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Date Created: 08/03/16
INTRODUCTION TO FINANCIAL Normative theory THE FINANCIAL REPORTING ACCOUNTING THEORY Concerned with what should be done ENVIRONMENT What is a theory? Reliance on double-entry accounting (policy prescription) A coherent set of hypothetical, Derived from the notion of a norm, Many criticisms including: conceptual, and pragmatic principles standard, or an ideal model » Not taking into account the various forming the general framework of Seeks to provide guidance to select social and environmental reference for a field of inquiry appropriate accounting procedures consequences of a reporting entity’s Why is it important to study existence accounting theory? » Focuses on deriving an ideal Rationale for regulation financial accounting system by inductive To aid in the analysis of financial reasoning accounting practice statements Positive theory Parties who argue that regulation is To aid in decision-making Explains and predicts by searching for necessary give the following reasons: Brief overview of theories of reasons why an event occurs » Markets for information are not accounting efficient without regulation a sub- » Aims to explain current practice Early development of accounting theory » Aims to predict the role of optimal amount of information will Relied on the process of induction accounting and associated be produced » The development of ideas or information in decision-making » Although some people argue that theories through observation Does not seek to tell us that what is the free market on average is – The number of observations efficient, on average arguments being done in practice is the most ignore the rights of individual forming the basis of a efficient or equitable process investors, some of whom can lose generalisation must be large; and Process – The observations must be » Begins with assumptions and, their savings as a result of relying repeated under a wide variety of through logical deduction, on unregulated disclosures conditions; and predictions are made (generate a » Some parties who demand – No accepted observation should information about an organisation hypothesis) can obtain their desired information conflict with the derived universal » Predictions or hypotheses are tested due to the power they possess as a law by empirical evidence using the result of their control over scarce » In generating theories based on scientific method what accountants do, it is assumed The scientific method resources required by the that what is done by the majority of Identify and define the research organisation. Conversely, parties accountants is the most appropriate with limited power will generally be problem unable to secure the information practice (accounting Darwinism) Develop theoretical structure about an organisation Modern development of accounting theory State hypotheses to be tested » Investors need protection from Started to develop theories using Construct the research design deductive reasoning fraudulent organisations that may » Started to describe what Gather data (sampling) produce misleading information, accountants should do Analyse observations and evaluate which, due to information results asymmetries, cannot be known to » Start with a general proposition and Consider limitations and constraints be fraudulent when used reason down » Regulation leads to uniformity which Assumes that the regulatory body is a How powerful is the accountant leads to comparability neutral arbiter of the ‘public interest’ The output of the accounting process Parties who argue against regulation and does not let its own self-interest impacts on many decisions give the following reasons impact on its rule-making process Accountants can transfer to interested » People are willing to pay for Capture theory parties a source of power to drive accounting information which will Although regulation is often introduced changes in a corporation’s behaviour lead to an optimal supply to protect the public, the regulatory Accountants can give legitimacy to » Any organisation that fails to mechanisms are often subsequently provide information will be punished organisations but emphasising controlled (captured so as to protect particular performance attributes by the market; an absence of the interests of particular self- Regulation and accounting standards information will be deemed to imply interested groups within society, The view that financial accounting bad news typically those whose activities are should be objective, neutral and » Regulation will lead to an over- most affected by the regulation apolitical can be challenged supply of information (at a cost to Private interest theory the producing firms as users will » Standard setting is a political Relaxes the assumption that process because it affects wealth tend to overstate the need for the regulations are initially put in place to distribution information protect the public interest, as well as » Proposed regulation may be » Regulation typically restricts the the assumption that government technically sound and logical, but accounting methods that may be regulators are neutral arbiters not not implemented due to political used driven by self-interest » Performance of managers impacts power or influence of affected on remuneration they can command Governments are made up of parties individuals who are self-interested and Standard-setters encourage parties to in the market for their services seeking re-election, so those which an make submissions on proposed – Incentive to adopt strategies interest in particular legislation are standards to maximise value of firm and more likely to get it if they can form provide information about themselves into large organised groups Accounting standards and financial performance reports are the result of various social – Poor performance can with strong cohesive voting power and environmental considerations The role of professional judgment in » Tied to the values, norms and increase the likelihood a firm accounting theory expectations of society will be a takeover target At the core of the accounting process is NORMATIVE THEORIES OF ACCOUNTING – Accounting information can an expectation that accountants should – THE CASE OF ACCOUNTING FOR minimise cost of capital and increase firm value be objective and free from bias when CHANGING PRICES Three theories performing their duties Measurement in accounting Some accounting methods may be Accountants measure the elements of Public interest theory selected at different times, such as financial statements Regulation be introduced to protect the those that best reflect their underlying Elements have various measurable public performance (efficiency perspective) or Protection may be required as a result properties designed to serve a self-interest Property reported is to AASB Framework of inefficient markets (opportunistic perspective) » Provide financial information about However, three components of the Associated with maintaining present the reporting entity that is useful in modern economy make this assumption level of operating capacity making decisions about providing less valid than it was at the time the Performing current purchasing power resources to the entity model was developed adjustments » Represent faithfully the most » Specific price level changes, When applying CPPA, all adjustments relevant information about occasioned by such tings as are done at the end of the period, with resources, claims, and efficient technological advances and shifts in the adjustments being applied to discharge of management consumer preferences accounts prepared under the historical responsibility over resources » General price level changes » Be justifiable on analysis of costs cost convention (inflation) When considering changes in the value and benefits » Fluctuation in exchange rates for of assets as a result of changes in the Examples of properties that are currencies purchasing power of money (due to measured in AASB standards Historical cost accounting information inflation) it is necessary to consider » Historical cost may suffer from problems of irrelevance monetary and non-monetary assets » Net realisable value in times of rising prices, as it may not separately » Fair value be useful to know what something cost » Monetary assets are those assets » Present value years ago when its current value may that remain fixed in terms of their Historical cost be considerably different monetary value (such as trade Measurement technique that uses Historical cost accounting can tend to debtors and investments that are acquisition cost as evidence of the overstate profits in times of rising redeemable for a set amount of value received prices, and that distribution to cash) Measures sacrifice, rather than future shareholders of historical cost profits » Non-monetary assets are those benefits can actually lead to an erosion of assets whose monetary equivalents Defined as cash or cash equivalents operating capacity will changes over time as a result of paid or the fair value of other Historical cost accounting distorts the inflation (such as plant and consideration given to acquire an asset current year’s operating results by equipment) » Monetary liabilities are fixed in term (AASB 116, ) including in the current year’s income Advantages holding gains that actually accrued in (such as an obligation to pay a fixed Argued to be more reliable than other previous years amount) measurement techniques Current purchasing power accounting » Non-monetary liabilities include Adjustments may need to be made if Calculating indices obligations to transfer goods in the When applying general price level future accounts are to reflect value over time » Net monetary assets = monetary Associated with financial capital accounting, a price index must be maintenance applied assets – monetary liabilities Limitations of historical cost accounting in A price index is a weighted average of Current cost accounting times of rising prices the current prices of goods and services CCA differentiates between profits from relating to a weighted average of prices trading and those gains that result from One assumption of historical cost holding an asset accounting is that the money holds a in a prior period, often referred to as a constant purchasing power ‘base period’ Holding gains can be considered as Used in practice when cash flows, » Generally, the addition of current realised or unrealised discount rate, and horizon are known cost information does not add predictive power to the models Exit price accounting Value in exchange A form of valuing assets at their net Net market value is an objective Attitudes of individuals to current cost selling prices at the reporting date and measure of an asset’s true value disclosures was surveyed by Madison on the basis of orderly sales Market is a conglomerate of firms and and Radig (1983) The present selling price is the proper individuals, so each may place a » Managers of 229 ‘Fortune 500’ firms » Concluded the data were perceived and correct valuation coefficient for the different value on an asset by managers to be of low relevance measurement of wealth at a point in Information asymmetry leads to time and income is the difference imperfect markets to internal-decision making between dated wealths so calculated Deprival value Barth (1994) noted that current cost Multiple measures Value to owner, or amount an entity research results are possibly due to a Multiple measures have been applied lack of reliability in current cost should receive for loss of the asset measures as a solution to the measurement Could be problem » Current replacement cost Research suggests that provision of fair Movement away from strict historical » Net market value value information is useful cost to a mixed measurement system » Present value of future economic Studies by Eccher (1996) and Barth Standard-by-standard consideration of (1994) suggest that provision of fair- benefits (value in use) value information has incremental the appropriate measurement approach Cannot be What is value? » > current replacement cost information content for share prices Not a clearly defined concept so » < net market value relative to historical cost information measurement can be difficult Measurement research FOREIGN CURRENCY TRANSACTION AASB Framework defines assets in Research to date suggests that current AASB defines ‘exchange rate’ as the ratio of exchange for two currencies’. terms of those future economic cost disclosures have no incremental benefits, therefore value should be information content over historical cost Where debts, receivables, or other ascertained by measurement of these disclosures monetary items are denominated other benefits Beaver and Landsman (1983) examined than the domestic currency they are Value in use = benefits from use; value the value of current cost information: converted into a single currency Examples of foreign currency in exchange – benefits from sale » Current cost numbers did not add » Acquisition or sale of goods from or » Value-in-use > Value-in-exchange = significantly to regressions of share retain asset returns on historical cost numbers to a foreign supplier where the » Value-in-exchange > Value-in-use = » Historical cost numbers did add transaction is denominated in a sell asset significantly to the regressions of foreign currency Value in use share returns on current cost » Loan from foreign lender denominated in a foreign currency Difficult to measure and often entity numbers A foreign currency transaction initially specific Studies have also considered whether Can be measured by determining the current cost information increases the recognised in the functional currency by PV of future economic benefits predictive accuracy of statistical models applying to the foreign currency of economic events amount the spot exchange rate at the date of the transaction (AASB 121, » Qualifying assets » Argued that recognition of a profit or para.21) » Certain types of hedges loss at reporting date is Functional currency is the currency of Example inappropriate the primary economic environment in » On 1 June 2010, ABC Ltd acquired Qualifying asset exception under AASB which an entity operates goods on credit from UK supplier 123 Borrowing Costs » Competitive forces and regulations » Goods shipped 1 June 2010, FOB UK » A qualifying asset is an asset under influence sales prices for goods and » Cost of goods was GBP200 000, construction or otherwise being services; and labour, material and remained payable at 30 June 2010 made ready for future productive other costs of goods and services » Exchange rates: use of the company or for the use of Spot exchange rate is the exchange – 1 June 2010 AUD1.00 = GBP another entity under a contract rate for immediate delivery 0.50 » Borrowing costs for an asset that Example – 30 June 2010 it was AUD1.00 takes a substantial period of time » ABC Ltd is an Australian company = GBP 0.55 (more than 12 months) to get ready that is listed on the ASX and NYSE – As at 1 June, the debt would for use or sale » AASB 123 requires the borrowing » Labour is sourced from Asia-Pacific be equal to AUD 400 000 at » Sales are invoiced in USD the spot rate (200,000/0.50) costs be capitalised » Debt is with US banks – Initial entry on 1 June 2010 Exchange differences are capitalised » Last three share issues on the NYSE would be If exchange differences cause the » Shareholding: New York (15%), – Dr Inventory 400 000 recoverable amount of a qualifying Australia (75%), and Tonga (10%) asset to be exceeded, the excess is – Cr Accounts Payable 400 000 Foreign currency monetary items – (Inventory contract payable in taken to the income statement (AASB outstanding at the reporting date must GBP) 123, para.19) be translated using the closing rate – As at 30 June, the debt would Hedging Arrangements » Foreign currency monetary items be equal to AUD 363 636 at A hedge contract is an arrangement include: the spot rate (200,000/0.55) with another party in which that other – Accounts payable and party accepts the risks associated with – Entry on 30 June 2010 would receivable, cash, interest, be changing commodity prices, cash flows, notes, loans and dividends – Dr Accounts Payable 36 363 or exchange rates receivable, bank overdraft, – Cr Foreign Currency Derivatives often used to hedge gains income taxes, wages, notes Exchange Gain 36 363 or losses in relation to other assets or payable liabilities » Closing rate is the spot exchange – (Adjustment to profit and loss for exchange rate change GBP » Currency conversion, market price, rate at reporting date payable) interest rate Exchange differences (foreign exchange Exchange gain or loss for non-current Hedging protects the income statement gains or losses) are brought to account receivables and payables are recorded from volatility caused by changes in fair in profit and loss for the reporting value period in which the exchange rates » Unpopular with Australian Hedge contract change companies; doubt as to whether unrealised gains or losses will be Exceptions realised » Arrangement with another party in Arrangement under which the which that party accepts the risks obligation relating to a loan associated with changing fair values denominated in one currency is Hedging Instrument (AASB 139, paras.9 swapped for a loan denominated in and 88): another currency. » Instrument must be designated as a TRANSLATING FINANCIAL STATEMENTS hedge OF FOREIGN OPERATIONS » Nature of risk, risk management AASB 121 – The effects of changes in objective, hedging strategy, and foreign exchange rates assessment of effectiveness are to Consolidation accounting involves be documented combining the financial statements of a statements of the foreign operation into » Must be derivative unless it is parent and its subsidiaries the functional currency hedging foreign exchange risk If some of the controlled entities have » Only necessary to translate the » Must be expected to offset changes foreign operation’s financial in fair value of the hedged item account balances denominated in statements into the group’s different foreign currencies there is a presentation currency (a one-step » Must be with a party external to the need to translate these accounts to a reporting entity given presentation currency (AUD) as opposed to a two-step process) » At inception and throughout its life before consolidation If a parent entity has a subsidiary in the hedge must be ‘highly effective’ Local currency another country the first task is to in offsetting fair value changes Three principal types of hedges: » Currency used in the country in which the foreign operation is » Fair value hedges located – Used to hedge the value of Functional currency particular assets or liabilities » Currency of the primary economic » Cash-flow hedges – Used to hedge future environment in which the entity expected cash flow operates Presentation currency » Hedges of net investments in » Currency in which the financial foreign operations statements are presented IASB is currently revising IAS 39 » IAS 39 is progressively being Translating the financial statements of updated by development of IAS 9 an entity into a particular functional currency » Stage 1 which addresses accounting Translating the financial statements of determine the functional currency for financial instruments is complete an entity from a functional currency » If a subsidiary is located in New » Stage 2 which addresses accounting for hedge arrangements is almost into a presentation currency, which is Zealand then it is likely that the complete required prior to consolidation subsidiary would use the local Foreign currency swaps If the functional currency is the same as currency NZD the local currency, then there will be no » AUD would be the functional need to translate the financial currency if there was a high degree of dependence by the subsidiary on – Retained earnings 710 the parent » Gain to foreign currency translation If the functional currency is AUD then reserve 1 840 – (1 000 + 710) = there will be a need to translate the $130 New Zealand accounts into AUD BIOLOGICAL ASSETS If the subsidiary operates AASB 141 Agriculture independently the functional currency Why do we need a special accounting might be NZD and there would be no standard? To deal with (i) development and need to translate the accounts into a different functional currency growth; and (ii) harvesting an inventory Once the subsidiary’s accounts have » Original been translated into the appropriate – DR Wheat Crop functional currency then the accounts – Cr Gain on Wheat Crop will need to be translated to the » Once harvested: appropriate presentation currency prior – Dr Biological Asset to consolidation – Cr Gain on biological asset Before consolidating it will be necessary Definitions to convert statements of the various Because assets less liabilities equals Agriculture owners’ equity, it follows that the total foreign subsidiaries from their of owners’ equity is translated at the » Management by an entity of the functional currencies into the reporting date spot rate biological transformation of presentation currency of the parent biological assets for sale, into Assets and liabilities are to be Individual components of owners’ agricultural produce, or into translated using the spot rate at equity will be translated differently additional biological assets reporting date » Share capital will be translated Biological assets using the rate in place when the Income and expenses are translated at investment was acquired » A living animal or plant the exchange rates in place at the » Retained earnings will be the Non-human-related living assets dates of transactions » Trees held as forestry If expense and revenue transactions balance provided from the » Animals held as livestock occur uniformly, average rates may be statement of comprehensive » Orchards and vineyards income, which might use a variety used of rates » Aquaculture and fishery holdings Any resulting translation gains or losses The translation gain that remains part Does not apply to (expressly are taken directly to reserves mentioned): of equity is the balancing item » An investment in a forest as a Foreign currency translation reserve » Net assets at 30 June 2012 carbon sink, which gives rise to – 800 × 2.30 = 1 840 carbon credits that can either be All assets and liabilities of the foreign » Less components at historical rates subsidiary are translated at the – Share capital 500 × 2.00 = 1 sold or used to offset pollution reporting date spot rate. 000 caused by the entity » Greyhounds, whippets, horses, and Measurement been a significant change in pigeons used for racing Net market value is used to value economic circumstances » Performing animals held by theme – Market prices for similar biological assets () parks » A biological asset shall be assets, with adjustment to » Non-human living assets other than recognised on initial recognition and reflect differences animals and plants, such as viruses at each reporting date at its fair – Sector benchmarks (e.g. the and blood cells value less costs to sell, except for value of cattle expressed per Recognition the case where the fair value cannot kilogram) An entity shall recognise a biological be measured reliable » Where market-determined prices or asset or agricultural produce ONLY Gain or loss associated with biological values are not available, an entity is WHEN: assets shall be included in the profit to use the present value of » It controls the asset as a result of and loss for the period in which it arises expected net cash flows past events () » There may be no separate market » It is probable that future economic » A gain or loss arising from initial biological assets attached to land benefits associated with the asset » A market may exist for the recognition of a biological asset at will flow to the entity fair value less costs to see and from combined assets » The fair value or cost of the asset a change in fair values less costs to » Improved land value may be can be measured reliable () sell of a biological asset shall be deducted from the fair value of the Unique characteristics included in profit and loss for the combined assets to determine the Unique character of biological assets period in which it arises value of biological assets () » Capacity to grow or reproduce » When it is not possible to measure Costs to sell () fair value reliably: affects value » Costs to sell are the incremental » Value increases from the input of costs directly attributable to the – Measure at cost less any free goods disposal of an asset, excluding accumulated depreciation and » Costs generally incurred early, but finance costs and income taxes any accumulated impairment economic benefits derived later Fair value is determined from quoted losses » Long production cycle » Once the fair value can be » Expenditure on asset and ultimate prices in active markets with measured reliably, the biological deductions made for transaction costs return can be substantially different » An active market is where: asset is measured at fair value less Reporting – The items traded within the costs to sell () Prior to AASB 141, various market are homogenous Separate disclosure of change in fair classification, valuation methods, and – Willing buyers and sellers can value for both price and physical reporting systems were used change is encouraged () normally be found at any time » Separate disclosure is useful in Biological assets are not presented – Prices are made available to separately in the balance sheet, along the public appraising performance and future with information in notes that describes » Where there is no active market an prospects each group of biological assets () entity is to use the following – This information is generally Can be classified into current and non- less useful when the – Recent transaction price, production is less than one current elements provided that there has not year Agricultural produce Key issue addressed by AASB 6 is » Costs are expected to be recovered Agricultural produce of a biological whether expenditure on exploration and through successful development and exploitation asset is defined the harvested product evaluation is to be capitalised of the entity’s biological assets Discovery of economically recoverable » Activities have not yet reached a » Includes fruit pulled form trees, wool reserves enables an entity to capitalise stage that permits a reasonable shorn from sheep, felled logs, exploration and evaluation expenditure assessment of the existence of slaughtered livestock Area of interest economically recoverable reserves, AASB 102 inventory requires inventory and active and significant Area of interest accounting method is operations are continuing to be valued at the lower of cost and required by AASB 6 net realisable value » Area of interest is an individual During the exploration and evaluation » Agricultural produce harvested from geological area which is considered phase there is typically: biological assets is to be measured to constitute a favourable » No revenue against which at its fair value less costs to sell at environment for the presence of a capitalised costs can be amortised the point of harvest deposit or field » No asset in use that can be depreciated » Such measurement is the cost at » An area of interest will comprise a the date when applying AASB 102 single mine, deposit, or separate oil Exploration and evaluation assets are or similar standards or gas field subject to impairment testing EXTRACTIVE INDUSTRIES Measurement Expenditure after exploration and AASB 6 Exploration for and Evaluation Exploration and evaluation assets are evaluation IS NOT covered by AASB 6 of Mineral Resources Once a decision has been made to initially measured at cost Extractive industries engage in the Subsequent measurement is at cost or develop and area of interest, search for natural substances of re-valued amount capitalised exploration and evaluation commercial value such as minerals, oil » Intangible assets can only be re- costs will be reclassified and natural, and in extracting these valued if there is an active market » Assets under construction rather substances from the ground than exploration and evaluation Five project phases (AASB 6 addressed Exploration and re-valuation costs assets » Acquisition of rights to explore the first two stages ONLY) » Topographical and other studies When development phase is complete » Exploration » Exploratory drilling and production commences, costs are » Evaluation » Trenching again reclassified » Development » Sampling » Property, plant and equipment » Construction » Technical and commercial feasibility » Intangible assets » Production and viability of extracting a mineral Costs carried forward to the production Searching for deposits is likely to resource phase should generally be allocated involves considerable expenditure to » General and administration costs over the life of the economically determine whether areas are suitable related directly to operational recoverable reserve for commercial development activities of area of interest to which » Production output Other expenditures (post-exploration) exploration and evaluation relates » Time as tenure over the areas of often required before development Costs for a currency tenured area of interest leading to production interest can be capitalised if: Identifiable tangible and intangible » Long service leave – DR Annual leave expense assets carried forward are to be » Superannuation – CR Provision for annual leave » Share entitlements accounted for in accordance with the » When annual leave taken requirements of the relevant AASBs » Bonuses – Dr Provision for annual leave » AASB 116 Property, Plan and AASB 119 divides employee benefits – CR PAYG tax payable equipment into four categories: – CR Cash » AASB 138 Intangible assets » Short term On costs A provision for restoration costs may be » Post employment » Termination » ‘On costs’ are to be considered required (AASB 137) when calculating employer’s » Best estimate with periodic » Other long-term (superannuation) obligations for employee benefits reassessment Short-term benefits – Payroll tax » Present value if the effect of the Generally expensed in the current – Workers’ compensation time value of money is essential period (i.e. salaries and wages) Forms part of cost of respective phase Benefits payable more than 12 months insurance – Superannuation contributions of operations after the end of the reporting period Sick leave Once production commences, treated should be discounted to the PV » Vesting sick leave – employee has a as cost of production Liabilities accrue when services have right to benefit on termination AND AASB 118 Revenue been rendered but benefits not paid at reporting date accounted for in same way as » Sales revenue brought to account annual leave when resource is in the form in May be capitalised where: – DR Sick leave expense which it is to be sold (requires no » Used in the production of – CR Provision for sick leave further proceeding) and risks and inventories (AASB 102 – Inventories) » Non-vesting sick-leave – payable rewards of ownership have passed » Establishment of property, plant and only for valid sick leave claimed. to the purchaser equipment (AASB 116 – PP & E) Accumulated entitlement which is AASB 102 Inventory Salaries and Wages WORKED EXAMPLE expected to be taken should be » Before being recorded as inventory, 13.1 recognised as a liability if it is resources must be extracted and » Accrued salaries capable of being reliably measured able to be reliably measured » PAYG tax withholding – DR Sick-leave expense EMPLOYEE BENEFITS » Amounts deducted on behalf of – CR Provision for sick leave Regulatory framework employees AASB 119 – Employee Benefits Long service leave Annual leave » Employees may be entitled to Definition – Employee benefits are all » Employees may have annual leave extended leave after a specified forms of consideration given by the entitlement number of years entity in exchange for services » If obligation is payable within 12 » LSL liabilities are accrued rendered by the employees months of balance date, there is no Examples include: need to discount the obligation to » Liability is measured at present value for obligations payable 12 » Salaries and wages its present value months after balance date » Annual leave » To recognise annual leave » Sick leave obligation: » Three categories: (i) pre-conditional employment life insurance and managing fund, probability period; (ii) conditional period; and health care employee will stay until (iii) unconditional period » Defined contribution plan retirement » Judgment in determining LSL – Retirement benefits are – Employer bears the risks liability: determined by contributions associated with the earnings – Probability employee will stay made and investment of the fund until such time as they have earnings on contributions POSITIVE THEORY I LSL entitlement – Contributions recognised as Objectives – Salary at the time of receiving an expense (unless part of Understand agency theory, agency the LSL subject to increase, inventory or PPE) costs of debt and equity, and the role of promotion etc. – Liability limited to amount of accounting in minimising agency costs – Discount rate for entitlements obligation unpaid by employer Explain how accounting policy choice is (based on high quality bonds at end of year related to agency costs that match the timing of the – Obligations are measured on Outline how positive accounting LSL entitlements) an undiscounted basis, except research has informed understanding of » Calculating LSL liability where they do not fall due accounting choice – Current salary x (1 + inflation wholly within 12 months after Positive accounting theory rate)n the end of the period in which A positive theory seeks to explain and » Accumulated LSL benefit the employees render the predict particular phenomena – (Years of employment/total related service periods required to be served – Entity to disclose the amount » PAT ‘… is concerned with explaining accounting practice. It is designed before leave can be taken) x recognised as an expense for to explain and predict which firms [(Weeks of LSL entitlement defined contribution plans will and which firms will not use a available after conditional » Defined benefit plan particular method … but it says period has been served/(52 x – Retirement benefits are paid nothing as to which method a firm projected salary)] form an aggregated fund by » Present value of LSL obligations reference to annual salary or should use.’ (Watts and Zimmerman, 1986) – Accumulated LSL benefit/n1 + a specified amount regardless Focuses on relationships between appropriate bond rate) of contributions made by the various individuals and how accounting » Probability that LSL will be paid employee is used to assist in the functioning of – Determined by reference to – Established by employer to these relationships prior experience within the provide a pension which is a organisation and industry proportion of final salary after » Owners and managers » The company and debt providers Superannuation retirement Agency theory » AASB 119 - addresses how an entity – Employer contributes to fund Contracting theory explains the is to account for superannuation to ensure pension obligation is company as a legal ‘nexus’ of benefits, as well as post- met, taking into account: contractual relationships employment benefits such as post- projected final salary, earnings rates of the fund, costs associated with Company is an efficient means of minimise future agency and Often achieved by remunerating organising economic activity to reduce contracting costs managers on performance based » Managers select accounting contracting costs measures Within the complex set of contracts are methods which most efficiently » Accounting performance measures agency agreements reflect underlying firm performance » Share price Agency: » Regulation for a particular Bonus schemes are standard practice. » One party (principal) engages accounting method is deemed to Deegan (1997) reported that bonus impose unwarranted costs schemes are often based on: another (agent) to act on their Opportunistic perspective behalf » EPS » Underlying assumption of self- » Seeks to explain managers’ actions » ROA interest once contracts are already in place » ROE » Contracts are used to ensure the » Not possible to write complete Healy (1985) linked accounting choice agent acts in the principal’s best contracts, so managers are to managerial remuneration interests assumed to opportunistically act to considerations maximise own wealth Agency costs Transfer of earnings between periods Accounting information is used to » Known as ex post perspective – (earnings management) affects the reduce agency costs considers opportunistic actions after present value and certainty of the Jensen and Meckling (1976) – Outlined the fact manager’s bonus Hypotheses frequently used: Bonus plan hypothesis – firms with the agency costs that arise from » Bonus plan hypothesis manager-shareholder and shareholder- » Debt hypothesis performance based management debt holder agency relationships compensation plans use profit » Monitoring – costs of monitoring » Political cost hypothesis increasing accounting policies agents’ behaviour; for example Agency costs of equity auditing financial statements Incentives exist for managers to act in » Bonding – costs involved in agents their own self interest rather than that of the shareholders; managers do not bonding their behaviour to bear the full cost of their actions expectations of principals; for example preparing financial (creates ‘agency costs of equity’) statements Costs arise from: » Residual – cost of residual » Consuming prerequisites opportunistic behaviour » Risk aversion » Over-retention of profits Research on agency costs Efficiency perspective » ‘Horizon’ problem » Researchers explain how Costs can be reduced by shareholder- contracting mechanisms minimise management contracting agency costs of the firm » Tie manager’s well-being to that of » Known as ex ante perspective – shareholders » Price protection mechanisms put in place up front to Agency costs of » Firms approaching debt covenant debt violation associated with In the manipulation of accruals and presence of strategic adoption of new standards risky debt, to increase income (De Fond et al managers 1994; Sweeney 1994) (as agents of POSITIVE THEORY II Objectives Allocation of funds to the bonus pool, based on accounting profit Understand how the political cost shareholders) have incentives to expropriate those claims effect, corporate governance and » Creates ‘agency costs of debt’ information asymmetry relate to accounting policy choice Expropriation External influences » Increased dividend payments External parties may influence » Issue of additional secured debt » Asset substitution managerial accounting preferences » Under-investment Such externalities are referred to as ‘political costs’ The inherent conflict of interest Wealth redistribution can occur as a between shareholders and debt holders result of government action in respect can be managed by contracts which restrict the extent to which of taxes, industry assistance, tariffs, shareholders can engage in subsidies etc. opportunistic behaviour Interest groups and government More recent research has provided agencies can also be inf
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