accept that the entity has a responsibility (and an accountability) for its social and environmental performance. In such a situation they might accept a duty to provide ‘an account’ (or a report) of the organisation’s social and environmental performance – perhaps by way of releasing a publicly available corporate social responsibility report. If, by contrast, they considered that the only

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responsibility of the organisation was to maximise its financial returns then they might believe that the only account they need to provide is a financial account.

In terms of issues about ‘to whom’ they owe an accountability they also need to consider the breadth of stakeholders who should be provided with an ‘account’ – for example, should it be restricted to shareholders, or do employees, local communities, and others also have a right to be provided with particular information?

Therefore, we can see the role of a corporate report (and corporate reporting) is to inform relevant stakeholders about the extent to which the actions for which an organisation considers it is responsible have actually been fulfilled. Reporting provides a vehicle for an organisation to fulfil its requirement to be accountable.

Of course, different people will have different views about the responsibilities of organisations, and therefore will hold different views about what ‘accounts’ should be produced by an organisation.

7.16

Different students will have different answers to this and there is no ‘right’ or ‘wrong’ answer. What is important is that students understand that different people will have different perspectives about the responsibilities and accountabilities of organisations, and this will in turn influence the nature of the expected reporting undertaken by the entity.

The broader the perceptions of corporate accountability embraced by managers, the broader the ‘accounting’ that would also be embraced by an organisation.

A review of the IASB Conceptual Framework would seem to indicate that the IASB believe that reporting entities are accountable for their financial performance and the accountability for financial performance is for the benefit of informing existing and potential investors, lenders, and creditors so as to enable them to make efficient resource allocation decisions.

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Across time, a number of objectives of general purpose financial reporting have been proposed. These include to:

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•

enable people, particularly shareholders, to assess the stewardship of management – that is, whether the resources entrusted to management have been used for the intended or expected purposes;

•

demonstrate an accountability between an entity and the various parties to which the entity owes a responsibility. This responsibility can extend to parties who do not have a financial interest in the entity. This accountability perspective was embodied within The Corporate Report (UK);

•

assist financial report readers to make economic decisions – this is often referred to as a decision usefulness perspective.

Within the IASB Conceptual Framework, the objective of general-purpose financial reporting can be directly related to the decision usefulness perspective, with the decision-making needs of existing and potential investors, lenders, and creditors being the focus. There is also a focus on stewardship for the financial resources that have been entrusted to management. The IASB Conceptual Framework states that the objective of 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 about 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 c) exercising rights to vote on, or otherwise influence, management’s actions that affect the use of the entity’s economic resources.

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This is really a matter of opinion. If we believe that organisations have a responsibility to be accountable for their financial performance to a group of stakeholders beyond existing and potential investors, lenders and other creditors, then we might reject the objective of the IASB Conceptual Framework. Students should be encouraged to debate this point.

What needs to be remembered, and emphasised, is that the contents of the Conceptual Framework build upon the objective that has been developed. That is, 176

the contents follow from the objective, so we need to know the objective so as to understand the context of the material that follows within the IASB Conceptual Framework. Whether we tend to accept, or reject, the contents of the Conceptual Framework would be influenced by whether we agree or disagree with the objective of financial reporting on which the balance of the Conceptual Framework is based. For example, if we did not agree with the focus upon providing financial information that is ‘useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity’, then we might tend to reject the remaining contents of the IASB Conceptual Framework

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The answer to this question is very much a matter of opinion. Possible answers would include: •

Users of financial statements might be considered as possible beneficiaries of a conceptual framework as financial statements will be more consistent and comparable and this should assist various resource allocation decisions. It should also reduce costs associated with using financial reporting data, as there will be less need to adjust for differences in accounting approaches between alternative reporting entities.

•

Following the above point, it could be argued that society as a whole will benefit because more informed resource allocation decisions will be made, and this might reduce the likelihood of resources flowing to inefficient uses.

•

Reporting entities could benefit because they will be given explicit guidance on many key reporting issues. Further, they will have general guidance when no accounting standards exist in relation to a specific accounting issue. Also, global acceptance of one conceptual framework could assist in the flow of resources from foreign investors (the perspective being that differences in accounting practices between countries might otherwise impede foreign investment).

•

There are a number of perspectives which suggest that standard-setters might benefit from the development of conceptual frameworks. One argument is that standard-setters will be subject to less political pressure and interference because the basis for many of their decisions will be 177

embodied within an accepted framework. Another perspective is that conceptual frameworks benefit standard-setters because they legitimise the existence of the standard-setters, thereby enabling them to maintain selfregulation and to counter threats to their own employment. Conceptual frameworks have also been argued to represent a means of boosting the public image of the accounting profession as a whole. Authors such as Hines argue that conceptual frameworks promote notions of objectivity, reliability and so forth and such qualities themselves are generally deemed to be the cornerstone of a sound profession.

•

It has also been argued that conceptual frameworks provide benefits to people with a financial interest in the firm, as opposed to people with other interests. For example, conceptual frameworks define the elements of accounting in such a way as to ignore social and environmental issues and to emphasise financial performance. Hence, the implication is that organisations with ‘sound’ financial performance will appear to be ‘better’ performers, even if they have many negative social and environmental implications (most of which might be ignored). ‘Better’ performers will in turn generate greater community support and this should increase the value of the entity.

7.20

There will be a number of different opinions on this. Arguably, conceptual frameworks have been less than a complete success. Reasons for this view include: •

There appear to be many inconsistencies between existing financial reporting standards (for example, assets such as inventory are to be measured at the lower of cost and net realisable value, while other assets, such as marketable securities are to be valued at fair value) and this was one of the problems (relating to ‘additivity’) that the conceptual framework was expected to solve.

•

In recent years conceptual frameworks have appeared to have made very slow progress. For example, many of the building blocks remain unaddressed many years after various projects commenced. The IASB Conceptual Framework has been very slow to address a number of key

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issues, and in recent years, there have been times when work on the Conceptual Project has been put on hold.

•

Conceptual frameworks have failed to tackle the more difficult issues (for example, measurement issues) and where they have, they have tended to be very permissive and to admit many alternatives (for example, the United States experience with measurement guidance).

•

Hines argues that a key objective of a conceptual framework is to legitimise the standing of the accounting standard-setters and the accounting profession. Whether conceptual frameworks have been successful in this regard is a matter of debate.

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Conceptual frameworks have failed to provide clear guidance in relation to contentious measurement issues. Reasons for this could include: •

There is so much debate and disagreement on what the appropriate basis of measurement is (for example, historical cost, market values, replacement costs, present values, fair values) and whether one method should be applied to all items, that perhaps the standard-setters are currently unsure which approach is the best and are awaiting further debate/knowledge before endorsing one approach in preference to another.

At the present time the IASB does favour the use of one measurement basis (for example, fair value) in preference to all other bases. Rather, a ‘mixed attribute model’ is currently favoured by the IASB.

•

Perhaps the efforts of accounting standard-setters have been diverted to other more ‘pressing’ issues. Since standard-setters typically have limited resources, when pressing issues arise, the conceptual framework might tend to be put on the ‘back-burner’ despite its central importance and relevance.

•

Hines has argued that conceptual frameworks are put in place to bolster the image and support for the accounting profession and accounting standard-setters. Because measurement issues generate a wide amount of debate, support of one method in preference to another may reduce the support of the accounting-standard-setters. Perhaps this might have influenced their lack of support for one approach to measurement in favour of another. Perhaps it is easier to ‘cop-out’ (Solomons 1986).

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•

When the IASB released its revised Conceptual Framework in 2018 the Conceptual Framework did not stipulate one basis of measurement for all assets and liabilities. Instead, the Conceptual Framework notes that the selection should be based on which measurement basis provides the most ‘useful’ information to the readers of the financial statements. Paragraph 7.2 of the IASB Conceptual Framework states: 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.

Therefore, the IASB has gone from a position wherein it was publicly noting that there was much work to be done before prescribing a particular measurement approach, to a situation now in which it appears to claim that different measurement bases are appropriate for different types of assets, liabilities, income and expenses. This was an interesting change of direction.

7.22

The basis of this comment is that a conceptual framework, with its logical structure and reliance on qualitative characteristics such as representational faithfulness, neutrality, freedom from bias, and so forth, provides a symbol of legitimacy for the accounting profession. If projected properly, such a framework contributes to perspectives that a group of people belong to a ‘profession’ of high standing. That is, a well-designed conceptual framework (with reliance on neutrality, objectivity and so forth) can arguably make the accounting profession appear even more ‘professional’.

Once a document or a framework is perceived as being of high standing, or legitimate, then to the extent that standard-setters can justify particular decisions by reference to the ‘legitimate’ framework, then any level of criticism and attack can be countered or minimised. Decisions about what is included within a particular accounting standard can be justified to the extent they are consistent with the conceptual framework which has widespread acceptance.

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The basis of Hines’ argument is that conceptual frameworks promote certain qualities that are considered as central to a ‘legitimate’ profession. Such qualities 180

include objectivity, neutrality, representational faithfulness and reliability. An absence of a ‘formal body of knowledge’ can be detrimental to the integrity of a profession. If a group of professionals that seek to self-regulate can demonstrate that they adopt standards that are beyond reproach, then this should act as a defence against outside interventions.

The history of conceptual frameworks does appear to provide some support for Hines’ perspective. She advances the case of the Canadian Institute of Chartered Accountants’ work in 1980 and 1986 as cases to support the view that the work only commenced when the body was under threat. The fact that standard-setters have also not provided definitive guidance in relation to measurement issues could also provide support for Hines’ position. If a standard-setter embraced one method in preference to another, then this would conceivably generate criticism from many members of the community which might undermine the standard-setters’ position.

According to Horngren (1981), it is more important for survival that a standardsetting body resolves conflicts of opinion, rather than creating them.

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The Corporate Report embraced a broader notion of accountability, rather than focusing on the notion of decision usefulness from the perspective of investors, potential investors, lenders, and creditors. The view of the authors of The Corporate Report was that organisations do not have any absolute right to exist within the community and that those organisations that are given ‘permission to operate’ have a related obligation, or responsibility, to provide information about their financial performance to members of the community in which they operate.

This notion of who were deemed to be the target of the disclosures was wider than that adopted within other attempts to develop a conceptual framework. Most other frameworks emphasise the information needs of parties with a direct financial interest. For example, the FASB framework emphasised the information needs of ‘present and potential investors and creditors and other users in making rational investment, credit and similar decisions’. This is similar to the position taken within the IASB Conceptual Framework.

The former Australian Conceptual Framework – which was superseded by the IASB Framework – emphasised the needs of ‘resource providers, recipients of goods and services, and parties performing a review or oversight function’. While 181

the Australian definition of ‘users’ was broader than the IASB position, it was narrower than the position proposed in the United Kingdom by The Corporate Report.

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There is an expectation held by accounting standard-setters that users of financial statements have a reasonably sound knowledge of business and economic activities which in turn seems to imply that there is an expectation that a certain basic level of financial accounting knowledge is expected. The IASB Framework makes reference to users who are expected to ‘have a reasonable knowledge of business and economic activities and who review and analyse the information diligently’.

Hence, a view has been adopted by the IASB that users of financial statements should have a certain level of knowledge and when financial reporting standards are being developed, this level of knowledge is assumed. In defence of this position, we could probably argue that if such an assumption was not made then the development of financial reporting standards would be much more difficult and time consuming given that the standard-setters would need to consider how uninformed users might react to the particular standards. The position adopted is also consistent with other professions which also typically assume a certain level of expertise when developing guidance for their professions’ members (however, we need to be careful with justifications like this – just because others do a certain thing does not mean it is the ‘right’ thing). If users find it necessary, there are many experts who would be available to provide advice on how particular numbers were derived. Of course, such advice will generally be at a cost which does raise the issue that it can be costly for some individuals to gain an understanding about the operations of organisations that perhaps have an impact on their ongoing existence. Hence, while there is arguably a ‘right-to-know’, for people without any accounting knowledge, this right can only be exercised at some cost.

7.26

The view being promoted is that accountants by their own actions can highlight those issues that are important (and for which the entity is subsequently accountable), and can also downplay those issues which they consider are not important. If accountants do not measure and report information in respect of a 182

particular issue, then that issue will tend to be ignored. Accounting is not seen as being neutral by researchers such as Hines. Rather, much subjectivity goes into determining what attributes of performance will be separately monitored and reported. Until accountants determine that something is worthy of being the subject of the accounting system, then in a sense, the issue or item does not exist – it does not have its own reality. As Handel (1962, p. 36) states,

things may exist independently of our accounts, but they have no human existence until they become accountable … 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 is acted on so long as it remains accountable.

People are deemed to act on the basis of the information the accountant presents.

In a sense, it is assumed by many financial statements users that accounting reports reflect some sort of underlying economic reality – a reality that exists independent of whoever prepares the reports, and that the same reality will be generated independent of which accountant is involved. Because the accountant is involved in preparing the reports upon which others act, the accountant is deemed to be involved in creating reality.

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If newly developed accounting proposals represent a major departure from existing practices, then history indicates that the degree of opposition to the requirements could be quite significant. There are a number of reasons for this.

Firstly, accountants will be familiar with existing generally accepted accounting principles and will potentially be sceptical about whether the benefits associated with new approaches will outweigh the costs associated with learning the new approaches. Secondly, it could be quite costly to implement changes to existing recording systems to collect the new information potentially required by the new accounting approaches. There might also be a view that financial statement readers are familiar with existing rules, and that changing them might lead to confusion for the users. Managers might also consider that the rules they currently use provide the best reflection of the entity’s economic performance and that to change them will lead to inefficiencies in the ability of external parties to assess the performance of the entity.

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It is also possible that new accounting rules could lead to significant economic consequences for some sectors of the community. For example, if a new rule comes in that requires certain assets to be measured on a new basis, then this might deflate the assets of some entities and this could be deemed, in turn, to affect community confidence in an organisation. Also, some companies might be put into technical default on certain borrowing agreements as a result of the newly proposed rules. Hence, potential economic consequences might impact support for newly developed requirements. Accounting standard-setters are quite open in stating that they consider the economic consequences of new rules before implementing them. This has obvious implications for the neutrality and objectivity of the new rules.

The newly proposed rules might also eliminate some discretion that the firm previously had in relation to choosing the methods of accounting it would apply in given circumstances. This discretion might have been used to smooth accounting earnings in periods which would otherwise show great volatility in earnings.

Lack of support for particular proposals has been shown in the past to lead to standard-setters removing particular issues from their agenda. Standard-setting is a political process, and the continuity of the standard-setter (and the employment of the people working therein) can be very much dependent upon constituency support.

An interesting and relatively recent case of a new financial standard being developed that represented a significant change to pre-existing practice is the case of IFRS 16 Leases that was released in 2016. Pursuant to IFRS 16, many more leased assets (and therefore lease liabilities) are recognised in the balance sheet relative to the previous standard on leasing. The perception was that the former standard for leasing failed to recognise many of the liabilities associated with leases because of its reliance on the outdated use of the operating versus financial classification of leases.

The new requirements for accounting for leases had major implications in terms of increasing the apparent debt (and ratios such as debt to asset ratios and debt 184

equity ratios – ratios that are frequently used in debt covenants negotiated between organisations and their lenders) of reporting entities. Because of potentially adverse effects on balance sheets (and also on the statement of profit or loss and other comprehensive income as IFRS 16 increases expenses in the early years of the lease), and the related economic effects this might create, the development of the new accounting standard attracted much interest – much of which was in the form of heated opposition. The result was that IFRS 16 took many years to be completed and a number of exposure drafts were released as part of the process.

Whilst a new accounting standard was initially expected to be released in 2011 yet another exposure draft was released for comment in mid-2013. Arguably, had the proposals for change not been so ‘radical’, a new accounting standard would have been released many years earlier than 2016.

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This is really a matter of opinion. Many people believed that one method for the measurement of assets should have been prescribed when the IASB Conceptual Framework was revised as this would have resulted in the amount ‘Total Assets’ representing a particular form of measurement, rather than being the aggregate of various different measurement bases. Knowledgeable researchers, such as Ray Chambers (see Chapter 6) had argued strongly for the acceptance of one approach to measurement that should be applied to all assets of all types. This would then address what is commonly referred to as the ‘additivity problem’, which is the problem that arises when some assets measured on one basis (perhaps historical cost) are simply added to assets measured on another basis (such as fair value).

Arguably, further research needs to be undertaken before we will get to the point that one basis of measurement is prescribed for all assets. At this point in time the IASB has embraced – at least publicly – the opinion that to maximise the usefulness of financial reports, different measurement bases should be used for different classes of assets. It is quite likely that this issue will attract debate amongst financial accounting researchers and standard-setters for many years to come.

7.29

This is a very interesting issue and one worthy of debate. As we know, expenses are defined in the IASB Conceptual Framework as:

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decreases in assets, or increases in liabilities, that result in decreases in equity, other than those relating to distributions to holders of equity claims.

This definition excludes dividends from being recognised as expenses. This is very interesting, albeit it is a fact that many of us might simply take for granted.

As critical thinkers, a point to consider here is that organisations require various factors of production. For example, organisations require financial capital (perhaps as contributed by shareholders) and organisations also require labour capital (provided by employees). While it is an accepted part of how capitalist societies operate, it is nevertheless interesting to ponder why we have a system – and one that has existed for hundreds of years – that seeks to maximise the payments to one group of factor-of-production providers (investors), while at the same time trying to minimise the payments to a different group of factor-ofproduction providers (employees). That is, why do we have a system of accounting that directly prioritises the interests of one group of resource providers over another group of resource providers given that both sources of capital (financial and labour) are necessary to operate an organisation? This may appear somewhat of a rhetorical question, but hopefully it stimulates some thought about how financial accounting rules can influence how organisations deal with some stakeholders relative to others. We further consider issues such as this in Chapter 13 when we address critical theories of accounting.

7.30

As Chapter 7 has discussed, issues of existence uncertainty, probability of expected inflows or outflows of economic benefits, and measurement uncertainty are among the key factors to consider before an accountant should recognise an asset, liability, income, expense or equity item within the financial statements.

Factors relating to existence uncertainty, probability and measurement uncertainty can require a great deal of professional judgement, and as such, different accountants might make different judgements in respect of whether particular items should be included within the financial statements. Any differences in judgements made by accountants would, in turn, ultimately result in different financial statements being prepared, with different profits being reported.

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The point being made here is that we require financial accountants to make judgements about such factors as: •

the expected probabilities associated with expected flows of economic benefits

•

the level of uncertainty associated with the measurement of the expected future economic benefits

•

whether rights associated with the future economic benefits are clearly in existence.

This, therefore, necessarily introduces a degree of professional judgement into the financial accounting process. It is likely that different accountants will make different judgements. This means that if different accountants were to be provided with the same information, they would likely process the information differently and therefore produce different financial statements. Indeed, if different teams of accountants were given details of all the transactions and events with which an organisation was involved throughout a particular reporting period, and each team was asked to separately prepare financial statements for that organisation, then it would be quite improbable that they would generate identical financial statements.

Therefore, the preparation of financial statements requires a great deal of professional judgement. While managers and their accountants might make judgements objectively, the fact that there is so much professional judgement involved does allow the possibility that various ‘professional judgements’ might not be objective but might be made in a way that provides results that favour the interests of managers and the owners (and this possibility will be considered in more depth within Chapter 8). This therefore brings into question the belief that financial statements are representationally faithful. As the chapter notes, a faithful representation would be complete, neutral, and free from error. Professional judgement and neutrality are not always considered to exist together. Students should be asked to consider whether financial statements can provide a representationally faithful account of an organisation’s financial position and financial performance if the judgements made by different teams of accountants result in different financial statements, and therefore in different measures of profits, assets, and liabilities.

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To answer this question we need to consider the definition of a ‘liability’ and of ‘equity’. Within the IASB Conceptual Framework, a liability is defined as:

a present obligation of the entity to transfer an economic resource as a result of past events.

The above definition of liability refers to an ‘obligation’. An ‘obligation’ is defined in the IASB Conceptual Framework as:

a duty or responsibility that the entity has no practical ability to avoid.

Paragraph 4.63 of the Conceptual Framework defines equity as:

the residual interest in the assets of the entity after deducting all its liabilities.

An interest-free loan from a related party with no set repayment date could arguably be considered as either debt or equity depending upon the judgements being made. While the organisation might have no legal obligation to repay the debt, an ‘equitable obligation’ or ‘constructive obligation’ might nevertheless be deemed to exist. An equitable obligation is governed by social or moral sanctions or customs rather than legal sanctions. A constructive obligation is created, inferred, or construed from the facts in a particular situation rather than contracted by agreement with another entity or imposed by government. One consideration in determining whether a constructive obligation exists is whether the entity has any realistic alternative to making the future sacrifice of economic benefits. If the situation implies that there is no discretion, then a liability would be recognised.

In cases where the entity retains discretion to avoid making any future sacrifice of economic benefits, a liability does not exist and is not recognised. On balance, it would likely be argued that the organisation does have an obligation to repay the monies and therefore it should be recognised as a liability. However, if it is not recognised as a liability, then it would become part of equity.

In terms of if it matters whether the advanced funds are treated as debt or equity, the simple answer is yes it does matter, and the bigger the amounts involved, the more it matters. As we shall explain in Chapter 8, managers often negotiate 188

various terms as part of the process of borrowing funds and most larger organisations will typically have various ‘debt contracts’ in place that include various financial accounting-based debt covenants, such as some form of debt to assets constraints (that require that total debt should be maintained at or below a certain percentage of assets). To an organisation that is close to breaching some negotiated agreements (referred to as being in ‘technical default’, and potentially being required to repay borrowed funds), there will be incentives to recognise the funds as part of equity.

7.32

To answer this question we need to consider the definition of ‘assets’ as provided within the IASB Conceptual Framework, this being:

a present economic resource controlled by the entity as a result of past events.

Central to this definition is the requirement of ‘control’. It is generally accepted that people should not, and cannot, be ‘controlled’. Therefore, employees will not be considered as ‘assets’ from a financial reporting perspective. Good employees are certainly a valuable resource to an organisation, but general purpose financial reporting restricts which resources are recognised as ‘assets’ for financial reporting purposes.

7.33

At issue here is whether the social costs imposed upon problem gamblers and their families should be considered as ‘expenses’. The IASB Conceptual Framework defines expenses as:

decreases in assets, or increases in liabilities, that result in decreases in equity, other than those relating to distributions to holders of equity claims.

Assuming that there are no fines or other sanctions being imposed upon a casino for failing to care for the welfare of problem gamblers, then there will be no decrease in the value of any ‘asset’ controlled by the organisation, and there will be no increase in any ‘liabilities’ of the organisation. The failure to account for such ‘social costs’ is also consistent with the entity principle, which is a key convention of financial accounting. The entity principle effectively requires that

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an organisation be treated as an entity that is separate from its owners and the communities in which it operates.

Therefore, the profits of the casino would not be directly impacted by any social costs that result from their operations.

7.34

The definition of users will have implications for what measurement methods are used, but we also need to consider, concurrently, the ‘objective’ of general purpose financial reporting to more fully understand what approach to measurement might be applied to meet the information needs of the identified users.

The objective of general purpose financial reporting that has been embraced in recent years is often referred to as the ‘decision usefulness’ approach with less emphasis now being placed on the traditional stewardship function of financial reports, although stewardship was reintroduced when the 2018 revision of the Conceptual Framework was released by the IASB.

Embracing decision-usefulness with the related focus on users with a financial interest in the entity does have some implications for how assets and liabilities might be measured. For example, once we move towards the notion of decision usefulness, we might question whether historical cost information (which arguably is useful for assessing stewardship) is useful for financial report users’ decisions, such as whether to invest in, or lend funds to, an organisation. Arguably, such decisions could be more effectively made if information on current market values was made available – the relevance of fair values appears to be greater.

7.35

If we consider the objective of general purpose financial reporting then we can see that there is clearly a bias towards considering users that have an economic interest in the reporting entity. Other members of the community that do not have a direct economic interest are effectively excluded from specific consideration.

General purpose financial reports do not provide useful information to people trying to assess a reporting entity’s social and environmental performance. Such people need to look elsewhere, such as in corporate sustainability reports, or 190

corporate social responsibility reports. The focus of general purpose financial reports is on the financial performance of an organisation and not on its social and environmental performance. Indeed, the way assets are defined (with reliance on considerations such as ‘control’) means that many social and environmental impacts are ignored by general purpose financial reporting.

7.36

The stewardship function of financial reporting refers to the role of financial reporting in demonstrating whether the resources entrusted to management have been used for their intended or appropriate purposes. This stewardship focus is also commonly referred to as an accountability focus (although some people also argue there is a difference between stewardship and accountability). Stewardship involves monitoring the past actions of management (which relates to such factors as the integrity of management) as well as providing information to enable predictions about future cash flows.

An alternative objective of financial reporting, and one that has become a commonly accepted goal of financial reporting, is to assist in report-users’ economic decision making. This is often referred to as the ‘decision usefulness’ approach.

In recent times less emphasis has been placed on the stewardship function of financial reports.

7.37

Moves towards standardisation of accounting standards and also conceptual frameworks imply a one-size-fits-all approach. As we know, this is a goal of the IASB. Chapter 5 referred to the work of different researchers who have shown that previous international differences in accounting standards (prior to the efforts for international standardisation) can potentially be explained by international differences in culture, religion and business ownership and financing systems. The view provided by a good deal of the research indicates that underlying differences in how people think and how they conduct their business in turn impacts the information they require (which seems a reasonable proposition). A number of researchers have explicitly questioned the relevance of ‘Western-style’ accounting standards to the needs of people within developing countries, or the relevance of ‘Anglo-American’ standards in ‘continental European’ countries.

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As we know, the standard-setting process in many countries is a political process (or perhaps ‘was’, given that domestic standard-setters are increasingly being replaced by the IASB) in which the standard-setters invite submissions from constituents as part of the due process of developing accounting standards. The submissions are considered to influence the contents of the final standards. When developed in this manner, accounting standards developed in one country tended to be different to standards developed in other countries. For many years such differences were accepted as being reasonable. However, such differences no longer appear to be considered as ‘reasonable’ (particularly to parties such as the IASB).

If we accept that people in different countries have different values and consequently different information needs, then it is perhaps somewhat naïve to expect that one system of accounting will meet the needs of all people within all countries. Nevertheless, work towards international standardisation is ongoing.

Obviously, those organisations that are pushing for standardisation in financial accounting across the world (for example the IASB) do not consider that different people, of different cultures and religions, require different information.

7.38

It would seem logical to argue that both of the qualitative characteristics – ‘relevance’ and ‘representational faithfulness’ – should be satisfied before particular information is included within a financial report. This is consistent with Paragraph 2.20 of the IASB Conceptual Framework which states:

Information must be both relevant and provide a faithful representation of what it purports to represent if it is to be useful. Neither a faithful representation of an irrelevant phenomenon nor an unfaithful representation of a relevant phenomenon helps users make good decisions.

7.39

The fundamental qualitative characteristics of useful financial information are relevance

and

faithful

representation.

These

fundamental

qualitative

characteristics are supported by ‘enhancing qualitative characteristics’, which in the IASB Conceptual Framework are noted as comparability, verifiability, timeliness and understandability. The enhancing qualitative characteristics are 192

characteristics or attributes that enhance the usefulness of information that otherwise satisfies the fundamental qualitative characteristics of useful information. That is, efforts to increase the comparability, verifiability, timeliness and understandability of the financial information effectively ‘feed back’ to improve the relevance and representational faithfulness of the information.

7.40

The fundamental and enhancing qualitative characteristics of useful financial information, as identified within the IASB Conceptual Framework are relevance, faithful

representation,

comparability,

verifiability,

timeliness

and

understandability.

If we consider the above characteristics, then we should be able to realise that any information we use to make decisions would benefit from having these characteristics. For example, if we were considering buying a car or going on a holiday and we were using information about alternative options to inform our choice, then we would hope that the information has all of the above attributes.

If we look at the reporting frameworks that address various sustainability-related issues, such as frameworks developed by the Global Reporting Initiative (see https://www.globalreporting.org), the International Sustainability Standards Board (https://www.ifrs.org/groups/international-sustainability-standards-board), the Task Force on Climate-Related Financial Disclosures (https://www.fsbtcfd.org)

and

the

Water

Accounting

Standards

Board

(see

https://www.bom.gov.au/water/standards/wasb), then we will see almost identical qualitative characteristics identified. Therefore, the qualitative characteristics identified within the IASB Conceptual Framework appear to have some acceptance globally and in respect of different types of information. Again, for any information to be useful it should have these attributes

7.41

This is a very interesting question and reflects the broader social and environmental implications of financial accounting.

For many years accountants failed to report information about the carbon-related emissions of organisations. Further, because of the way we define assets and expenses (with reliance upon ‘control’), contributions to climate change do not 193

negatively impact ‘profits’ and therefore highly emitting organisations are able to report high profits – thereby likely leading to positive plaudits – at the same time that unrecognised (hidden) damage is being done to the planet.

Had accountants developed a system that placed a cost of carbon-related emissions which was actually deducted from profits then perhaps efforts would have been made to reduce the ‘expense’ (to thereby lift reported profits) – but this was not the case. So, for hundreds of years the cost of climate change and environmental degradation was hidden, and therefore uncontrolled. Companies grew, investors become wealthier, all at the same time that massive levels of damage were being done to the planet. We can only wonder how much better the planet might be if ‘accountants’ had been ‘accounting’ for climate change, thereby making it visible. Therefore, any claim that the IASB Conceptual Framework’s definitions of the elements of financial accounting have had ongoing negative implications for climate change seem rather easy to support.

7.42

Ball (2016, p. 557) is suggesting that the existence of a conceptual framework for financial reporting will hinder needed changes to reporting practices as environments and societies change. As Deegan and Shelly (2014) note, this is an argument that many business organisations and industry bodies often raise in opposition to the potential introduction of new laws and regulations. That is, it is an argument often used to counter the introduction of guidelines, rules and regulations and is an argument that is often proffered by advocates of a ‘free market’ approach to accounting regulation. There are also researchers which take a counter view to this.

Students should be encouraged to consider the logic of Ball’s opinion. Will the contents of the Conceptual Framework really restrict innovation in financial reporting practices?

7.43

Arguably, the measurement issue is the most controversial and the one on which it will be most difficult to get widespread agreement. As Chapter 6 discussed, there are many different views on which alternatives to historical cost are the most appropriate. For example, there are supporters of replacement costs, market/fair

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values, present values, and so forth. There are also many people who strongly support the retention of historical cost.

Accounting standard-setting and the development of conceptual frameworks are political processes in which the final output (for example, a financial reporting standard) are often a negotiated outcome. Submissions will be made by many parties in relation to the issue of the ‘best’ measurement basis. Where there are numerous parties with strong, but different, views on the appropriate measurement basis then the generation of a negotiated outcome will conceivably take a protracted period of time.

The selection of a particular measurement basis will have direct implications for the net assets and the reported profits of an entity. Because these numbers are used in various ways across society (for example, managers might be paid on the basis of a percentage of profits; companies may be subject to debt constraints such as debt/asset restrictions; dividends may be restricted to a particular percentage of profits; community-based groups may determine the apparent ability of a company to pay for community-based initiatives on the basis of the reported profits of an entity; and so forth), then any changes in these numbers will likely have direct cash flow consequences (both good and bad) for an organisation.

Because of the use of financial accounting numbers throughout society we can expect that any proposals by standard-setters for the adoption of a particular basis of measurement will attract a great deal of submissions from a variety of interested parties. Evaluating a large number of submissions would be expected to take a relatively long period of time.

7.44

To answer this we need to consider the definitions of assets and liabilities as per the IASB Conceptual Framework. They are defined as follows:

An asset is ‘a present economic resource controlled by the entity as a result of past events’.

A liability is ‘a present obligation of the entity to transfer an economic resource as a result of past events’.

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Applying the above definitions to leased assets, then to the extent that a reporting entity has a present obligation to make future lease payments over the term of the lease then it has a liability. Further, to the extent that the organisation has a right to use a leased asset over the term of the lease, and this use will generate future economic benefits (as would typically be the case), then it also has an asset. This would be the case whether the lease is for 18 months or 18 years and irrespective of the total economic life of the leased asset. IFRS 16 Leases embraces this view and is therefore consistent with the definitions provided within the IASB Conceptual Framework.

The situation in the pre-existing accounting standard for leasing (IAS 17 Leases) in which leased assets and liabilities are not required to be capitalised because the lease term is not for the ‘major part of the economic life of the asset’, or because ‘the present value of the minimum least payments does not amount to substantially all of the fair value of the leased asset’ (and leases that do not satisfy one of these tests are considered as operating leases and therefore excluded from balance sheet recognition) is not consistent with the asset and liability definitions of the IASB Conceptual Framework.

7.45

Hines’ arguments are informed from a ‘critical perspective’ of accounting. Rather than necessarily seeing the role of conceptual frameworks as being part of a process to improve the process of general purpose financial reporting, she sees conceptual frameworks as a process to provide benefits to those parties that are responsible for developing the frameworks. The view is that there are certain attributes that society expects a profession to exhibit (such as objectivity, neutrality, reliability, etc.) and therefore, if a profession wants to be seen as being legitimate, then a profession should release documents which associate them with these legitimising characteristics. Hines further promotes a view that if professions are able to establish a perspective that they are objective and professional then this assists their quests for autonomy and enhances their ability to self-regulate without the unwanted intervention of government.

Whether we agree with Hines’ perspective is a matter of opinion and tied to our own values and beliefs. There does seem to be some logic to what Hines is 196

arguing, but there are also some grounds to believe that many people (but perhaps not all) involved in the development of conceptual frameworks have a ‘public interest’ in improving the process of general purpose financial reporting (in accordance with the public interest theory of regulation discussed in Chapter 3).

Perhaps, rather than believing Hines is either right or wrong, we might adopt a position that her view of the world provides some insights into what might have motivated some individuals involved in developing conceptual frameworks, but perhaps not all people.

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Chapter 8: Positive Accounting Theory Solutions 8.1

A positive theory of financial accounting would seek to explain and/or predict particular financial reporting practices (or perhaps how different users will react to particular accounting disclosures) whereas a normative theory of financial accounting would seek to prescribe particular approaches to/methods of financial accounting with these prescriptions being based on particular perspectives about the role of financial accounting, and the needs and expertise of financial statement readers.

Because normative theories serve a different role from positive theories, it is not appropriate to say one is better than the other. Indeed, rather than seeing them as competing, they can actually be used in a complementary manner. For example, positive research and positive theories might provide valuable insights into how different categories of financial statement readers react to particular forms of accounting disclosures. These insights can then be used by other people – normative theorists who are seeking to make prescriptions about the types of disclosures that reporting entities should make.

8.2

Early research considering share price reactions to accounting information relied on various assumptions about the efficiency of the capital market and assumed that capital market participants could ‘undo’ the effects of organisations using different accounting methods. It also assumed the absence of transaction costs.

Accepting these assumptions, and to the extent that the selection of accounting method did not affect taxation, then the choice of accounting method would have limited implications for the firm and hence managers should be indifferent when choosing between alternative accounting methods. However, evidence indicates that managers are not indifferent.

The development of agency theory suggested that where there is a delegation of decision making within an organisation there can be inefficiencies because agents will not necessarily work in the interests of the organisation, but rather will work in their own interests. However, the principals will anticipate the opportunistic 198

actions of the agents and will reduce their payments accordingly (that is, the principals will price protect). To minimise the agency costs, and to align the interests of principals and agents, numerous contractual arrangements will be put in place.

Accepting the perspectives provided by Agency Theory, Watts and Zimmerman (1978) showed how accounting-based contractual arrangements can act to minimise the transaction costs that might arise within an organisation. The choice of one method of accounting in preference to another was deemed to be important in maximising the value of an organisation. For the reason that there are many uncertainties when investing or lending funds to an organisation, managers will agree to provide investors and lenders with financial statements. This reduced risk associated with being able to monitor the performance of the entity will be expected to reduce the costs associated with attracting funds to the entity. Since some methods of accounting are better able to reflect the performance of an entity, managers will select some methods in preference to others (the efficiency perspective). This will have direct implications for the cost of attracting funds into the organisations.

Further, accepting that managers might not always work in the interests of the owners, it is common to find accounting-based bonus plans. Again, some methods of accounting might be more relevant in some organisations than alternative methods of accounting and again, PAT provides an explanation for why certain accounting methods might be selected in preference to others.

8.3

Organisations can be described in a multitude of ways. One description is that organisations are effectively a ‘nexus of contracts’. Such a description is often used within the Agency Theory literature, with the contracts being put in place with the intention of ensuring that all parties, acting in their own self-interest, are at the same time motivated towards maximising the value of the organisation. The view of the firm as a nexus of contracts is consistent with Smith and Watts’ (1983, p. 3) definition of a corporation. They define the corporation as: … a set of contracts among various parties who have a claim to a common output. These parties include stockholders, bondholders, managers, 199

employees, suppliers and customers. The bounds of the corporation are defined by the set of rights under the contracts. The corporation has an indefinite life and the set of contracts which comprise the corporation evolves over time.

Agency Theory does not assume that individuals will ever act other than in selfinterest, and the key to a well-functioning organisation is to put in place mechanisms (contracts) that ensure that actions that benefit the individual also benefit the organisation. The firm will have many contracts negotiated with various individuals and parties – hence the reference to a ‘nexus of contracts’ – and these contracts will aim to reduce the many conflicts of interest and related uncertainties that might otherwise arise. The establishment of the firm, with all the related contractual mechanisms, is seen as an alternative and efficient way to produce or supply goods and services relative to individuals dealing with ‘the market’ by way of a series of separate transactions.

8.4

Managers are often rewarded in terms of accounting-based bonus plans. Such plans are introduced to align the interests of the managers of the firm with those of the owners. The establishment of management bonus plans can be explained from an efficiency perspective. The management bonus plan hypothesis predicts that managers who are rewarded in terms of accounting numbers are more likely to select accounting methods that increase income to the extent that this will lead to an increase in the size of the bonus. This is an opportunistic perspective. (The efficiency perspective relates to the initial establishment of the bonus scheme and the opportunistic perspective relates to the subsequent efforts to manipulate profits and, hence, the bonus.)

The debt hypothesis (also called the debt/equity hypothesis) predicts that firms with higher debt/equity or debt/assets ratios are more likely to adopt accounting methods which increase income (and assets and residual equity) than firms with lower ratios. This prediction is made on the basis of an assumption that firms will have entered into debt contracts with external lenders (with the purpose of reducing agency costs and hence explained from an efficiency perspective) and these debt contracts will rely upon accounting numbers. The incentive to adopt

200

income-increasing methods will grow the closer the firm comes to breaching the accounting-based debt covenant. While debt contracts will initially be entered into in an endeavour to reduce the costs of borrowing (the efficiency perspective), the view that management will subsequently choose ‘favourable’ methods to loosen the restrictions imposed by debt-related contractual covenants is considered to represent an opportunistic perspective.

8.5

Drawing on the material provided in Chapter 8 we know that numbers generated through the application of financial reporting standards and other generally accepted accounting procedures will be used in various contractual arrangements that have been negotiated by the organisation with various other parties. For example, there will be accounting-based debt agreements negotiated with lenders and there will be accounting-based management bonus plans negotiated with managers.

When the IASB releases a new financial reporting standard then this has a high probability of impacting some of the financial accounting numbers that are used within the various contractual arrangements that the organisation has negotiated with different parties. This might in turn have implications for the transactions that the organisation might subsequently elect to enter.

For example, when the IASB’s financial reporting standard on intangible assets was applied for the first time in many countries (for example, in Australia and the European Union from 2005) it meant that many intangible assets that were previously recognised as assets within the statement of financial position (balance sheet) were no longer eligible for capitalisation. Rather, they were required to be expensed as incurred. This would conceivably have caused a reduction in the acquisition of such assets, particularly for organisations that were close to breaching accounting-based debt contracts, such as debt to equity ratios.

As a general principle we can argue that if an organisation has negotiated various contracts with various parties, and those contracts – with related cash flows – rely upon financial accounting numbers, then when new financial reporting standards are released there will be potential cash flow consequences. To alleviate potentially negative cash flow consequences managers might elect to alter the 201

operating strategies, and therefore transactions, that the organisation enters.

Therefore, the release of a new financial reporting standard by the IASB can have implications for how an organisation in Melbourne conducts its operations.

8.6

It is predicted by Positive Accounting Theory (PAT) that on an ex ante basis (that is, upfront), mechanisms will be put in place that align the interests of the managers (agents) with those of the owners (as principals). As the evidence provided in the chapter indicates, such mechanisms will include offering management a bonus which is tied to reported profits. Assuming self-interest, such mechanisms will lead to a reduction in agency costs (they will encourage the selfinterested manager to work harder) and hence can be explained from an efficiency perspective.

However, maintaining the assumption of self-interest, it is assumed that once a profit-sharing bonus scheme is put in place then management will seek to undertake actions to increase the size of the bonus and hence their own financial rewards. One way is to work harder, but another way is to manipulate reported profits by selecting financial accounting methods that lead to an increase in reported profits (the opportunistic perspective).

Within PAT it is assumed that principals expect managers to be opportunistic and unless managers can demonstrate that they have not been opportunistic principals will assume that they have been and accordingly the principal will pay the managers a lower salary (this is called ‘price protection’). The lower salary compensates the principals for the expected opportunistic behaviour of the agents.

To reduce this ability to be opportunistic (with consequent implications for increasing the managers’ bonuses) contractual agreements will be put in place upfront to reduce the ability of the managers to manipulate accounting profits (but this ability can never be fully removed). Such agreements may include a clause which restricts the choice management has when selecting between alternative accounting methods or it may include a requirement that the financial statements

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be audited by an independent third party who will attest to whether appropriate accounting methods have been selected by the manager.

8.7

An agency relationship occurs when decision-making authority is delegated from one party (the principal) to another party (the agent). Jensen and Meckling (1976, p. 308) define the agency relationship as:

a contract under which one or more (principals) engage another person (the agent) to perform some service on their behalf which involves delegating some decision-making authority to the agent.

From the Agency Theory perspective, the ‘contract’ itself does not need to be written. Because it is assumed that all individuals will act in their own selfinterest, there will be costs (agency costs) associated with appointing agents to make decisions on behalf of the principals. Agency costs can be defined as costs that arise as a result of the agency relationship and relate to the costs that arise as a result of the process of delegating decision making to others.

Pursuant to Agency Theory it is argued that various contractual arrangements will be put in place to minimise anticipated agency costs and hence to increase the value of the organisation. For example, to minimise the agency costs relating to appointing a manager, contractual arrangements might be put in place to provide the manager with a share of profits. That way, the manager will be motivated to make decisions that lead to an increase in profits and, all things being equal, this will also be in the interests of the owners.

An organisation is considered to represent a nexus of contracts between many selfinterested individuals and the reason for having the various contracts is to reduce the agency costs that the organisation might otherwise encounter and consequently to maximise the expected value of the organisation.

8.8

Political costs are those costs that particular groups external to the firm may be able to impose on the firm as a result of various actions. For example, the costs associated with the community lobbying the government to decrease the subsidy support for an organisation, the costs associated with labour unions taking actions 203

to increase the wages of their members, or the costs associated with consumer boycotts associated with the firm’s products.

The political cost hypothesis predicts that those organisations under political scrutiny (usually assumed to be larger firms) will undertake actions to minimise the possibility of adverse cash flows associated with the scrutiny. For example, if a company is being scrutinised in a particular period because of its perceived monopoly powers and those external parties undertaking the scrutiny claim that these monopoly powers enable it to generate excessive profits, then in such periods the entity may elect to adopt accounting methods which reduce its reported profits, and hence, its susceptibility to actions to reduce the wealth of the organisation (perhaps, in the form of increased taxes). Watts and Zimmerman provide the following explanation of the political cost hypothesis:

The political cost hypothesis predicts that large firms rather than small firms are more likely to use accounting choices that reduce reported profits. Size is a proxy variable for political attention. Underlying this hypothesis is the assumption that it is costly for individuals to become informed about whether accounting profits really represent monopoly profits and to ‘contract’ with others in the political process to enact laws and regulations that enhance their welfare. Thus, rational individuals are less than fully informed. The political process is no different from the market process in that respect. Given the cost of information and monitoring, managers have incentive to exercise discretion over accounting profits and the parties in the political process settle for a rational amount of ex post opportunism (1990, p. 139).

As reflected in the above quote, the political cost hypothesis assumes that various parties will simply react to the quantum of reported profits and will not necessarily focus on which accounting methods were used to generate these profits.

8.9

Accounting is important in political processes because of the emphasis society tends to place on accounting numbers. We constantly hear about the financial performance of various companies, with the financial press often running stories about the profits (often ‘record profits’) or losses of various companies. Profits are portrayed as a form of benchmark measure of firm performance.

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Throughout society, various contractual arrangements are directly linked to accounting numbers. For example, when companies borrow funds, they typically agree to various accounting-based debt covenants, the breaching of which will cause the organisation to be in ‘technical default’ – something that attracts negative publicity. Also, senior managers’ salaries – which often attract extensive negative media attention if they are deemed to be excessive – are often tied to accounting numbers.

Politicians, consumer groups, trade unions, environmental groups, and others, often use accounting numbers (such as profits) as a basis for various arguments that the company is not paying enough to its workers, is exploiting consumers by charging high prices, or is not investing enough in cleaner production processes.

Because accounting numbers are used as a justification for various claims made in favour of, or in opposition to, corporate activities we can see that accounting does play an important part in various political processes.

8.10

It is generally accepted that accounting numbers play an important role in reducing conflicts of interest within an organisation.

It has generally been argued in the literature that potential conflicts of interest between agents and principals are better managed when conservative accounting methods are used as it restricts the ability of the managers (agents) to opportunistically use income and net-asset-increasing accounting methods. The use of fair value to measure assets – which would not be considered to be a conservative approach to accounting – provides managers with a greater ability to use professional judgement relative to more conservative measures, such as historical cost. Historical cost accounting numbers are less able to be manipulated by management and are more readily verified than information based on current values. Conservative accounting methods are considered to provide relatively greater efficiency from a contracting perspective.

In Chapter 6 we learned that the two fundamental qualitative characteristics of useful financial information, according to the IASB Conceptual Framework for Financial Reporting (a normative framework of accounting), are relevance and

205

representational faithfulness. While equity investors (owners) and debtholders will be interested in receiving information that is relevant for valuing the firm (for example, fair values), they will also recognise that management has an incentive to opportunistically introduce bias to this information. From a contracting perspective, there will be a trade-off away from relevance in favour of verifiability (which is tied to ‘representational faithfulness’). Historical cost information tends to be more verifiable (and representationally faithful) than fair value, though its relevance in times of changing prices can be questioned.

Conservative accounting methods are argued to contribute to efficient contracting (Watts, 2003). There is a belief amongst a number of researchers that it is more efficient for parties (for example, shareholders and debtholders) to monitor the activities of managers when those managers use conservative accounting methods to produce financial accounting information. Conservative accounting methods are typically more verifiable and subject to less possibility of manipulation. For example, debtholders are typically concerned about the possibility that they will not be repaid their invested funds. Because conservative accounting methods tend to defer profit recognition, such accounting methods reduce the likelihood that the firm will pay excessive dividends, and this will act to allay some of the concerns of the debtholders. Further, because conservative accounting methods tend to reduce net assets and profits relative to other accounting methods, this means that accounting-based debt covenants will be activated earlier (that is, technical default will be triggered earlier) – and this means that debtholders will be able to take earlier steps to safeguard their investments. The earlier the intervention of debtholders (or their representatives), the more likely that assets will still be available within the firm to repay the debts.

Because conservative accounting methods can reduce the possibility that management will undertake opportunistic earnings management, organisations that use conservative accounting methods might be able to attract debt and equity capital at a lower cost because of perceptions about lower risk. Applying this reasoning, authors such as Iyengar and Zampelli (2010), Khan and Watts (2007) and LaFond and Watts (2008), argue that the IASB and FASB should take note of the advantages inherent in conservative accounting procedures before finalising 206

any judgements about accounting measurement. That is, whilst information about fair values will be useful to various financial stakeholders in terms of assisting them to make informed investment/resource allocation decisions (and fair value measurements would not be considered to constitute a conservative approach to measurement) more conservative accounting methods also provide benefits in terms of controlling potentially divergent behaviour of individuals involved in various contractual arrangements. There is a clear trade-off between the advantages of having relevant information about current values and the contracting benefits that more conservative accounting benefits provide.

Hence, advocates of efficient contracting would not favour the use of fair value measurement in all situations. In particular they would not favour the use of fair value in situations where the determination of fair value requires a great deal of professional judgement. In this regard we can consider the accounting standard on fair value, IFRS 13 Fair Value Measurement. Fair value is defined in IFRS 13 as:

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.

If there is an active and liquid market in which assets are traded that are identical to the asset to be valued, then the fair value will be equivalent to the quoted price (market value) of the asset. This would be a fairly objectively determined number and would not have great consequences for efficient contracting. However, the IASB and FASB recognise that there will be instances where assets, for which fair value measurements are required, do not have markets where identical assets are actively traded, so a directly comparable market value might not be available. In such instances, fair value can still be used for assets and the market price of a very similar asset or liability can be used or, where there is not an active market for the form of asset that is to be fair valued (so market values for an identical or similar asset cannot be observed), an alternative is to use an accepted valuation model to infer the fair value.

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If a valuation model is applied because there is not an active market, then many assumptions and professional judgements must be made by management as part of the valuation process, and this creates an opportunity for biased reporting to be introduced – something which would be of concern to researchers seeking ways to minimise contracting costs. The IASB’s (and FASB’s) accounting standard on fair value measurement – IFRS 13 – establishes a ‘fair value hierarchy’ in which the highest attainable level of inputs must be used to establish the fair value of an asset or liability. Levels 1 and 2 in the hierarchy can be referred to as mark-tomarket situations, with the highest level, level 1, being described as (paragraph 76 of IFRS 13): Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the entity can access at the measurement date.

Level 2 are directly observable inputs other than level 1 market prices (level 2 inputs could include market prices for similar assets or liabilities, or market prices for identical assets but that are observed in less active markets). As paragraph 81 states: Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly.

Level 3 inputs are mark-to-model situations where observable inputs are not available and risk-adjusted valuation models need to be used instead. It is particularly in regard to the Level 3 ‘mark-to-model’ valuation methods that advocates of efficient contracting have concerns. In this regard, Kothari et al.

(2010, p. 265) state: Given the efficient capital allocation objective for GAAP, it is useful to consider whether fair value is an appropriate measurement basis for balance sheet items generally. If reliably measured, it seems clear that measurement at fair value is superior to the use of the historic cost basis as a means of providing information about the potential economic values of assets, provided those assets are separable. Thus, a sufficient condition for the reliable measurement of these items is that they trade in liquid secondary markets, as is the case currently for investment securities. If such markets are unavailable, however, it is harder to envision fair value being viable,

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especially if the determination of fair value is largely a matter of managerial judgment.

Of course, we must also realise that minimising contracting or transaction costs – which is the basis of the above objections to fair value measurement – is not the only purpose, or objective, of general purpose financial reporting.

8.11

The efficiency perspective takes the view that contractual arrangements will be designed to reduce future conflicts of interest (and associated agency costs) between various individuals involved in the operations of an organisation. Welldesigned contracts are expected to reduce future transaction costs. By reducing future costs, well designed contracts can have the effect of increasing the value of an organisation. Because the contractual arrangements are designed to reduce future conflicts, they are considered to be introduced on an ex ante (upfront) basis.

Many of the contractual arrangements use the output of the accounting system (such as rewarding managers on the basis of a share of profits, or utilising debt to asset ratios in debt contracts).

The opportunistic perspective relies upon the assumption that individuals are always motivated by their own self-interest (at the possible expense of others) and once they enter contractual arrangements, they will subsequently capitalise upon any flexibility within the contracts to cause any related pay-offs to be more favourable to themselves (again, at the expense of others). Because it is not practical to attempt to write ‘complete contracts’, there will always tend to be some degree of flexibility in most agreements, and it is anticipated that the opportunistic manager will uncover such flexibility. In relation to the selection of accounting methods, independent external auditors will frequently be used to ensure that the accounting methods adopted by managers appear to be reasonable and in accordance with generally accepted accounting practice. Because the opportunistic behaviours frequently occur after transactions have been negotiated (after the fact) the actions are described as occurring on an ex ante basis.

8.12

Offering managers only a fixed salary would not be in the interests of the owners of an organisation because it could encourage them to be overly conservative, or risk averse, in how they run the organisation. That is, if the manager was rewarded 209

purely on a fixed basis, then, assuming self-interest, that manager would not want to take great risks as they would not share in any potential gains. If managers are paid a fixed salary, then there would also be limited incentives for the manager to adopt strategies that increase the value of the organisation (unlike equity owners, whose share of the organisation may increase in value). Like debtholders, managers with a fixed claim would want to protect their fixed income stream.

Apart from rejecting risky projects, which may be beneficial to the owners of the organisation, the manager with a fixed income stream may also be reluctant to take on optimal levels of debt, as the claims of the debtholders would compete with the manager’s own fixed income claim.

8.13

There have been various researchers who have argued that fair value measurements are not efficient from a contracting perspective. It has generally been argued in the literature that potential conflicts of interest between agents and principals are better managed when conservative accounting methods are used as it restricts the ability of the managers (agents) to opportunistically use income and net asset increasing accounting methods.

Measuring assets at cost (or recoverable amount if it is lower) would be considered as a conservative accounting method relative to measuring the assets at fair value.

If assets are measured at the lower of cost or recoverable amount then this means that increases in fair value would not be recognised (keeping asset values lower), but if there is a decrease in value then a reduction in assets, and a consequent expense, would be recognised. By contrast, the use of fair values is more symmetric with equal consideration given to both increases and decreases in fair value. The use of fair values also provides management with some discretion in determining fair values, particularly if the values are determined by use of a valuation model (such as level 3 valuations) rather than on the basis of quoted prices in active markets.

Conservative accounting methods are typically more verifiable and subject to less possibility of manipulation. For example, debtholders are typically concerned about the possibility that they will not be repaid their invested funds. Because conservative accounting methods tend to defer profit recognition, such accounting methods reduce the likelihood that the organisation will pay excessive dividends, 210

and this will act to allay some of the concerns of the debtholders. Further, because conservative accounting methods tend to reduce net assets and profits relative to other accounting methods, this means that accounting-based debt covenants will be activated earlier (that is, technical default will be triggered earlier), and this means that debtholders will be able to take earlier steps to safeguard their investments. The earlier the intervention of debtholders (or their representatives), the more likely that assets will still be available within the organisation to repay the debts. It is particularly in regard to the level 3 ‘mark-to-model’ fair value valuation methods that advocates of efficient contracting have concerns.

8.14

Creative accounting refers to instances where those responsible for the preparation of financial statements select accounting methods that provide the result desired by the preparers. PAT – the focus of Chapter 8 – provides an explanation of why organisations might be creative – or opportunistic – with respect to their financial accounting practices.

Some of the scenarios in which creative accounting might be expected to occur include the following: •

When managers are rewarded with bonuses that are linked to accounting numbers. Managers might be paid a bonus that is linked to, for example, profits. In such a situation managers might adopt income increasing accounting methods opportunistically to increase the rewards paid to themselves.

•

Where organisations have negotiated agreements with lenders that use accounting-based debt covenants. For example, an organisation might have borrowed funds from a lender and as part of the agreement might have become subject to restrictive debt to assets constraints. By adopting income and asset increasing accounting methods, this can have the effect of loosening the impact of the covenant.

•

Where organisations are subject to political scrutiny linked to the level of profits. By reducing profits this might – particularly for larger organisations in politically sensitive industries – lead to a reduction in potential political scrutiny and associated costs.

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From the material presented within Chapter 8, we know that PAT researchers would expect managers to apply creative accounting whenever it is in their interests to do so.

8.15

Where an accounting-based contractual arrangement is to be calculated according to the accounting rules in place at the end of reporting period (and these rules may change as new financial reporting standards are issued), then such agreements are considered to be relying on ‘rolling GAAP’ (also called ‘floating GAAP’). By contrast, if a contractual arrangement stipulates that accounting-based agreements are to rely on those accounting rules in place at the time the contract was negotiated then this is referred to as relying upon ‘frozen GAAP’.

We would expect that managers who have negotiated debt contracts with accounting-based covenants based around ‘rolling GAAP’ will be relatively more likely to lobby an accounting standard-setter about a proposed accounting standard than would a manager who has negotiated accounting-based debt contracts that use frozen GAAP. This is because if the contracts rely upon accounting methods in place at the end of the reporting period, and if these change, perhaps as a result of the release of a new or revised financial reporting standard, then this could have direct implications for the cash flows associated with the contractual arrangements. For example, if an organisation has negotiated a debt to asset constraint, and if it was otherwise close to breaching the covenant, then a change in accounting standards may change total assets or liabilities and this in turn may place the organisation in technical default of the debt agreement and this could have direct implications for the cash flows, and hence the value of the organisation.

The above perspective assumes that submissions would be made on the basis of self-interest rather than on the basis of what managers might otherwise consider to be the most appropriate or efficient accounting method.

8.16

(a)

The perspective taken by PAT is that managers of organisations can elect to either enter, or not enter, contracts which provide various safeguards to debtholders. It is anticipated that debt funds would be available in either case (perhaps not necessarily from the same investors, but perhaps from other market participants). However, assuming the notion of price 212

protection, those firms that provide contractual safeguards (and hence reduce the expected risk associated with the debtholders’ funds) will attract funds at a lower cost than might otherwise be available. Hence, while organisations might be able to attract funds in the absence of negotiated safeguards, managers that negotiate to restrict their ability to expropriate debtholders’ wealth will be expected to attract funds at lower cost and this in itself will motivate managers to agree to such arrangements (which might include agreements not to use the funds in particular types of investments, to borrow additional or excessive levels of debt from other parties, or to pay dividends unless certain earnings requirements are met).

(b)

The argument is that capital markets are efficient, and that higher risk requires a higher rate of return. Hence, it is assumed that debtholders are indifferent such that if organisations do not contractually commit to restrict actions which might be detrimental to the interests of the debtholders, then the debtholders (the same debtholders or other participants in the market) will simply charge a higher price for the funds in the form of higher interest charges – that is, they will price protect. The view taken is that the expected returns (based on agreed future cash flows and the probability of receiving the interest and principal repayments) to debtholders do not change as a result of particular contractual arrangements, and hence debtholders neither gain nor lose as result of negotiating restrictive covenants (while negotiated safeguards will reduce the amount of the interest payments, the probability of the debtholders ultimately receiving the cash flows will increase and hence the risk rate will decline).

8.17

Pursuant to the political cost hypothesis there is a view that disclosing high profits can lead to costly political scrutiny. To reduce this scrutiny, managers can elect to apply accounting methods that lead to a reduction in reported profits. That is, rather than actually changing their operations, or increasing the payments to particular groups, the managers simply change the accounting practices they use.

Because political processes can involve many parties, the likelihood that individual actors can influence particular outcomes is low. As such, if politicians, labour delegates or other officials use reported profits as a justification for 213

particular actions, then the constituents will have little incentive to unravel the accounting numbers used to support the politicians’ or officials’ arguments. That is, the constituents will elect to be ‘rationally uninformed’. Being ‘rationally uninformed’ implies that it is actually efficient (rational) not to spend too much time and effort to be aware of the basis of political decisions if the individual (perhaps as a voter) has a limited expectation of affecting the outcome of a decision. Maintaining the assumption of self-interest, politicians and other representatives are anticipated to know that constituents will not spend too much time investigating the background to their various decisions and hence they can justify decisions simply on the basis of reported profits. Managers are also assumed to be aware of this and as a result believe that benefits will follow from simply changing accounting methods.

8.18

The policy decisions made by members of the IASB should give some consideration to the insights provided by PAT. PAT provides numerous insights into what motivates managers to report certain information, to choose certain accounting methods, and so forth. It also provides insights into why management might not favour particular accounting methods. For organisations such as the IASB, it is useful, and perhaps imperative, that they understand some of the factors that might motivate corporate managers, and other interested parties, to lobby for or against particular accounting methods or practices. PAT provides some such insights. By understanding the motivations that might be motivating corporate managers to make particular submissions, accounting standard-setters, such as the IASB, are better placed to understand and evaluate the submissions being made by various stakeholder groups.

Further, PAT can also provide insights into the implications that might follow should an accounting standard be released (for example, implications for efficient contracting), and this is useful to consider before any accounting standard is ultimately mandated.

8.19

According to Watts and Zimmerman (1990, p. 139) the political cost hypothesis predicts that large firms rather than small firms are more likely to use accounting choices that reduce reported profits. Size is deemed to be a proxy variable for political attention – that is, the larger the organisation the more likely it is assumed 214

to be subject to political scrutiny.

If we assume that an entity is subject to a high degree of political scrutiny, and if we assume that high profits will attract unwanted political attention, the entity would expense an item of expenditure rather than capitalising it.

8.20

Conservative accounting methods tend to delay the recognition of revenue, accelerate the recognition of expenses, and tend to lead to lower asset and higher liability measures. For example, measuring assets at cost (or recoverable amount if it is lower) would be considered as a conservative accounting method relative to measuring the assets at fair value. If assets are measured at the lower of cost or recoverable amount then this means that increases in fair value would not be recognised (keeping asset values lower), but if there is a decrease in value then a reduction in assets, and a consequent expense, would be recognised. By contrast, the use of fair values is more symmetric with equal consideration given to both increases and decreases in fair value. The use of fair values also provides management with some discretion in determining fair values, particularly if the values are determined by use of a valuation model rather than on the basis of quoted prices in active markets.

Generally speaking, managers rewarded by way of accounting-based bonus plans would be expected to oppose conservative accounting methods as such methods would tend to delay income recognition and would also tend to reduce the ability of managers to be able to use their own discretion with respect to measuring assets and liabilities, as well as income and expenses (that is, conservative accounting methods reduce the ability of managers to be opportunistic). By contrast, owners/shareholders who are not directly involved in the management of an organisation would prefer that conservative accounting methods are used.

Conservative accounting methods reduce the possibility that management will undertake opportunistic earnings and asset management, and this will tend to increase the efficiency with which owners (equity holders) and debtholders can monitor the activities of managers. This in turn will reduce the risks inherent in the investments held in the organisation. The consequence of this is that organisations that use conservative accounting methods might be able to attract debt and equity capital at a lower cost because of perceptions of lower risk.

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Hence, in summary, managers who are being rewarded by way of accountingbased bonus schemes would be expected to oppose the use of conservative accounting methods whereas owners would prefer the use of conservative accounting methods as it will enable them more efficiently to monitor the actions of the managers.

8.21

This should stimulate some interesting debate among students. The fact that certain economics-based theories (such as Agency Theory or Positive Accounting Theory) portray individualistic and opportunistic actions as ‘rational’ could lead to an inference that cooperative and morally driven actions are somehow ‘irrational’. The more that students are exposed to such views the greater the potential that such values would be embedded in the minds of impressionable students, and that beliefs that morally based behaviour is neither appropriate nor expected become accepted. This would then potentially influence the decisions the students subsequently make as managers, thereby becoming a self-fulfilling prophecy.

Because of problems like climate change, species extinction, and so forth, it has become increasingly accepted that organisations, and indeed, all people, need to embrace sustainable development. This requires sacrificing current consumption and wealth in order to allow future generations to have the ability to meet their own needs. Moves towards sustainability require a movement away from ‘self interest’ as a guiding principle.

8.22

Earnings management occurs when managers and their accountants adopt particular accounting policies, or make particular accounting-based decisions primarily to generate desired measures of profits/earnings. Earnings management is often classified into two types – accruals-based earnings management and real earnings management.

Accruals-based earnings management can be, and often is, undertaken as a result of making (or deferring) various discretionary accruals of income or expenses.

Examples would include choices of (and changes made to) depreciation rates and methods, inventory cost flow assumptions and measurement assumptions, bad and 216

doubtful debt calculations, timing of revaluations of property, plant and equipment, and assumptions around revenue recognition.

Examples of ‘real earnings management’, on the other hand, relate to selecting to undertake, or not undertake actual transactions and would include altering amounts of research and development, bringing forward sales perhaps by offering limited term pricing discounts, altering advertising expenditure, changing shipping schedules and the transfer of ‘control’ of goods to bring forward the recognition of revenue, altering maintenance schedules, and changing the timing of sale on non-current assets.

8.23 (a) Arguably, it is more difficult to effectively determine the risk of investing in an organisation if we do not know about existing debt covenants. For example, we might not know it, but a company might be very close to breaching its debt covenants which means that the company could be on the verge of going into technical default. At the extreme this might lead to creditors taking actions which lead to the organisation being wound up. Hence, it is reasonable to argue that to make a more efficient assessment of risk we really do need to know about existing debt covenants. Nevertheless, the disclosure of information about debt covenants is not required by an existing financial reporting standards.

(b) Price protection works on the principle that the greater the risk of an investment, the greater the required rate of return (and vice versa). Without knowing about important risks (for example, that the organisation is party to debt covenants that are potentially binding), the required rate of return cannot be properly determined. Therefore, if potential investors are unaware of existing debt covenants, then price protection mechanisms cannot properly function.

(c) To the extent that the debtholders who negotiated the debt covenants have a prior claim to the assets of the organisation if the company defaults on the terms of the debt covenants (that is, the debt has been ‘secured’), then this will increase the risks of other creditors.

(d) The material provided within Chapter 8 would tend to suggest that companies 217

should disclose information about existing debt covenants. By making such disclosures, investors and creditors will be able to more efficiently determine the risks inherent in investing in the organisation. Increasing the efficiency of assessing risk will tend to lower the cost of capital of the organisation.

Therefore, on efficiency grounds, and on the basis of reducing the level of information asymmetry, organisations should publicly disclose information about existing debt covenants.

8.24

(a)

The debt/equity hypothesis (or simply, the debt hypothesis) predicts that the higher the firm’s debt/equity (or debt/asset) ratio, the more likely managers will use financial accounting methods that increase income (increase assets) and thereby decrease the likelihood that an entity would breach any debt covenants that might exist.

If Kahuna Company Ltd undertook an upward asset revaluation just prior to year-end, then the debt hypothesis would suggest that perhaps the company was close to breaching a debt covenant and the revaluation was required to reduce the likelihood of a technical default of the debt agreement.

(b)

The management compensation (or bonus plan) hypothesis predicts that managers of firms with bonus plans (tied to reported profits) are more likely to use accounting methods that increase current period reported income. To determine whether the act of undertaking an upward asset revaluation is consistent with the management compensation hypothesis we need to establish whether an upward revaluation has the implication of increasing reported profits.

If we undertake an upward revaluation and the assets are depreciable, then this will increase the depreciable base of the assets, leading to an increase in depreciation expense and therefore a reduction in profits. Further, the upward revaluation will result in a credit to revaluation surplus (and an increase in ‘other comprehensive income’), rather than being treated as part of profits. Also, any gain on sale of a non-current asset will be reduced as a result of a revaluation increment (the gain on sale being the difference 218

between the fair value of the consideration less the carrying amount of the asset). Hence, the effect of an upward revaluation is to decrease reported profits despite the fact that the revaluation acts to increase the net assets of the entity.

Therefore, an upward revaluation cannot be explained by the management compensation hypothesis. If we accept that PAT provides sound predictions or explanation of accounting choices then perhaps the firm was close to breaching a debt covenant and the benefits to managers of avoiding the breach more than offset the potentially negative impacts on management compensation (also, the firm may have been subject to political costs and an upward revaluation may have been part of a portfolio of accounting choices used to reduce reported income and therefore the possibility of political costs being imposed).

8.25

Mather and Peirson (2006) provide evidence that the debt covenants appearing in privately negotiated debt agreements are more restrictive than the covenants appearing in public debt agreements. That is, they show that it appears easier for a firm to breach covenants associated with private debt agreements compared with public debt agreements.

The fact that private debt contracts are more restrictive than public debt contracts can be explained from an efficiency perspective. Where a covenant is violated then an organisation is in technical default of the debt contract. If an organisation is in technical default, it often has the option to try to negotiate with the debtholders to come up with a compromise that does not involve immediate repayment of the debt. However, it is very difficult to come up with a negotiated outcome in a public debt issue as there are so many diverse parties involved – some of which might not even be able to be contacted – and therefore it is relatively difficult or nearly impossible to have a successful renegotiation – hence we would expect to find the covenant restrictions to be less restrictive in public debt contracts relative to private debt contracts.

8.26

There can be no predetermined solution to this question as students will provide different evidence depending upon the companies they have selected. It will be 219

interesting to see the extent/detail of information the companies disclose and how detailed the descriptions of the various components of the plans are.

With the increase in recent times in the public commitments of companies to various social and environmental (and sustainability) principles it will be interesting to see whether students are able to identify components of management compensation plans which utilise key performance indicators that are linked to social and environmental performance. If the companies reward their managers solely by way of financial performance indicators, then any public commitments to sustainability principles can arguably be questioned.

Where particular components of management bonus plans have been identified, students will need to indicate how (or whether) an improvement in the respective performance indicator used within the plan will benefit both the manager, as well as the owners of the organisation. An alignment of interest occurs when actions that are undertaken by the manager – which increases the manager’s wealth – also increase the wealth of the owners. For example, a remuneration plan which provides the manager with a bonus linked to profits will encourage the manager to increase reported profits, and this will also benefit the owners in terms of potential capital gains and dividend payments.

8.27

(a)

As we have indicated in this chapter there are many theorists who challenge the assumption that all individuals are driven by wealthmaximising self-interest. What must be remembered is that this is a theoretical assumption which cannot be expected to hold for all people in all situations. It is an assumption that forms the basis for much economic theorising, and arguably, does provide many useful predictions. However, hopefully our own evidence indicates that not everybody we know is totally driven by self-interest. We can perhaps reflect on whether we individually believe that the self-interest assumption (tied to wealth maximisation) provides a realistic portrayal of individual behaviour.

(b)

If we maintain this assumption that all individuals are driven by selfinterest (and not the public interest) then we would argue that politicians will only introduce regulation once it is determined that the regulation 220

provides benefits to the politicians themselves. These benefits might be in the form of increased likelihood of gaining the support of voting constituents. As we discussed in Chapter 4, there are different theories of regulation. Some theories of regulation – for example, public interest theory of regulation – have a maintained assumption that politicians would work in the public interest and are not motivated by their own self-interest.

By contrast however, the economic interest group theory of regulation assumes that all people, inclusive of politicians, act in their own selfinterest such that politicians would only support particular legislation to the extent that it was expected to lead to benefits accruing to themselves.

(c)

Maintaining the assumption that all individuals are wealth-maximising individuals, researchers will only research particular issues if the research generates outcomes which will positively influence their wealth (perhaps through career advancement). Again, we must remember that the assumption of self-interest is a theoretical assumption. While it is probably not unreasonable to assume that one factor motivating research might be the expected payoffs, there is also evidence to suggest that people research issues because they actually have an interest in the issue under investigation!

8.28

There are a number of criticisms of PAT: •

One criticism of PAT is that by limiting its focus to explaining and predicting accounting practice it fails to provide guidance to practitioners.

In defence, Positive Accounting theorists might argue that before we prescribe one method of accounting in preference to others it is necessary to predict the consequences of alternative methods of accounting.

•

Another criticism of PAT is that it is not value free as it asserts. As explained in this chapter, no research can really be value free. Hence, while we might not criticise PAT because it is not value free, we can challenge the early claims that it was value free.

•

A further criticism that has been made of PAT relates to the assumption that all individual actions are driven by wealth maximising self-interest considerations. Some individuals consider that such a perspective provides 221

a ‘morally bankrupt view of the world in general and of accounting in particular’. However, most theories about human behaviour rely upon simplifying assumptions about how people behave. At issue is whether the assumption is too simplistic.

•

PAT provides predictions which are not always supported by available evidence. However, we can probably expect that most theories about human behaviour will not always provide accurate predictions of actual behaviour.

•

PAT relies upon various assumptions about the efficiency of markets, including the capital market, the managerial labour market, and the market for corporate takeovers. In practice, markets will not always be efficient.

Further, Positive Accounting theorists often use the idea of efficient markets to support calls for the deregulation of accounting practice by arguing that accounting information should be treated like any other good and hence, the forces of supply and demand should be allowed to operate to determine the optimal amounts of information to produce. Such a perspective ignores the fact that accounting information has ‘public good’ characteristics (the good can be used without payment) and that it is generally accepted that markets do not operate efficiently with respect to public goods.

•

PAT researchers typically undertake their research by collecting a large number of observations of data emanating from different reporting entities.

They ignore many underlying differences in organisations and assume that their unit of measurement provides an accurate reflection of the issue under investigation (realist philosophy). Researchers that are critical of the PAT paradigm argue that no two organisations are the same and hence that doing large scale studies over many organisations is quite naïve.

8.29

Positive Accounting Theory assumes that all individuals, at all times, and in all places, will act in their own self-interest and will undertake various actions to the extent that it will benefit their own wealth. This is obviously a fairly simplistic assumption (but one that nevertheless provides some fairly useful predictions in relation to individual behaviour). Considerations of public interest, business ethics, morality, and the like are not explicitly considered within the theory.

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Applying this perspective to Wayne Swan, who was the Australian Federal Treasurer, it could be assumed that Wayne Swan was driven by the desire to retain his own position as Federal Treasurer and that potentially manipulating budget figures could bolster the likelihood that his political party (the Australian Labor Party) would be re-elected. This could then increase the likelihood that he would retain his own position (with the related salary and the significant retirement benefits that accrue to politicians, and which increase as time in office increases).

Therefore, applying the assumptions inherent within Positive Accounting Theory (that all people in all situations are driven by self-interest), and to the extent that manipulating budget figures will provide benefits (for example, by increasing the probability of re-election) that exceed expected costs (and these costs could relate to the costs associated with potentially being associated with applying ‘creative accounting’), then we can expect all Federal Treasurers to be ‘creative’ with budget accounts. Hopefully, however, the simplistic assumption that self-interest motivates everybody in society will not always be in accordance with the facts. It would be ‘nice’ to think that politicians are driven by the public interest – but students should be asked to think whether they are inclined to believe that politicians are driven by the public interest (or perhaps, in reality, politicians are driven by a mixture of both public and private interests).

8.30

Conservative accounting policies are those methods that tend to delay the recognition of revenue, accelerate the recognition of expenses, and tend to lead to lower asset and higher liability recognition.

Conservative accounting methods are argued to contribute to efficient contracting (Watts, 2003). There is a belief amongst a number of researchers that it is more efficient for parties (for example, shareholders and debtholders) to monitor the activities of managers when those managers use conservative accounting methods to produce financial accounting information. Conservative accounting methods are typically more verifiable and subject to less possibility of manipulation. For example, debtholders are typically concerned about the possibility that they will not be repaid their invested funds. Because conservative accounting methods tend to defer profit recognition, such accounting methods reduce the likelihood that the firm will pay excessive dividends, and this will act to allay some of the concerns 223

of the debtholders. Further, because conservative accounting methods tend to reduce net assets and profits relative to other accounting methods, this means that accounting-based debt covenants will be activated earlier (that is, technical default will be triggered earlier) – and this means that debtholders will be able to take earlier steps to safeguard their investments. The earlier the intervention of debtholders (or their representatives), the more likely that assets will still be available within the firm to repay the debts. As Iyengar and Zampelli (2010, p.

122) state:

One explanation for why firms might choose to implement conservative accounting practices lies in efficient contracting theory, i.e. conservative accounting can be used as part of a firm’s strategy to mitigate the conflicts that arise among the many claimants of a firm’s net assets. This is due to the fact that conservative accounting methods place constraints on the distribution of those net assets thereby limiting the scope for self-serving opportunistic behaviour. For example, Ahmed et al. (2002) look at the role of accounting conservatism in mitigating the conflict between bondholders and shareholders. Specifically, because conservative accounting lowers earnings and retained earnings, dividend policy is necessarily restricted, reducing the probability of excessive dividend payouts. Consequently, firms using more conservative accounting practices tend to incur lower costs of debt.

As reflected in the above quote, because conservative accounting methods can reduce the possibility that management will undertake opportunistic earnings management, organisations that use conservative accounting methods might be able to attract debt and equity capital at a lower cost because of perceptions about lower risk.

8.31

It is true that assuming that all actions, by all individuals, are driven by selfinterest is quite simplistic. Individuals would likely be motivated by various factors, and not simply by a desire to maximise their own wealth. Nevertheless, assumptions are an important component of any theories. Whether we are prepared to use a theory, or believe its prescriptions, explanations, or predictions

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will, in part, be influenced by whether we are prepared to accept the underlying assumptions utilised within the theory.

If a positive theory provides explanations or predictions of particular phenomena, and the explanations or predictions are ‘better’ than those provided by competing theories, then we might use the theory despite the simplicity of the assumptions.

Indeed, a parsimonious explanation/theory (see Chapter 1 for a description of the idea of parsimony) is often preferred to one that utilises a multitude of assumptions and variables.

8.32

The basis for Zhang’s (2008) argument is that conservative accounting methods bias the organisation towards more readily recognising losses than gains.

Conservative accounting practices would also restrict the organisation from undertaking numerous (or perhaps, any) asset revaluations. The effect of conservative accounting methods is that both profits and net assets (and therefore equity) would tend to be understated (that is, they provide ‘conservative measures’ of financial position and financial performance) relative to organisations that do not adopt conservative accounting methods. It also means that debt covenants restricting the amount of debt relative to assets (or debt to equity), or the amount of times profits must cover interest (known as an interest coverage clause) will tend to be more restrictive or binding for those organisations that adopt conservative accounting methods.

As Zhang (2008) argues, the more binding covenants will provide an earlier warning of default risk, and thereby will reduce the risk exposure of the lending party (for example, a bank). The reason for this is that because management will have less ability to circumvent restrictive covenants (for example, by undertaking asset revaluations), such covenants will create a technical default of a loan agreement earlier than if management has the scope to loosen the restrictions, perhaps through undertaking an asset revaluation. The earlier the lender can take actions to safeguard its funds, the lower the risk of the lender.

In accordance with the above expectations, Zhang (2008) reports that borrowers who adopt conservative accounting methods attract funds at lower rates of interest (a benefit to the borrower). Zhang (2008) also found that borrowers that adopt 225

more conservative accounting methods are also more likely to violate debt contracts and to violate them sooner (and the early default signal creates lower risk for lenders – which explains why they are prepared to lend the money at lower cost).

8.33

Conservative accounting methods provide greater protection for debtholders relative to situations when conservative accounting methods are not in use. The basis for this belief is that it is more efficient for debtholders to monitor the activities of managers when those managers use conservative accounting methods to produce financial accounting information. Conservative accounting methods are typically more verifiable and subject to less possibility of manipulation.

Debtholders are typically concerned about the possibility that they will not be repaid their invested funds. Because conservative accounting methods tend to defer profit recognition, such accounting methods reduce the likelihood that the firm will pay excessive dividends, and this will act to allay some of the concerns of the debtholders. Further, because conservative accounting methods tend to reduce net assets and profits relative to other accounting methods, this means that accounting-based debt covenants will be activated earlier (that is, technical default will be triggered earlier) – and this means that debtholders will be able to take earlier steps to safeguard their investments. The earlier the intervention of debtholders (or their representatives), the more likely that assets will still be available within the firm to repay the debts.

8.34

Rob Gray was a vocal opponent of PAT. Gray was an advocate of attempts to persuade organisations and their managers to take more care for society and the environment and he provided insights into how accounting could – if thoughtfully reimagined – be used in a way that leads to improvements in organisations’ social and environmental performance. What he emphasised was the need to move away from self-interest towards a more morally just society. As such, he was opposed to theories that he considered encouraged or rationalised self-interest – he viewed such theories as promoting views of the world that were devoid of morality, that is, were morally bankrupt. He considered PAT to be one such theory.

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8.35

In Chapter 8, reference was made to some researchers (for example Watts, 1995) who argued that hypothesis forming and testing were essential for good research.

However, this represents a biased view about what constitutes ‘good research’. A hypothesis would be formed to test a prediction, for example, a prediction that under specific conditions accountants would select a particular method of accounting – this type of issue is something that fascinates researchers working within a PAT framework. The reason that normative researchers, on the other hand, would not form and test hypotheses is that such researchers would not be as concerned with, or interested in, explaining or predicting what is (which could be tested empirically); rather, they are more concerned with what should be. Hence, normative researchers do not necessarily develop any predictive hypotheses, but this in itself should not be used to dismiss their work as not being ‘good research’.

Such rejection represents an inherent and arguably inappropriate philosophical bias.

8.36

From a PAT theory perspective, an organisation would negotiate a particular debt restriction with lenders on the basis that it was the most efficient basis for the organisation to attract funds at lower costs. Arguably, management must have believed had they not agreed to the restriction then they would not have been able to attract funds at the same low cost. Further, by agreeing to a restriction that is not directly under the control of management (it would be more difficult to manipulate share prices than it would be to loosen an accounting-based debt covenant through perhaps undertaking an asset revaluation) this might have been perceived by lenders as further reducing the risks of lenders which might have further contributed to the organisation attracting funds at lower cost.

When the organisation negotiated the restriction there was probably only perceived to be a very small likelihood that the minimum market capitalisation requirement would be violated (the shares fell from $34.63 to $5.25 in twelve months). However, the risk involved for borrowers when market-based measures are used is that share prices respond at least in part, to market-wide factors that are beyond the control of the company. This would be a reason why many organisations would not elect to use market-based measures. Nevertheless, assuming that management is ‘rational’ then they must have assumed that the risk

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they were accepting must have at least been offset by the benefits they received from agreeing to the restriction.

From the lenders’ perspective, and if we believe that markets are ‘efficient’, then using the market price as a signal of the ‘health’ of an organisation could be an efficient policy to adopt. As we explain in Chapter 11, the common assumptions of market efficiency assume that the capital market at any point in time reflects all publicly available information about an organisation. Therefore, if a share price falls then this is a reflection of the market revising expectations about the future net cash flows associated with holding a security and provides a basis for monitoring the value of a particular investment. From the lenders’ perspective they would have agreed to the restriction because they would have believed that it provided them an acceptable amount of risk in relation to the return they were receiving on the investment (but remember, under PAT there is an assumption that lenders price-protect such that if borrowers do not agree to certain restrictions then lenders – not necessarily the same lenders – will simply charge higher costs in return for the higher risk).

8.37

(a)

It is accepted within PAT (as derived from economic and finance theory) that the value of an organisation is based upon expectations about future cash flows. Hence, if expectations about future cash flows change then the value of the firm’s securities will also change. There could be many contractual arrangements within a firm which rely upon profit calculations.

For example, managers might be paid a percentage of profits or, due to restrictive debt covenants, managers may be restricted from taking on more debt unless certain levels of profits are achieved. Also, pursuant to the political cost hypothesis, a change in reported profits could have implications for the political visibility of an organisation with consequent implications for wealth transfers related to the political process.

Hence, if an accounting standard has implications for reported profits, and if we accept the existence of political scrutiny linked to profitability, as well as the existence of various contractual arrangements with cash flows associated with reported profits, then the release of the new accounting standard can affect the value of the organisation. For example, the new 228

requirements pertaining to goodwill which no longer require goodwill to be systematically amortised mean that, to the extent that the value of goodwill has not declined (there are no impairment losses) then reported profits will increase. This could have cash flow consequences because potentially this could increase the political scrutiny of the organisation, or it could lead to increases in bonuses paid to managers if they are given a percentage of reported profits. In either case, the change in cash flows could translate to a change in firm value.

(b)

From the ‘efficiency perspective’ of PAT it is assumed than managers will select accounting methods that best reflect the underlying performance of the entity. Among other things, this will enable them to attract funds at lower costs. If accounting regulators prohibit the use of methods that the firm had been using, then it can be argued that the firm is then less able to present a reliable measure of the firm’s performance, and this will have implications for the costs associated with attracting funds. That is, inefficiencies will be introduced. This view assumes that managers have an extremely comprehensive knowledge of the existence and relevance of alternative accounting methods.

8.38

(a)

It could be costly for the firm from an efficiency perspective if it is considered that management had selected particular methods (for example, to recognise the cost of options at their intrinsic value rather than their fair value) on the basis that the accounting methods selected best reflected the underlying performance of the entity, and those methods were subsequently prohibited. If an entity is able to provide external parties (for example, shareholders) with information that is deemed to provide a reliable measure of the firm’s performance, then the belief is that this will lead to a reduction in the costs of attracting funds (and in the ‘agency costs’ of the entity). If less-reliable methods are used (perhaps because others have been prohibited) then this will have negative implications for the costs of attracting funds. This efficiency perspective assumes that managers will not be opportunistic. However, in practice the regulators may have prohibited particular methods of accounting because evidence indicated that managers were using the methods in an opportunistic 229

manner. Alternatively, perhaps there was a difference in opinion between the regulators and corporate managers about what methods of accounting best reflect a particular type of transaction such that the regulators might mandate a particular requirement (such as the requirement to measure the cost of share options at fair value) which has not previously been embraced by corporate managers.

(b)

If the manager is paid a percentage of profits, then the granting of share options has to be recognised as an expense at the fair value of the share options. This can be contrasted with what typically happened previously under former accounting standards when they were previously recorded at their intrinsic value (which was lower than fair value). This change will reduce profits and consequently, reduce any profit-based bonus payment.

This argument assumes that the bonus payment is directly related to reported profits using whatever rules are required at that particular time (often referred to as relying upon ‘floating GAAP’). If the bonus plan had stipulated how share options were to be measured (for expense purposes when calculating the bonus) then the release of the new rules on share options may have no effect on managers’ bonuses.

(c)

Different theories of regulation are considered in Chapter 4. There are some theories that suggest that regulators are motivated by the ‘public interest’ and will only introduce regulation that provides positive net benefits to the community (public interest theory). PAT adopts the perspective that all actions by all individuals are driven by self-interest (consistent with private economic interest theories of regulation). Hence, Positive Accounting theorists would argue that regulators will only introduce regulation if it provides benefits to them. These benefits might be in the form of increased probability that the regulators will be reappointed to their position.

8.39 (a)

Because of the significant impacts the new leasing standard was likely to have on financial statements, it proved to be a controversial standard. Many submissions were made to the various exposure drafts that were released as part of the process 230

of developing IFRS 16. Because the standard-setting processes of bodies such as the IASB are political in nature, the greater the interest in a topic, the longer the related standard will typically take to be developed. Also, as part of the process of developing accounting standards, the IASB must carefully consider the various economic and social consequences. Because this standard was going to greatly impact reported assets, liabilities, and expenses, and because there would be a seemingly infinite number of contracts internationally that linked to these financial accounting numbers, the potential economic and social impacts were immense – hence the extended period of time to develop IFRS 16.

(b)

The recognition of leased assets and lease liabilities will lead to a worsening of debt to asset, or debt to equity ratios (applying the view that an increase in the ratios is considered to represent a ‘worsening’ of the ratio). If a company is close to breaching a particular debt covenant, then the new accounting standard could ‘tip’ the company over the negotiated upper limit of the ratio thereby bringing the company into a situation of being in technical default of the debt covenant.

(c)

It would be likely that prior to the release of IFRS 16, the proposed/draft accounting standard would already have influenced whether organisations would enter leases, and the associated terms of the lease contracts. It is common for organisations and their advisers to look for loopholes in particular accounting standards and then devise transactions in a way that exploits those loopholes. In general, organisations will prefer to keep debt off the balance sheet.

(d)

Debtholders would generally prefer that managers do not have discretion to loosen the effects of negotiated debt contracts. They would also generally prefer that debt covenants are activated earlier than later (that is, that the organisation is in ‘technical default’ earlier). The basis for this is that they would prefer to be able to access the assets over which they have security before the organisation potentially gets into further financial stress. Therefore, debtholders would prefer that leases are recognised in the balance sheet.

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Chapter 9: Unregulated corporate reporting decisions – systemsoriented theories Solutions 9.1

A ‘social contract’ is a theoretical contract between one party, perhaps a company, and society. It is not written, but is implied. The social contract (or as it is sometimes called, the community licence to operate) incorporates community norms and expectations about how an organisation should conduct its operations (including what information it produces). As community norms and expectations are expected to change across time, the ‘terms’ of the social contract are also expected to change across time.

Different people will have different perceptions about what the terms of the social contract are and hence, they will have different expectations about how an organisation should operate and the extent of accountability that is due. One can certainly not say with any precision what the terms of the contract are at a particular point in time.

In linking the notion of a social contract with the concept of organisational legitimacy, it is argued that for an organisation to be legitimate it must conform to the expectations of the community in which it operates. According to Lindblom (1993) an organisation is legitimate when its value system is perceived as being congruent with the value system of the larger social system of which the entity is a part. To be legitimate the organisation must conform to the terms of the social contract. Failure to comply with these terms will bring the legitimacy of the organisation into doubt and this in turn is expected to have implications for the ongoing survival of the organisation.

As the chapter indicates, Shocker and Sethi (1974, p. 67) provide a good overview of the concept of a social contract. They state: Any social institution – and business is no exception – operates in society via a social contract, expressed or implied, whereby its survival and growth are based on: 232

(1) the delivery of some socially desirable ends to society in general, and (2) the distribution of economic, social or political benefits to groups from which it derives its power.

In a dynamic society, neither the sources of institutional power nor the needs for its services are permanent. Therefore, an institution must constantly meet the twin tests of legitimacy and relevance by demonstrating that society requires its services and that the groups benefiting from its rewards have society’s approval.

As an additional issue, students should consider how management might actually be able to determine the terms of the social contract.

9.2

According to Lindblom (p. 2), legitimacy is: … a condition or status which exists when an entity’s value system is congruent with the value system of the larger social system of which the entity is a part. When a disparity, actual or potential, exists between the two value systems, there is a threat to the entity’s legitimacy.

Within Legitimacy Theory, ‘legitimacy’ is considered to be a resource on which an organisation is dependent for survival (Dowling & Pfeffer, 1975; O’Donovan, 2002). It is something that is conferred upon the organisation by society, and it is something that is desired or sought by the organisation. However, unlike many other ‘resources’, it is a ‘resource’ that the organisation is considered to be able to impact on or manipulate through various disclosure-related strategies (Woodward et al., 1996). It is considered to be a resource because for many organisations it is something that is necessary to the ongoing operations and survival in much the same way as raw materials, labour or other resources would be necessary for the organisation to continue operations.

9.3

Organisational legitimacy is considered to be dependent upon the organisation complying with community expectations (that is, to be in compliance with the ‘social contract’). Because community expectations change across time, the terms of the social contract will also change across time. What was acceptable business practice at one point of time will not necessarily be acceptable at a future point in time.

233

In relation to changing or evolving community expectations Lindblom (1993, p.3) states:

Legitimacy is dynamic in that the relevant publics continuously evaluate corporate output, methods and goals against an ever-evolving expectation.

The legitimacy gap will fluctuate without any changes in action on the part of the corporation. Indeed, as expectations of the relevant publics change the corporation must make changes or the legitimacy gap will grow as the level of conflict increases and the levels of positive and passive support decreases.

Further, because community expectations will be related to such factors as culture, religion, historical events and so forth, it is to be expected that community expectations about appropriate business conduct will be different across different countries – that is, legitimacy will also be place specific. Hence, we would expect there to be differences in the social contracts in place within different countries.

9.4

Pursuant to the notion of organisational legitimacy there is a view that organisations must be seen (or perceived) to be operating in compliance with community norms and expectations. That is, they must be believed to be operating in compliance with the social contract.

Accepting this theoretical perspective, it is not just important that management actually be doing the ‘right’ things, there must be a perception by the community that they are doing the right things. Hence, it is important that the organisation tells the community about what it is doing and one way of doing this is by various corporate disclosures through such media as the annual report. As the chapter indicates, the disclosure of information is deemed by Dowling and Pfeffer (1975) and Lindblom (1993) to be an important course of action to maintain or reinstate legitimacy.

9.5

Determining the terms of the social contract (that is, what the norms and expectations of the community are) is clearly not an easy exercise. Different managers will have different perceptions about what is expected. It could be argued that a successful manager is one who is best able to understand community expectations, and to respond to changes therein.

234

The social contract can be construed as being made up of some ‘clauses’ that are explicit, and some that are implicit. Explicit clauses may be ‘easier’ to determine.

Gray, Owen and Adams (1996) suggest that legal requirements provide the explicit terms of the contract, while other non-legislated societal expectations embody the implicit terms of the contract. That is, there is an imperfect correlation between the law and societal norms (as reflected by the social contract) and according to Dowling and Pfeffer (1975) there are three broad reasons for the difference. Firstly, even though laws are reflective of societal norms and values, legal systems are slow to adapt to changes in the norms and values in society.

Secondly, legal systems often strive for consistency whereas societal norms and expectation can be contradictory. Thirdly, it is suggested that while society may not be accepting of certain behaviours, it may not be willing or structured enough to have those behavioural restrictions codified within law. It is in relation to the composition of the implicit terms of the ‘contract’ that we can expect managers’ perceptions to vary greatly.

Various approaches have been suggested as a means of understanding community expectations (which relate particularly to the implicit terms of the social contract), and these include the following:

(a)

Reviewing various community-based surveys that have been undertaken to establish community views on particular issues. In most countries, various government departments (as well as a number of private sector ‘polling’ organisations) undertake different attitudinal surveys from time to time.

(b)

Many organisations subscribe to services that scan the news media and which identify the issues that are attracting the most coverage. Such an approach adopts a perspective that the news media reflects, or perhaps shapes, public perceptions in particular, perhaps, in relation to unobtrusive issues).

(c)

Managers typically directly engage their stakeholders through various stakeholder meetings. Within these meetings the managers ask representatives of groups such as local community, environmental, 235

employee, investment and consumer groups about what expectations they have about the organisation and whether the organisation is perceived to be operating in a manner consistent with their expectations.

There is no universally accepted way of learning about the community’s expectations. While a minority of management teams might appear to ignore community expectations (they do not see themselves as part of a broader social system), it is generally accepted that more and more organisations are undertaking greater dialogue with various stakeholder groups.

Failure to consider community expectations (and changes therein) are expected to lead to negative implications for an organisation with an extreme result being that the organisation will be driven out of business. Organisations are not considered to have any absolute right to exist. As Mathews (1993, p. 26) states:

The social contract would exist between corporations (usually limited companies) and individual members of society. 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 to 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.

Pursuant to Legitimacy Theory, if an organisation does not comply with community expectations, the community may revoke its ‘contract’ to continue its operations. This may occur through consumers reducing or eliminating the demand for the products of the business, factor suppliers eliminating the supply of labour and financial capital to the business, or constituents lobbying government for increased taxes, fines or laws to prohibit those actions which do not conform to the expectations of the community.

9.6

As the chapter indicates, Dowling and Pfeffer (1975) and Lindblom (1993) identify a number of strategies that management might take when their organisation’s perceived legitimacy is in question. For example, Dowling and

236

Pfeffer outline the following means by which an organisation may legitimise its activities (p. 127): •

adapt its output, goals and methods of operation to conform to prevailing definitions of legitimacy;

•

attempt, through communication, to alter the definition of social legitimacy so that it conforms to the organisation’s present practices, output and values; and

•

attempt through communication to become identified with symbols, values or institutions which have a strong base of legitimacy.

Lindblom (1993) also suggests that if management perceives that the organisation’s legitimacy is in question then it can adopt a number of strategies.

Lindblom (1993) identifies four courses of action (there is some overlap with Dowling and Pfeffer) that an organisation can take, including seeking to: •

educate and inform its ‘relevant publics’ about (actual) changes in the organisation’s performance and activities;

•

change the perceptions of the ‘relevant publics’ – but not change its actual behaviour;

•

manipulate perception by deflecting attention from the issue of concern to other related issues through an appeal, for example, emotive symbols; or

•

change external expectations of its performance.

According to Lindblom, and Dowling and Pfeffer, the public disclosure of information can be employed by an organisation to implement each of the above strategies. As the chapter indicates, this is a perspective that many researchers of social responsibility reporting have adopted. For example, a firm may provide information to counter or offset negative news which may be publicly available, or it may simply provide information to inform the interested parties about attributes of the organisation that were previously unknown. In addition, organisations may draw attention to strengths (for instance environmental awards won or safety initiatives that have been implemented) while sometimes neglecting or down-playing information concerning negative implications of their activities, such as pollution or workplace accidents. Consistent with the positions taken by 237

Dowling and Pfeffer, and Lindblom, Hurst (1970) suggests that one of the functions of accounting, and subsequently accounting reports, is to legitimise the existence of the corporation.

9.7

On the basis of evidence provided by various research studies, some of which are referenced in the chapter, evidence suggests that when an organisation has been involved in a major accident or event (such as loss of oil at sea or a mine-collapse) then corporate disclosures will be used as a means to bolster the damaged image of the organisation involved. Consistent with the strategies suggested by Lindblom (1993) and Dowling and Pfeffer (1975), disclosures within annual reports, sustainability reports, or on corporate websites can be used to distract attention from the event itself and to highlight positive aspects of the organisation’s performance (for example, if the organisation has received publicity for breaching particular environmental laws, then it might use the annual report to talk about particular environmental awards that it has received).

Alternatively, the corporate disclosures might be used as a means of down-playing the significance of the event or as a means of providing information to suggest that such an event will not occur again (perhaps because additional mechanisms have since been put in place).

What the evidence shows is that disclosure, in media such as the annual report, sustainability report, or corporate website, is a strategy that many organisations use when their legitimacy, and hence their livelihood, is threatened. Of course, other disclosure strategies could also be implemented at the same time.

9.8

As we saw in Chapter 9, a number of studies have investigated corporate reporting behaviour around the time of major adverse social and environmental events. The argument typically used is that the events caused an erosion in the ‘legitimacy’ of the organisation thereby necessitating disclosures aimed at restoring lost legitimacy. That is, the adverse social or environmental event causes the perceived legitimacy of the organisation to fall following the event. But can we actually place a measure on this reduction in legitimacy?

Placing a measurement on ‘legitimacy’ would be a very subjective exercise, influenced by a number of factors not the least of which would be the researchers’ 238

own values and perspectives. Therefore, rather than trying to gauge an organisation’s legitimacy directly, we can perhaps infer its existence through the actions of various parties within society. One way to do this is to consider the flow of resources going to an organisation – something that can be more objectively determined. If people continue to provide resources to the entity then, in a sense, they must believe that organisation is worthy of support. Conversely, they would not be expected to provide resources to an entity that they believe acts inappropriately. Hence, the level of resource transfer can be used, perhaps somewhat imperfectly, as a measure of the legitimacy of an organisation. As Hybels (1995, p. 245) states:

Legitimation derives from increases in the flow of resources, while delegitimation occurs as the flow of resources declines. I do not mean to imply, however, that resources and legitimacy are synonymous, only that resource flows are among the best evidence of legitimacy. Resources evidence legitimacy not simply because legitimation provokes the transfer of resources, but because resources are media by which approval and consent are expressed. Legitimacy exists only so long as it is instantiated in the transferral of resources, and that transfer must be ongoing to ensure the continual reproduction of legitimacy. This means that each act of exchange is a moment of legitimation. The flow of resources and the building of legitimacy are mutually reinforcing dynamics…. Since legitimacy is an intrinsically abstract concept, it is necessary to infer its existence from the behaviour of people involved.

As Hybels (1995, p. 244) explains, we can consider the resource flows from different stakeholder groups. The ‘public in general’ consume goods and supply labour – they are therefore critical to survival. Therefore, ‘because of these influences, public opinion is watched closely by the guardians of corporate legitimacy’ (Hybels, 1995, p. 244). A reduction in the consumption of a firm’s products might then be reflective of a change in perceived legitimacy from the perspective of the public (of course, there could also be other contemporaneous events, such as a change in preference for particular products or a change in the prosperity of consumers). The government (or as it is sometimes called ‘the state’) provides crucial resources in terms of legislation, regulation, grants, and so on 239

(which can provide a positive or negative influence on the organisation).

Therefore, perhaps, the introduction of legislation which might extract resources from the organisation (negative resource flows) might be reflective of a change in the perception of government officials about the legitimacy of an organisation (and the changes in laws would be reflective of broader community expectations, albeit possibly with some lag). Investors provide financial capital inflows. The media also can be considered as providing a powerful resource in terms of influencing the resource allocation decisions of other members of the community (either positively or negatively). By measuring resource flows from different groups within society we can see whether views are different across different groups and whether legitimacy threats appear particularly apparent.

Therefore, with this discussion in mind, researchers in the future might consider monitoring the change in resource flows of an organisation as a basis for confirming their belief that the legitimacy of an organisation has declined following major legitimacy threatening events.

9.9

The term ‘legitimacy gap’ has been utilised by many researchers to describe the situation where there appears to be a lack of correspondence between how society believes an organisation should act and how it is perceived the organisation has acted. In relation to how legitimacy gaps arise, Sethi (1978) describes two major sources of the gaps. Firstly, societal expectations might change, and this will lead to a gap arising even though the organisation is operating in the same manner as it always had. Secondly, according to Sethi (1977), the legitimacy gap occurs when previously unknown information becomes known about the organisation – perhaps through disclosure being made within the news media. Within the chapter, O’Donovan provides a diagrammatic representation of the legitimacy gap (see page 433).

9.10

As Ashforth and Gibbs (1990) indicate, the use of substantive management techniques might ‘involve real, material change in organisational goals, structures, and processes or socially institutionalised practices’ (p. 178). By contrast, symbolic management techniques of legitimation involve the portrayal of corporate behaviour in a manner to ‘appear consistent with social values and expectations’ (Ashforth & Gibbs, 1990, p. 180). According to Ashforth and Gibbs, 240

it is not necessary for corporations to use either substantive or symbolic management techniques exclusively and they may adopt a mix of substantive and/or symbolic legitimating techniques which they apply with varying levels of intensity. It is not clear whether one technique is more effective than the other.

9.11

Figure 9.3 in Chapter 9 (p. 437) identifies some potential phases within the legitimation process, these being the establishment, maintenance, defence, and loss phases. Not all firms will enter all phases. As Figure 9.3 shows, and applying Legitimacy Theory, most organisations will initially seek to establish legitimacy, after which time they will reach the stage where they will try to maintain legitimacy. As legitimacy-threatening events arise the organisation might then try to defend its legitimacy; however it might reach a stage where legitimacy has effectively been lost. At that point the organisation might choose to either seek to re-establish its legitimacy, or alternatively, elect to abandon efforts to maintain legitimacy. As emphasised in Chapter 9, corporate disclosure would be used as part of the strategy to establish, maintain, or repair lost legitimacy.

9.12

There might come a time in the lifecycle of some organisations that their legitimacy has been so badly eroded that strategies to repair or defend legitimacy might ultimately be abandoned. Some organisations might have limited legitimacy to start with – such as an armaments manufacturer. Such an organisation would not be expected to have widespread appeal and therefore disclosures might be limited to showing compliance with legal requirements.

Other organisations might initially have legitimacy, but lose it across time. For example, we can consider the tobacco industry. In this regard, Tilling and Tilt (2010) undertook research in which they reviewed the disclosure policies of Rothmans Limited – an Australian producer of tobacco products – over the period from 1955 to 1999. According to the authors, this industry moved from being one of relatively high legitimacy (prior to scientific confirmation of the negative health effects of tobacco) to being one of relatively low legitimacy. Whilst there is a general expectation that companies would increase disclosures as part of a legitimation process and as legitimacy is threatened, they found that there came a time – which Tilling and Tilt referred to as the ‘loss phase’ – when it appeared that the company ceased making disclosures of a positive nature about the 241

organisation to try and defend or repair lost legitimacy. That is, there came a time when efforts to regain lost legitimacy are deemed ‘useless in the legitimation effort’ (de Villiers and van Staden, 2006, p. 767).

9.13

Consistent with Legitimacy Theory, the successful operation of an organisation is dependent upon community expectations and perceptions. Hence, if we adopt this perspective then management would only react to particular events (such as an oil spill, lay-off of workers) if they perceived that the community was concerned about the action or event – that is, they will respond if they believe the action or event was not in accordance with the ‘social contract’ negotiated between the organisation and the community. If management considers that their actions are consistent with the terms of the ‘contract’ then no remedial or legitimating action would be necessary. If a broader notion of accountability was assumed, then such a position would not be adopted. Disclosures would be made because of a responsibility to do so – not because legitimacy was threatened.

9.14

Within the theoretical perspective provided by Political Economy Theory, and according to Gray, Owen and Adams (1996, p. 47), the ‘political economy’ can be defined as ‘the social, political and economic framework within which human life takes place’. The perspective embraced is that society, politics and economics are inseparable, and economic issues cannot meaningfully be investigated in the absence of considerations about the political, social and institutional framework in which the economic activity takes place. It is argued that by considering the political economy a researcher is able to consider broader (societal) issues that impact on how an organisation operates and what information it elects to disclose.

According to Guthrie and Parker (1990, p. 166):

The political economy perspective perceives accounting reports as social, political, and economic documents. They serve as a tool for constructing, sustaining, and legitimising economic and political arrangements, institutions, and ideological themes which contribute to the corporation’s private interests. Disclosures have the capacity to transmit social, political, and economic meanings for a pluralistic set of report recipients.

Guthrie and Parker (1990, p. 166) further state that corporate reports cannot be 242

considered as neutral, unbiased (or representationally faithful) documents, as many professional accounting bodies might suggest, but, rather, that corporate reports are ‘a product of the interchange between the corporation and its environment and attempt to mediate and accommodate a variety of sectional interests’. This view is consistent with Burchell et al. (1980, p. 6), who suggest that accounting can ‘not be seen as a mere assembly of calculative routines, it functions as a cohesive and influential mechanism for economic and social management’.

The insights provided by Political Economy Theory are important because they emphasise an important role that accounting and accounting reports play within society, and that accounting is very much a social practice. The insights cause us to question whether claims that accounting can be neutral and unbiased are objective.

9.15

What the statement is emphasising is that the public disclosures made by an organisation will influence how an organisation is perceived by various stakeholder groups. The disclosures being made by an organisation will potentially create social, political and economic influences/ impacts upon various stakeholders, as well as for the organisation. The nature of the disclosures being made by an organisation can influence not only how the organisation is perceived, and whether it is adjudged as legitimate and so forth but can also influence other organisations and related social structures with which the organisation interacts.

The quote emphasises that corporate disclosures are an important and strategic aspect in shaping how different stakeholders perceive the organisation and the environments in which it operates. The quote also emphasises that accounting is very much a social practice.

9.16

Placing a measurement on ‘legitimacy’ would be a very subjective exercise, influenced by a number of factors not the least of which would be the researchers’ own values and perspectives. Therefore, rather than trying to gauge an organisation’s legitimacy directly, we can perhaps infer its existence through the actions of various parties within society. One way to do this is to consider the flow of resources going to an organisation – something that can be more objectively determined. As Hybels (1995, p. 243) states: 243

Legitimacy itself has no material form. It exists only as a symbolic representation of the collective evaluation of an institution, as evidenced to both observers and participants perhaps most convincingly by the flow of resources. Resources must have symbolic import to function as value in social exchange. But legitimacy is a higher-order representation of that symbolism. Terreberry well explained the relationship between resources and organizational legitimacy nearly thirty years ago when he said ‘the willingness of firm A to contribute to X, and of agency B to refer personnel to X, and C to buy X’s product testifies to the legitimacy of X’ .

The view being promoted in the above quote is that if people continue to provide resources to the entity then, in a sense, they must believe that organisation is worthy of support. Conversely, they would not be expected to provide resources to an entity that they believe acts inappropriately. Hence, the level of resource transfer can be used, perhaps somewhat imperfectly, as a measure of the legitimacy of an organisation.

Hybels (1995, p. 244) also explains that we can consider the resource flows from different stakeholder groups. The ‘public in general’ consume goods and supply labour – they are therefore critical to survival. Therefore, ‘because of these influences, public opinion is watched closely by the guardians of corporate legitimacy’ (Hybels, 1995, p. 244). A reduction in the consumption of a firm’s products might then be reflective of a change in perceived legitimacy from the perspective of the public (of course, there could also be other contemporaneous events, such as a change in preference for particular products or a change in the prosperity of consumers). The government (or as it is sometimes called ‘the state’) provides crucial resources in terms of legislation, regulation, grants, and so on (which can provide a positive or negative influence on the organisation).

Therefore, perhaps, the introduction of negative legislation which might extract resources from the organisation (negative resource flows) might be reflective of a change in the perception of government officials about the legitimacy of an organisation (and the changes in laws would be reflective of broader community expectations, albeit possibly with some lag). Investors provide financial capital inflows. The media also can be considered as providing a powerful resource in 244

terms of influencing the resource allocation decisions of other members of the community (either positively or negatively). By measuring resource flows from different groups within society we can see whether views are different across different groups and whether legitimacy threats appear particularly apparent.

9.17

Media Agenda Setting Theory proposes a relationship between the relative emphasis given by the media to various topics and the degree of salience these topics have for the general public (Ader, 1995, p. 300). In terms of causality, increased media attention is believed to lead to increased community concern for a particular issue. The news media are not seen as mirroring public priorities; rather, they are seen as shaping them. That is, Media Agenda Setting Theory posits that the news media shapes public awareness, with the news media agenda preceding public concern for particular issues (McCombs & Shaw, 1972). The view taken is that members of the public need the news media to tell them how important an issue within the ‘real world’ is, as, for many issues, individuals do not learn this from available real-world cues. Neuman (1990) identifies a distinction between ‘obtrusive’ and ‘unobtrusive’ issues. He notes, for example, that inflation is seen as a ‘classic example’ of an obtrusive issue because the public would become aware of it every time they went to the supermarket, and they do not need the news media to report the official statistics to realise that this issue affects their lives. Unobtrusive issues, on the other hand, would include foreign events (such as polluting activities undertaken at offshore locations, or workplace practices in remote factories) that cannot be experienced or known by the public without the media functioning as a conduit (Zucker, 1978; Neuman, 1990). It is argued that the media’s agenda-setting effect is most apparent in relation to unobtrusive events.

Media Agenda Setting Theory was initially introduced to the accounting literature

by Brown and Deegan (1998). They used it because they were proposing, in accordance with Legitimacy Theory, that changing patterns in corporate social and environmental disclosures were explained by changes in community concerns. Brown and Deegan did not have a direct measure of community concerns, but rather, utilised Media Agenda Setting Theory. Relying upon Media Agenda Setting Theory, the greater the news media attention directed towards particular social and environmental issues/events, the greater the assumed community concern about these issues/events.

245

Using a joint consideration of Media Agenda Setting Theory and Legitimacy Theory, the arguments provided in Brown and Deegan (1998) can be summarised as: 1.

Management uses the annual report as a tool to legitimise the ongoing operations of the organisation (from Legitimacy Theory).

2.

Community concerns with the environmental performance of a specific firm (or, indeed, any aspect of corporate performance) in an industry will also impact on the disclosure strategies of firms across that industry (consistent with Patten (1992), who adopted Legitimacy Theory). In a simple equation form we can represent this as Corporate Disclosures = fn (Community Concern), where ‘fn’ refers to ‘a positive function’ (or positive relationship).

3.

The media are able to influence community perceptions about issues such as the environment (from Media Agenda Setting Theory). In simple equation form we can represent this as Community Concern = fn (Media Attention).

4.

If management responds to community concerns, and if it is accepted that community concerns are influenced by media attention given to particular social and environmental issues, then we should find a relationship between the extent of disclosure of social and environmental issues within the annual report and the media attention given to those issues. That is, if we substitute the second equation above into the first equation then we will be left with: Corporate Disclosure = fn (Media Attention).

The results in Brown and Deegan (1998) indicate that, for the majority of the industries studied, higher levels of news media attention (as determined by a review of a number of print media newspapers and journals) are significantly associated with higher levels of annual report environmental disclosures.

Therefore, Media Agenda Setting Theory would be of relevance to other accounting researchers who are seeking to explore how particular accounting practices respond to changing community expectations.

9.18

In accordance with Gray, Owen and Adams (1996, p. 45): … a systems-oriented view of the organisation and society … permits us to focus on the role of information and disclosure in the relationship(s) between 246

organisations, the State, individuals and groups.

Systems-oriented theories have also been referred to as ‘open-systems’ theories.

Commenting on the use of open-systems theorising, Suchman (1995, p. 571) states:

Open-system theories have reconceptualised organisational boundaries as porous and problematic … Many dynamics in the organisational environment stem not from technological or material imperatives, but rather, from cultural norms, symbols, beliefs and rituals. Corporate disclosure policies are considered to represent one important means by which management can influence external perceptions about their organisation.

Within a systems-based perspective, the entity is assumed to be influenced by and in turn, to have influence upon, the society in which it operates.

9.19

Stakeholder Theory has both an ethical (moral) or normative branch (which is also considered as prescriptive) and a positive (managerial, or as it is also sometimes called, instrumental) branch. The name ‘Stakeholder Theory’ itself can be a confusing term. Many different researchers have stated that they have used Stakeholder Theory in their research, yet when we look at the research, we see that different theories with different aims and assumptions have been employed – and all have been labelled ‘Stakeholder Theory’. As Hasnas (1998, p. 26) states:

Stakeholder Theory is somewhat of a troublesome label because it is used to refer to both an empirical theory of management and a normative theory of business ethics, often without clearly distinguishing between the two.

More correctly, perhaps, we can think of the term ‘Stakeholder Theory’ as an umbrella term that represents a number of alternative theories that address various issues associated with relationships with stakeholders, including considerations of the rights of stakeholders, the power of stakeholders, or the effective management of stakeholders.

9.20

(a) Advocates of the managerial branch of Stakeholder Theory would tend to suggest that the disclosure of information is one way of managing powerful 247

stakeholders. As Gray, Owen and Adams (2010, p. 26) state:

Here (under this perspective), the stakeholders are identified by the organisation of concern, by reference to the extent to which the organisation believes the group needs to be managed in order to further the interests of the organisation (what Mitchell, Agle & Wood, 1997 call ‘salience’). (The interests of the organisation need not be restricted to conventional profitseeking assumptions.) The more important (salient) the stakeholder is to the organisation, the more effort will be exerted in managing the relationship.

Information – including financial accounting and social accounting information – is a major element that can be employed by the organisation to manage (or manipulate) the stakeholder in order to gain their support and approval, or to distract their opposition and disapproval.

Information can be used to manage particular stakeholders because the company can specifically respond to the information needs of these stakeholders, which would then potentially increase the support they receive from these stakeholders. Also, the organisation might also manipulate information about the organisation so that it tends to match the expectations that these stakeholders have about how the organisation should be performing. (b) Whether we believe that ‘managing stakeholders’ is an appropriate rationale for producing information will be a matter of opinion. If we believe that information should be produced in an unbiased and neutral manner, and/or that information should be produced on the basis that people have a ‘right-toknow’ about various aspects of an organisation’s operations, then we would not consider that it is appropriate to produce information to manage stakeholders. However, if we were adopting a more managerial focus wherein we are attempting to advance the interests of the organisation, then we might consider it more appropriate to produce information for strategic purposes.

9.21

For an organisation to be judged to be ‘legitimate’, Legitimacy Theory would suggest that the organisation needs to appear, to the relevant public, to be complying with community expectations. That is, it is about appearance and 248

perceptions. If aspects of an organisation’s activities are unknown to society, then the society will not react to these unknown activities, and legitimacy – which is effectively a resource conferred by society – will not be influenced. The implication of this is that if managers want to gain or maintain legitimacy then they not only need to do what society expects, but they need to generate reports that document what they are doing. Efforts that are unknown or unnoticed by society will not influence corporate legitimacy. This emphasises the important and strategic aspect of corporate reporting in terms of influencing corporate legitimacy.

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Some researchers simply infer that if an adverse social or environmental event occurs that was caused by, or related to, an entity then this will erode the legitimacy of an organisation. Obviously, such an inference is simplistic. Other researchers have argued that if the news media run a number of negative stories about an organisation, then this will impact the legitimacy of the organisation.

Again, this is rather simplistic. Such approaches are adopted because determining changes in legitimacy is a very subjective exercise. Another approach towards showing that legitimacy has been eroded would be to look at the resource flows coming from different stakeholder groups. If it is shown that the resources being contributed by particular stakeholder groups has declined, then this would be consistent with the view that the legitimacy of the organisation has been eroded.

The assumption here is that if people no longer believe that an organisation is ‘legitimate’ then they will be less likely to transact with that organisation.

Applying this view to the tobacco industry, such an industry would probably have more difficulty than many others in attracting good employees and investment capital, as well as in receiving favourable government or media attention.

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The ethical (sometimes referred to as normative or moral) branch of Stakeholder Theory is concerned with prescribing how management should act with regards to its various stakeholder groups. Stakeholders themselves have been broadly 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.

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The ethical branch of Stakeholder Theory is very much concerned with the responsibilities of an organisation and does not consider that people’s rights should be influenced by issues such as how powerful they are. Typically, researchers in this branch of Stakeholder Theory will argue that all stakeholders should benefit from the existence of an organisation and the rights and interests of one class (for example, shareholders) should not dominate the rights or interests of others. There are certain key rights (for example, safe working conditions) that should never be violated. Accepting the perspective that all stakeholders have certain minimum rights that must not be violated, we can acknowledge that this perspective can be extended to a notion that all stakeholders also have a right to be provided with information about how the organisation is impacting them (perhaps through pollution, community sponsorship, provision of employment, safety initiatives, etc.), even if they choose not to use the information or cannot directly impact the survival of the organisation.

Since the ethical branch of Stakeholder Theory provides prescription about how management should act, the theory cannot be validated or invalidated by empirical investigation. That is, the theory does not set out to predict how managers will behave (which can be empirically tested). Rather, it prescribes how they should behave. As Donaldson and Preston (1995, p. 67) state:

In normative use, the correspondence between the theory and the observed facts of corporate life is not a significant issue, nor is the association between stakeholder management and conventional performance measures a critical test. Instead, a normative theory attempts to interpret the function of, and offer guidance about, the investor-owned corporation on the basis of some underlying moral or philosophical principles.

The managerial branch of Stakeholder Theory, by contrast, suggests or predicts that managers will attempt to manage the relationship with various stakeholders to ensure that the interests or goals of the organisation are best achieved. The more important the stakeholder is to the organisation achieving its goals, the more effort will be spent in managing the relationship. The disclosure of information is considered to represent an important strategy in managing the relationship. Not

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all stakeholder groups will be treated equally and some ‘rights’ might be ignored if they are not important to the organisation’s operations.

The managerial branch of Stakeholder Theory asserts that the power of stakeholders to influence management will be related to the stakeholders’ control over resources needed by the organisation. As Ullman (1985, p. 2) states: … organisations survive to the extent that they are effective. Their effectiveness derives from the management of demands, particularly the demands of interest groups upon which the organisation depends.

The disclosure of information is considered to represent one of the strategies to manage powerful stakeholder groups.

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This quote is important because it emphasises the strategic nature of accounting rather than the important role of accounting in demonstrating corporate accountability. The quote highlights that accounting disclosures can and will be used by managers to manage, or manipulate, particular stakeholders. The targeted stakeholders would generally be those upon whom the organisation is dependent for survival and success. Rather than assuming that corporate disclosures will always be made objectively, the quote reinforces the view that corporate disclosures can be a valuable instrument to be used strategically by managers. As such, the quote alerts us to the potential opportunistic nature of accounting disclosures and it highlights the need to protect the rights to information – perhaps through regulation – of those stakeholders without the necessary power over the organisation, but who might nevertheless be impacted by the operations of an organisation. The results of research – some reported within Chapter 9 – shows that organisations do react to the information demands of powerful stakeholders and do seem to use disclosures to garner their support. Hence, the claim by Gray et al. (2014) appears to be empirically supported.

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There is no precise definition of accountability. One definition is provided by Gray, Owen and Adams’ (1996). They define accountability (1996, p. 38) as:

The duty to provide an account (by no means necessarily a financial account) 251

or reckoning of those actions for which one is held responsible.

According to Gray, Owen and Adams, accountability involves two responsibilities or duties: 1.

the responsibility to undertake certain actions (or to refrain from taking actions); and

2.

the responsibility to provide an account of those actions.

Under their accountability model, reporting is assumed to be responsibility-driven rather than demand-driven. The view being projected is that people in society have a right to be informed about certain facets of the organisation’s operations, and the organisation has a responsibility to provide information.

The view that organisations have a responsibility to provide certain information to affected stakeholders would be consistent with the ethical branch of stakeholder theory as discussed in Chapter 9.

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Under the managerial branch of Stakeholder Theory we would expect the organisation to meet the information demands of particular stakeholder groups if those groups are important to the organisation achieving its goals. As Gray, Owen and Adams (1996, p. 46) state, information (including financial accounting information and information about the organisation’s social performance)

is a major element that can be employed by the organisation to manage (or manipulate) the stakeholder in order to gain their support and approval, or to distract their opposition and disapproval.

If the stakeholder group is not considered to be ‘powerful’ then their information demands might be ignored. Organisations will have an incentive to disclose information about their various programs and initiatives to the respective powerful stakeholder groups to clearly indicate that they are conforming to those stakeholders’ expectations. Organisations must necessarily balance the expectations of the various stakeholder groups. As these expectations and power relativities can change across time, organisations must, it is argued, continually adapt their operating and reporting behaviours.

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The ethical (or normative) branch of Stakeholder Theory provides various prescriptions in terms of how organisations should treat stakeholders (particularly those that are impacted by the organisation), about what information the organisation should provide to stakeholders, and so forth. The prescriptions will rely upon various ethically based philosophies, and the prescriptions could represent significant departures from current corporate operational and reporting practices. Because the prescriptions will likely be different to current practices, it is not relevant to go and test whether these prescriptions are found to be currently practised. The failure to find instances of organisations embracing the prescriptions does not in itself invalidate the prescriptions because the prescriptions reflect what ‘should be’ and not ‘what is’. That is, any correspondence between what the theory prescribes and what is observed is not, of itself, greatly significant.

By contrast, the managerial (or positive) branch of Stakeholder Theory often produces predictions about what managers will do. For example, it might lead to predictions that if powerful stakeholders want certain information, then managers will likely disclose such information. Because it provides predictions, then it is appropriate to empirically test whether these predictions are supported by empirical data.

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Chapter 9 devoted a number of pages to the limitations and gaps within Legitimacy Theory. This information was provided because Legitimacy Theory is a very widely used theory, particularly in the social and environmental accounting literature, but it is a theory that needs further refinement if it is to remain useful and relevant. Too many researchers are using Legitimacy Theory without properly considering some of its inherent limitations. In summary, some of the limitations and gaps that have been identified include:

A lack of detail about how ‘legitimacy’ can be measured Most researchers do not attempt to measure any perceived reduction in legitimacy.

At the present time researchers applying Legitimacy Theory typically assume, or infer, that the particular adverse event caused a reduction in legitimacy and the organisation will thereafter respond strategically with legitimacy-enhancing 253

disclosures. However, this failure to measure legitimacy changes is something that has started to attract criticism from fellow researchers.

Obviously, placing a measurement on ‘legitimacy’, and changes therein, would be a very subjective exercise, influenced by a number of factors not the least of which would be the researchers’ own values and perspectives. Therefore, rather than trying to gauge an organisation’s legitimacy directly, we can perhaps infer its existence through the actions of various parties within society. One way to do this is to consider the flow of resources going to an organisation – something that can be more objectively determined. Most researchers however ignore any possible changes in resource flows around events that supposedly impact corporate legitimacy.

Which disclosures are more effective in the legitimation process?

Another potential limitation of research that applies Legitimacy Theory is that, to date, relatively little insight has been provided into the type of disclosures that are most effective in establishing, maintaining, or repairing legitimacy. That is, more development is necessary. The sorts of issues that are largely unaddressed include: •

What medium of disclosure is most effective – for example are disclosures in annual reports, sustainability reports, websites, social media, advertisements or some other form of disclosure more effective in the legitimation process?

•

Further, do different groups of stakeholders react differently to different types of disclosures, or disclosures provided in different media. To date, most social and environmental accounting researchers review changes in disclosures in annual reports and/or sustainability reports and they typically do not consider how different stakeholders react to the different disclosures. Greater precision would be helpful.

•

Relatedly, which social groups actually confer legitimacy? Further, do different groups have different interests and legitimising power at different points in time. Also, how do we balance different interests at a point in time, particularly if some of the interests or expectations are irreconcilable between groups?

Assumptions that disclosure strategies are driven by self-interest

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In Chapter 8 we discussed Positive Accounting Theory. As we learned, there is a simplifying assumption made within PAT (and many economic theories) that all actions by all individuals are driven by self-interest, and this assumption has drawn criticism from various other researchers. Similar criticisms could be made of Legitimacy Theory in that it assumes that actions – such as corporate reporting – are strategically undertaken for advancement and/or survival purposes (rather than perhaps being responsibility driven). Obviously, this is a rather simplistic assumption. As Oliver (1991) points out, socially responsible organisations may choose to undertake actions beyond self-interest:

For example, corporate social responsibility and the maintenance of sound organizational ethics may not be invariably reducible to strategic behaviours induced by the anticipation of organizational gain. Organizations may act ethically or responsibly not because of any direct link to a positive organizational outcome (e.g., greater prestige or more resources) but merely because it would be unthinkable to do otherwise. In this way, organizational behaviour may be driven not by processes of interest mobilization (DiMaggio, 1988), but by preconscious acceptance of institutionalized values or practices (pp. 148–9).

Further, certain actions may become ‘institutionalised’. That is, managers and organisations themselves will be influenced by their social environments and will naturally embrace certain social norms and values, rather than consciously and instrumentally choosing actions – such as making disclosures – for strategic surviving or advancement purpose (for legitimacy). Oliver (1991, p. 148) argues when external social norms and practices ‘obtain the status of a social fact, organizations may engage in activities that are not so much calculative or selfinterested’. That is, ‘the exercise of strategic choice may be pre-empted’ (Oliver 1991, p. 148) when managers and organisations unconsciously conform to takenfor-granted social norms and practices.

Researchers who apply Legitimacy Theory typically do not consider actions that are aimed at legitimising the broader social system While the research we have discussed in Chapter 9 has mainly looked at how organisations attempt to legitimise their own existence within a particular society, 255

disclosures might also be taken to legitimise particular aspects of the broader social system in place at a particular point in time. Archel et al. (2009) suggest that whilst individual organisations might be making disclosures to create ‘organisational-level legitimacy’, the same organisations as well as governments (the State) might also be making related disclosures to legitimise particular systems that they hope will become institutionalised within the broader society.

Archel et al. (2009) suggest that researchers need to think more broadly about the legitimation strategies undertaken by organisations. Whilst disclosure strategies might be undertaken to inform, educate or even manipulate society in a manner intended to provide legitimacy to the organisation, researchers should also consider whether the disclosures might have a broader impact in terms of efforts to legitimise particular economic, social and political systems that potentially undermine the interests of particular stakeholders (such as employees).

Researchers should also consider complimentary disclosures that might also be made by government as the disclosures made by government could influence the necessity for legitimising disclosures by a corporation.

The process of legitimation is really no different to reputation risk management According to Bebbington et al. (2008), an alternative and more compelling explanation for corporate disclosures (in particular, corporate social responsibility disclosures) is that corporate disclosure can be considered as a key part of an organisation’s reputation risk management (RRM) strategies (Friedman and Miles, 2001; Toms, 2002; Hasseldine et al., 2005), rather than as part of a process of legitimation.

Although there is a depth of reputation risk management literature, some of the explanations given to corporate behaviour are very similar to the explanations provided by Legitimacy Theory even though the two bodies of literature may have developed in a somewhat independent manner. Nobody, including Bebbington et al., have clearly identified the key differences between ‘reputation’ and ‘legitimacy’. Do we think there is a difference?

Whilst Bebbington et al. have been unable to clearly articulate the difference 256

between legitimation and reputation management it does raise issues for researchers in terms of what are the differences, if any. Do any differences matter?

Are the strategies for managing reputation interchangeable with those for managing legitimacy? Also, given that the RRM literature has developed independently of the literature which addresses corporate legitimacy then interested researchers who currently apply legitimacy theory might find it useful to review the RRM literature for any insights that might not otherwise be apparent.

We could list more potential criticisms of, or gaps in, Legitimacy Theory. But the point of this discussion is to show that there will always be competition amongst theories and various researchers will try to advance alternative theories in place of those that might be accepted. Researchers might also advance refinements which improve the usefulness of particular theories. We must remember that no ‘theory’ will ever be perfect.

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The idea of ‘legitimacy’ is central to both Legitimacy Theory and Institutional Theory. Most Legitimacy Theorists restrict their analysis to investigating how individual organisations legitimise themselves within a particular society – commonly known as ‘organisational legitimacy’, and these researchers typically assume, often implicitly, that the business environment, government, social systems, and so forth are static. However, a limited number of Legitimacy Theorists (for example, Archel et al., 2009) consider how legitimation strategies might be undertaken with the aim that certain organisational structures and processes (institutions) gain the acceptance of society – this often being referred to as ‘institutional legitimacy’. Once we consider this ‘macro form’ of legitimation then legitimacy as used within Legitimacy Theory, and institutionalisation as used within Institutional Theory, are very difficult to differentiate.

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A parsimonious explanation is one that provides the simplest, or most straightforward, explanation of a particular phenomenon. In explaining the idea of parsimony, Chapter 1 referred to ‘Occam’s razor’, which prescribes that if multiple theories are available, each of which satisfactorily explains something that is occurring then the theory making the fewer assumptions or having the fewest variables should be the one that is ultimately chosen.

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As Chapter 9 demonstrates, because Legitimacy Theory does not introduce many variables and does not have too many underlying assumptions, it can be deemed to provide parsimonious explanations of various reporting decisions. In large part, the reason that Legitimacy Theory provides a relatively parsimonious (or simple) explanation of reporting behaviour is because the way it has been applied/ developed by researchers has tended to fixate on the strategic aspect of legitimacy.

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If important stakeholders, or society generally, considered that the casino was acting in a way that was unethical and breached stakeholder/ society expectations, then the legitimacy of the casino would be brought into question. Consistent with Legitimacy Theory, and a number of the studies referred to in this chapter, we would expect the casino to use disclosures as a strategy to minimise the damage to reputation (and profitability) that might follow publicity such as this – but only to the extent that the legitimacy of the organisation was perceived by the managers to be threatened in a way that negatively impacted its operations. It would be an interesting exercise for students to review the various reports generated by the casino and see the types of social disclosures they are making. Do the disclosures appear to be of a legitimating character and reactive to such negative publicity?

Applying the managerial perspective of Stakeholder Theory, the managers of the casino might only care about, and react to, the negative publicity to the extent that, as a group, the powerful stakeholders care about such news.

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If we believe, consistent with Legitimacy Theory, that the successful operation of an organisation is dependent upon it maintaining congruence with societal expectations (that is, compliance with the ‘social contract’), then management should be interested in the results of various community-based attitudinal surveys to the extent that they consider the surveys are accurate portrayals of what the community actually thinks.

Throughout the world, companies started providing environmental information in such places as the annual report around the time of the early 1990s. This time period seemed to also tie in with the period in which environmental concerns seemed to become a broader issue of concern for the international community. It was also a time when membership of community-based environmental groups 258

started to increase (Deegan & Gordon, 1996). In more recent years, community concern has seemed to have increased in relation to issues associated with large multinational companies using suppliers in third-world countries – whose employees are paid unacceptable wages and are provided with unacceptable working conditions (unacceptable often from a ‘Western’ viewpoint). Many companies are now providing information about how they ensure that poor conditions do not exist in relation to the manufacture of their products – a possible response to community concerns.

The emphasis here is that evidence suggests corporate disclosure policies seem to change as community expectations change. Hence, if a reputable survey indicates a change in community expectations, then this in turn will have implications for how the organisation operates and the information it elects to disclose.

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If the response was in accordance with Legitimacy Theory, then one of the initial considerations might be whether the managers of the organisation think that the legitimacy of the respective organisation has been threatened as a result of the newspaper coverage. If the managers were of the opinion that legitimacy was not threatened – perhaps because they believed that society fixated more on price and quality rather than the health and safety of workers – then perhaps no legitimising strategies would be adopted. However, if legitimacy is deemed to have been impaired then the organisations might be encouraged to pursue various strategies to repair the damaged legitimacy. An important component of the legitimation strategies will be the public disclosure of information.

Some of the general strategies that the company could pursue in pursuit of addressing organisational legitimacy when it is threatened were summarised by Dowling and Pfeffer (1975) and Lindblom (1993). For example, as the chapter explains, Lindblom identified four courses of action (there is some overlap with Dowling and Pfeffer) that an organisation can take, particularly when it needs to defend or repair legitimacy.

Of course, not all actions by a company can be perfectly explained by any theory.

As such, organisations could undertake activities to ensure poor treatment of workers does not occur throughout its supply chains, regardless of whether the 259

newspaper coverage affected corporate legitimacy.

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Applying the managerial branch of Stakeholder Theory, we could argue that the high-profile radio announcer has the power to influence the survival and success of the organisation. As such, we would expect the managers of the organisation to react. If we were to apply Legitimacy Theory, then given the profile of the announcer, and given the power of the news media to influence community expectations (as explained through Media Agenda Setting Theory), we would also expect the organisation to react.

The nature of the reaction could take several forms. For example, disclosures might be made: to challenge the claims being made by radio announcer; to divert attention to other more favourable aspects of the organisation’s activities; or to accept the criticisms made by the announcer and to show how the organisation has changed its activities in response to the criticisms.

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The term ‘isomorphism’ is used extensively within Institutional Theory.

DiMaggio and Powell (1983, p. 149) have defined it as ‘a constraining process that forces one unit in a population to resemble other units that face the same set of environmental conditions’. That is, organisations that adopt structures or processes (such as reporting processes) that are at variance with other organisations might find that the differences attract criticism. Carpenter and Feroz (2001, p. 566) further state:

DiMaggio and Powell (1983) label the process by which organizations tend to adopt the same structures and practices as isomorphism, which they describe as a homogenization of organizations. Isomorphism is a process that causes one unit in a population to resemble other units in the population that face the same set of environmental conditions. Because of isomorphic processes, organizations will become increasingly homogeneous within given domains and conform to expectations of the wider institutional environment.

Dillard, Rigsby and Goodman (2004, p. 509) explain that ‘Isomorphism refers to the adaptation of an institutional practice by an organization’. As voluntary corporate reporting by an organisation is an institutional practice of that reporting 260

organisation, the processes by which voluntary corporate reporting adapts and changes in that organisation are isomorphic processes.

Decoupling – another key dimension of Institutional Theory – implies that while managers might perceive a need for their organisation to be seen to be adopting certain institutional practices, and might even institute formal processes aimed at implementing these practices, actual organisational practices can be very different from these formally sanctioned and publicly pronounced processes and practices.

As Laine (2009, p. 1031) states:

Factual organisational activities may become decoupled from the accounts given outside (Carruthers, 1995; Meyer & Rowan, 1977), leading to window dressing (Mouritsen & Skaerbaek, 1995). The external appearance may be rationalised and used to help the organisation meet the social expectations and to ‘confer legitimacy upon the organisation’ (Carruthers, 1995, p. 315; also Meyer & Rowan, 1977), even though the underlying factual organisational reality may remain unchanged.

The actual practices can be decoupled from the institutionalised (apparent) practices. According to Dillard, Rigsby and Goodman (2004, p. 510):

Decoupling refers to the situation in which the formal organizational structure or practice is separate and distinct from actual organizational practice. In other words, the practice is not integrated into the organization’s managerial and operational processes [it is decoupled]. Formal structure has much more to do with the presentation of an organizational self than with the actual operations of the organization.

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Decoupling might occur because managers believe there are benefits in being seen to apparently apply particular processes, practices or organisational forms (being seen in a certain way might bring legitimacy to the organisation). However, managers might think that despite how society thinks an organisation should be organised, or should be run, there will be benefits to the organisation if it is organised in a way that is not in accordance with societal/institutionalised expectations. As such, there might be benefits in appearing to be organised in a 261

particular way, whilst at the same time actually operating in a way that is unknown or unseen by society. As Dillard, Rigsby and Goodman (2004, p. 510) state:

Decoupling refers to the situation in which the formal organizational structure or practice is separate and distinct from actual organizational practice. In other words, the practice is not integrated into the organization’s managerial and operational processes (it is decoupled). Formal structure has much more to do with the presentation of an organizational self than with the actual operations of the organization (Carruthers, 1995). Ideally, organizations pursue economic efficiency and attempt to develop alignment between organizational hierarchies and activities.

However, an organization in

a highly

institutionalized environment may face conflicts and inconsistencies between the demands for efficiency and the need to conform to ‘ceremonial rules and myths’ of the institutional context (Meyer & Rowan, 1977). In essence, institutionalized, rationalized elements are incorporated into the organization’s formal management systems because they maintain appearances and thus confer legitimacy whether or not they directly facilitate economic efficiency.

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These concepts come from Institutional Theory and they represent key components of Institutional Theory.

DiMaggio and Powell (1983, p. 149) have defined isomorphism as ‘a constraining process that forces one unit in a population to resemble other units that face the same set of environmental conditions’. That is, organisations who adopt structures or processes (such as reporting processes) that are at variance with other organisations might find that the differences attract criticism. As voluntary corporate reporting by an organisation is an institutional practice of that reporting organisation, the processes by which voluntary corporate reporting adapts and changes in that organisation are isomorphic processes.

Coercive isomorphism arises where organisations change their institutional practices because of pressure from those stakeholders upon whom the organisation is dependent. For example, the company might be coerced into adapting its existing voluntary corporate reporting practices (including the issues upon which they report) to bring these into line with the expectations and demands of its 262

powerful stakeholders (while possibly ignoring the expectations of less powerful stakeholders). Since these powerful stakeholders might have similar expectations of other organisations as well, there will tend to be conformity in the practices being adopted by different organisations – institutional practices will tend towards some form of uniformity.

Mimetic isomorphism involves organisations seeking to emulate (perhaps copy) or improve upon the institutional practices of other organisations, often for reasons of competitive advantage in terms of legitimacy. According to DiMaggio and Powell, when an organisation encounters uncertainty then it might elect to model itself on other organisations. This argument links pressures for mimetic isomorphism with pressures underlying coercive isomorphism, as Unerman and Bennett (2004) maintain that without coercive pressure from stakeholders, in this case it is unlikely there would be pressure to mimic or surpass the social reporting practices (institutional practices) of other companies.

Normative isomorphism relates to the pressures arising from group norms to adopt particular institutional practices. In the case of corporate reporting, the professional expectation that accountants will comply with accounting standards acts as a form of normative isomorphism for the organisations for whom accountants work to produce accounting reports (an institutional practice), which are shaped by accounting standards. In terms of voluntary reporting practices, normative isomorphic pressures could arise through less formal group influences from a range of both formal and informal groups to which managers belong – such as the culture and working practices developed within their workplace. These could produce collective managerial views in favour of or against certain types of reporting practices (such as collective managerial views on the desirability or necessity of providing a range of stakeholders with social and environmental information through the medium of corporate reports).

Having described the three forms of isomorphic processes (coercive, mimetic and normative), it should be noted that such processes do not necessarily make the organisations more efficient. While three types of isomorphism have been described above, in practice, it will not necessarily be easy to differentiate between the three.

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Whilst some formal structures and practices might be considered by society as legitimate, and might therefore become institutionalised, this does not necessarily mean they are the most efficient choice in terms of technical efficiency.

Organisations conform to institutionalised approaches (also referred to as ‘myths’ within the literature) by building gaps or ‘buffers’ between the formal structures which people see (the ‘myths’ that maintain legitimacy) and the actual work processes that create internal functional and technical efficiency (Meyer & Rowan, 1977). As Carpenter and Feroz (2001, p. 569) state:

Institutional theory assumes that organizations adopt structures and management practices that are considered legitimate by other organizations in their fields, regardless of their actual usefulness. Legitimated structures or practices can be transmitted to organizations in a field, through tradition (organization imprinting at founding), through imitation, by coercion, and through normative pressures … Institutional theory is based on the premise that organizations respond to pressure from their institutional environments and adopt structures and/or procedures that are socially accepted as being the appropriate organizational choice … Institutional techniques are not based on efficiency but are used to establish an organization as appropriate, rational, and modern … By designing a formal structure that adheres to the prescription of myths in the institutional environment, an organization demonstrates that it is acting in a proper and adequate manner. Meyer and Rowan (1977) maintain that myths of generally accepted procedures – such as generally accepted accounting procedures (GAAP) – provide a defence against the perception of irrationality and enhanced continued moral and/or financial support from external resource providers.

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The evidence provided in the regular surveys of Sustainability Reporting produced

by KPMG indicates that large companies throughout the world are increasingly deciding to produce reports documenting their social and environmental performance and they are tending to give similar labels or names to the reports.

Such findings can be explained through the insights (or ‘lens’) provided by Institutional Theory.

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Arguably, the increasing trend to report is driven by changes in the institutional environments in which organisations operate. Increasingly, community members will be expecting organisations to embrace greater responsibility and accountability in respect of sustainability-related issues (which we might link to cognitive legitimacy), and increasingly we are finding that professional associations and educational institutions are addressing various sustainabilityrelated issues (which we might link to moral legitimacy as well as to the process of normative isomorphism which relates to the pressures arising from group norms to adopt particular institutional practices). Further, as the numbers of organisations producing sustainability reports increases, the practice can tend to become somewhat institutionalised with stakeholders potentially questioning the legitimacy of those organisations that depart from the increasingly accepted practice.

In the case of the companies preparing ‘sustainability’ reports there might have been global pressures exerted by, for example, particular banks, institutional investors, or other parties upon which the large organisations were dependent.

This could be linked to coercive isomorphism.

Linked to some of the above argument, it might also have been the case that when ‘industry leaders’ started producing sustainability reports, other large organisations decided to emulate their practice. ‘New’ producers of sustainability reports might look at, or copy, the practices of industry leaders because of a perception that industry leaders may have adopted a reporting approach that represents best practice. This could be referred to as a process of mimetic isomorphism.

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Arguably it would be incorrect to consider the three theories as being mutually exclusive. Rather, there are many overlaps between the three theories – which are all considered to be ‘systems-oriented theories’ (also known as ‘open systems theories’) – such that a joint consideration of the three theories might provide a richer insight into particular corporate activities. All three theories can be linked back to political economy theory.

In considering the overlaps between Legitimacy Theory and Stakeholder Theory 265

as they pertain to social disclosure practices, Gray, Kouhy and Lavers (1995, p. 67) state:

The different theoretical perspectives need not be seen as competitors for explanation but as sources of interpretation of different factors at different levels of resolution. In this sense, legitimacy theory and stakeholder theory enrich, rather than compete for, our understandings of corporate social disclosure practices.

Institutional Theory provides an explanation of how mechanisms, through which organisations may seek to align perceptions of their practices and characteristics with social and cultural values (in order to gain or retain legitimacy), become institutionalised in particular organisations. Such mechanisms could include those proposed by both Stakeholder Theory and/or Legitimacy Theory, but could conceivably also encompass a broader range of legitimating mechanisms.

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The definition of stakeholders provided by Volkswagen is consistent with the definition provided within the ethical branch of Stakeholder Theory. The ethical branch of Stakeholder Theory considers stakeholders that are able to influence the activities of the organisation as well as those that are affected by the operations of the organisation. By contrast, the managerial branch of Stakeholder Theory would focus on the needs and expectations of powerful stakeholders who have the ability to affect the organisation.

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The ‘social licence to operate’, or ‘community licence to operate’ is terminology that is increasingly being used by corporate management. Its use as part of ‘corporate language’ signals that managers understand that for survival purposes it is essential that corporate strategies react to community expectations. The ‘social licence to operate’ is effectively the same as what we might refer to as a ‘social contract’. The ‘social contract’ is not easy to define, but the concept is used to represent the multitude of implicit and explicit expectations that society has about how the organisation should conduct its operations.

Shocker and Sethi (1974, p. 67) provide a good overview of the concept of a social contract: 266

Any social institution – and business is no exception – operates in society via a social contract, expressed or implied, whereby its survival and growth are based on: 1.

the delivery of some socially desirable ends to society in general, and

2.

the distribution of economic, social, or political benefits to groups from which it derives its power.

In a dynamic society, neither the sources of institutional power nor the need for its services are permanent. Therefore, an institution must constantly meet the twin tests of legitimacy and relevance by demonstrating that society requires its services and that the groups benefiting from its rewards have society’s approval.

It is emphasised that the social contract is a theoretical construct, and hence an individual cannot simply go and find a copy of the social contract ‘negotiated’ between an organisation and the society in which it operates. Different managers will have different perceptions about how society expects the organisation to behave across the various attributes of its activities (that is, they will have different perspectives of the contract) – and this in itself can explain, at least in part, why some managers will elect to do things differently from other managers.

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From an Institutional Theory perspective we would expect that students who have been widely exposed to sustainability-related issues will later accept a responsibility and related accountability for sustainability-related matters relative to students without such exposure.

As the chapter has explained, we can envisage the operations of organisations to be influenced by different ‘institutional pillars’ which we might consider to be the regulative pillar, the normative pillar, and the cultural cognitive pillar, each of which brings its own form of legitimacy. Of direct relevance to this question is the normative pillar, which links to ‘moral legitimacy’, and which incorporates values and norms reflecting certain social obligations or expectations – that is, certain processes or structures become socially accepted as the ‘right or moral ways’ to do things. Expectations about the ‘right or proper’ ways to do things will in turn be influenced by various processes, including educational experiences. In 267

a sense, compliance with this pillar is based upon an ‘ought to’ mentality.

Therefore, those students who have had sustainability-related issues incorporated throughout their education are arguably more likely to embrace sustainabilityrelated concerns in their subsequent workplace relative to students without such exposure.

9.44

(a) This chapter has provided insights from Legitimacy Theory, Stakeholder Theory and Institutional Theory – all of which have relevance to answering this question. From a Legitimacy Theory perspective, we can expect that instances of animal cruelty will be viewed differently in different countries and the impacts upon organisational legitimacy following an association with animal cruelty would be different. From a Stakeholder Theory perspective (the managerial branch) we would expect powerful stakeholders in different countries to have different views about animal cruelty. From an Institutional Theory perspective, we would expect differences in regulatory requirements, as well as differences in normative and cultural-cognitive beliefs, all of which will flow through to expectations about animal cruelty.

Therefore, we would expect that community and stakeholder perceptions about animal cruelty will be different in different countries and this will influence the responsibilities and accountabilities of organisations. It will also influence the governance policies in place. Therefore, we would not necessarily expect the governance practices associated with animal welfare to be the same in different countries. However, as organisations become larger and more global in their orientation, we would expect similarities to exist across organisations. That is, their institutional structures would tend – perhaps through various isomorphic process – towards some form of homogeneity.

(b) Applying the theoretical insights from this chapter, whether the Indonesian factories will change their practices will be dependent upon the pressures that are placed upon the factories. For example, if powerful stakeholders (such as the large multinational companies that use their materials) demand changes then the factories might have no realistic option other than to change. But they would need to report information to clearly show how they have changed.

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(c) We will probably expect these large organisations to respond, particularly if they believe that the report released by PETA has the potential to impact the legitimacy of their respective organisation. What often happens in such situations is that an organisation that is linked to such shocking news will publicly note that it was not previously aware of the production processes and that it will now implement immediate independent expert reviews/ audits of factories’ practices which it will then make publicly available on its website.

It would likely be the case that such treatment of animals, as was reported by PETA, would not be reflective of the expectations held by many of the large organisations’ consumers.

(d) If we accept that NGOs such as PETA can influence community expectations which in turn can influence the success of particular organisations, then it would be likely that such organisations would monitor the activities of the NGOs and would regularly review the reports being released by the NGOs. NGOs, as surrogates for various stakeholders (who often have little power or ‘voice’), play a vital role in society particularly where there is lack of effective regulation with respect to various aspects of social and environmental performance. Many shifts in organisational practices would not have occurred in the absence of NGO-related initiatives.

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Chapter 10: Extending corporate accountability: the practice of social and environmental reporting Solutions 10.1

This is an interesting question and one that has certainly raised much debate in the past. To answer it we need to first consider how we would define accounting. If our definition of accounting is restricted to providing information about the financial performance of an entity to individuals that primarily have a financial interest in the organisation then we might argue that the environment has limited relevance to accounting other than if particular cash flows relate to the use or abuse of the environment (for example, fines for misuse, purchase or sale of pollution permits, recognition of contingent liabilities in relation to clean-ups of contaminated sites, and so on). However, once we accept that organisations are accountable for not only their economic, but also their social and environmental performance then the role of accounting in fulfilling this accountability becomes relevant. In this sense we are directly relating the practice of accounting with the notion of accountability. In doing so we can rely on the perspective of accountability provided by Gray, Owen and Adams (1996, p. 38), this being the duty to provide an account (by no means necessarily a financial account) or reckoning of those actions for which one is held responsible.

Hence, adopting this broader perspective which links accounting with accountability we can argue that if stakeholders expect an organisation to take certain actions (or perhaps, to refrain from taking particular actions) then that organisation has a responsibility to provide information (an account) to enable others to determine whether the expectations have been met. Therefore, if we accept that many people within society expect an organisation to be accountable for its environmental performance (and to act responsibly) then the role of the accounting system should become apparent. Accounting does not have to be confined to the provision of financial accounting alone, and the audience should not be narrowly defined as just including shareholders.

10.2 (a) We can refer to the definition of accountability provided by Gray, Owen and Adams (1996, p. 38), this being: 270

The duty to provide an account (by no means necessarily a financial account) or reckoning of those actions for which one is held responsible.

According to Gray, Owen and Adams, accountability involves two responsibilities or duties, these being: 1. the responsibility to undertake certain actions (or to refrain from taking actions); and 2. the responsibility to provide an account of those actions.

In relating accountability to accounting we need to consider what we actually mean by ‘accounting’. There is no iron-clad definition of accounting but perhaps we can describe accounting as the process of providing information to various stakeholders to allow those stakeholders to assess various aspects of the entity’s performance and position for the purposes of making various decisions about the entity (inclusive of whether they will support the entity through providing labour, investment capital, consuming the entity’s products, and so on). Traditionally, accounting has been considered to be a process of providing information about financial performance and position to parties that have a direct financial interest in the organisation – but this is an extremely restricted perspective of accounting. (As an example of this myopic perspective, for a number of years in the early to mid-1990s the author of your textbook was often asked ‘what has the environment got to do with accounting?’ Thankfully, many more people can now understand the relationship). In a sense, accounting provides the mechanism through which accountability can be performed or exercised. Since different managers will have different perspectives about what is expected of them from their various stakeholders, different entities will develop different accounting systems (for example, some organisations develop systems that can generate social and environmental performance reports, while others do not).

(b) In considering the relationship between accountability and organisational responsibilities, we can say that the two are directly linked. An organisation has a responsibility to provide an account of its activities (it is accountable) to enable others to determine whether the entity has been acting in the manner in 271

which it is expected to act. Gray, Owen and Adams (1996) developed an ‘accountability model’ to explain the relationship. They consider that accounting and the act of reporting is responsibility driven, rather than demand driven. The view is that people have a right to be informed about certain facets of an organisation’s operations. By considering rights, it is argued that the model avoids the problem of considering users’ needs and how such needs are established. The role of corporate reporting under this perspective is to inform society about the extent to which actions for which an organisation is considered responsible have been fulfilled.

10.3

This is obviously a matter of opinion. Whatever our opinion about whether accounting students should be required to study various aspects of ‘accountability’, the reality is that many students of accounting complete their accounting qualifications without ever considering issues associated with the accountability of business. But the practice of accounting, which, at a fairly simplistic level, can be defined as the provision of information about the performance of an entity to a particular stakeholder group, cannot be divorced from a consideration of the extent of an entity’s responsibility and accountability.

That is, an organisation will provide an account of those things for which it is deemed to be accountable. One cannot be considered without the other. Therefore, we should be left wondering how a study of accounting can be undertaken without a detailed consideration of the concept of corporate accountabilities.

10.4

The term ‘sustainable development’ is used in many different ways by different organisations. For example, some managers discuss how they seek to be sustainable at the same time that they pursue increasing profits. Many people would argue that pushes for increased profits do not sit well with visions of maintaining a sound environment – also raising issues such as how much profit is enough.

From a theoretical perspective a sustainable organisation is one that leaves the environment no worse than it was at the beginning of the period and considers the interests of the communities in which it operates such that it does not advantage some people at the expense of others. Sustainability also necessitates

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consideration of future generations such that the current activities of the organisation should not adversely impact people of the future.

The most widely used definition of sustainable development is the definition provided in the Brundtland Report, this being development that meets the needs of the present world without compromising the ability of future generations to meet their own needs.

The notion of sustainable development, and the view that we must consider future generations, necessarily requires us to give some consideration to reducing our current (unsustainable) consumption patterns. Wealth creation should not be the all-consuming motivation of modern business if sustainability is a ‘real’ goal.

Sustainable development necessarily requires reduced reliance on performance indicators, such as profitability. This requires thinking other than in self-interest.

As we have seen throughout the text, central to many economic theories is the assumption that individual action is driven by consideration of oneself, rather than consideration of others. If we are to believe that self-interest drives all actions (as the positive accounting theorists assume) then we would be resigned to a view that sustainable development is nothing other than a fanciful dream.

10.5

Arguably, conventional financial accounting practices discourage us from embracing sustainable business practices. There are a number of reasons for this, including the following:

The objective of general purpose financial reporting, as noted in the IASB Conceptual Framework for Financial Reporting, is to provide information to present and potential investors, lenders and other creditors to assist them in their resource allocation decisions. Other stakeholders who are making decisions unrelated to the allocation of resources are not directly considered.

The accountants’ notion of materiality also tends to preclude the reporting of social and environmental information.

As highlighted in Gray, Owen and Adams (1996), another issue that arises in financial accounting is that reporting entities frequently discount liabilities, 273

particularly those that will not be settled for many years, to their present value.

This tends to make future expenditure less significant in the present period. This has particular relevance to future ‘clean-up costs’ and remediation costs.

Discounting liabilities can tend to make them immaterial in the current period and therefore not presented in the balance sheet – that is, discounting can effectively make the liabilities ‘disappear’.

Financial accounting adopts the ‘entity assumption’, which requires the organisation to be treated as an entity distinct from its owners, other organisations and other stakeholders. If a transaction or event does not directly impact upon the entity, the transaction or event is to be ignored for accounting purposes. This means that the externalities caused by reporting entities will typically be ignored, thereby meaning that performance measures (such as profitability) are incomplete from a broader societal (as opposed to a ‘discrete entity’) perspective.

In financial accounting and reporting, expenses are defined in such a way as to exclude the recognition of any impacts on resources that are not controlled by the entity (such as the environment), unless fines or other cash flows result. For example, under the International Accounting Standards Board’s conceptual framework (as discussed in chapter 6), expenses for financial reporting purposes are defined as:

decreases in assets, or increases in liabilities, that result in decreases in equity, other than those relating to distributions to holders of equity claims.

An understanding of expenses therefore requires an understanding of assets. An asset is defined as:

a present economic resource controlled by the entity as a result of past events.

The recognition of assets therefore relies upon control, and hence environmental resources such as air and water, which are shared and therefore not controlled by the

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organisation, cannot be considered as ‘assets’ of that organisation. Thus, their use, or abuse, is not considered as an expense.

There is also the issue of ‘measurability’. For an item to be recorded for financial accounting purposes it must be measurable with reasonable accuracy. Trying to place a value on the externalities caused by an entity often relies on various estimates and ‘guesstimates’, thereby typically precluding their recognition from the financial accounts on the basis of the potential inaccuracy of the measurement.

General purpose financial reporting also requires us to break the life of the organisation (which could be deemed to be indefinite) into smaller periods, such as yearly (or quarterly, or half-yearly) periods. We are then required to calculate the profit for each period. Focusing on yearly periods can act to discourage the managers of the organisation from taking a longer-term perspective (particularly, perhaps, if they are paid bonuses that are linked to annual profits). By contrast, a consideration of sustainability would require us to take a longer-term focus.

Taken together, the above limitations of financial accounting do tend to indicate that financial accounting practices do not provide an ‘ideal’ vehicle to encourage corporations to embrace sustainable business practices.

10.6

Understanding what has motivated a company to produce a sustainability report is not a straightforward exercise. Given that it is a generally a voluntary activity, a number of factors might be motivating the disclosure. Different researchers will have differing views about why companies adopt particular operating and reporting strategies. For example:

1.

Chapter 9 considered Legitimacy Theory and the associated notion of a ‘social contract’. Adopting this perspective, we could argue that an entity would undertake certain social activities (and provide an account thereof) if management perceived that the particular activities were expected by the communities in which it operates. Failure to undertake those activities that are expected by society may, according to Legitimacy Theory, result in the entity no longer being considered legitimate (it is perceived as breaching its 275

social contract) and this in turn will impact on the support it receives from the community, and hence its survival Success is contingent upon complying with the social contract.

2.

Chapter 9 also considered Stakeholder Theory. One version of Stakeholder Theory (the managerial/positive version and not the ethical/normative version) predicts that management is more likely to focus on meeting the expectations of powerful stakeholders. Powerful stakeholders are those who control resources that are both scarce and essential to the achievement of the organisation’s (or its managers’) objectives. For most businesses, powerful stakeholders will be those who have the greatest potential to influence the firm’s ability to generate maximum financial returns (or profits) – in other words, those stakeholders with the most economic power and influence over the firm. Under this managerial stakeholder perspective, management would be expected to embrace those economic, social and environmental activities expected by the powerful stakeholders, and to provide an account of those activities to these stakeholders. If powerful stakeholders expect a company to produce a sustainability report, then this could motivate the company to do so. Chapter 9 also described the ethical branch of Stakeholder Theory. This branch adopts a normative position and prescribes that an organisation should consider the rights of all parties affected by the operation of the entity regardless of the power they can exercise. Hence, the answer to the ‘why produce a sustainability report’ question is directly a function of whether management embraces ethical or managerial reasoning (or somewhere on the continuum between these two extremes).

3.

Chapter 9 further considered the accountability model developed by Gray, Owen and Adams (1996). Under this normative model, which has much in common with the ethical branch of Stakeholder Theory, organisations have many responsibilities (at a minimum, as required by law but expanded by society’s expectations that have not also been codified within the law), and with every organisational responsibility comes a set of rights for stakeholders, including rights to information from the organisation to demonstrate its accountability in relation to the stakeholders’ expectations. Hence, applying this model, managers might produce a sustainability report because they 276

believe they have an ‘accountability’ to do so.

4.

Institutional Theory was also considered in Chapter 9. This perspective assumes that the managers of an organisation will develop or adopt new practices (such as sustainability reporting) because of a variety of institutional pressures, such as other organisations developing new practices in these areas and managers being concerned that, if they do not emulate these organisations, they will risk disapproval from some of their economically powerful stakeholders.

5.

Chapter 8 considered Positive Accounting Theory, which predicts that all people are driven by self-interest. As such, this theory predicts that particular social and environmental activities, and their related disclosure, would occur only if they had positive wealth implications for the management involved.

Hence, there could be various motivations for managers to decide to disclose information – inclusive of information about social and environmental performance. The various theoretical perspectives on the broad reasons why organisations might engage in voluntary social and environmental reporting practices are not mutually exclusive. Furthermore, as emphasised throughout this book, the acceptance of particular theories to explain particular actions (such as the decision to produce a sustainability report) is, at least in part, tied to one’s own value system.

10.7

Economic rationality as defined by economists and many accounting researchers is generally accepted as meaning to undertake activities that maximise one’s own wealth. It is very much related to self-interest and takes the attitude that one cannot ever have too much wealth.

As should be clear, economic rationality (as briefly defined above) and sustainability are mutually inconsistent. Consideration of one’s own self-interest and the pursuit of continually increasing profits or wealth (which in turn are associated with more and more consumption) cannot be sustained indefinitely. It is generally accepted that what might be described as economically rational

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behaviour is totally irrational when it comes to trying to solve the ongoing environmental and social problems of the planet.

10.8

The Brundtland Report defined sustainable development as ‘development that meets the needs of the present world without compromising the ability of future generations to meet their own needs’. Any move towards sustainable development, as defined in the Brundtland Report, therefore requires that something other than short-term selfinterest should drive decision making. It implies that wealth creation for current generations should not be held as the all-consuming pursuit, and that consumption and personal wealth creation by us (now), while perhaps being considered as economically ‘rational’ (using the definition often applied in the economics literature), is not necessarily rational from a global and intergenerational perspective.

Hence, the quest towards sustainable development ultimately relies upon people not being driven solely by their own self-interest and not putting wealth creation above all else. If we believed the assumptions embraced by positive accounting theorists, as described in Chapter 8, that all action is driven by self-interest then there would be little hope that people will ever consider the needs of future generations (perhaps we need to hope that the assumptions of PAT are not always right). The advocates of PAT would only believe that the managers of organisations would embrace sustainable development if it was in the direct interests of the managers to do so (often referred to as ‘enlightened self-interest’).

10.9

Externalities can be defined as impacts that an entity has on parties (not necessarily restricted to humans) external to the organisation, parties which typically have no direct relationship with the organisation. Financial accounting practices can tend to ignore externalities because of the way the elements of financial accounting are defined and because accounting adopts an entity assumption.

In relation to the entity assumption adopted within financial accounting, this assumption requires the organisation to be treated as an entity distinct from its owners, other organisations and other stakeholders. The implication is, if a transaction or event does not directly impact on an entity, the transaction or event is to be ignored for accounting purposes. This means that the externalities caused

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by reporting entities will typically be ignored, thereby meaning that performance measures are incomplete from a broader societal perspective.

In relation to the definition of the elements of financial accounting, the definitions of assets and expenses as provided in the IASB Conceptual Framework rely on the concept of control. In the IASB Conceptual Framework an asset is a ‘a present economic resource controlled by the entity as a result of past events’.

If something is not controlled, such as the waterways, the air, the local national parks, then it is not considered to be an asset. As such, any reduction in the quality of the ‘public’ resource will not be considered an expense of an entity (unless there are some associated cash flows, for example, environmental fines). Also, local communities are not ‘assets’ of an entity from a financial accounting perspective and hence any health problems caused to them by the entity’s operations will typically be ignored (unless, again, some legal action has been instigated). Such externalities caused by the reporting entity will be ignored.

As indicated in Deegan (1996), and using a rather extreme example, under traditional financial accounting if an entity was to destroy the quality of water in its local environment, thereby killing all local sea creatures and coastal vegetation then to the extent that no fines or other related cash flows were incurred, reported profits would not be directly impacted. No externalities would be recognised, and the reported assets/profits of the organisation would not be affected.

10.10 Stakeholder engagement obviously relates to ‘engaging’ stakeholders and involves discovering what really matters to the key stakeholders, providing them with feedback on corporate strategies and performance, and identifying what and how things can be changed. This also includes monitoring and managing stakeholder contributions and satisfaction levels.

One way of engaging stakeholders is through undertaking periodic social audits.

A policy of undertaking periodic social audits should arguably be included within an organisation’s corporate governance policies. Companies often do not understand their stakeholders well and, as a result, many do not even try to encourage their participation in shaping the future of the company. The long-term 279

success of an organisation requires knowing, anticipating and responding to stakeholder expectations and changes therein.

10.11 Different students will come up with different answers to this question depending upon the organisation they have identified, and on the externalities they have focused upon. (a) One negative externality identified might be the organisation’s contribution to climate change, and the stakeholders affected would include current and future generations, as well as various animals and plant-life that might be negatively influenced by rising land and sea temperatures, and rising sea levels. A positive externality might include positive social benefits generated by the organisation’s products. For example, if the organisation provided leisure- or health-related products then this might contribute to the level of physical and mental health in the community which in turn will reduce health costs being incurred within society.

(b) Generally speaking, positive and negative externalities would not directly impact the organisation’s income and expenses, and therefore profits. This is because of financial accounting conventions such as the entity principle and because of the way we define the elements of financial accounting. As an example, if we emit greenhouse gases, and we are not taxed or fined for such emissions, then we will not record any expenses despite the potential contribution to climate change. In large part this will be because we do not recognise the atmosphere as an ‘asset’ of the organisation.

(c) This will be a matter of opinion. As indicated in Chapter 10, there is a view that measures of performance, such as accounting profits, provide a very restricted measure of performance. Effectively, an understanding of the measure ‘profit’ – and its limitations as a measure of performance – is only possible if we really understand the contents of the various financial reporting standards, and importantly, the aspects of ‘performance’ that are ignored by generally accepted accounting practices. To achieve a more comprehensive understanding of organisational performance, interested stakeholders should not only consider the financial statements of the organisation but also other 280

available information, such as that included within CSR or sustainability reports.

10.12 As Chapter 10 indicates, there are various potential reasons as to why management might decide to provide particular reports. Furthermore, different theories will provide different potential motivations. For example, there might be a belief, consistent with the managerial branch of Stakeholder Theory, that reporting is undertaken to satisfy the demands of, and gain the support of, powerful stakeholders. Alternatively, there might be a belief that reporting might be undertaken to regain lost legitimacy (from Legitimacy Theory), or because management believes they have a responsibility to provide information to affected stakeholders (from the ethical branch of Stakeholder Theory).

Once it has been established ‘why’ the company is reporting, then the target of the reports can be determined – that is, a decision about ‘to whom’ to report can be made. For example, if the decision to report is made so as to generate business benefits, then the reporting expectations of powerful stakeholders will then be determined and the reports will be tailored to satisfy the powerful stakeholders’ expectation. However, by contrast, if the reports are being produced to inform those stakeholders who are most affected by the operations of the entity, then the organisation will need to consider who is most likely affected by the operation of the entity (regardless of their power), and then provide the affected stakeholders with information about the organisation’s operations.

As we can see, we need to firstly determine ‘why’ we are reporting before we can determine ‘to whom’ we are reporting.

10.13 (a)

This is a normative question that is based on personal opinion and therefore there will be a range of opinions. It will be interesting to see the range of answers that students come up with and how they might range from views that are quite managerial in reasoning, to views that tend to be more ethical or normative in nature. Students that tend to take a broader perspective of corporate responsibilities, and who accept sustainability as a key corporate goal, will tend to include future generations as being an important consideration when making corporate decisions.

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(b)

Again, there will be differences in answers given to this question. Some students will believe that managers are more likely to focus on maximising financial performance for the benefits of financial stakeholders, whereas other students will believe that management will consider various social and environmental responsibilities when making operating decisions. In reality, we might expect that managers will be motivated by a mixture of both managerial (wealth-enhancing) as well as ethical objectives.

In terms of why management might operate in one way or the other we often need to consider how they are remunerated. If they are paid by way of bonus schemes that are linked to financial performance – which is typically the case – then this will encourage them to focus on financial performance.

Further, corporations are dependent upon investors and other financial stakeholders for support, and to the extent that such stakeholders fixate on financial performance, then this will motivate managers to emphasise financial performance. However, because organisations operate within society, in the long run they cannot ignore the broader social and environmental expectations of society – however some prioritisation will be necessary.

10.14 A social audit can be very broadly defined as an activity undertaken to assess an entity’s performance relative to society’s requirements and expectations. The results of a social audit often form the basis of an entity’s publicly released social accounts (thereby increasing the apparent transparency of the organisation) and the outcomes of social audits can be considered as an important part of the ongoing dialogue with various stakeholder groups.

Despite the existence of various guidance documents, there is no generally accepted methodology for a social audit. Social audits can be undertaken via questionnaires, site visits, personal interviews with corporate members or other stakeholders, reviews of written materials produced by the media or interest groups, and so on. The social audit might consider a broad or narrow area of the corporation’s performance.

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A social audit can make good business sense to a profit-seeking entity, the view being that it is preferable to know the entity is not complying with community expectations as early as possible, and before costly community actions are invoked. Chapter 9 provides several illustrations where organisations were perhaps not aware of the community anger that was mounting in respect of certain facets of the entity’s operations (for example, Nike, Shell and Disney). Had they been aware of community sentiments, possibly through the vehicle of a social audit, then they would perhaps have been able to act earlier than they ultimately did. Once social audits are undertaken, they can act as catalysts for organisations and, importantly, for senior management to embrace new values that might be necessary for continued profitable operations. Of course there are also broader ethical considerations associated with social audits – for example, it is important to determine whether anybody within the organisation is being exploited or disadvantaged. Undertaking social audits on a periodic basis is becoming accepted as a necessary part of a well-functioning management system.

10.15 The call was probably made because of the deficiencies considered to exist in the traditional approaches to financial accounting. Financial accounting with its reliance upon notions of ‘control’ (for example, in relation to defining assets and expenses) and the ‘entity principle’ (in delineating the boundaries of accounting) typically acts to ignore many social and environmental externalities caused by a reporting entity. The implication of this is that reported profits tend to be overstated and product prices understated relative to what they would be if some way was found of putting a price on the ‘so-called’ free goods (for example, to put a price on the use of air, water and so forth).

It is often considered that if prices are adjusted to reflect the ‘full costs’ of the externalities caused by a reporting entity then the consumption of goods or services with high externality components (for example, goods that generate high levels of pollution when produced) would be reduced and consequently, the community would be better off. However, such a perspective does raise an ethical issue. Goods or services that generate significant amounts of externalities will only be available to the wealthier members of society – perhaps they should not be available to anybody (this is a value-laden social-justice issue.)

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10.16 Triple bottom line reporting was defined by Elkington (1997) as reporting which provides information about the economic, environmental and social performance of an entity. It represents a departure from previous ‘bottom line’ perspectives which had traditionally focused solely on an entity’s financial or economic performance. The notion of reporting against the three components (or ‘bottom lines’) of economic, environmental and social performance is directly tied to the concept and goal of sustainable development. For an organisation (or a community) to be sustainable (a long-run perspective) it must be financially secure (as evidenced through such measures as profitability), it must minimise (or ideally eliminate) its negative environmental impacts, and its actions must conform to societal expectations. These three factors are obviously highly interrelated.

10.17 All individuals make choices that lead to various social and environmental impacts and outcomes. Personal social responsibility refers to considerations that we personally make in terms of weighing up the benefits that flow to us from various decisions against the impacts, or costs, that our decisions might have on other people, societies (both current and future), animals, environments, and so forth. For example, we might question the necessity for particular travel and the mode of travel being used, how much energy we consume, how much waste our activities are generating, how social and environmental responsibilities were embraced by the suppliers of our clothing, and so forth. The emphasis here is that tackling important issues such as climate change and poverty alleviation requires ‘the community’ to also embrace the need for change and not to simply rely upon (or blame) organisations for the necessary improvements. One can also argue for personal social responsibility on the grounds that asking for corporations to be socially responsible becomes a way of ‘passing the buck’ – evading personal responsibility for ‘doing good’. This is the flip side of blaming corporations for everything from obesity to scalding from spilt coffee – both the subject of lawsuits in recent years.

The reality is that in a capitalistic society driven by market-based mechanisms, business organisations tend to produce the goods that we demand. If we elected to only acquire goods that are produced in a socially and environmentally

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responsible manner, and to acquire only those goods that we really ‘need’, then we could have a profound effect on the sustainability of business practices.

Students might also be encouraged to consider whether personal social responsibility should be explored or taught within universities, and in particular, to business students.

10.18 The basis of Chandler’s opinion is that firms respond to the demands of the people within the societies in which they operate. If firms operate in a relatively freely operating market, then they will respond to market demand. If people do not demand particular goods, then they will not be produced. Further, if people do not like the way particular goods have been produced (and this will require them to have access to information – information provides ‘power’ in terms of enabling informed decisions to be made), then they should buy the goods from alternative suppliers who produce in a socially responsible manner (or not buy the goods or services at all). Therefore, consumers must take some responsibility for the production outputs and processes of business organisations.

Making informed choices to support a particular firm requires the consumer to have relevant and representationally faithful information. Such information will not always be available, particularly as it relates to social and environmental outcomes and performance. Any quests towards sustainability arguably require that firms are required, on a mandatory basis, to provide information about various aspects of their social and environmental performance. This will then enable more informed choices to be made by consumers, investors, and other interested stakeholders.

The Chandler quote also makes an interesting statement that we need to ‘get beyond the idea that firms are inherently evil’. Firms are made up of people and many of us work for ‘firms’. Do we think we are evil? Or is it the ‘others’ that are ‘evil’? Or do we somehow become ‘evil’ when we walk through the firm’s doors, or when we get together with other employees of the firm? It is true that there is much scepticism about ‘firms’, but is that rational? What is true is that capital markets, various borrowing agreements, and dividend and capital gains expectations of various individuals (which include us) do motivate corporate 285

managers to fixate on financial performance measures, sometimes to the detriment of various social and environmental aspects of performance.

Students should be encouraged to consider whether they sometimes feel conditioned

towards

considering

business

organisations,

and

‘senior

management’ as being somewhat ‘evil’.

10.19 It has been argued by some authors that the concept of the triple bottom line is severely restricting as; firstly, the term bottom line conveys the impression of something which can be measured in a single number. The economic profit figure is the summation, in a common currency, of all the income and expenses figures over a period of time. Brown, Dillard and Marshall (2005) demonstrate that it is highly problematic, and probably impossible in practice, to reduce all environmental impacts, or all social impacts, to a common currency.

Secondly, the economic bottom line is commonly understood among managers as being a metric which should be maximised. Brown, Dillard and Marshall (2005) argue that it is difficult to apply this objective of maximisation to nature. While there could be agreement on maximising a factor such as biodiversity, there is no commonly accepted understanding of what this might mean and how it could be measured. Even more problematic, is knowing which social metric should be maximised. Thus, attempting to equate the notion (and management) of the bottom lines of social and environmental with the more conventional economic bottom line is not possible in practice. Therefore, attempting to report upon, or manage, all three bottom lines in a common manner is not appropriate.

Thirdly, if it is not possible to adopt metrics that treat each of the bottom lines equally, then the notion of three separate bottom lines might give the impression that the economic, social and environmental are not interconnected. Many people believe this would be a fundamental misconception, and from a social and environmental sustainability viewpoint could be highly damaging.

Hence, from the above discussion, it is questionable whether triple bottom line reporting can lead to separate and meaningful bottom lines for social, environmental and economic performance.

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10.20 As Chapter 10 indicates, the economy (including business activities) and all social systems operate within the natural environment. If business (and other human) activities contribute to the destruction of the biosphere, there will be no humans left to run businesses, buy the products of businesses or operate social systems. In an extreme scenario, destruction of the environment leads to destruction of the human race, following which there would clearly be no profits and no social systems.

10.21 While it is true that in the past many accountants would not have given any consideration to the notion of sustainable development, it is nevertheless an issue that is of direct relevance to the accounting profession. Moves towards sustainable development (accepted by many to be a global imperative) require new systems of providing information – and accountants are very well placed to be involved with this.

In many countries, issues associated with sustainable development have led to the introduction of various community-based initiatives. For example, the requirements being introduced around the world to measure and report carbonrelated emissions. Accountants are getting involved in measuring, reporting and verification issues associated with carbon emissions. They are also getting involved with issues associated with the recognition and valuation of tradeable pollution permits, such as those generated in cap-and-trade schemes.

As sustainable development becomes more of a priority and concern for the community, it is expected that there will be increased demand for information about entities’ social and environmental performance (two components of sustainability, the other one being financial/economic performance), and firms will be expected to react to this concern or else risk being in breach of their ‘social contract’. Accountants are already reacting to this increasing demand. Throughout the world professional accounting bodies have established taskforces to address the issues and the major accounting firms (for example, the ‘Big 4’) typically have special divisions which consider social and environmental accountability and reporting issues. As a further indication of the relevance of sustainability-related issues to the accounting profession, many accounting education programs within 287

universities and other educational institutions are explicitly considering social and environmental issues. Your institution must be considering the issue given that you have just read this answer!

10.22 This is an interesting issue. For many years the relevance of the environment to financial accounting was not really accepted by the accounting profession. Only those transactions and events which were associated with property rights and/or market transactions were recorded in the accounts. As Chapter 10 indicates, the IASB Conceptual Framework effectively excludes environmental issues from asset/expense recognition because environmental resources (such as the air or waterways) are typically not controlled and therefore are not expected to be recognised for financial reporting purposes.

In more recent years the accounting profession has taken some interest in various accounting issues associated with the environment. However, to date, where documents have been released, they often relate to issues associated with ensuring that liabilities properly reflect any future cash flows that relate to such things as environmental remediation and clean-ups. Implications for asset measurement have also been linked to sustainability-related issues. That is, the various releases have tried to account for the environment in accordance with traditional methods of financial accounting and have restricted the consideration to the financial implications of sustainability.

At an international level, while there are over fifty financial reporting standards (IFRS) in place, none relate specifically to the environmental or social impacts that cannot be quantified in monetary terms. Financial reporting standards tend to emphasise financial performance over and above social and environmental performance. Financial performance has generally been the domain of accountants and accountants have overwhelmingly been trained to consider economic performance, rather than social and environmental performance. It is the author’s expectation that this is changing – the ‘new breed’ of accountants are being relatively more exposed to social and environmental performance issues (perhaps due to such things as global calls for moves to sustainable development, and the increasingly obvious bad state of the environment) and as a result, it is an expectation that across time accounting standards will be released that relate to 288

such issues (as Chapter 10 indicates, a number of non-accounting bodies are currently developing social, ethical and environmental accounting and auditing guidance documents).

In 2021 the International Sustainability Standards Board – which is overseen by the IFRS Foundation (which also oversees the IASB) – was created. The ISSB released two exposure drafts in early 2022 (pertaining to General Requirements for Disclosure of Sustainability-related Financial Information and Climate-related Disclosures). These standards will focus on providing sustainability-related financial disclosures for capital markets, including disclosures that address the financial implications associated with climate change. Although the establishment of the ISSB in 2021 will ultimately increase corporate reporting globally with respect to the financial implications of sustainability-related issues, such an initiative does little to compel organisations to disclose impacts that cannot be quantified in monetary terms.

10.23 As Chapter 10 noted, in his widely cited book Capitalism and Freedom, Friedman (1962) rejects the view that corporate managers have any moral obligations beyond maximising their profits. In relation to the view that organisations have social responsibilities, he notes (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, 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.

Milton Friedman adopted the view that the overriding obligation of a company is to maximise the profits, and therefore the wealth, of shareholders. Social and environmental responsibilities would only be considered if undertaking particular social and environmental initiatives were perceived as leading to a maximisation of shareholder value.

Quests towards sustainable development would require organisations to consider current and future generations and the environment and not to embrace 289

maximising profits and shareholder value, as well as economic growth, as the sole criteria to focus upon. If managers do adopt the views of Milton Friedman – and there is some evidence to suggest that many do – then quests towards sustainable development could be construed as somewhat unrealistic. Arguably we need to ‘rethink’ the role of ‘business entities’ within society and we need to rethink the goals many of us have about maximising financial wealth. Students should be encouraged to discuss whether they think we can realistically expect to move away from this fixation on wealth creation and maximisation. How bad must the environment become, and how bad must various inequities become within society, before we question our current business models?

10.24 A number of chapters in the textbook provide reasons why management typically prefers to be able to select its own methods of accounting, rather than being subject to mandated reporting requirements. Some arguments are based on an efficiency perspective, while other arguments are based on an opportunistic perspective.

If we are to adopt an efficiency perspective, perhaps managements prefer to have the option to select those methods of reporting which best reflect the underlying social and environmental performance of the entities, rather than having particular methods imposed upon them. From an opportunistic perspective, perhaps the managers would rather have the option to select those disclosures which provide the most favourable position of the organisations’ social and environmental performance. Currently, the reporting of social and environmental performance information is overwhelmingly voluntary. While many entities state that they are embracing

the

‘Global

Reporting

Initiative’s

Sustainability

Reporting

Guidelines’, evidence indicates that many organisations select those items of disclosure within the GRI Guidelines which provide the most favourable representation of the organisations’ performance – consistent with an opportunistic perspective.

10.25 (a)

Collison argues that traditional financial accounting practices act to emphasise the importance of financial returns to owners of capital, relative to distributions to other parties. It appears to be generally accepted by many people that profits are ‘good’ and that larger profits are ‘better’ than smaller profits. Expenses act to reduce profits and hence are typically 290

considered as bad news (interestingly, distributions to owners, which are ‘dividends’, are not expenses – hence they do not represent bad news).

Distributions to employees in the form of salaries and wages are considered as expenses and, all things being equal, the smaller the better.

Such a perspective certainly seems to emphasise the ‘favoured’ position of owners of capital, relative to other people associated with an organisation.

As Collison (2003, p. 7) states:

Financial description of the factors of production in the business media, and even in textbooks, makes clear that profit is an output to be maximised while recompense to labour is a cost to be minimised. Financial Times contributors are fond of words like ‘ominous’ to describe real wage rises: such words are not used to describe profit increases.

(b)

It does appear that communities are increasingly expecting organisations to consider the interests of a broader group of stakeholders than just the shareholders. Because profits emphasise the returns to shareholders, we might expect greater emphasis to be given to other performance indicators, such as those that relate to an entity’s social and environmental performance.

In recent years many organisations have indeed started producing additional information in respect of their social and environmental performance, with many organisations producing stand-alone social and environmental (and sustainability) reports. These reports provide various measures of performance, not necessarily restricted to information that can be presented in financial terms. Performance indicators might include information about whether an organisation has undertaken a social audit, and the results of that audit; whether it has an environmental management system in place and whether it conforms with particular standards; whether the organisation has put in place affirmative action policies; how much the organisation spends annually on training initiatives; how much the organisation has contributed to community-based projects; what the organisation has done to minimise the risk that modern slavery exists within its supply chains; or what the entity is doing for indigenous peoples.

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(c)

Collison’s comments could provide justification towards moves for full-cost accounting. If expenses are considered as ‘bad things’, and if profits are to be maximised (and, further, if externalities are quantified in financial terms), then efforts will be undertaken to decrease the externalities, and hence, to increase the returns to the owners of capital. However, the adoption of fullcost accounting would still not eliminate the perspective that payments to some stakeholders (such as the providers of labour) are to be minimised, while payments to other stakeholders (such as to owners of capital, in the form of dividends) are to be encouraged.

10.26 This issue is extensively covered in Chapter 9. Utilising Legitimacy Theory, if the media runs a number of stories on a particular social or environmental incident involving or associated with an organisation, then that organisation will use corporate disclosures as a means of trying to maintain or re-establish the legitimacy of the organisation.

As Chapter 9 indicates, Dowling and Pfeffer (1975) outline the means by which an organisation may, perhaps when confronted with legitimacy-threatening events, legitimise its activities (p. 127). They propose that the organisation can: •

adapt its output, goals and methods of operation to conform to prevailing definitions of legitimacy;

•

attempt, through communication, to alter the definition of social legitimacy so that it conforms to the organisation’s present practices, output and values;

•

attempt through communication to become identified with symbols, values or institutions that have a strong base of legitimacy.

Consistent with Dowling and Pfeffer’s strategy of ‘communication’, Lindblom (1993) proposes that an organisation can adopt a number of strategies where it perceives that its legitimacy is in question because its actions (or operations) are at variance with society’s expectations and values. Lindblom (1993) identifies four courses of action (there is some overlap with Dowling and Pfeffer) that an organisation can take to obtain, or maintain, legitimacy in these circumstances.

The organisation can seek to: 292

•

educate and inform its ‘relevant publics’ about (actual) changes in the organisation’s performance and activities which bring the activities and performance more into line with society’s values and expectations;

•

change the perceptions that ‘relevant publics’ have of the organisation’s performance and activities – but not change the organisation’s actual behaviour (while using disclosures in corporate reports to falsely indicate that the performance and activities have changed);

•

manipulate perception by deflecting attention from the issue of concern on to other related issues through an appeal to, for example, emotive symbols, thus seeking to demonstrate how the organisation has fulfilled social expectations in other areas of its activities; or

•

change

external

expectations

of

its

performance,

possibly

by

demonstrating that specific societal expectations are unreasonable.

According to Lindblom, and Dowling and Pfeffer, the public disclosure of information in such places as annual reports can be used by an organisation to implement each of the above strategies.

10.27 We will all agree that a dollar to be received or paid in the future has a value that is less than a dollar to be received or paid now. Therefore, the present value of a liability to be paid in the future will be less than its ‘face value’. As time passes, the liability’s value will approach its face value.

Now while the above comments are true, and make economic sense, the implications of discounting liabilities to their present value – as required within financial reporting standards – is that liabilities or commitments – such as those relating to remediating contaminated sites – will reduce in size. At the extreme this could make the liabilities immaterial in the current period and therefore not separately disclosed on the balance sheet or in the notes to the financial statements.

Effectively, discounting can make some obligations ‘disappear’ in current periods.

Discounting liabilities to their present value perhaps encourages an entity to undertake activities that will damage the environment but that will not need to be remedied for many years. In a sense, the practice of discounting encourages us to 293

shift problems of an environmental nature on to future generations – something that is arguably inconsistent with the sustainability agenda. It is also a practice that arguably does not make a great deal of ecological sense. As already noted, if we discount future obligations, then, in the current period, they often are not considered to be material and will not even be seen on corporate balance sheets.

Nevertheless, future generations will be left with obligations to remediate the environment. For example, if we were anticipating that our activities would necessitate a clean-up bill of $100 million in thirty years’ time to remove some contamination, and if we accept that our normal earnings rate is, say, 10 per cent, then the current expenses to be recognised in our financial statements under generally accepted accounting principles would be $5.73 million. This could well be judged as immaterial and therefore not worthy of disclosure. The obligation is therefore, effectively, rendered invisible.

10.28 (a)

Positive Accounting Theory predicts that all individual action is ‘economically rational’ – that is, the decision to undertake certain activities, such as reporting, is based on self-interest tied to the goal of wealth maximisation. Hence, managers will elect to provide social responsibility disclosures to the extent that it increases the value of the organisation. Managers would be motivated to do this as a result of various mechanisms that align the interests of the manager with increasing firm value, such as profit-sharing bonus schemes, holding shares in the firm, the market for managers, and the market for corporate takeovers (these mechanisms are discussed in Chapter 8). Research which has adopted the PAT paradigm has suggested that social responsibility disclosures are made to reduce the political visibility the firm is subject to and hence to reduce the wealth transfers that are associated with political scrutiny.

(b)

Legitimacy Theory predicts that firms will undertake various actions to ensure that they appear to be operating in a manner consistent with the norms and expectations of the community in which they conduct their operations. That is, that they appear to comply with the terms of the ‘social contract’ (the theoretical notion of a social contract is discussed in Chapter 9). Hence, various social responsibility disclosures will be made in an effort to legitimise the ongoing existence of the organisation. If it is 294

considered that the community does not expect the firm to make social and environmental disclosures (that is, it is not part of the social contract), then no disclosures will be made. As the chapter indicates, where the legitimacy of an organisation has been brought into question (perhaps as the result of a major environmental accident or event), corporate management often use media such as the annual report in an effort to restore legitimacy.

(c)

As Chapter 9 explains, there are two branches of Stakeholder Theory – the managerial branch and the ethical (or normative, or moral) branch. Under the managerial branch, disclosures are used as one strategy to control the actions of powerful stakeholders. Powerful stakeholders are often considered as those parties who have resources which are important to the ongoing survival of the organisation. Under this perspective, it is the needs of the powerful stakeholders that are attended to over and above the needs of other parties affected by the entity’s operations. If the powerful stakeholders expect social responsibility disclosures, then the firm is predicted to make them. By contrast, under the ethical, or normative, branch of Stakeholder Theory there is a view that disclosures are responsibility driven and that all stakeholders that are impacted by the operations of the entity have a right to information about its operations (the notion of right-to-know). Hence, under this perspective, social responsibility disclosures are made in response to an ethical responsibility, rather than in response to any desire to maximise wealth or to appease particular powerful parties.

(d)

As Chapter 9 indicates, Institutional Theory provides a number of reasons why corporations might make corporate social responsibility disclosures.

There is a view that organisational form and practices might tend towards some form of homogeneity – that is, the structure of the organisation and the practices adopted by different organisations tend to become similar in order to conform with what is considered to be ‘normal’. Organisations that deviate from being of a form that has become ‘normal’ or expected will potentially have problems in gaining or retaining legitimacy. There are two main dimensions to Institutional Theory. The first of these is termed isomorphism while the second is termed decoupling. Both of these 295

can be of central relevance to explaining voluntary corporate reporting practices.

The term ‘isomorphism’ is used extensively within Institutional Theory and DiMaggio and Powell (1983, p. 149) have defined it as ‘a constraining process that forces one unit in a population to resemble other units that face the same set of environmental conditions’. That is, organisations that adopt structures or processes (such as reporting processes), that are at variance with other organisations, might find that the differences attract criticism. DiMaggio and Powell (1983) set out three different isomorphic processes. These three isomorphic processes are referred to as coercive isomorphism, mimetic isomorphism and normative isomorphism.

Pursuant to coercive isomorphism, organisations will only change their institutional practices because of pressure from those stakeholders upon whom the organisation is dependent. This form of isomorphism is related to the managerial branch of Stakeholder Theory whereby a company will use ‘voluntary’ corporate reporting disclosures to address the economic, social, environmental and ethical values and concerns of those stakeholders who have the most power over the company. The company is therefore coerced (in this case usually informally) by its influential (or powerful) stakeholders into adopting particular voluntary reporting practices. Since these powerful stakeholders might have similar expectations of other organisations as well, there will tend to be conformity in the practices being adopted by different organisations – institutional practices will tend towards some form of uniformity.

Mimetic isomorphism involves organisations seeking to emulate (perhaps copy) or improve upon the institutional practices of other organisations, often for reasons of competitive advantage and in terms of legitimacy. When an organisation encounters uncertainty then it might elect to model itself on other organisations. There are links between the pressures for mimetic isomorphism and pressures underlying coercive isomorphism. Unerman and Bennett (2004) maintain that without coercive pressure from stakeholders it

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is unlikely there would be pressure to mimic or surpass the social reporting practices (institutional practices) of other companies.

Normative isomorphism relates to the pressures arising from group norms to adopt particular institutional practices. In the case of corporate reporting, the professional expectation that accountants will comply with accounting standards acts as a form of normative isomorphism for the organisations for whom accountants work to produce accounting reports that are shaped by accounting standards. In terms of voluntary reporting practices, normative isomorphic pressures could arise through less formal group influences from a range of both formal and informal groups to which managers belong – such as the culture and working practices developed within their workplace. These could produce collective managerial views in favour of or against certain types of reporting practices (such as collective managerial views on the desirability or necessity of providing a range of stakeholders with social and environmental information through the medium of corporate reports).

Turning to the other dimension of Institutional Theory, decoupling implies that while managers might perceive a need for their organisation to be seen to be adopting certain institutional practices (and might even institute formal processes aimed at implementing these practices) actual organisational practices can be very different to these formally sanctioned and publicly pronounced processes and practices. Thus, the actual practices can be decoupled from the institutionalised (apparent) practices.

In terms of voluntary corporate reporting practices, this decoupling can be linked to some of the insights from Legitimacy Theory whereby social and environmental disclosures can be used to construct an organisational image very different from actual organisational social and environmental performance. Thus, the organisational image constructed through corporate reports might be one of social and environmental responsibility when the actual managerial imperative is maximisation of profitability or shareholder value.

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10.29 The ‘community licence to operate’ can be interpreted as meaning the expectations that the community has in relation to how the entity will perform its operations. Certain ‘conditions’ (typically implied) are imposed upon the organisation in exchange for allowing the organisation to exist and operate within the community. Of course, this licence does not actually exist in tangible terms, and different people will have a different interpretation of the terms or conditions inherent within the ‘licence’. Nevertheless, a review of corporate reports indicates that in recent years, more and more corporate executives are making reference to the ‘community licence to operate’, or similar, and discussing how they are ensuring that their activities are in accordance with the licence.

From a theoretical perspective, the ‘community licence to operate’ can be equated to the ‘social contract’ often linked to the application of Legitimacy Theory (as explained in Chapter 9). Within Chapter 9 we defined the ‘social contract’ as representing the multitude of implicit and explicit expectations that society has about how the organisation should conduct its operations and we emphasised that an organisation that does not comply with the terms of the social contract might consequently be considered as not being legitimate. Failure to be considered as legitimate can in turn have negative implications for the ongoing operations of the entity.

10.30 The idea that doing the ‘right thing’ by the community and the environment (and any other stakeholders) will happen to the extent it can be shown to provide benefits to the owners of the business is often referred to as ‘enlightened selfinterest’. Within Chapter 10, reference is made to particular ‘drivers’ identified by the Business Council of Australia that will direct companies towards embracing greater levels of corporate social responsibility (for example, employee recruitment, reputation management, operation efficiency and investor relations).

In relation to one of the business cases for corporate social responsibility identified above (employee recruitment, motivation and retention), the Business Council of Australia (BCA) (2005, p. 16) stated:

The reputation of a company affects its desirability as a potential workplace.

It is in the company’s strategic interests to attract and retain the most highly skilled and expert employees, and this can be encouraged by maintaining an 298

ethical and attractive reputation.

Pursuant to enlightened self-interest, companies will embrace activities that benefit the environment and stakeholders other than just shareholders to the extent – and only to the extent – that such activities maximise the value of the business.

If the activities cannot somehow be linked to increasing shareholder value, then such activities will not be undertaken. As Chapter 9 stated, in a submission to a government inquiry on corporate social responsibility the Business Council of Australia continually referred to the imperative to maximise shareholder value.

They stated in their submission to government that:

The litmus test for any activity or responsibility is whether the performance of that activity or responsibility can reasonably be seen to be contributing to the growth of shareholder value.

Students should be encouraged to debate this view of the world as espoused by the BCA – that is, that enlightened self-interest should be the guiding principle.

Do they think it is ethical? Do they think it is appropriate? Do they think such views provide hope that organisations will embrace moves towards sustainable development?

10.31 The view that maximising corporate profits and increasing shareholder value will ultimately lead to benefits to all people within society relies upon the operation of a ‘trickledown effect’ – that is, that higher levels of wealth in one stakeholder group (shareholders) will lead to greater levels of wealth across the community (perhaps through increased demand for goods and resultant increases in wages, and so forth).

Proponents of the above view (including the famous economist, Milton Friedman) tend to argue that if the actions of all individuals (and businesses) are motivated solely by a self-interested desire to maximise personal wealth, then this will benefit all in society because (through the resulting economic growth) the wealth generated by the successful parties will ‘trickle down’ to the less successful. In this way, they argue, the conditions of all in society will be improved if all people in society actively pursue their own self-interest (or ‘enlightened self-interest’), 299

with this being a morally desirable outcome. Indeed, this ‘trickle down’ belief is commonly repeated as a key moral justification for the capitalist system. But reflecting the disparity of opinions, critics argue that a problem with this moral justification for a narrow and exclusive focus on maximising shareholder wealth (or shareholder value) is that there is little, if any, evidence to show it benefits others. As Gray (2005, pp. 6–7) states: It is disturbing … to discover that there is no direct evidence to support this precarious construction. The view relies, for its empirical support, on the generalised argument that, for example, we are all better off than we have ever been; that we are all getting better off all the time; and that this increase in well-being has coincided with the triumph of international capitalism. Such arguments are, at best, contestable. While for many in the West this statement has a superficial veracity, it ignores the growing gap between rich and poor …

10.32 (a)

Powerful stakeholders are typically considered to be those stakeholders who can affect the operations of an entity through their ability to control the flow of necessary resources to that entity. There is evidence in various research studies to show that organisations often react to the demands of powerful stakeholders and provide them with the information they desire. A stakeholder’s (for example, owner’s, creditor’s, or regulator’s) power to influence corporate management is viewed as a function of the stakeholder’s degree of control over resources required by the organisation (Ullman, 1985). The more critical the stakeholder’s resources are to the continued viability and success of the organisation, the greater the expectation that the stakeholder’s demands will be addressed. Under this perspective, a successful organisation is one that satisfies the demands (sometimes conflicting) of the various powerful stakeholder groups.

If we accept that stakeholder power is an important issue to consider when making management decisions, then a major role of corporate management becomes one of assessing the importance of meeting stakeholder demands in order to achieve the strategic objectives of the firm. Further, as Friedman and Miles (2002) also point out, the expectations and power relativities of the various stakeholder groups can change over time. Organisations must therefore continually adapt their operating and disclosure strategies.

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Embracing this perspective, Roberts (1992, p. 598) states:

A major role of corporate management is to assess the importance of meeting stakeholder demands in order to achieve the strategic objectives of the firm. As the level of stakeholder power increases, the importance of meeting stakeholder demands increases also.

In relation to corporate social responsibilities, Roberts (1992, p. 599) further states: … social responsibility activities are useful in developing and maintaining satisfactory relationships with stockholders, creditors, and political bodies. Developing a corporate reputation as being socially responsible through performing and disclosing social responsibility activities is part of a strategy for managing stakeholder relationships.

In considering managements’ reactions to powerful stakeholders, Islam and Deegan (2008) investigated the social and environmental disclosure practices of a major trade organisation operating within a developing country. Specifically, they investigated the social and reporting practices of the Bangladesh Garments and Manufacturing Enterprise Association (BGMEA). This organisation is authorised by the government in Bangladesh to provide export licences to garment manufacturers, thereby enabling local garment manufacturers to sell their products to foreign buyers, many of which are large multinational companies. Islam and Deegan interviewed senior executives from BGMEA. The executives indicated that the operating and disclosure policies of BGMEA and its member organisations were particularly influenced by the demands and expectations of multinational buying companies (such as Nike, Gap, Reebok, Hennes & Mauritz), the group they considered to be their most powerful stakeholders.

The senior executives also stated that they believed that the demands and expectations of the multinational buying companies directly responded to the expectations of Western consumers, and that the expectations of Western consumers were influenced by the Western news media. In this regard, the 301

executives of BGMEA noted that, prior to the mid-1990s, multinational companies placed no requirements or restrictions on the Bangladesh manufacturing companies in relation to factory working conditions or the use of child labour. However, once the Western news media began running stories on the poor working conditions in ‘sweatshop’ factories and stories on the use of child labour, this caused concern for Western consumers, who started to boycott the products of the large multinational sportswear and clothing companies. The Western consumers were key stakeholders of the multinational companies. At this point the multinational companies started imposing operating and reporting requirements on suppliers in terms of their employee conditions and their use of child labour, and suppliers responded to these demands.

(b)

Whether we consider that managing relationships with powerful stakeholders is an appropriate rationale for producing CSR reports will be a matter of opinion. Some people will think that placing the interests of the organisation and its shareholders at the forefront of their consideration is appropriate and therefore utilising various strategies, including reporting, to manage the stakeholders is the correct thing to do. By contrast, there will be other individuals that argue that the disclosure of information should be based upon different groups’ ‘rights-to-know’, and considerations of power and the like are not directly relevant. Instead, under this alternative perspective, reporting should be responsibility driven.

10.33 This quote shows that the BCA embraces ‘enlightened self-interest’ as the guiding principle for business. That is, that doing the right thing by shareholders will ultimately result in benefits to others. The view taken is that if important and powerful stakeholders (such as customers, employees, lenders, government, and so forth) believe certain responsibilities should be embraced – such as a responsibility to care for the environment – then it is in the interests (self-interests) of the business for them to be responsible in this area – otherwise support for the corporation, and hence its profitability, might decline. Conversely, if powerful stakeholders do not care about particular responsibilities, then neither should the company, regardless of various ethical considerations. In the 2005 Federal Government Inquiry into Corporate Social Responsibility, a submission by the St James Ethics Centre 302

provided an interesting insight. It stated:

The broad legal obligation to act in the best interests of the company as a whole is often (and somewhat problematically) reduced to being nothing more than the financial interests of shareholders. In its most enlightened form, the duty to shareholders has been described as a duty ‘to shareholders in perpetuity’ – and this formulation has been argued not merely to permit but actually require a concern for a broader range of stakeholders. However, the status of stakeholders other than shareholders is entirely derivative. If a concern for their interests were not ultimately in the interests of shareholders, then they would be of no concern to the corporate decision maker.

Following on from the above view, the reason a corporation would embrace sustainable development would not be directly related to an intention to do the right thing by the planet. Rather, it would be about undertaking a strategy that will lead to an increase in shareholder value. Apparently, the BCA considers that corporations should be primarily responsible to their shareholders. Other considerations are secondary.

10.34 Sustainable development basically refers to development that can be maintained into the indefinite future (unlike unsustainable development which clearly cannot) and which respects and cares for the interests of current and future generations.

For an organisation’s operations to be considered ‘sustainable’, the results of the operations should reflect that the planet is no worse off as a result of the operations, and the wellbeing of current and future generations should not have been adversely affected.

From a financial accountant’s perspective, a going concern is an organisation that will continue operations indefinitely, that is, that will operate into the foreseeable future. To do so, managers must carefully consider financial performance and position. Achievement of ‘going concern’ status might be possible even if the organisation is damaging the environment and creating significant implications for future generations (and such damage might be going unrecognised from a financial reporting perspective), and even if it is undermining the interests of some people across its supply chain.

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Therefore, with the above discussion in mind, the two concepts are arguably quite different.

10.35 The majority of large companies do disclose information about their social and environmental performance. Chapter 10 discussed the regular surveys of sustainability reporting conducted by KPMG. As that discussion clearly indicates, there has been a growth in such reporting, and most large companies internationally do report.

In terms of some of the implications from not reporting, these would include potential negative reactions from various stakeholder groups who expect organisations to accept a responsibility and associated accountability for their various social and environmental impacts. Employees, lenders, customers, investors, suppliers, local communities, NGOs and so forth are all expecting organisations – particularly larger ones – to be accountable in relation to sustainability-related matters. Organisations that fail to be accountable will potentially find it difficult to garner the support of the different stakeholders.

There would tend to be a lack of ‘legitimacy’ now associated with organisations that do not embrace the necessary, or expected, accountability.

Another point is that to produce sustainability reports requires systems to be put in place to monitor and report information. This process is vital to identifying various sustainability-related risks and opportunities.

10.36 Because GDP is a measure which is positively influenced by any form of expenditure (including expenditure on jails, pollution clean-ups, combating civil unrest, and so forth), then arguably it does not provide a very holistic measure of national performance. As an extract from a newspaper article written by McHugh (‘Measure our welfare’, Australian Financial Review, 15 August 2005, p. 22) states:

Most economists acknowledge that GDP is a defective indicator of welfare.

We know, for example, that a car accident or an oil spill increases GDP but obviously decreases welfare. So why have we used such a measure?

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The answer is that GDP was developed around the time when our enemies were fascism and communism. It was therefore a sensible measure of industrial militarisation. But even though these foes are now long defeated, the same old war-cry continues: produce, produce, produce and all your enemies shall be vanquished.

Unfortunately, our newly recognised enemy is itself a factor of production.

Much of the GDP growth this century has come about due to massive exploitation of fossil fuels.

We are completely reliant on the black stuff and desperate for it to keep flowing. But we are also quite certain that the burning of hydrocarbons is now resulting in increasing global temperatures, and this new enemy is looming as one of the greatest threats to human welfare ever faced.

10.37 Arguably, it would only be misleading to those people who wrongly believe that financial accounting practices generate a calculation of profit or loss that incorporates an estimate of the costs associated with the social and environmental externalities created by an organisation (and perhaps there are many such people who have this mistaken belief, meaning that financial accounting is potentially very misleading). For those people who are knowledgeable in respect of financial accounting, the profit figure would not be misleading as they know that financial accounting typically ignores the social and environmental externalities caused by an organisation. Such people would know that information about the environmental impacts of a corporation would need to be obtained from sources other than financial statements. In summary, the profits shown for an organisation may be misleading for some people but not to others who are knowledgeable in relation to financial accounting.

Nevertheless, because financial accounting does not recognise the expenses associated with the environmental damage being done (unless there are associated cash flows, for example relating to fines), financial accounting might act to provide information (for example, profit disclosures) that cause various stakeholders to support the organisation thereby allowing it to remain in business (and to continue causing environmental damage). In a sense, if an organisation is shown to be generating record profits, then this might legitimise the operations of 305

the organisation. Because the accountant fails to identify the ‘costs’ associated with the damage being done (and there are various experimental approaches that could be used to measure the externalities of the organisation), the existence of such costs typically fails to be recognised by most stakeholders. In effect, the accountant acts to create a certain ‘reality’ in terms of what revenues and expenses are measured and therefore are visible and subject to some form of public scrutiny or monitoring.

As a side issue, students might want to consider whether a change in financial accounting practices is necessary in assisting any quests towards more ecologically sustainable business practices.

10.38 As Chapter 10 notes, the Brundtland Report defined sustainable development as: ‘Development that meets the needs of the present world without compromising the ability of future generations to meet their own needs’ (World Commission on Environment and Development, 1987). This definition incorporates notions of both intergenerational equity and intragenerational equity, both of which are central to the sustainability agenda.

From the intergenerational equity perspective, we must ensure that our generation’s consumption patterns do not negatively impact upon future generations’ quality of life. Specifically, we should be in a position to say that the planet that we leave our children is in as good shape as the planet we inherited (and preferably in better shape given the damage already done).

From the intra-generational equity perspective, we also need to ensure that the needs of all ‘of the present world’ inhabitants are met, which requires strategies to alleviate the poverty and starvation that currently beset the peoples of various countries. While from a moral perspective effort should clearly be undertaken with a view to eradicating poverty and starvation, from a broader perspective communities cannot be expected to focus on local or global environmental issues (necessary for sustainability) if they are in desperate need of money. For example, if they are starving, can they really be expected to keep their forests intact when such forests provide a means of ‘free’ heating and income?

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10.39 The questions raised in the Institute of Chartered Accountants in Australia (ICAA) document are actually quite broad-ranging and very much based on personal opinion. There would certainly be a diversity of opinion on these issues. In this question students should consider their own views and the author of these answers will refrain from giving a ‘right’ answer. Possible (brief) answers would include:

(a)

As the chapter indicates, many guidelines have been released in relation to social and environmental (and sustainability) reporting. Clearly, the parties developing the guidelines must consider that some guidelines are necessary (or perhaps it could be argued that the guidelines were developed to increase or maintain the legitimacy of the body responsible for writing the guidelines). However, as guidelines they are not mandatory, meaning that while some of the guidance provided in the documents is followed, some is not (perhaps because it might involve the disclosure of unfavourable information). This has been the reason why some researchers have called for mandatory environmental reporting guidelines. Because environmental reporting (and sustainability reporting) is relatively new and because there is much uncertainty about the hows, the whats and the to whoms, it is arguable that some guidance is necessary. Whether reporting requirements should be made mandatory is dependent upon one’s views about the importance of the information and whether organisations can be expected to provide needed information in the absence of regulation. These are quite difficult issues to address.

(b)

As the chapter indicates, environmental information is frequently not reported by reason of the fact it was not considered to be ‘material’.

However, because many environmental impacts cannot be reliably quantified in monetary terms it is argued that the accountants’ notion of materiality is not appropriate to the decision to disclose (or not to disclose) environmental performance issues. Other criteria, such as significance, are required. The notion of significant environmental impacts has been used within the environmental literature for many years and is not tied to issues associated with quantifying effects in monetary terms.

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(c)

This is an interesting issue, and again one in which there is considerable argument. It is frequently argued that the design of controls and systems is a core skill of accountants, and that expertise can be used, in conjunction with the skills of others, in designing such things as environmental management systems and procedures for undertaking environmental audits. Do you agree or disagree with this?

(d)

Again, there is much debate on this. As this chapter has demonstrated, the definition of assets (and its reliance on control) has restricted or precluded the recognition of many social and environmental effects generated by reporting entities. Perhaps this suited reporting entities as they, on average, did not want to report such information. While some of us might argue that definitions of assets and liabilities, as included in the IASB Conceptual Framework, should be changed in the near term we could expect that this would be very unlikely. Changing such key definitions could have many economic consequences and, as we discussed in Chapter 4, the expected economic consequences could be used as a rationale for not amending current asset and liability definitions. What must be remembered is that the current definitions do not preclude a firm from making various qualitative disclosures in relation to their social and environmental performance.

(e)

It is generally accepted that the notion of materiality, as used by the financial accountant, is not relevant to environmental reports. Many significant environmental impacts cannot be quantified and if they can be quantified, the effects cannot be quantified with reasonable accuracy.

(f)

Again, this is a matter of opinion. If one is to believe that the current system of financial accounting is flawed (or perhaps supports the interests of particular ‘elites’) then it could be argued that it is a waste of time. What do you think?

(g)

There have been a number of generic social and environmental reporting documents released throughout recent decades, as indicated in the chapter.

In recent decades, a number of industries have also commenced developing industry-specific benchmarks. Hence while some disclosures 308

may be relevant to all industries (for example, details about stakeholder consultation mechanisms), some disclosures (such as emissions of particular substances) should perhaps be industry specific. Again, what do you think?

10.40 (a)

If conventional financial accounting practices were employed, then unless it was probable that particular financial penalties were going to be imposed – thus potentially creating a liability – then no recognition of the health effects of the products would need to be recorded. Financial accounting employs the entity assumption and through the definitions of assets and expenses embraced by conceptual framework projects – such as the IASB Conceptual Framework – externalities caused by the entity would be ignored.

(b)

If some form of ‘full cost’ accounting was embraced then the social impacts generated by the products of the cigarette companies would be described both quantitatively and qualitatively.

10.41 Large banks would not directly account for the job losses such a practice creates other than by showing a subsequent decrease in salary costs. The social costs brought about by many people being out of work would not be recognised within the financial reports of the banks. In adopting the entity assumption, such social costs incurred by other parties will not be recognised unless they have direct cash flow consequences for the reporting entity.

Whether we believe that it is a limitation of financial accounting that the large banks can potentially record an increase in profits at the same time that other stakeholders – past employees – are negatively impacted is a matter of opinion.

Certainly, the way our system of financial accounting has been developed is to encourage the minimisation of expenses – which includes payments to employees – and to maximise the ability of the company to make dividend payments to shareholders. As Collison (2003, p. 7) states:

Financial description of the factors of production in the business media, and even in textbooks, makes clear that profit is an output to be maximised while 309

recompense to labour is a cost to be minimised. Furthermore, a high cost of capital may be described as an exogenous constraint on business, rather than as an indication of the size of resource flows to providers of capital. Financial Times contributors are fond of words like ‘ominous’ to describe real wage rises: such words are not used to describe profit increases.

As Chapter 13 discusses, some accounting researchers (whom we refer to as critical theorists) consider that our whole system of accounting acts to support the interests of those with power (often proxied by financial wealth) and to undermine others (such as employees). Promoting performance indicators such as ‘profits’ will, it is argued, maintain the ‘favoured’ position of those in command of financial resources.

10.42 The rationale for governments to develop disclosure requirements in relation to modern slavery is based on a belief that various organisational stakeholders care about modern slavery and that being linked to modern slavery would be detrimental to an organisation’s operations. That is, there appears to be a maintained assumption by governments that consumers and ‘the market’ will punish an organisation for any apparent link to modern slavery. Disclosures required by modern slavery acts also create awareness for managers within organisations about where they are sourcing their goods from, and how employees in those supply chains are being treated.

The choice to leave it to ‘the market’ and consumers to punish perceived poor behaviour, as seems to be the intention driving the creation of Modern Slavery Acts such as that operating within Australia, appears to rely upon key assumptions that: •

consumers actually want to be aware of such information.

•

they will then act negatively towards organisations that are associated with modern slavery.

That is, the intended impacts of the Act rely upon concerns managers have about their ‘reputational risk’. The further assumption here is that managers, being concerned about their reputational risk, will take actions to ensure that elements of modern slavery are not in existence within their supply chains and that this,

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ultimately, will lead to a reduced incidence of modern slavery throughout the world. Students should be encouraged to debate the logic of such assumptions.

10.43

(a)

Pursuant to traditional financial accounting practices, a casino would not financially account for the social costs created for problem gamblers and their families. The only time that the financial costs would be recorded would be where particular stakeholders are able to take action against a company that subsequently results in direct cash flows away from the organisation.

(b)

This is a matter of opinion. That is, this is a normative issue as reflected by the use of ‘should’ in the question. We know that the application of traditional financial accounting practices would not require the organisation to account for the social costs. However, many organisations are now producing ‘sustainability reports’. A ‘true’ sustainability report would provide some form of an account (not necessarily represented in monetary terms) of the impacts of the organisation’s products and services.

(c)

GDP is a measure of performance that is directly impacted by levels of expenditure at the national level. As such, GDP would be positively impacted by the costs associated with problem gambling. This brings into question the relevance of GDP as a measure of national success. Many people believe it is actually a defective measure of performance.

10.44 (a)

Obviously we cannot be sure why the companies did what they did. What should be emphasised to the students is that our own perspective would be based on our views about what we believe motivates people (and therefore, managers) to take certain actions. If we were to believe that managers are driven by consideration of the ‘public good’, then perhaps the managers put in place the mechanism to help ensure workers’ rights are taken into account – although we would have to wonder why the actions only appeared to be taken after the news media ran extensive articles on the matter. If we were to embrace Legitimacy Theory then we would argue that the organisations put in place the various mechanisms to protect factory workers because the organisations’ legitimacy had been threatened and they needed to win back 311

community support, or else the livelihood of their organisation might have been threatened.

(b)

Again, we cannot be sure, and our answer would be influenced by what we believe drives companies to take certain actions. If we were to embrace the views of the Business Council of Australia that ‘the litmus test for any activity or responsibility is whether the performance of that activity or responsibility can reasonably be seen to be contributing to the growth of shareholder value’, which is the enlightened self-interest view, then we would accept the view that managers believe that shareholders are at the top of the ‘pecking order’ of all stakeholders. Consequently, any concern shown towards factory workers would only exist because it benefits the shareholders. If the working conditions of the factory workers were not perceived to be likely to influence shareholder value, then it would be of no concern if enlightened self-interest was the driving motivation of business.

Hence, if the views of BCA do reflect the views of business, then it appears essential for groups such as NGOs and the news media, to highlight poor business practices as this in turn might cause various powerful stakeholders to become concerned and it will only be at that time that the corporations might react.

10.45 The question here is to encourage debate among students. Any answer to this question is dependent on personal views about organisational responsibilities and associated accountabilities. However, from an ethical perspective, it would be hoped that students do have a belief that organisations have responsibilities and accountabilities associated with modern slavery. Chapter 2 is of relevance here. Chapter 2 discussed the link between responsibilities, accountabilities, and accounting. Chapter 2 also discussed a four-step accountability model that can be applied to the issue of modern slavery.

10.46 Counter accounts, also referred to as ‘shadow accounts’, are accounts that are often developed from different philosophical and political standpoints relative to ‘traditional’ accounting practices and which can potentially contradict the 312

accounts being prepared by the managers of the focal organisation. Counter accounts are often produced by NGOs with the intent to address alleged imbalances in power and various social inequities.

The production of counter accounts has the potential to stimulate debate, which can lead to managers taking on new views and implementing new processes that ultimately have favourable consequences for otherwise marginalised or disadvantaged stakeholders, inclusive of the environment.

The production of counter accounts could also lead to the discovery of new opportunities or reveal potential risks that need to be addressed.

10.47 The risks and opportunities associated with climate change are often subdivided into physical risks and opportunities, and transitional risks and opportunities. See page 558 of Chapter 10 (Figures 10.6 and 10.7) for details of these risks and opportunities.

Whether the risks and opportunities should be disclosed by an organisation will depend upon our views about organisational responsibilities and accountabilities. Arguably, such risks and opportunities should be disclosed and various standard-setters have developed reporting guidance that prescribes disclosures about risks and opportunities that climate change poses for organisations. Many stakeholders would use such information to assess whether to support an organisation. For example, investors and lenders would require such information to enable them to assess the risks associated with advancing funds to an organisation. If managers fail to disclose such information, they might find it relatively difficult and/or costly to attract funds to the organisation.

10.48 The materiality determination process is the process managers undertake to determine whether information is ‘material’ to organisational stakeholders and therefore warrants disclosure. Information is considered to be material if it is likely to impact the decisions that stakeholders make about an organisation. The materiality determination process involves various forms of engagement with 313

stakeholders and ultimately a prioritisation of particular stakeholders’ information demands.

An organisation should report information about the materiality determination process because it provides context (and logic) to the information that is being reported. That is, 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 can 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 that the managers have employed, the disclosure about the processes should enable readers to better understand the context in which some information is reported and other information is not. This should increase the understandability of the report.

10.49 To address what will be reported within a CSR report we can apply the four-step accountability model introduced in Chapter 2, and further discussed within this chapter. As we should know, the four steps require consideration of:

1. Why is the organisation collecting and reporting particular information?

2. To whom is the organisation reporting the information?

3. What information is it collecting and reporting?

4. How is it reporting the information – where is the information appearing and what reporting or measurement frameworks are being used?

So, the point to be made here is that if we are ever asked to help prepare a sustainability report, then it is necessary that we understand why the organisation is wanting to prepare one. Ideally, the organisation is wanting to report information about its significant social and environmental impacts and is wanting to report to a broad group of affected stakeholders. The reason why we are producing a sustainability report will then have direct implications for determining which stakeholders to consider.

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If an organisation was motivated to report simply because of potential financial benefits, then we might only engage those stakeholders who can impact financial performance. Conversely, if the organisation is wanting to produce a sustainability report because it wants to be accountable for its significant social and environmental impacts then we might extend the range of stakeholders to be considered to those who are most impacted – regardless of whether such stakeholders have any ability to influence the performance of the organisation.

As students should appreciate, once we then engage the stakeholders we can then, and only then, address the next steps in terms of what to report (Step 3), and how to report (Step 4).

10.50 For financial reporting purposes, ‘expenses’ are defined in a way which acts to exclude the recognition of any impacts on resources that are not ‘controlled’ by the organisation (such as impacts upon a workforce), unless fines or other cash flows will result. Pursuant to the IASB Conceptual Framework, expenses are defined as follows:

Expenses are decreases in assets, or increases in liabilities, that result in decreases in equity, other than those relating to distributions to holders of equity claims.

An understanding of expenses therefore requires an understanding of assets. An asset is defined in the IASB Conceptual Framework as:

A present economic resource controlled by the entity as a result of past events.

The recognition of assets therefore relies upon ‘control’. Employees are vital resources to an organisation, but they are not ‘controlled’ in a financial reporting sense, and hence cannot be considered to be ‘assets’. Therefore, impacts upon the personal livelihoods of employees are not considered ‘expenses’. For financial reporting purposes, the recognition of an expense arises at the same time as:

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1. the initial recognition of a liability, or an increase in the carrying amount of a liability, or 2. the derecognition of an asset, or a decrease in the carrying amount of an asset.

Therefore, the social costs do not meet the definition of ‘expenses’ and hence will be ignored for financial reporting purposes. Transactions and events are only recognised for financial reporting purposes if one of the five elements of financial accounting (assets, liabilities, income, expenses, equity) are affected.

10.51 This is an interesting question for students to debate, particularly whether a senior executive should make such a statement.

To many readers, this would be a highly inappropriate response – but of course, this is a matter of personal opinion. Being socially responsible does require an organisation to embrace responsibilities beyond those that are codified in the law.

Further, the governments of some countries are known to be less socially responsible than others, and in some respects, this will be reflected within their laws. ‘Best practice’ social and environmental performance is not incorporated within the laws of many countries – and in particular – in many developing countries. Large multinational organisations are nevertheless expected to embrace ‘best practice’ social and environmental standards of operations regardless of where they are operating.

Consistent with the discussion in Chapter 10, being socially responsible requires the managers of an organisation to undertake activities not solely because the law requires particular actions, but because the actions are consistent with minimising the negative (maximising positive) social and environmental impacts imposed upon different stakeholder groups, including future generations and the ‘environment’ as stakeholders.

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If managers are on the public record making statements that their organisation should do business with all organisations that ‘stick to the law’ and it is not the role of the organisation to ‘make judgements about whether laws are right or wrong’, then this appears to reflect that the organisation is abdicating significant responsibilities and judgements to governments who might, or might not be, socially or environmentally responsible. This could likely impact the perceived legitimacy of the organisation – particularly if such statements are reproduced in mainstream news media – as was the case with these statements.

10.52 The perspective taken is that if organisations took more responsibility, and embraced greater accountability, for the impacts of their operations – including the social, environmental, and economic impacts – then they would provide more information about such impacts, why they are created, and what they are doing to address them. Such information would then tend to highlight impacts that were otherwise unreported and often unknown by the community.

With such information becoming available, this could create various challenges for organisations as various stakeholders insist on the organisation addressing the problems it is creating. In a sense, the provision of information to stakeholders provides them with power to make informed decisions about what organisation to oppose, or support. Hence any moves towards a ‘full accountability’ – which in reality would not actually be possible because of the seemingly infinite array of impacts being created by organisations – would tend to create many costs for an organisation (which would in turn impact corporate profitability). The argument is that, being focused on such profits, powerful people, who are considered to be in charge of such organisations (as well as the regulators who often seek the support of such powerful constituents), will oppose moves to increase corporate accountability.

There is indeed a deal of evidence to show that corporate managers do tend to oppose the introduction of further reporting requirements – particularly in relation to provisions about social and environmental performance. Generally, organisations prefer such reporting to be voluntary, thereby giving them the flexibility to determine what to report. Governments also tend to support the

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voluntary disclosure of social and environmental information and rely upon the concept of ‘enlightened self-interest’ to motivate disclosure.

10.53 As the chapter discusses, due to such factors as the definitions of the elements of financial accounting (particularly, that assets must be controlled), and the requirement that expenses and the other elements of accounting must be able to be reliably measured prior to recognition, environmental externalities are typically ignored in financial accounting reports generated by reporting entities. Relying upon a rather extreme example, Chapter 10 states that under traditional financial accounting, if an entity was to destroy the quality of water in its local environment, thereby killing all local sea creatures and coastal vegetation, then to the extent that no fines or other related cash flows were incurred, reported profits would not be directly impacted. No externalities would be recognised, and the reported assets/profits of the organisation would not be affected. Adopting conventional financial reporting practices, the performance of such an organisation could, depending upon the financial transactions undertaken, be portrayed as being very successful.

There is an acknowledgement by a number of entities throughout the world that new systems of financial accounting must be developed if we are going to make reporting entities more accountable for their financial performance, as well as social and environmental performance. What must be appreciated is that our current system of financial accounting is heavily based on a system of accounting that was developed in the 15th century by Pacioli, a Franciscan monk. Arguably, at that time, issues such as the environmental externalities and other social costs generated by business entities were not the focus of attention they are today.

Chapter 10 identified that there are various approaches to reporting (including ‘sustainability reporting’) that attempt to provide information about an organisation’s social and environmental performance. However, the implications associated with social and environmental performance is typically not quantified or monetised as part of attempts to make adjustments to reported profits or losses.

That is, reported profits or losses still tend to exclude the consideration of many

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social and environmental impacts (both positive and negative) caused by a reporting entity.

Mindful of the limitations of traditional financial reporting, many entities are voluntarily providing additional information that is not required by conventional financial accounting practices. For example, many entities are providing environmental information on a performance-against-targets approach, while other entities are providing information on the basis of the mass-balance approach.

This information is provided as a supplement to the information required to be presented pursuant to generally accepted accounting principles.

10.54 There could be various motivations for managers to report counter accounts. Some motivations might be tied to economic benefits while some might be linked to beliefs about broader accountability.

If managers report counter accounts, then it suggests that they are engaging with, and potentially responding to, the concerns of different stakeholder groups. This could lead to useful debate and could lead to a reduction in the risk that certain stakeholder groups might take adverse action against the organisation. The support of different stakeholders will likely increase. It will also open the possibility of pursuing opportunities that are favourable to certain stakeholders, as well as to the organisation itself.

10.55 Brown (2009) suggests the use of ‘dialogic accounting’. Such an approach represents a view that there is often more than one way to see organisational performance – particularly social and environmental performance. By contrast, ‘monologic accounting’ would show only one perspective of performance, and this would typically be the perspective of corporate managers.

According to Brown (2009), the views of different stakeholders in relation to specific aspects of social and environmental performance should be publicly reported, even if they are quite different. For example, different stakeholders might have different views about the social performance of a large multinational sportswear company with respect to its supply chains operating within developing countries. The diverse perspectives from different stakeholders might be due to 319

varying outlooks on corporate responsibilities, or different philosophies about the role of business and so on (that is, there will be more than one ‘logic’ – hence the use of the term ‘dialogic accounting’). There is also a view that reporting different perspectives about social performance will stimulate constructive debate between various stakeholders who hold contrasting perspectives. The views of Brown (2009) are very interesting and are counter to those often proffered by many accounting practitioners and researchers wherein there is one ‘view of the world’, which can be objectively reflected (‘faithfully represented’) within accounting reports.

Brown’s call for ‘multiple voices’ and an acceptance that providing the views or perspectives of different stakeholders in relation to the same situations or events – particularly in relation to matters of a social or environmental nature that can be evaluated from numerous perspectives – is considered preferable to simply providing one view (perhaps the views of managers), which inevitably is biased and privileges the rights of some members of society over others.

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Chapter 11: Reactions of capital markets to financial reporting

Solutions 11.1

Capital market research explores the role of accounting and other information in equity (capital) markets. As shown in the chapter, one branch of capital market research explores the reaction of share prices to the release of particular information. The view taken is that if share prices change around the time of the release of particular information, then (assuming the price reaction did not relate to other events) the information must have been useful in enabling the capital market to revise its expectations about the future earnings and cash flows of the organisation in question. The market is only expected to react to new information and hence a price change around the time of the release of the information indicates that the information is useful.

A second branch of capital market research that we explored in this chapter related to research which considers how accurately accounting data reflects the information used by the market in determining share prices. This research, which has been described as ‘looking back the other way’, adopts the view (from the efficient markets hypothesis) that share prices reflect information gathered from many sources, one source of which is accounting. Accepting that the share market has correctly priced a security, the share price, and changes therein, are used as a basis (or benchmark) for evaluating accounting data. Under this branch of capital market research, accounting data that does not relate to, or correlate well with, share prices is deemed to have limitations.

11.2

Capital market research typically adopts the assumption that equity markets are efficient, and accordingly, that they react swiftly to the public release of new information that relates to an entity’s future earnings and cash flows. This assumption is referred to as the efficient markets hypothesis (EMH). There are different assumptions about market efficiency, these being the weak-form assumption (which assumes that existing security prices simply reflect information about past prices and trading volumes); semi-strong-form efficient (which assumes that all publicly available information, including that available 321

in financial statements and other financial disclosures, is rapidly and fully impounded into share prices in an unbiased manner as it is released); and, strongform efficient (which assumes that security prices reflect all information known to anybody at that point in time, including information that is not publicly available). Capital market research typically adopts the semi-strong-form efficiency perspective.

In the context of capital market research, efficiency means that the market reacts swiftly to new information. It does not mean that the market necessarily makes a correct assessment of future earnings and cash flows (which can only be determined with hindsight).

However, it needs to be noted that in recent years there has been a great deal of research in the area of finance that has questioned assumptions about market efficiency.

11.3

As Chapter 11 questions, if further evidence continues to surface that capital markets do not always behave in accordance with the efficient markets hypothesis, then should we reject the research that has embraced the EMH as a fundamental assumption? In this regard we can return to earlier chapters of this book in which we emphasised that theories are abstractions of reality. Capital markets are made up of individuals and as such it would not (or perhaps, should not) be surprising to find that the market does not also act in the same predictable manner. Nevertheless, the EMH has helped provide some useful predictions and no doubt will continue to be relied upon by many researchers for a considerable period of time. As Lee (2001, p.238) states:

A common assertion is that even if the EMH is not strictly true, it is sufficient to serve as a starting point for research purposes. Like Newtonian physics, it is more than good enough for everyday usage. Unfortunately, it has becoming increasingly more difficult to accommodate what we know about the behaviour of prices and returns within this traditional framework.

At the present time there is a great deal of research into capital markets that does not rely upon market efficiencies. The consideration of ‘other forces’ that shape

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share prices and returns might eventually lead to a revolution in thought (Kuhn, 1962)—but it will arguably take a long time.

11.4

In an event study, a researcher explores whether an event, such as an earnings announcement, conveys new information to market participants as reflected in changes in the level or variability of security prices or trading volume over a short time period around the event. If the level or variability of prices changes around the event date, then the conclusion is that the accounting event conveys new information about the amount, timing, and/or uncertainty of future cash flows that revised the market’s previous expectations. The maintained hypothesis in an event study is that capital markets are informationally efficient in the sense that security prices are quick to reflect the newly arrived information.

The underlying objective of general purpose financial reports, according to the IASB Conceptual Framework for Financial Reporting (paragraph 1.2) is as follows:

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 about 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 (c) exercising rights to vote on, or otherwise influence, management’s actions that affect the use of the entity’s economic resources.

The use of accounting information by investors is therefore of central importance to the accounting profession, in particular, the issue of whether accounting information is used by investors in their decision-making processes. Capital markets research explores the market’s (investors in aggregate) reaction to various releases of information – including accounting information – and therefore capital markets research should be of interest to the accounting profession and to accounting standard-setters.

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11.5

Accounting earnings announcements, because of their potential information content, can have some impact on share prices. That is, share prices change in relation to information as it becomes available. However, the impact of ‘new’ information seems to be more significant for smaller firms and this is explained by the fact that there tends to be more information available for larger firms (for example, through more analysts paying particular attention to the larger firms).

Hence, as firm size increases, the general perspective taken is that share prices incorporate information from a wider number of sources (including, perhaps, numerous forecasts of the larger entity’s earnings) and therefore there is relatively less unexpected information when earnings are ultimately announced.

For large firms, we might actually be able to argue that share prices anticipate future accounting earnings announcements with some degree of accuracy. As Brown (1994, p. 105) states, if we take the perspective that share prices anticipate earnings announcements, we are effectively ‘looking back the other way’ from traditional perspectives that assume that accounting earnings or profit announcements actually drive share price changes.

‘Event study’ type research investigates how accounting information influences or drives share price, whereas the other branch of research explores an association between accounting measures – such as profits – and share prices without assuming a causal association. Both perspectives have merit, since the earnings announcement is likely to contain some information about a firm’s activities that was not previously known to investors, as well as information that investors have already determined (or anticipated) from alternative sources.

In considering why share prices convey information about future accounting earnings, Brown (1994, p. 106) argues:

In a world of rational expectations, events that affect future distributions to shareholders will be reflected in today’s share price, whereas accounting standards often require that the recognition of those events be deferred until some future accounting period.

Share prices are deemed by some researchers to represent a benchmark measure of firm value (per share), which can be compared against the value of a firm as 324

represented in its balance sheet. Also, share returns represent a benchmark measure of firm performance (per share) which can then be compared to another measure of firm performance – accounting earnings (or profits).

These market-based benchmarks (share prices and returns) are in turn used to compare the usefulness of alternative accounting and disclosure methods. For example, this methodology of looking at the association between share prices and accounting earnings is used to answer questions such as: are cash flows from operations a better measure of a firm’s performance than earnings calculated using the accruals system? Each of these accounting measures of performance is compared with the market benchmark measure of performance (share returns) to determine which accounting measure best reflects the market’s assessment of company performance. This type of capital markets research, which is often referred to as value-relevance research, also assumes that the market is efficient, and acknowledges that financial statements are not the only source of information available to the markets, such that security prices reflect information that is generally available from a multitude of sources. In particular, it assumes that investors and financial analysts actively seek out relevant information when making investment decisions or recommendations, rather than awaiting the release of the annual report. Further, this area of the research allows researchers to consider questions about balance sheet (statement of financial position) measures.

11.6

If it were assumed that capital markets were not efficient in assimilating information then the basis of efforts to link security price changes to information disclosures would be flawed. If they were not considered to be linked, then there would be little reason to investigate the association. If information is useful then the market is expected to react because it can differentiate useful information from other disclosures. If it cannot differentiate between ‘new’ information and ‘old’ information then market reaction could relate to anything and any reaction, or lack thereof, could not be used as a basis for assessing whether information should be disclosed.

In the branch of research which assesses accounting information based on how well it relates to existing share prices (research that ‘looks back the other way’) 325

the market is used as a basis for assessing the appropriateness of particular accounting disclosures. The market is assumed to provide the benchmark valuation. If the market is not deemed to be efficient, then this type of research and evaluation would not be logical.

11.7

The typical explanation from advocates of an efficient market would be that the disclosures provide no new information in relation to enabling investors to assess the future cash flows and profitability. The information being released by the organisation might have already been anticipated; alternatively, the information might already have been gathered from another source. As a further possibility, the market might not believe the information is credible (perhaps it has not been subject to an independent review and/or the management releasing the information are not considered to be reliable).

11.8

Typically, if an item of information is released and the market price of the firm’s securities does not change, then it is argued that the information is not being used by the market participants; otherwise there would have been a reaction.

Conversely, if security prices change around the time of the release of particular information, and assuming that the information and not some other event caused the price change, then it is considered that the information was relevant and useful for investment decision making. It would be relevant because it allows market participants to reassess the future cash flows of the entity. That is, it is assumed that relevant information is not ignored by the market.

Capital market research relies on the underlying assumption that equity markets are efficient. Market efficiency is defined in accordance with the EMH as a market that adjusts rapidly to fully impound information into share prices when the information is released (Fama et al., 1969). Capital market research in accounting typically assumes that equity markets are semi-strong-form efficient.

That is, that all publicly available information, including that available in financial statements and other financial disclosures, is rapidly and fully impounded into share prices in an unbiased manner as it is released.

11.9

The assumption of market efficiency typically used in capital market research is the assumption of semi-strong-form efficiency which assumes that all publicly 326

available information, including that available in financial statements and other financial disclosures, is rapidly and fully impounded into share prices in an unbiased manner as it is released. Under this assumption the market is not expected to have adjusted prices to take into account privately held information.

Therefore, a finding that people have made profits from trading on insider information would not invalidate assumptions about market efficiency.

If, by contrast, an assumption of strong-form efficiency is adopted (which assumes that security prices reflect all information known to anybody at that point in time, including information that is not publicly available), then gains would not be expected as a result of trading on privately held information.

However, such an assumption about market efficiency is generally considered to be unrealistic.

11.10 From a capital markets perspective, and if we assume that equity markets are semi-strong-form efficient (that is, that all publicly available information, including that available in financial statements and other financial disclosures, is rapidly and fully impounded into share prices in an unbiased manner as it is released) then a failure to see a share price reaction might imply that the information is not relevant to the market. However, there could be various reasons why the share price did not change. Perhaps there was other information released on the day that offset the effects of the specific information, or perhaps there were market-wide movements that offset the firm-specific price movements, or perhaps the assumptions of market efficiency do not hold.

The other point that must be made is that share price studies only consider the reactions of one group of stakeholders—investors. Information might be relevant to other parties who do not directly participate in the capital market, but nevertheless have a right to know about particular information. Hence, failure to find a share price reaction does not mean that information is necessarily irrelevant to all stakeholders.

11.11 There is evidence that the relationship between earnings announcements and share price movements is inversely related to the size of an entity. That is, earnings announcements have been found generally to have a greater impact on 327

the share prices of smaller firms relative to larger firms. This is explained on the basis that with larger firms there is generally more information available in the marketplace and therefore greater likelihood that projections about earnings have already been impounded in the share price. The earnings announcement for larger firms would have a relatively limited unexpected component. For example, research has shown that the relationship between the information content in earnings announcements and changes in share prices tends to be more significant for smaller firms. That is, in general, larger firms’ earnings announcements have relatively less information content (for example, Collins, Kothari & Rayburn, 1987; Freeman, 1987). This is consistent with the EMH and is explained by the fact that larger firms tend to have more information being circulated about them as well as attracting more attention from such parties as security analysts. Hence, on average, earnings announcements for larger firms tend to be more anticipated, provide less surprise, and are already impounded in the share price prior to the earnings announcement.

11.12 As the chapter explains, the larger the organisation the more likely it is that there will be more information publicly available about the entity. Larger firms tend to attract more attention from parties such as security analysts who are likely to spend the necessary time to find out about various things such as earnings projections, the market position of the entity, the performance of its competitors, and so on. Since it is assumed, pursuant to the EMH, that share prices will reflect information from various publicly available sources, the larger the organisation (and hence the greater the alternative information sources) the smaller the reaction of the market to accounting disclosures made by the entity. Research shows that the relationship between the information content in earnings announcements and changes in share prices tends to be relatively more significant for smaller firms.

11.13 The theory generally used within capital markets research (with its reliance on the EMH) effectively treats decision making by individuals as occurring within a ‘black box’ – that is, no investigation is made of how individuals make their decisions, but rather, the same decision-making abilities and motivations are attributed to all individuals. By contrast, behavioural research focuses on individual decision making and can show that some individuals are not ‘rational’ 328

wealth maximisers in the way that capital markets researchers have traditionally assumed.

Behavioural research relies in part on work often done in psychology-based research to explore various factors that influence decision making including the potential use of heuristics and the impacts of environment and formats of information presentation on decision making. The research is often done in a laboratory-type setting. Capital markets research typically uses archival (secondary data) to reveal how share prices in aggregate react to different types and forms of disclosure.

Another important difference between capital market and behavioural research as applied in the accounting literature is that capital markets research considers only investors, while behavioural research is often used to examine decision making by other types of financial statement users, such as bank managers, loan officers or auditors.

11.14 The theory used within capital markets research (with its reliance on the EMH) effectively treats decision making by individuals as occurring within a ‘black box’. This means that no investigation is made of how individuals make their decisions, but rather, the same decision-making abilities and motivations are attributed to all individuals. By contrast, behavioural research focuses on individual decision making and can show that some individuals are not ‘rational’ wealth maximisers in the way that capital markets researchers have traditionally assumed.

11.15 A confounding event is an event or occurrence which influences the relationship between the dependent variable (perhaps share prices) and the independent variable (for example, a particular earnings announcement. Confounding events can distort or bias a researcher’s results and they are often referred to as ‘omitted variable bias’. It is important to control for potentially confounding events or effects. Laboratory experiments often provide a way of controlling the potential influence of confounding effects or events.

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In relation to capital markets research, it should be noted that across time there will be many events that will affect share prices and trading volumes. One of the difficult tasks in undertaking event studies that review share price reactions to announcements is to try to ensure that there have been no other (confounding) events around the same time which might also have influenced share prices. For example, if accounting profits are announced on the same day that the chief executive officer has resigned then it would be difficult to determine what caused any possible share price reaction – was it the profits, or the resignation?

11.16 Where share prices are found to take time to react to particular information – such as a corporate earnings announcement – this is referred to in the literature as ‘drift’, or ‘post-earnings-announcement drift’. As Kothari (2001, p. 193) states:

Post-earnings-announcement drift is the predictability of abnormal returns following earnings announcements. Since the drift is of the same sign as the earnings change, it suggests the market under-reacts to information in earnings announcements. Ball and Brown (1968) first observed the drift. It has been more precisely documented in many subsequent studies. The drift lasts up to a year and the magnitude is both statistically and economically significant for the extreme good and bad earnings news portfolios.

A disproportionate fraction of the drift is concentrated in the three-day periods surrounding future quarterly earnings announcements, as opposed to exhibiting a gradually drifting abnormal return behavior. Because of this characteristic and because almost all of the drift appears within one year, I characterize the drift as a short-window phenomenon, rather than a longhorizon performance anomaly. The profession has subjected the drift anomaly to a battery of tests, but a rational, economic explanation for the drift remains elusive.

If further evidence continues to surface that capital markets do not always behave in accordance with the EMH, then as the question asks, should we reject the research that has embraced the EMH as a fundamental assumption? In this regard we can return to earlier chapters of your textbook in which it was emphasised that theories are abstractions of reality. Capital markets are made up 330

of individuals and as such it would not (or perhaps, should not) be surprising to find that the market does not always act in the same predictable manner.

Nevertheless, the EMH has helped provide some useful predictions and no doubt will continue to be relied on by many researchers for a considerable period of time. As Lee (2001, p. 238) states:

A common assertion is that even if the EMH is not strictly true, it is sufficient to serve as a starting point for research purposes. Like Newtonian physics, it is more than good enough for everyday usage. Unfortunately, it is becoming increasingly more difficult to accommodate what we know about the behavior of prices and returns within this traditional framework.

11.17 Accounting standards, such as AASB 138 Intangible Assets (its international equivalent being IAS 38), restrict the recognition of many intangible assets.

Internally generated intangibles which are unique in nature – such as many intangible assets relating to intellectual capital – are generally not recorded in an entity’s statement of financial position (balance sheet). This is despite the fact that the revenues being generated through the expertise and knowledge held by the entity might be significant. Because accounting standards fail to recognise many assets which nevertheless have value, and if we assume that share prices reflect expectations about future cash flows, then we would expect that there would be a low level of correspondence between the market capitalisation of an entity and the net assets of the entity, if such an entity generates a great deal of its revenues through the use of its intangible assets. Many capital market researchers would use this low level of correspondence as an argument that the financial reporting standard on intangible assets needs to be revised.

Conversely, we would expect a higher correspondence between the net assets of an entity, and its market capitalisation, for organisations that rely more heavily upon tangible assets. Many tangible assets can be valued at fair value, and these fair values will often represent expectations about future cash flows of the assets in question.

11.18 The research shows that the earnings announcements of firms within an industry can impact the share prices of other firms in the same industry. This effect has 331

been labelled as the ‘information transfer effect’. The ‘information transfer effect’ highlights the belief that share prices react to public information emanating from various sources – including information emanating from the entity’s competitors. Research shows (for example, Clinch and Sinclair 1987) that within an industry, the ‘information transfer effect’ tends to be more significant in relation to those entities that make the earlier earnings announcements. Once a number of firms within an industry report their earnings then most of the industry-wide information would have been incorporated in competitors’ share prices.

11.19 The key point to be made here is whether efficiency is the same thing as ‘getting it right’. Researchers would typically claim that there is a difference. Efficiency relates to how quickly the market reacts to new and potentially relevant information. For example, a share price reaction to the release of financial information or other information is taken to indicate that the announcement has ‘information content’ (and the information might later prove to be either correct or incorrect). The absence of a share price movement indicates either that the information is considered by the capital market as irrelevant or that it confirms market expectations. An efficient capital market is predicted to respond to all types of information to the extent that it is of relevance in predicting future cash flows associated with a company’s securities. The view held by many (but not all) researchers that markets are efficient does not imply that share prices will always provide an accurate prediction of the value of future cash flows. Market predictions are sometimes proved in hindsight to be wrong, thus necessitating subsequent adjustments. As Hendriksen and Van Breda (1992, p. 177) state:

It needs to be stressed that market efficiency does not imply clairvoyance on the part of the market. All it implies is that the market reflects the best guesses of all its participants, based on the knowledge available at the time.

New information appears all the time that proves the market was incorrect.

In fact, by definition, the market will not react until it learns something that it did not know the day before. One cannot prove the market inefficient, therefore, by looking back, using the benefits of hindsight and pointing to places where the market was incorrect. Market efficiency simply asserts that

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prices are appropriately set based on current knowledge; practical evidence shows that with hindsight the market is always incorrect.

11.20 Some of the factors that would impact whether the news about the bumper profits would have led to a change in the share price would include: •

Were the announced profits different to market expectations? If they were different to market expectations, then a share price change would be likely. If the market had anticipated record profits, then perhaps there would be no price change. Indeed, if the market had expected even greater ‘record profits’ then the disclosure of the actual profits could even lead to a price decline. What should also be appreciated is that for large firms, there would be many interested analysts and many sources of information, so the likelihood that a profit announcement provides unexpected information is lower relative to smaller companies – meaning that the likelihood of a share price adjustment is also lower around the time of a profit announcement;

•

There could be confounding impacts of other announcements or events that occur on the same day. That is, although the bumper profits and the news about dividend payments might have provided positive news to the market there is always the chance that negative news about the company, or about the industry, might have been released on the same day, which in turn has the consequence of offsetting the good news about profits.

•

Whether increased profits lead to price changes might be due to whether the profit is due to increases in revenues or decreases in expenses. In this case it would appear that a great deal of the increase relates to revenue increases, and this would be more likely to lead to share price increases (as per the results of Jegadeesh and Livnat (2006) reported on page 493).

Hence, we can see that there are various factors that will influence whether a profit announcement will, or will not, impact share prices.

11.21 It is considered that the results of capital market research are not consistent with the view that historical cost information is meaningless and useless. If it is assumed that the capital market is efficient (and there is some evidence to 333

suggest that it is also sometimes inefficient), and if it the market reacts to information derived from the application of historical cost accounting, then that information must be useful for assessing future earnings and cash flow. Such a view, however, hinges on the central assumption that capital markets are efficient. If we do not accept that capital markets are efficient, then we might not accept the view that historical accounting information is useful because a share price reaction occurred around the time of the release of historical cost information.

11.22 Much of the research based on the EMH assumes that there are zero contracting and information costs. It also assumes that the capital market can efficiently ‘undo’ the implications of management selecting different accounting methods.

For example, if an entity elected to switch its inventory cost-flow assumptions and this led to an increase in reported income, the market is assumed to be able to ‘see through’ this change, and, to the extent that there were no apparent cashflow implications (for example, through changing taxes), there would be no share price reaction. Hence, if the particular accounting method had no direct taxation implications, and assuming that markets were efficient and able to understand the effects of using alternative accounting methods, then in the absence of further theoretical insights, there would be an inability to explain why one method of accounting was selected or preferred by management in preference to another. As Watts and Zimmerman (1990, p. 132) state:

An important reason that the information perspective (e.g. Ball and Brown, 1968) failed to generate hypotheses explaining and predicting accounting choice is that in the finance theory underlying the empirical studies, accounting choice per se could not affect firm value. Information is costless and there are no transaction costs in the CAPM frameworks. Hence if accounting methods do not affect taxes, they do not affect firm value. In that situation there is no basis for predicting and explaining accounting choice.

Accounting is irrelevant.

Yet, evidence indicates that corporate managers expend considerable resources lobbying regulators in regard to particular accounting methods that could potentially be included in accounting standards. To such individuals, the choice 334

of accounting method matters.

A key to explaining managers’ choice of particular accounting methods came from Agency Theory. Agency Theory provided a necessary explanation of why the selection of particular accounting methods might matter, and hence was an important facet in the development of PAT. Agency Theory focuses on the relationships between principals and agents (for example, the relationship between shareholders and corporate managers), a relationship which, due to various information asymmetries, creates much uncertainty. Agency Theory accepts that transaction costs and information costs exist.

Relying on traditional economics literature (including accepting assumptions such as that all individuals are driven by a desire to maximise their own wealth), Jensen and Meckling considered the relationships and conflicts between agents and principals and how efficient markets and various contractual mechanisms can assist in minimising the cost to the firm of these potential conflicts. Within Agency Theory, a well-functioning firm was considered to be one that minimises its agency costs (those costs inherent in the principal–agent relationship).

Positive Accounting Theorists built on the work of Agency Theory to explain why accounting method choice mattered. As they note, many contractual arrangements negotiated between the owners and managers, and between managers and debtholders, rely upon accounting numbers. It is assumed that managers will select those accounting methods which minimise potential conflicts. Because some accounting methods will be more efficient than others in terms of minimising agency costs, management will have preferences about which accounting methods they use – the choice of accounting method will matter. Managers (agents) will themselves have an incentive to enter into contractual arrangements that appear to be able to reduce agency costs (that is, that reduce their ability to undertake actions detrimental to the interests of the principals). By reducing the risks of owners, managers will typically receive higher returns (consistent with the idea of ‘price protection’).

Once contractual arrangements have been negotiated that rely upon accounting numbers (and these might have been negotiated for reasons of efficiency), 335

management will care about whether liabilities – such as those relating to leases – are included in the notes to the financial statements, or in the balance sheet. If the company has borrowed funds, then it might have entered debt contracts and these contracts might include covenants which restrict the amount of debt the company has relative to its assets or equity. If the company is required to recognise additional debt (for example, leases that were once considered to be operating leases are subsequently required to be recognised for balance sheet purposes) then this could potentially lead to the organisation being in technical default of its debt covenants – and this could have costly implications for both the owners and the managers.

Therefore, whilst notions of market efficiency might suggest that ‘the market’ might not care about whether one method of accounting is selected in preference to another (as long as there is enough information to enable them to undo the effects of alternative accounting methods), Agency Theorists and Positive Accounting Theorists would argue that it does matter which methods of accounting are used.

11.23 If we accept that the market is able to determine the appropriate price of a firm’s securities on the basis of information from a multitude of sources (the market has it ‘right’) then the role of financial accounting is to confirm these expectations. Of course, it is questionable whether markets can be expected to ‘get it right’ and as such it would typically be expected that there will be some unexpected information when financial statements are released. What must also be remembered is that the capital market is not the only user of financial accounting information and hence financial accounting has a role beyond informing or confirming the expectations of investors. An accountability is owed to other stakeholder groups, such as employees, customers, local communities, and so on, and one medium for providing information in response to this accountability is the annual report.

11.24 For markets to be deemed to be efficient there would be an expectation that markets react rapidly to fully impound information within share prices once the information is released. There would be an expectation that such reaction would

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not be biased in nature and would be reflective of changing expectations about future cash flows.

If there is evidence (and we always must be mindful of the quality of the research) that mood, rainy days, daylight hours, and sporting events impact the speed and extent to which the entire market reacts to impound the information (the market is ‘under-reacting’ to the information), then this is arguably not consistent with notions of efficiency. However, if a sub-group of market participants are not influenced by mood, rainy days, and so forth, and if they trade on the information to make gains through the process of arbitrage (at the expense of those people that are moody, impacted by rain, and so forth), and if these arbitrage forces allow prices to fully reflect the available information, then concerns about market efficiency might be somewhat alleviated.

The study of capital market efficiency, or otherwise, is a topic that enthrals many capital market researchers. What we need to remember is that assumptions about market efficiency are just that – they are assumptions. Markets are made up of people and to assume that there is some sort of ‘force’ that somehow just works for this mass of people, and works all the time, is actually somewhat ridiculous.

11.25 Capital market researchers would argue that the information, when released, had the overall effect of changing market expectations about the future cash flows to be generated by the organisation. However, they would need to differentiate between whether there were market wide, or industry-specific events (systematic changes) that might also have influenced share prices. Such market-wide and industry-specific events would be isolated to determine non-systematic price changes which they could then relate to firm-specific information.

Because there are two company-specific events (and the researchers would also need to ensure there are no other potentially confounding events) that could be related to the company-specific (non-systematic) component of the price change, the researchers would need to carefully determine the time at which information about the Mexican ban and the company takeover became available. They would then look for price changes around this time. This might require the use of quite short ‘event windows’.

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11.26 If we accept that markets are efficient, then share price changes around the date of announcements about executives will occur because the information was unexpected, and further, that the information was considered to have implications for the future cash flows of the respective company. If there is a share price movement (which was not related to market wide changes or to any other potentially confounding events), then the announcement about the corporate executives apparently was seen as providing news about the future prospects, and related cash flows, of the company.

In relation to the question of market efficiency we must remember that from the perspective of capital market research, ‘efficiency’ means that the market adjusts rapidly and in an unbiased manner to the public disclosure of new information.

Market efficiency does not mean that the market will make perfect predictions about future cash flows. Whether the market ‘gets it right’ will only be determined with hindsight. If the market does react to new information which has implications for future cash flows, it could be considered that the change in the price of the shares is consistent with market efficiency.

11.27 Capital markets researchers would use large-scale data to separate out companyspecific share price movements from market-wide movements. Systematic risk, which is the non-diversifiable or unavoidable risk that investors are exposed to through general market-wide movements would be identified for the company and this would be linked to what are referred to as ‘normal returns’. Normal returns are expected to vary from company to company, depending on their level of systematic risk relative to the market.

Abnormal returns, by contrast, provide an indication of how the share price of the company relates, or moves, with respect to specific events, such as the release of information about the large impairment loss. That is, abnormal returns are expected to vary from company to company, depending on whether there is new information about the company that causes investors to revise expectations about future earnings.

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It is the abnormal component of the share price movement – which cannot be related to market-wide movements – that capital markets researchers are typically interested in identifying, as the abnormal returns are considered to reflect the reaction of the company’s shares to the new information being disclosed. It reflects the difference between what the market return on that organisation’s shares was expected to be (based on some form of modelling) and what it was following a particular event, such as the release of information about the impairment loss.

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Chapter 12: Reactions of individuals to financial reporting: an examination of behavioural research in accounting Solutions 12.1

According to Birnberg and Shields (1989, p. 24):

Behavioral Accounting Research applies theories and methodologies from the behavioral sciences to examine the interface between accounting information and processes and human (including organizational) behavior.

Behavioural research is typically grounded in organisational theory, and theories from psychology and sociology rather than from economics.

Many early accounting researchers that undertook this form of research initially undertook education that incorporated majors in psychology. This provides an example of how research insights developed in particular disciplines can then be ‘borrowed’ by researchers working in other disciplines.

12.2

As students in accounting we should all be interested in the ways different people use and process accounting information. Behavioural research in accounting provides such insights.

Some students of accounting will ultimately work as accounting regulators and standard-setters. By generating knowledge about how different categories of financial statement users (investors, research analysts, auditors, bankers, loan officers and so on) react to particular accounting disclosures, corporations, the accounting profession and regulators (such as the International Accounting Standards Board, Securities and Exchange Commission in the US, the Australian Securities and Investments Commission in Australia, and so forth) will be better placed to anticipate how different individuals will react to particular information.

Because behavioural research is typically undertaken by exposing individuals to experiments, this body of research is particularly relevant to the accounting standard-setting process. That is, before particular disclosure requirements are 340

made mandatory it would be advisable for standard-setters to identify particular stakeholder groups (such as investors) and then test within a controlled setting how they react, if at all, to particular disclosures or accounting methods. Such testing can be done before an accounting standard is finalised and as a key part of the development of the accounting standard. By contrast, capital markets research would test how ‘the market’ in aggregate reacts to the finalised accounting standard.

Because many students of accounting will also work as bankers, loan officers, or auditors – all of which are the subjects of behavioural research in accounting – it will also be useful to have insights into how fellow workers make decisions, particularly if exposing the decision-making process highlights limitations and strengths in the process.

12.3

Behavioural research can be used to investigate the individual reactions of different categories of individuals. In accounting-related studies this could involve investigating how a variety of financial statement users (including, but not restricted to, investors) react to a variety of accounting information, often presented in different forms. Capital market research, on the other hand, is used to investigate the aggregate reactions of investors to events, typically explored by reviewing movements in share prices around the time of particular events. Capital markets research ignores the information demands of people who do not participate in the capital market, and it relies on an assumption that the capital market is efficient (usually, the semi-strong-form efficiency assumption).

Behavioural research typically makes no assumptions about the efficiency of the subjects. Behavioural research often uses a restricted number of observations (due to the ‘costs’ involved in getting subjects) whereas capital market studies can use large numbers of observations given the availability of share price data.

Behavioural research can be particularly useful to accounting standard-setters as it can enable them to investigate how different classes of financial statement users will react to proposed accounting standards. That is, this form of research can enable standard-setters to investigate possible reactions in advance of the rules being put in place. Again, this can be contrasted to capital markets research which looks at the aggregate reaction of investors to actual releases made by the 341

accounting standard-setters (although, reactions can be investigated in relation to the release of draft accounting standards).

12.4

Behavioural research can be used to address issues that might be unresolved by researchers who embrace other research paradigms, such as those used in capital markets research. For example, certain indicators of market inefficiency have been advanced by some capital markets researchers. Behavioural research might provide some relevant insights to explain the perceived market inefficiency. As Trotman et al. (2011, p. 315) state:

As noted earlier, the availability of financial databases during this period (1980s and 1990s) greatly facilitated the use of econometric techniques to investigate financial accounting issues. Several market inefficiencies, including the post-announcement earnings drift, were uncovered using this approach. The prevalence of these inefficiencies challenged the widely held belief that capital markets were semi-strong-form efficient. The difficulty of controlling for all confounding factors in a natural setting made it difficult for archival researchers to identify the causes of these inefficiencies. In contrast, experiments were eminently suited to this form of investigation. The experimental researcher could manipulate variables of interest and could use randomisation to control for potentially influential variables. Specifically, judgement- and decision-making-researchers were motivated to investigate whether the cognitive limitations and bias of individual investors contributed to these observed inefficiencies.

Some researchers who are interested in exploring potential inefficiencies in capital markets have referred to insights provided within the behavioural finance literature. This literature, which has much in common with the behavioural research that we explored in Chapter 12, relies in part on work often done in psychology-based research to explore the apparent phenomenon that individual investors appear to sometimes make decisions that cannot be considered as economically rational. In making their decisions, investors often use various ‘heuristics’, or simplifying shortcuts. For example, investors have been found to be more inclined to hold on to shares for too long to avoid finally realising a loss, but at the same time might sell valuable stocks too early and miss out on future 342

gains. What the research shows is that individuals often make decisions in a way that is not consistent with ‘economic rationality’ – and this research can provide some interesting insights into why there is a certain degree of inefficiency in capital markets. It should be appreciated that the theory used within capital markets research (with its reliance on the EMH) effectively treats decision making by individuals as occurring within a ‘black box’ – that is, no investigation is made of how individuals make their decisions, but rather, the same decision-making abilities and motivations are attributed to all individuals.

By contrast, behavioural research focuses on individual decision making and can show that some individuals are not ‘rational’ wealth maximisers in the way that capital markets researchers have traditionally assumed.

12.5

Yes, behavioural research can complement research being undertaken using other paradigms. For example, in capital markets research (which utilises large data bases of secondary data) it is typically assumed that all individuals act in the same way and that they are all motivated by self-interest tied to wealth maximisation – that is, they are economically rational. Behavioural research can allow researchers to test to see if this seems to hold in all situations, and if not, what situations particularly seem to provide stimuli to depart from economic rationality.

Therefore, if the capital markets research shows that market participants do not always appear to act ‘efficiently’, behavioural research might provide some insights into why.

12.6

The accounting profession can use the results of behavioural research to enable them to understand how various types and forms of disclosure will impact different categories of financial statement users (for example, analysts versus shareholders versus lenders, and so on). This form of research can be undertaken prior to particular disclosure requirements being introduced. If it is found that particular disclosures do not influence the decisions of any of the various classes of financial statement users then perhaps the implication might be that the development of a particular disclosure requirement will be abandoned. (An interesting issue arises if some categories of financial statement users are influenced by the disclosures but others are not – would this be sufficient to justify the requirement, and are the needs of some classes of financial statement users more important than the needs of others?) This can be contrasted with capital 343

markets research which considers the reactions of investors in aggregate after requirements have been introduced. Some capital market studies, though, do assess the reactions of capital market participants to proposed accounting requirements by looking at share price reactions around the time of the release of draft reporting requirements.

12.7

It would seem reasonable to believe that management would be interested in knowing how various categories of financial statement users are likely to react to disclosures that the organisation is contemplating making, particularly when the disclosures are made on a voluntary basis. Behavioural research can be used to provide information of this nature. Behavioural research can be used to see how different categories of financial statement users are likely to respond to particular types of disclosures. It could be useful to make this determination in advance of issuing documents such as the annual report. Of course, whether management should rely upon the results of the behavioural research will be dependent upon how well the subjects represent the actual users of the financial statements and the realism of the task assigned to the subjects.

12.8

The Brunswik Lens Model depicts the processes involved in making decisions. It represents the processes involved when people use information cues in a variety of ways, to come to a decision about future events. The Brunswik Lens Model also suggests that some of the cues might be interrelated. No individual cue is expected to provide a perfect predictor of the future event.

Mathematical modelling is typically used when the Brunswik Lens Model is applied and it can be used to model the relationship between the information cues and the actual judgement made by the individuals (because it is a model, it will not perfectly predict the judgements of individuals). The approach can also be used to model the relationship between actual phenomena and particular information cues without explicitly involving individual judgements.

The Lens Model can be used to investigate the use of inputs (for example, which information cues are used and whether they are perhaps influenced by how the data is presented), the decision process (for example, how various information cues appear to be weighted by the subjects) and the outputs (for example, how 344

‘accurate’ the decisions made by the subjects appear to be, or whether the judgements appear to be stable over time).

12.9

A heuristic can be defined as a simplifying rule of thumb. That is, rather than fully considering all the potentially relevant factors, a simplifying rule may be employed which takes a lot less time but nevertheless possibly generates an acceptable (and cost-effective) prediction or solution. According to Tversky and Kahneman (1974), there are three main categories of heuristics employed in decision making, these being: representativeness, anchoring and adjustment, and availability.

It might not always be clear to others, or to the individual, that a simplifying heuristic is being employed. If a researcher can highlight it, then remedial action might be encouraged if it is considered that a heuristic is potentially generating decisions that could be costly. For example, auditors might be inclined to ‘anchor’ on an initial belief (or hypothesis) about the soundness of an internal control system and thereafter they might simply seek a limited amount of evidence that is supportive of this initial belief. This could introduce a potentially costly bias into the audit process and if auditors are made aware of this, then such awareness might be beneficial to them in avoiding potentially costly errors of judgement.

From another perspective, it might be found that people applying relatively lowcost heuristics make judgements comparable with other individuals who go through costly decision-making processes. For example, loan officers might have a quick rule of thumb for predicting whether borrowers are likely to repay their debts and their decisions might be comparable (or perhaps better) than decisions made by others who go through various costly information searches. If this is the case, then loan officers might be encouraged to use the lower cost approaches to decision making.

12.10 There could be several reasons for modelling the decision-making processes of different financial statement user groups, including the following: •

To find out how users are making decisions and to see if they are using all available information, or whether they are employing any simplifying heuristics. If information which is relevant is ignored, or if heuristics are 345

being employed that could lead to wrong decisions being made, then knowledge of this would be useful for subsequent training initiatives.

Audit firms are often interested in this form of research if it shows that auditors, or trainee auditors, are inclined to make poor judgements in particular circumstances.

•

To understand the differences in the information demands and information processing of different financial statement user groups.

•

If the research shows that decisions made by way of simplifying heuristics are as good as decisions made from costly information searches, then such heuristics may be identified and implemented within an organisation.

•

Information about how people make decisions could be useful to organisations when they are considering whether to disclose information.

Perhaps the models indicate that people are not likely to take such information into account. In such a case, the organisations might elect not to make specific disclosures.

•

The model developed might indicate that the form of disclosure makes a difference to how people use information. If this is the case, then this has direct implications for how organisations disclose information.

•

Accounting standard-setters would be interested to know how financial statement users react to particular types and forms of disclosure when developing disclosure requirements. For example, does it matter whether information is provided in notes to the accounts, or in the main body of the financial statements? It would also be relevant when developing educational programs. If it appears that information that should be important to decision making (and this is a matter of opinion) is being ignored, then efforts might be made to highlight the relevance of the information.

•

If models are developed from studying the decision-making process of ‘expert’ subjects, these ‘expert models’ may be used to train lessexperienced people (or perhaps the models could be commercially marketed).

12.11 Many factors need to be considered when answering this question. Firstly, we need to consider the method and rationale behind the selection of the subjects used in the study. Are they representative of all of the relevant financial statement user 346

groups? If only investors are used, then the results must be considered in this light.

Perhaps other user groups which were not represented in the experiment might, or might not, use the information in the various decisions they make. Another consideration is the realism of the experiment. If the subjects did not take the experiment seriously, or if the setting was very different to the setting in which they normally make their decisions, then much care would need to be taken when interpreting the significance of the results. However, if the subjects were deemed to be representative of the larger population of financial statement users, and if the tasks appeared to be realistic then, in the absence of evidence to the contrary, the results could indeed be grounds for the accounting profession to abandon the development of particular disclosure requirements.

Of course, there is an alternative perspective. People might not be using a particular cue because they do not know how to use it, or perhaps because they have never been exposed to it before. In this case, the accounting profession might consider educating the users about how such information can be useful.

12.12 Some possible reasons for the disparity in results of different behavioural experiments could include differences in the: •

settings of the experiments (perhaps some settings were more representative of the ‘real world’ than others);

•

experience, training or backgrounds of the subjects;

•

tasks being undertaken by the subjects as well as differences in how the tasks were administered;

•

incentives associated with the subjects doing the task.

12.13 Protocol analysis typically requires subjects to ‘think aloud’ when they are making decisions, and what they say is typically recorded for subsequent analysis.

Trotman (1996) identifies a number of advantages and disadvantages of protocol analysis, including the following.

Advantages •

A useful way to find out about previously unknown decision-making processes – very useful for developing theory.

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•

The sequence in which information is used can be determined.

•

A useful way to confirm previous theories about how people make decisions.

•

Useful for people to learn about how they themselves make decisions.

Without the results of protocol analysis, this might not be obvious.

Disadvantages •

The process of ‘thinking aloud’ may affect how decisions are made – it is quite different to how decisions are normally made.

•

Subjects will not always verbalise all the processes involved in making a decision, hence resulting in omitted data.

•

Protocol analysis often generates considerable data (perhaps many hundreds of pages) for the researcher and what data is selected or utilised can be quite subjective.

12.14 In research that embraces the Lens Model approach, the research is typically of a ‘stimulus-response’ type. That is, the researcher determines the cues to provide to the research subjects and then as a result of the experiment, weights assigned to each cue can be determined statistically. As such, this type of research is more appropriate to situations or tasks where objectives and information cues are more clearly defined. By contrast, protocol analysis is useful for uncovering the use of various information cues that might not otherwise be known by the researcher and is also useful for analysing tasks that are not well structured. As Trotman et al.

(2011, p. 310) state:

Protocol analysis (or process-tracing techniques) traces the actual decisionmaking process of users of financial information and is suited to studying illstructured tasks. Protocol analysis allows the researcher to ‘identify cues, the sequence in which the cues are utilised and determine their relative importance by the frequency of their use or process modification accounted for by the cue’ (Dillard, 1984).

According to Trotman (1996), there are a number of advantages and disadvantages in the use of protocol analysis. In relation to possible advantages, he states (p. 56): 348

One of the main advantages of verbal protocol analysis is the ability to examine the process by which judgements are made. Understanding how judgements are made is an important start in improving those judgements.

Second, verbal protocols are particularly useful in examining information search. The sequence in which information is obtained can be traced and the amount of time a subject devotes to particular cues can be determined. Third, verbal protocol can be useful in theory development. For example, Biggs, Mock and Watkins (1989) suggest the need to ‘begin gathering data about how auditors make analytical review judgements in realistic settings and attempt to build a new theory from the results’ (p. 16).

12.15 Some general strengths of behavioural research relate to the fact that it enables researchers to manipulate a number of variables (for example, the form and type of disclosure; requiring decisions to be made by the subjects on an independent basis, or as part of a team; the impact of offering different amounts and types of incentives, and so on) in an endeavour to understand what factors influence the decision-making process. In the area of accounting, behavioural research can be undertaken in advance of any regulations being introduced to see if the introduction is warranted (this can be contrasted with capital market research). This would be a lot less costly than introducing regulation only to find that it generates minimal or adverse benefits.

In terms of the disadvantages of behavioural research, a major limitation is that it is often difficult to make the experiments realistic, which in turn has implications for the generalisability and external validity of the findings.

Subjects typically have limited accountability for the decisions they are required to make within the experiment which would normally be quite different to the situation associated with their usual employment. Since it is often difficult to get many cooperative subjects, laboratory studies often by necessity must use small sample sizes (this also has implications for the generalisability of the findings). Another limitation of behavioural research is that different studies often generate disparate results, and it is often quite difficult to reconcile the differences (which could be due to a multitude of

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causes, such as differences in the setting, the task, the subjects, the incentives, instructions provided, and so forth).

12.16 Care would need to be taken in generalising the results from behavioural research.

If we were to try to generalise the results from the research to the ‘real world’ we would need to ensure that the experiment was undertaken in a setting that was as realistic as possible – in practice this will be difficult. In the ‘real world’ there would typically be real incentives and ongoing implications from making decisions – this usually cannot be replicated in a laboratory setting. Related to the above point is the realism of the cues provided to the subjects. It is very difficult to replicate the various cues that would typically be available in the workplace.

Also knowing that the results on a particular judgement are being carefully scrutinised could clearly be expected to influence the decision-making processes being employed.

A number of studies also use students as surrogates for auditors, lending officers, and so on. This has also been seen as a limitation in terms of generalisability because such people have limited training in the area and have not had the same background experiences as the parties for whom they are acting as proxies (there has been some research that shows students do make judgements comparable to those of particular experts. However, such findings are not universal).

A further criticism that we can raise relates to the typically small number of subjects used in experiments. Whether results based on relatively small samples can be expected to be generalisable to the larger population can be questioned.

Also, there is typically no real accountability for the decisions being made within the experiments, such that the implications of making inappropriate decisions within an experimental setting have very different implications from making such decisions in the ‘real world’. Hence, care would need to be taken in generalising the results of the research.

Lastly, there are also the issues of differences in cultures, religions, and so forth.

Because it is reasonable to argue that an individual’s use of particular cues will be

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influenced by factors such as culture and religion, great care would need to be taken in generalising the results of behavioural research across different countries.

12.17 An experiment undertaken in a controlled environment, such as a laboratory setting, would have higher internal validity. Internal validity represents the extent to which a researcher can be confident that a change in a dependent variable was caused by identified independent variables and not by some other variables that were not identified or measured. Within a controlled environment, the research would be more able to control or remove many influences/variables that might be influencing decision making and would have more confidence that any change in behaviour could be associated with variations in the experimental variables.

12.18 There is merit to this statement. Internal validity represents the extent to which a researcher can be confident that a change in a dependent variable was caused by identified independent variables and not by some other variables that were not identified or measured. That is, an experiment with high internal validity would be one wherein the researchers are confident that they can rule out alternative explanations for why a dependent variable changed.

By contrast to internal validity, external validity refers to the extent that results can be generalised to settings or contexts other than the setting or context in which the research was undertaken. Because controlled settings are sometimes quite different to the workplace, the external validity of controlled settings is often questioned. That is, when a causal relationship between a dependent (perhaps a decision) and an independent variable (perhaps a cue) is tested in a controlled laboratory setting, this will tend to lead to higher internal validity due to external influences being minimised. However, external validity would often be considered lower because the environment in which the experiment is conducted is different to the ‘outside word’. It tends to be ‘artificial’. Whether the same results would be generated within the ‘outside world’ is often questionable.

Nevertheless, laboratory settings can be very useful to understanding what factors influence – positively or negatively – human behaviour.

12.19 Economics-based theories such as Positive Accounting Theory and Agency Theory make assumptions about what motivates human actions (for example, a 351

quest to maximise personal wealth), and such motivations are attributed to all individuals. By contrast, behavioural research studies individuals’ actions and choices and typically does not make broad-based assumptions about how all individuals behave, or about what motivates them to behave in a particular way (although there could be an acceptance that many individuals will tend to adopt specific strategies or biases when making decisions).

Further, behavioural research is typically grounded in organisational theory, and theories from psychology and sociology rather than from economics. However, like theories such as Positive Accounting Theory, Legitimacy Theory and Institutional Theory (discussed in Chapters 8 and 9), behavioural research can be thought of as ‘positive research’, because it seeks to explain particular actions or behaviours (in contrast to ‘normative research’, which prescribes how certain activities should be undertaken). However, unlike some theories that strictly limit their attention to explaining and predicting behaviour at an individual level, behavioural research typically also concerns itself with improving the quality of decision making – hence there can ultimately be a normative component to behavioural research.

12.20 The work being undertaken by the IASB could utilise techniques from behavioural research when revising the conceptual framework. For example, various classes of decision makers could be given various items of information to see how differences in the information in turn impact the decisions being made. Some of the cues could use information that has been generated using different measurement principles. The regulators could also investigate whether the way the information about measurement is presented impacts the ways in which decisions are made. Further, whether information about particular measurement issues evokes a different decision, depending upon whether the information is in footnotes, or in the body of the financial statements, could be explored.

Of course, whether the results of the research could be generalised to a global population needs to be carefully considered. Because the conceptual framework to be generated by the efforts of the IASB would be used across many countries it would seem to be particularly important that the standard-setter considers issues of differences in cultures, religions, and so forth. Since it is reasonable to argue 352

that an individual’s use of cues will be influenced by factors such as culture and religion, great care would need to be taken in generalising the results of behavioural research across different countries. Arguably, if behavioural research was undertaken by the IASB, then it should be undertaken in various cultural settings.

12.21 A heuristic can be defined as a simplifying rule of thumb. That is, rather than fully considering all the potentially relevant factors, a simplifying rule may be employed which takes a lot less time but nevertheless possibly generates an acceptable (and cost-effective) prediction or solution.

Heuristics represent short cuts when making various decisions. Decision makers might, or might not, know that they are applying heuristics. Heuristics often enable cost-effective decisions to be made and knowledge of them can be useful when designing decision rules to be applied within organisations. Heuristics can also introduce a level of bias into decision making which might lead decision makers away from making appropriate decisions.

Depending upon the nature of the decisions being made, it can be very important for researchers to uncover heuristics as part of the process of improving overall decision-making processes.

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Chapter 13: Critical perspectives of accounting Solutions 13.1

A critical perspective of accounting is a perspective that critically evaluates the role of accounting in society. The label ‘critical perspective’ is a broad umbrella term which has been used to describe research undertaken by many researchers that sometimes applies different philosophical perspectives. As Hopper et al.

(1995, p. 535) state: ‘critical theory is an umbrella term for a wide variety of theoretical approaches perhaps more united in what they oppose than what they agree upon’.

Consistent with the above perspective of critical theory, Reiter (1995, p. 53) states: In the critical world, there is no single established theory or approach, and little consensus on how to proceed, aside from an absolute horror of modernity and neo-classical economics.

Nevertheless, we can generalise by saying that a critical perspective does not consider issues such as which accounting methods should be used in which situations (an issue that often dominates the thoughts of many other accounting researchers) – rather, it tends to dismiss most of accounting as being against the interests of many people in society (the public interest), and often views accounting as a major contributor to perceived social problems and inequities. A ‘critical perspective’ considers accounting to be a highly partisan activity and it is generally considered that accounting is not a neutral or unbiased process (neutrality, objectivity and similar characteristics are promoted within vehicles such as conceptual framework projects) but is a process which tends to favour those people in control of capital (the ‘powerful elite’). Accounting is seen as a ‘tool for constructing, sustaining and legitimising economic and political arrangements, institutions and ideological themes’ (Guthrie & Parker 1990, p. 166).

13.2

The focus of the research is different. Most accounting researchers tend to accept current social systems as a ‘given’ and do not question whether current systems of accounting systematically favour certain classes in society at the expense of others.

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Consideration is given to such things as what accounting methods are most appropriate in certain circumstances, what motivates managers to use one accounting method in preference to another, how the share market will react to a particular disclosure, what information best suits particular users’ needs, and so on.

Critical theorists, on the other hand, tend to dismiss the whole of accounting as being highly partisan, favouring the interests of those with control of scarce capital and undermining the interests of those people without power or wealth. They do not tend to debate which methods of accounting should be employed – rather they would generally believe that we need to reconsider the structures of society in terms of whether the structures are equitable, and we need to explicitly consider the role of accounting in sustaining such structures and inequities. As Cooper and Sherer (1984, p. 222) state, ‘a critical approach to accounting starts from the premise that problems in accounting are potentially reflections of problems in and of society and accordingly that the latter should be critically analysed’.

Accounting is seen as ‘a social practice within political struggles and not merely a market practice guided by equilibrium in an efficient market’ (Hopper et al.

1995, p. 528).

13.3

From a critical perspective, the role of conceptual frameworks is not to improve the practice of financial accounting. Rather, conceptual frameworks legitimise the role of the accounting profession within society. Conceptual frameworks (CFs) emphasise the qualitative characteristics of objectivity, neutrality, reliability, and so on. Such characteristics are deemed to have positive connotations. As Hines (1991, p. 328) states:

CFs provide social legitimacy to the accounting profession. Since the objectivity assumption is the central premise of our society … a fundamental form of social power accrues to those who are able to trade on the objectivity assumption.

By further legitimising the role of accountants in society, conceptual frameworks are a source of ‘power’ for the accounting profession, and if it is accepted that accounting acts as an instrument to maintain existing social structures (and the perceived inequities), then conceptual frameworks also provide a source of power,

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or legitimisation, for those people currently holding positions of power and wealth.

13.4

From a critical perspective, financial statements would probably never be considered as objective or neutral. Critical theorists consider that accounting serves to maintain the interests of those individuals with financial capital.

Accounting is seen as a means of constructing and legitimising particular social orders. Arguments are also provided that those responsible for regulating accounting, and those involved in accounting research, act to sustain current social orders as such individuals typically benefit from the existing systems. So, while regulators (for example government) may look as though they are putting in place rules or mechanisms to further the interests of disadvantaged groups, in essence, the government is probably only attempting to legitimise the current social system.

Merino and Neimark (1982, p. 49) relate this view to the development of Securities Acts in the United States. They contend that ‘the securities acts were designed to maintain the ideological, social and economic status quo while restoring confidence in the existing system and its institutions’. This view is also held by Puxty. He argues (1986, p. 87):

Financial information is legislated by the governing body of society (the state) which is closely linked to the interests of the dominant power group in society (Offe & Ronge, 1982; Miliband, 1969, 1983) and regulated either by agencies of that state or by institutions such as exist within societies like the United Kingdom, United States, and Australia that are linked to the needs of the dominant power group in partnership with the state apparatus (albeit a partnership that is potentially fraught with conflict).

As the chapter further states, given that the practice of accounting is in the hands of reporting entities, such as large corporations, and that accounting regulation is in the hands of government and associated regulatory bodies (which as we noted above, are viewed as having a vested interest in maintaining the status quo), accounting information will, it is argued, never act to do anything but support our current social system – complete with all its perceived problems and inequities.

Also, as accounting is deemed to support particular social structures, the introduction of new forms of accounting will only help to sustain that social system.

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In arguing that financial reports cannot be considered as objective or neutral, authors such as Hines also emphasise that accountants impose their own views about what items or factors the reporting entity should be accountable for and what factors are not worthy of consideration. Identifying what shall be ‘accounted’ is a subjective issue influenced by one’s own values.

Hence, from the above overview, we can see that there are numerous arguments to support a view that while conceptual frameworks might embrace qualitative characteristics such as objectivity and neutrality, in practice, many forces operate against such ‘ideals’.

13.5

Critical theorists typically argue that introducing more accounting is not going to solve the inequalities they currently perceive exist within society. Accounting itself is considered a mechanism to sustain particular social structures and hence more accounting will only assist in furthering the interests of those who currently have ‘power’ while further undermining those who do not. Those in charge of regulating and applying accounting have a vested interest in maintaining the status quo and they will support methods of accounting that succeed in doing this.

Whether we accept these arguments is really a matter of personal opinion – do we accept that governments, accounting professions and accountants seek to serve the interests of those people with wealth, and at the same time, seek to undermine any possibility of the ‘less powerful’ succeeding?

13.6

Critical theorists tend to be vocal opponents of economics-based research, such as Positive Accounting Theory (PAT). Reasons for this include: •

PAT, like many other theories, does not challenge the existing social structures, and this is considered to be naïve.

•

PAT accepts that the functioning of markets (such as capital and labour markets) will lead to some form of ideal outcomes. Critical theorists believe that ‘leaving it to the markets’ will only act to undermine the interests of those people who should be protected. PAT is deemed to adopt a ‘conservative right-wing ideology’ in promoting the virtues of markets, the rights of shareholders (the capitalist class), and so on.

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•

Tied to the above point, PAT relies in part upon work from the efficient markets hypothesis, which assumes that if information is useful, then it will evoke a capital market reaction. A problem with this however, is that it ignores whether information may be useful to other non-capital market participants (who nevertheless, have a right-to-know about the operations of an entity).

•

PAT relies upon work from Agency Theory, which dictates that contractual arrangements should be put in place to minimise the agency costs of the firm and thereby to maximise the value of the firm – this will directly benefit the owners at the possible expense of others. Further, within the Agency Theory literature it is typically assumed that agents (employees) will always try to do things that benefit themselves at the expense of others. Critical theorists would probably argue that it is the owners of financial capital who are more likely to do this, along with anybody else who is likely to prosper as the owners of financial capital prosper.

•

PAT typically considers the motivations of managers, and owners (those with power) and pays little attention to the interests of others.

•

PAT researchers typically undertake research that uses corporate data from many different organisations on the assumption that all entities in a sample can be treated the same for the purpose of the analysis. Many critical theorists would emphasise that no two organisations are the same; hence it is naïve to treat them as such. PAT presumes that laws and principles can be generated that are expected to hold in different situations and that there is an underlying truth that can be determined by an independent, impartial observer who is not influenced by individual perceptions, idiosyncrasies or biases.

•

PAT research has often been promoted in the past as being ‘value-neutral’ as it does not provide prescription. Many critical theorists have been critical of this claim. All research involves value-judgements.

13.7

It can be argued earlier that all research is likely to be influenced to some extent by the (possibly subconscious) biases of the researchers involved. Therefore, generally speaking, no research can be totally objective or impartial. However, one key attribute of critical accounting researchers – and one that often 358

differentiates them from other researchers – is that they are typically very open about the partisan nature of their research. There is a view amongst critical accounting researchers that to create social change it is necessary to be very open about the problems inherent within current systems, and to highlight areas that need to be changed. Critical accounting researchers generally seek to be explicitly associated with particular philosophical perspectives about how society should be ordered.

In understanding what a ‘partisan’ approach means we can usefully consider a definition provided in the Oxford English Dictionary which states that a partisan approach is one taken ‘by an adherent or supporter of a person, party, or cause’.

Therefore, if critical theorists had a particular view (or theory) about how society should function to achieve certain ends or causes, then, in accord with a partisan approach, this will directly influence their choice about the practices they support or oppose.

13.8

(a) The way we practise financial accounting means that payments to suppliers of labour are deemed to be expenses (which all things being equal, should be minimised), whereas payments to suppliers of equity capital are deemed to be dividends (which, in general, should be maximised). Obviously, critical accounting theorists would see this as an obvious illustration of how accounting systems function to undermine the interests of workers whilst at the same time promoting the interests of owners of capital. Critical theorists would see this as an absurd basis of classifying corporate transactions. Why would the transfer of wealth to one supplier of a necessary factor of production (labour) be treated as an expense while the transfer of wealth to another supplier of a necessary factor of production (financial capital) be treated as a distribution of profits?

(b) Yes, critical accounting theorists would see this as an example of accounting practice advancing the interests of owners over and above the interests of workers. As Chapter 13 indicates, increases in wages are often described by such terminology as ‘ominous increases in wages’ but such terminology is not applied to increases in payments to owners (dividends). This is despite the fact that both workers and owners are supplying important resources to 359

the organisation – one is supplying labour and the other is providing financial capital. Also, it is very common to see the news media praise companies for being able to reduce wage costs – such praise does not arise when dividend payments are reduced. We are generally ‘conditioned’ to accept such practices as being acceptable and beyond criticism.

(c) Students will have differences of opinion in relation to this part of the question. Nevertheless, it does appear a little odd that distributions to one resource provider (workers) are treated as expenses whereas distributions to another resource provider (owners) are treated as a distribution of profits.

Whatever the case, the practice does certainly seem to bolster the interests of the holders of financial capital.

13.9

A number of critical theorists have been critical of the work of researchers whose work is grounded within Legitimacy Theory. Bases for this criticism include: •

Legitimacy Theory, like many other theories, does not challenge the existing social structures. Rather, it accepts the social system as a ‘given’ and does not question its fairness. By not addressing the underlying problems of society, it is considered that any concern with new systems of accounting is a waste of time.

•

Following from the above point, researchers who adopt Legitimacy Theory often discuss how societal perceptions can influence how an organisation operates (for example that it must conform to the ‘social contract’). Critical theorists argue that this is naïve – to assume that society operates in a pluralistic manner, in which no individuals or groups dominate, is a simplistic and incorrect assumption.

•

Some researchers who adopt Legitimacy Theory appear to have adopted a position that legitimising actions provide some form of benefits to society (for example, in the form of greater corporate disclosure). Legitimising disclosures mean that the organisation is responding to particular concerns that have arisen in relation to their operations. The implication is that unless concerns are aroused (and importantly, the managers perceive the existence of such concerns) then unregulated disclosures could be quite minimal. Disclosure decisions driven by the desire to be legitimate are not 360

the same as disclosure policies driven by a management view that the community has a right-to-know about certain aspects of an organisation’s operations. One motivation relates to survival, whereas the other motivation relates to responsibility. Researchers working within Legitimacy Theory do not typically make this point.

•

Following on from the above point, Cooper and Sherer (1984) would argue that legitimising disclosures simply act to sustain corporate operations that are of concern to some individuals within society. To the extent that the disclosures reflect or portray management concern as well as corporate moves towards actual change, the corporate disclosures may be merely forestalling any real changes in corporate activities. While researchers adopting Legitimacy Theory often do not question or, perhaps, consider this issue, some ‘critical’ researchers see legitimising behaviour as potentially quite harmful, particularly if it legitimises activities that are not in the interests of particular groups within society. For example, Puxty (1991, p. 39) states:

I do not accept that I see legitimation as innocuous. It seems to me that the legitimation can be very harmful indeed, insofar as it acts as a barrier to enlightenment and hence progress.

It is considered that proponents of Legitimacy Theory typically ignore this possibility.

13.10 The argument is that as long as there is no fundamental change in the way society is structured then accounting cannot be ‘fixed’. As Gray, Owen and Adams (1996, p. 63) state, a major concern of the critical (or ‘radical’ theorists) is that:

the very way in which society is ordered, the distribution of wealth, the power of corporations, the language of economics and business and so on, are so fundamentally flawed that nothing less than radical structural change has any hope of emancipating human and non-human life. The social, economic and political systems are seen as being fundamentally inimical.

13.11 The view is that the qualitative characteristics of objectivity and independence are beyond criticism and hence if a profession can portray a perspective that they are 361

objective and independent of vested interests then this will be construed in a positive way by the society in which the professionals operate. The professionals will be deemed to be ‘legitimate’.

As Chapter 13 has indicated however, proponents of a critical perspective dismiss accounting and accountants as not being objective and independent. Rather, accounting and accountants are perceived to act to sustain current social orders and practices which are considered inequitable, and hence accounting and accountants are not independent or objective but are highly partisan. The view is that accountants are not ‘disinterested, innocuous historians’ as they often portray themselves (Tinker, Merino & Niemark, 1982, p. 184), but rather that they play an active and central part in various social conflicts – conflicts in which they take the sides of the parties with control of scarce financial capital.

13.12 Critical accounting theorists would probably be quite critical of the quote provided

by Chandler (2010). The argument might be that there is unequal distribution of power within society and therefore many people do not have free will to create social change. Rather, mechanisms are embedded within society that give those people with greater wealth and control over resources more say and influence over what companies do, and how governments operate. For example, poorer people have less resources to expend and therefore do not have a voice in market-based mechanisms despite the many externalities being generated as a result of corporations operating within markets. Further, those members of society with power (and the power might come because of the resources they control) will be more likely to receive the information they want, meaning that less powerful people will be without information and therefore unable to make informed decisions.

Nevertheless, when we read a great deal of the critical accounting literature, we do sometimes get the impression that the authors believe that company management do have a level of evil intent – or at least an intent to undermine many people in society, or to advance business interests over and above considerations of the environment and future generations. Making such broadbased assumptions about all individuals could be criticised on various logical grounds.

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13.13 If one is to read the research published in various accounting journals, it is true that most researchers do not discuss the various value judgements they have made.

There could be various reasons for this, including: •

Some researchers might not appreciate that they are making value judgements (for example, about what to research, how to research or what theory to apply). For example, proponents of Positive Accounting Theory might not appreciate or even believe that their research takes a ‘conservative right-wing ideology’ in promoting the virtues of markets, the rights of shareholders (the capitalist class), and so on – as many critical theorists would argue.

•

Most researchers might consider it inappropriate to discuss the value judgements they have made (and for practical purposes, it is probably very difficult to identify the various value judgements made as there would certainly be many of them).

•

Because it is unusual to find discussion of value judgements in a research paper, there could be problems getting a paper that does discuss them published – and this would be a concern to many researchers. Discussing value judgements might be considered ‘unscientific’ research.

•

There could also be a possibility that although researchers know they are making value judgements, they would rather not make them explicit as this could negatively impact their ability to appear objective and detached, which in turn might have implications for whether people will support the researcher’s arguments.

13.14 The point being made is that we cannot expect to create change if we do not identify the problems inherent in current systems. Once we question or criticise existing systems, we are then effectively required to make suggestions for change.

Ongoing improvements to any systems, including social systems, require us to question current systems and to suggest improvements. Obviously, the criticisms we raise and the suggestions we make will be influenced by our own philosophical perspectives and these will not be shared by everybody. The more people that share views the more likely it is that social change will occur.

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13.15 Central to much critical accounting research is an underlying belief that the distribution of power in society is not even and that the way society is structured benefits a particular ‘elite’ and undermines the rest. Given that accounting is deemed to sustain particular social structures, critical theorists believe that the introduction of new forms of accounting will only help to sustain existing social systems. Critical accounting theorists seek to expose the role of accounting in supporting unequal distributions of power and wealth across society. By contrast, accounting researchers who adopt other theoretical perspectives typically do not consider issues associated with an uneven distribution of power in society. They accept the way society is currently structured as ‘a given’ and tend to make an implicit assumption that power is evenly spread throughout society.

13.16 From a critical perspective, such a statement by CPA Australia would be seen as an effort to sustain current social and regulatory structures – structures that support business (and the owners of business) but undermine the interests of those without capital. Within this perspective, accountants are complicit in supporting the interests of a powerful ‘elite’. As Sikka and Willmott (2005, p. 138) explain, some of the critical accounting studies in which they have been involved has: … shown that [some accountancy professional associations] have a long history of opposing reforms which arguably would have advanced the accountability of major corporations (Puxty et al., 1994); that accounting technologies play a major part in the exploitation of workers (Sikka et al., 1999); and that the accountancy industry is engaged in a ruthless exploitation of citizens (Cousins et al., 2000). We have also sought to mobilise opinion by holding a mirror to the accountancy trade associations and argue that their claims of ethics, integrity etc. are little more than rhetorical garnishes, and that neither their policies nor their actions come anywhere near their selfrepresentations (Cousins et al., 2000, Mitchell et al., 1994, Puxty et al., 1994, Willmott, 1990).

13.17 The basis of the criticism is that such research typically does not question existing social structures which in themselves allow, or even encourage, social and environmental degradation. By accepting a pluralist conception of society, such research thereby tends to ignore struggles and inequities. Adding more accounting to the existing social system will do little to help, and indeed, might act to further 364

bolster the positions of those with power. As Gray, Owen and Adams (1996, p.

93) state, critical theorists believe that:

Corporate social reporting (CSR) will be controlled by the reporting corporations and a State which has a vested interest in keeping things more or less as they are, CSR has little radical content. Furthermore, CSR may do more harm than good because it gives the impression of concern and change but, in fact, will do no more than allow the system to ‘capture’ the radical elements of, for example, socialism, environmentalism or feminism and thus emasculate them.

Thus, while to many of us calls for greater disclosure of social responsibility information would seem to be a move in the right direction, some critical theorists argue that such efforts are wasted unless they are accompanied by fundamental changes in how society is structured. They would tend to argue that the disclosure of corporate social responsibility information only acts to legitimise, and not challenge, those providing the information. Cooper and Sherer (1984), for example, argue that attempts to resolve technical issues (such as how to account for environmental externalities) without consideration of inequities in the existing social and political environment may result in an imperfect and incomplete resolution, owing to the acceptance of current institutions and practices – which are seen to be part of the problem itself.

Reflecting on some of the views of critical theorists about the deficiencies of social and environmental accounting research, Owen, Gray and Bebbington (1997, p.

181) refer to the work of Puxty:

Puxty writing in 1986 suggested the irrelevance of social accounting, in noting that ‘more radical critics of capitalist society have been more concerned with the broader issues of accountancy and accountants within that society than particular (almost parochial) issues such as social accounting which appears to be … rearranging the deck chairs on the Titanic’ (p. 107). However, by 1991, Puxty had taken his critique a stage further in arguing that by leaving basic social structures intact, social accounting can even lead to legitimation ‘since the powerful can point to their existence as evidence of their openness in listening to criticism, it paves the way for … the extension of power (p. 37).

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As accounting is deemed to sustain particular social structures, the introduction of new forms of accounting (for example, experimental methods relating to accounting for social costs) will – as this answer has stated above – only help sustain that social system. Reflecting on the critical theorists’ perception of the ongoing research being undertaken to explore how to account for the social and environmental implications of business, Gray, Owen and Adams (1996, p. 63) state that some critical theorists consider that by undertaking such research: … one is using the very process (current economics and accounting) that caused the problem (environmental crisis) to try to solve the problem. This is known as the process of ‘juridification’ and it is well established that one is unlikely to solve a problem by applying more of the thing which caused the problem.

13.18 The idea being promoted by Cooper is that if critical accounting researchers are serious about creating change in society, then they need to actively engage with various members of society. To engage with society, they need to make their work understandable to a broad cross-section of readers and they need to make their work accessible to large numbers of people (not just the hundred or so people that might read their article that is published in a specialised journal). Cooper’s concern appears to be that many critical accounting researchers write in a very convoluted manner in which they reference various philosophers and in which they use a great deal of intellectual jargon which would not be understandable other than to those that have been privileged enough to gain employment in a university, and thereby have the benefit of being able to become well versed with such literature. The more marginalised people within society would find some work inaccessible, thereby arguably increasing their potential feeling of marginalisation.

Acting in the way as described above does diminish the potential of such researchers to make any form of positive contribution to society. Writing research papers that are published in journals that tend to cater primarily to critical accounting researchers and limiting discussion and debate to 366

conferences (with the associated travel and associated carbon emissions) which cater for like-minded researchers does little other than to promote the private interests of the researchers involved. It would not be consistent with a remit of creating change to social systems which are deemed to be unjust.

13.19 From a critical perspective, the position of the BCA is one that simply is attempting to keep the control of activities associated with ‘corporate social responsibility’ in the hands of business, rather than allowing it to be subject to scrutiny through a political process. Critical theorists would challenge that existing approaches are ‘innovative and creative’, other than in perhaps supporting the interests of business. Allowing corporations to determine their own social responsibilities will simply lead to a situation where corporations will attend to certain ‘responsibilities’ only to the extent that such activities lead to increases in shareholder value. Indeed, as Chapter 10 demonstrated, the submissions from business entities to the 2005/2006 Australian Government Inquiry into Corporate Social Responsibility showed that corporations favoured embracing corporate social responsibility only to the extent that it leads to business benefits. Indeed, throughout their submission to government, the BCA continually referred to the imperative to maximise shareholder value. They stated in their submission to government that: The litmus test for any activity or responsibility is whether the performance of that activity or responsibility can reasonably be seen to be contributing to the growth of shareholder value.

The above view effectively ties in directly with how critical theorists would expect business leaders to think (and to some extent it is surprising that the BCA said this as openly as it did). Views such as those embraced by the BCA place shareholders at the top of the ‘pecking order’ of all stakeholders – again, consistent with how critical theorists would expect business leaders to think. Business organisations often justify corporate social responsibility activities in terms of the positive benefits the activities will have for the owners of the business – that is the shareholders. Business Council of Australia (2005, p. 11) states, ‘broader considerations, such as the community and environment are essential to contribute

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to and protect value in the long term and accordingly the potential shareholder wealth that can be achieved over time’. The idea that doing the ‘right thing’ by the community and the environment will provide benefits to the owners is often referred to as ‘enlightened self-interest’.

13.20 Baker’s view that positivist researchers and critical accounting researchers barely interact does seem to accord with reality – there is indeed very little interaction between the two. The types of research questions positivist researchers address tend to be very different to the questions or issues addressed by critical accounting researchers. The research methods are also very different, with positivist researchers being likely to utilise large-scale data analysis and statistical analysis – something not typically undertaken by critical accounting researchers.

Critical accounting researchers tend to question current social systems, the role of government, and the role of business organisations in undermining the interests of many people within society. They promote the need for social change. By contrast, positive researchers do not tend to question current social arrangements or inequitable distributions of power within society.

The theoretical perspectives embraced by critical accounting researchers also tends to be very different from the perspectives embraced by positive theorists.

Critical accounting theorists also tend to be cynical about ‘new’ approaches being introduced by government or business to address perceived social and environmental issues. Positive researchers do not tend to share such scepticism.

Because of the many philosophical differences in views about the role of research, the role of government, the motivations of corporate managers, the fundamentals of ‘sound research’, and so on, this means that positivists and critical accounting researchers have very little in common and will, unfortunately perhaps, believe they have little to learn from each other. This probably explains why critical accounting theorists tend to hold conferences that overwhelmingly cater to critical accounting researchers, as do many fields of positive accounting researchers.

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13.21 As we would appreciate by now, the term ‘critical accounting theory’ is used to refer to an approach to accounting research that goes beyond questioning whether particular methods of accounting and reporting should be employed, and instead focuses on the role of accounting, and therefore ‘accountants’ (and many accounting researchers), in sustaining the privileged positions of those in control of particular resources (financial capital) while undermining or restraining the voice of those without capital. Critical theorists would therefore argue that new systems of accounting do nothing more than simply provide another way to support or legitimise – and not challenge – the favoured positions of groups who already hold power. What is needed is to question or challenge the equity or morality of existing social and business arrangements. Changes in ‘accounting’ without associated changes in the way society is ordered are considered likely to simply allow a ‘business as usual’ position to be maintained. As Gray, Owen and Adams (1996, p. 63) state, critical theorists believe that:

Because corporate social reporting (CSR) will be controlled by the reporting corporations and a State which has a vested interest in keeping things more or less as they are, CSR has little radical content. Furthermore, CSR may do more harm than good because it gives the impression of concern and change but, in fact, will do no more than allow the system to ‘capture’ the radical elements of, for example, socialism, environmentalism or feminism and thus emasculate them. Critical theorists argue that any such emasculation (undermining or weakening) of these movements, which seek to protect and advance the interests of groups or entities often regarded as negatively affected by capitalism, will have the effect of protecting the capitalist system from ‘threats’ these movements pose to the power and wealth of capital.

13.22 Gaffikin appears to be arguing that we need to regularly question taken-forgranted views, or myths. Certain social processes, structures, laws and so forth might have been in place for many years and they become what we are used to, and what we expect to see. Effectively there is a form of institutionalisation. But this does not mean they should be there, or that they are the best processes possible, or that they serve all people equitably.

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Critical theorists would tend to argue that many social structures are in place because they advantage certain groups within society – perhaps those with wealth and power. Such processes are often projected as benefiting everybody within society, when the reality might be that they benefit some groups at the expense of others. At the heart of Gaffikin’s perspective is that we all need to be critical thinkers and not simply accept the status quo. We need constantly to think of better and more ethical and equitable ways to do things.

13.23 (a)

Counter accounts are alternative representations or alternative ‘accounts’ of organisations’ performance, produced often by NGOs with the intent to address alleged imbalances in power and various social inequities. Examples of counter accounts would be the reports prepared by various NGOs about instances of worker abuse in large multinational companies’ supply chains (when at the same time the companies might be reporting information about their respect for, and support of, workers), or reports about instances of animal abuse by organisations who claim to embrace animal welfare. These counter accounts are often designed to evoke emotional reactions and to create real change. They provide information that often challenges and contradicts the information being produced by organisations. They can cause outrage for those who read the accounts and they are released to create positive change for the stakeholders who are being poorly treated.

(b) Monologic accounting is the approach to accounting that provides one world view, typically that of managers. For example, monologic accounts might provide

management’s

view

about

an

organisation’s

social

and

environmental performance, and this view might not coincide with the views expressed by other stakeholder groups. Monologic accounting is a practice which is overwhelmingly embraced by organisations throughout the world.

While such accounts are likely biased in representing one world view, they are often projected as providing an objective representation of an underlying reality.

(c) Dialogic accounts provide multiple world views of an underlying phenomenon, such as organisational performance. Brown and Dillard (2015, p. 250) note that the aim of dialogic accounting is to enable a diverse range 370

of societal actors to account for things that traditional accounting ignores, and to develop systems of accounting that acknowledge divergent ideological positions. Brown and Dillard (2015) state that the role of dialogic accounting is to develop accounting systems that ‘prevent premature closure’ and ‘which infuse debate and dialogue, facilitating informed citizen participation in decision-making processes’ and which might also help make power relations more transparent.

13.24 The role of counter accounts is to provide alternative perspectives about the role and performance of organisations within society. Depending upon who is developing the counter accounts, the role of a counter account might be to create outrage or to stimulate debate. The end goal would be to create change to prevailing activities and processes.

Counter accounts might be used in an adversarial manner because the authors of the accounts might believe that this is the best way to create needed social changes and to bring any potential inequities into public view. They might be adversarial because they are produced in an emotive way and expose facts about an organisation which managers wanted to remain hidden, and which might always have been hidden. They might also challenge many taken-for-granted political or ethical beliefs and this can be confronting for many people. Critical theories are typically unapologetic in embracing a partisan view.

13.25 If we read the works of many researchers who write about dialogic accounting then we would tend to find that the key goal, as perceived by these researchers, is to create debate and learning. This can be done if the dialogic accounts thoughtfully challenge the logic of many taken-for-granted aspects of organisational life and society and provide different ways of seeing things.

Dialogic accounts will not point towards one incontrovertible truth, but rather should show that there are different ways to view the same underlying transactions, events, governance structures, social structures, and so forth. By showing that there are different ways to view things, thoughtfully constructed dialogic accounts can potentially encourage people to review their own beliefs and to learn about different views and philosophies which they might then decide have

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merit. There needs to be an acceptance that one approach to accounting is unlikely to fully reflect the implications of organisational activities.

13.26 Monologic accounts, by definition, provide one world view of a particular phenomenon. For example, they might provide management’s view about an organisation’s social and environmental performance, and this view might not coincide with the views expressed by other stakeholder groups. According to Brown and Dillard (2015, p. 251):

Conventional accounting is notably monologic in approach, with an official narrative overwhelmed by capitalist perspectives, positivism and neoclassical economics (Cooper & Sherer, 1984; Malsch, 2013).

The practice of monologic accounting has effectively been in place since the very beginning of ‘accounting’, and it has traditionally been accepted that management has the responsibility to provide an account of the organisation’s operations. That is, the practice of monologic accounting has effectively become institutionalised across time.

Monologic accounting has traditionally been assumed to serve everyone’s needs for information, regardless of their political viewpoints. Alternative perspectives were not traditionally considered because they can ‘distract’ from the main objective of monologic accounting: to provide current or potential investors with expected information. As Brown (2009, p. 316) argues, ‘Monologic accounting also reflects a finality orientation; the “facts speaking for themselves” ’. By not providing alterative views informed by different philosophical beliefs, monologic accounting did not, and does not, challenge current systems and therefore monologic accounts tended to sustain prevailing social and economic arrangements.

13.27 Critical theorists would generally argue that the accounting profession does not work in the public interest, despite the claims typically made by the profession.

The accounting profession is argued to operate in a manner to support the views and interests of ‘business’ rather than promoting broader accountability to stakeholders other than those who benefit from a corporation’s activities. Critical 372

theorists encourage us to question the view that professions will always act in the public interest. The insights provided by critical theorists encourage us to not take for granted that the policies and standards being released or supported by the accounting profession will provide benefits to stakeholders other than those directly related to the capital market.

The accounting profession is portrayed (through such vehicles as conceptual frameworks) as being objective and neutral – that is, free from any form of bias.

Such characteristics (if true) are apparently beyond reproach. But, as Gaffikin (2010, p. 34) states (and please remember, this is one philosophical perspective of accounting and accountants which many other people would challenge):

Over the last four hundred or so years the majority of mainstream accountants have seen themselves as handmaidens of what we refer to as capitalism, providing information to facilitate optimal economic decision making.

Accounting has been instrumental in maintaining the capitalist ethos – it has unashamedly served the interests of the providers of capital. Critical theories challenge the assumptions inherent in capitalism.

Given the role of accounting reports in ‘constructing, sustaining, and legitimising economic and political arrangements, institutions, and ideological themes which contribute to the corporation’s private interests’ (Guthrie & Parker, 1990, p. 166), many critical theorists view one of the key roles of accounting reports as being to legitimise the capitalist system as a whole, and to protect this system from threats arising as a result of the outcomes of the structural conflict inherent in the capitalist system. It is perceived as having little to do with the broader public interest.

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