Elaborate Accounting theory and practice.
A) ) Appreciate that there is no single unified theory of accounting d) Understand the various pressures and motivations that might have an effect on the methods of accounting selected by an organisation e) Understand what is meant by ‘creative accounting’ and why it might occur f) Understand Financial statement preparation process (from Business Activities to Financial Statements) and the various influencing factors from this document and from other credible sources. g) In-depth knowledge on Accounting Framework. 3 C) Go: a. Download Annual Reports (for 2 years at least) and explore b. Assess accounting policies and estimates of your selected ASX listed company i. Which accounting policies and estimates used by the firm? ii. Are there any flexibilities of accounting policies and estimates used by the firm? iii. Are these accounting policies and estimates used by their competitors? iv. Show a comparison of accounting policies and estimates used by the firm with one of its rival company. v. Do you agree with the policies and estimates? vi. Is accounting strategy hiding or revealing vii. Any Red Flags/questionable number in the accounting report? viii. Which accounting positions capture them? Why? Explain c. Critically evaluate accounting quality by assessing accounting policies and estimates i. consider the various pressures, many of which are political in nature, that influence the accounting standard-setting environment ii. consider the implications of organisations making particular accounting disclosures, whether voluntarily or as a result of a particular mandate iii. understand the possible implications of an organisation making particular accounting choices and disclosures d. Prepare an investigative report on the Managers’ Accounting Strategy and Reporting Strategy choices on the basis of the above evaluation. The report should have following sections for minimum:
B) Section 1:
C) Identify Key Accounting Policies Key policies and estimates used to measure risks and critical factors for success must be identified. Section 2: Assess Accounting Flexibility Accounting information is more open to distortion if managers have a high degree of flexibility in choosing policies and estimates. Section 3: Evaluate Accounting Strategy Flexibility in accounting choices allows managers to strategically communicate economic information or distort performance. Issues to consider include: • Norms for accounting policies with industry peers • Incentives for managers to manage earnings • Changes in policies and estimates and the rationale for doing so • Whether transactions are structured to achieve certain accounting objectives. Section 4: Evaluate the Quality of Disclosure Issues to consider include: • Whether disclosures seem adequate • Adequacy of footnotes to the financial statements • Whether notes sufficiently explain and are consistent with current performance • Whether GAAP reflects or restricts the appropriate measurement of key measures of success • Adequacy of segment disclosure. Section 5: Identify Potential Red Flags Issues that warrant gathering more information include: • Unexplained changes in accounting, especially when performance is poor • Unexplained transactions that boost profits • Unusual increases in inventory or receivables in relation to sales revenue • Increases in the gap between net income and cash flows or taxable income • Use of R&D partnerships, SPEs or the sale of receivables to finance operations • Unexpected large asset write-offs • Large fourth-quarter adjustments • Qualified audit opinions or auditor changes • Related-party transactions. Section 6: Compliant with the Conceptual Framework D) Gone/ Done!!! Submit the report in accordance with assessment policy stated in the Subject Outline and Student Handbook. Format of the Report and deliverables 1. You at least should have the following details: a. Assignment Cover page clearly stating your members name and student number s b. A table of contents, executive summary c. A brief introduction or overview of what the report is about. d. Body of the report with sections to answer the above sections and with appropriate section headings e. Conclusion f. List of references. 2. Diagrams and tables clearly labelled and explained. 3. Ensure all materials are correctly referenced. Plagiarism will be severely penalised. Back ground Information Positive Theory of Accounting (PAT) PAT seeks to explain and predict accounting-related phenomena, for example, study of capital market’s reaction to particular accounting policies; what motivates managers to select a given method of accounting; reasons for the existence of particular accountingbased contracts. It relies upon a fundamental assumption that individual action can be predicted on the basis that all action is driven by a desire to maximise wealth. It argues that selection of accounting methods can be explained by either efficiency or opportunistic arguments. So the theory provides insights into why managers favour particular accounting methods in preference to others. PAT also maintains that Accounting methods can impact on cash flows associated with debt and management compensation contracts .The use of particular accounting methods can have conflicting effects, For example, might ‘loosen debt covenants’ but increase political costs. The theory Emphasises the way in which accounting numbers are actually used throughout society and how a change in accounting methods can have implications for relationships with managers, debtholders, and the broader political environment Normative theories of accounting Prescribe how accounting should be practised. Argue typically that a central role of accounting theory is to provide prescription and inform about optimal accounting approaches and why a particular approach is considered optimal. Examples: Conceptual Framework Project, current-cost accounting, exit-price accounting and deprival-value accounting . It seek to provide guidance in selecting accounting procedures that are most appropriate and prescribe what should be done The Conceptual Framework: • is considered a normative theory • seeks to identify the objective of general purpose financial reporting • seeks to provide accounting guidance within a ‘coherent’ and ‘consistent’ framework • identifies the qualitative characteristics financial information should possess makes recommendations that sometimes depart from current practice Other normative theories Three main classifications • Current-cost accounting • Exit-price accounting • Deprival-value accounting Financial statement preparation process (from Business Activities to Financial Statements) and influencing factors: Financial statements are an important source of information to the capital markets. Quality financial reporting provides much-needed relevant and reliable information to capital market participants. The Following features of accounting systems facilitate quality information: a) The role of accrual accounting b) Accounting standards or generally accepted accounting principles (GAAP) c) Auditing of financial information d) Delegation of reporting to management Delegation of Reporting to Management The efficiency perspective of PAT concludes that Accounting methods adopted by firms best reflect the underlying financial performance of the entity and might select the most efficient way to portray the performance of the entity. Management is responsible for the application of accounting methods (recognition, measurement and disclosure) in financial statements. Management have some discretion in the choice of accounting policies and the estimates made in financial statements. Management can use this discretion in revealing their private information about the firm or in distorting the accounting numbers. Distortion of accounting may reflect incentives facing managers. It is not optimal to use accounting regulation to eliminate managerial flexibility completely. Accounting systems leave considerable room for managers to influence financial statement data. Corporate managers can choose accounting and disclosure policies to hide the true economic picture of their business and manipulate investors’ perceptions. Superior disclosure strategy will enable managers to communicate the underlying business reality to outside investors. Accounting and Reporting Standards Accrual accounting is subjective and relies on a variety of assumptions. Managers have incentives to use accounting discretion to distort reported profits. Accounting standards are developed to improve the quality of financial reporting. Accounting standards ensure that managers are not able to use their accounting flexibility to disguise reality for selfserving purposes. Accounting standards try to eliminate unsatisfactory reporting practices, thereby promoting consistency and comparability. Many countries in the world are now reporting or converging to International Financial Reporting Standards (IFRS). IFRS have been described as more principles-based (rather than rules-based). External Auditing of Financial Statements Audits provide an independent (third party) opinion on the quality of the financial statements. Audits are required for many companies, private and public. There is a move towards international auditing standards by many countries. Audit committees enhance the auditing process. Auditing is a verification of the integrity of the reported financial statements by someone independent of the preparer. Auditor ensures that managers use accounting rules and conventions consistently over time. Auditing improves the quality of accounting data. Threat of lawsuits and resulting penalties has the beneficial effect of improving the accuracy of financial information and disclosure. Accrual accounting Need for accrual accounting arises from investors’ demand for financial reports on a periodic basis. Corporate financial reports are prepared using accrual rather than cash accounting. Accrual accounting distinguishes between the recording of costs and benefits associated with economic activities. Effects of economic transactions are recorded on the basis of expected and not actual cash receipts and payments.
D) 7 The conceptual framework defines the following financial statement elements and their relation: Assets = Liabilities + Equity Profit = Revenues – Expenses Another important relation: Comprehensive income = profit for the period + items recognised directly in equity Financial statement preparation process 7 In summary, Corporate managers acquire physical and financial resources to create value for the firm’s investors through business activities. Financial statements measure and summarise the economic consequences of business activities. Financial statements are a source of widely available data on publicly traded corporations. Accrual accounting attempts to accurately reflect expectations of economic performance, but requires careful analysis. Accounting standards and auditing ensure quality of financial reports. Types of Financial Statements According to the International Accounting Standards Board (IASB), a ‘complete set of financial statements’ comprises: – Statement of financial position as at the end of the period – Statement of profit or loss and other comprehensive income for the period – Statement of changes in equity for the period – Statement of cash flows for the period – Notes (comprising a summary of significant accounting policies and other explanatory information). Factors Influencing Accounting Quality It is necessary to allow managers some discretion in applying accounting standards. As a result, three potential sources of noise and bias in accounting data include: a. Random estimation errors & Rigidity in accounting rules Efficiency perspective of PAT argues:
E) • Accounting methods adopted by firms best reflect the underlying financial performance of the entity—might select the most efficient way to portray the performance of the entity
F) • Regulation is therefore argued by PAT advocates to impose unwarranted costs on reporting entities—it causes the firm to provide an inefficient perspective of the performance and position of the organisation as it requires movement to a one-size-fits-all approach to reporting. Accounting standards may not reflect the economics of the firm’s transactions. So, some flexibility in accounting required. Accrual accounting requires forecast estimates that can be incorrect. b. Manager’s accounting choices. Managers have a number of incentives to choose accounting disclosures that are biased as suggest by Positive Accounting Theory (PAT):
G) • Accounting-based debt covenants
H) • Management compensation contracts • Contests for corporate control • Tax considerations • Regulatory considerations • Capital market and stakeholder considerations • Competitive considerations.
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