Lecture 7 Making Financial Reporting Decisions Critique of Positive Accounting Theories

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Lecture 7 Making Financial Reporting Decisions
Critique of Positive Accounting Theories
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Making Financial Reporting Decisions

• Modules 3, 4 5 deal with theoretical frameworks
  related to making financial reporting decisions

How do I make financial reporting decisions?
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Lecture Overview

• Review of Modules 3 4
• Positive Accounting Theory (PAT)
• Legitimacy Theory
• Stakeholder Theory
• Module 5
• Criticisms of positive accounting theories (5.1 -
  5.3)
• Usefulness of theories and research results (5.4)
• Intro to Modules 6 7
• Two ways to evaluate the impacts of financial
  reporting decisions

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Review - positive accounting theory (PAT)

• Major focus is on stewardship role of accounting
• Looks at reasons underlying financial reporting
  decisions
• Emphasis on relationship between financial
  reporting decisions and contracts, particularly
  management compensation contracts and loan
  agreements (debt contracts)
• Based on agency theory

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Review - Agency Theory

• Conflicts of interest give rise to agency costs
• Contracts are used to reduce these conflicts of
  interest (bonding) - contract terms sometimes
  rely on accounting information
• Firms prepare audited accounting reports to
  facilitate monitoring of these contracts
  (stewardship role of accounting)

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Review - Implications for financial reporting
decisions

• Because contracts are used to bond the agent to
  the principal, and financial statement
  information is often used to monitor the agents
  compliance with these contracts
• Agents have incentives to present the financial
  statements in a way that ensures the best outcome
  under the contracts
• Therefore, contracts need to be considered when
  making financial reporting decisions

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Review Legitimacy Theory

• Organisations seek to ensure they operate within
  the bounds and norms of their respective
  societies
• relies upon the notion of a social contract
• Represents the implicit and explicit expectations
  that society has about how the organisation
  should conduct its operations

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Review Legitimacy Theory

• Legitimacy Theory proposes a relationship between
  corporate disclosure and community expectations
• Consider implications of not meeting social
  contract when making financial reporting
  decisions
• may lead to sanctions such as legal restrictions
  on operations, limited resources provided, or
  reduced demand for products

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Review Legitimacy Theory

• Disclosures form part of the portfolio of
  strategies undertaken to bring legitimacy to or
  maintain legitimacy of the organisation
• Increase in environmental disclosures
• Over time
• Following social incidents or environmental
  disasters
• Disclosures mostly positive

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Review Stakeholder Theory

• Definition of stakeholders is very broad
• Two branches of Stakeholder Theory
• ethical (moral) or normative branch
• Management should be accountable to all
  stakeholders
• positive (managerial) branch
• Attempts to explain when corporate management
  will be likely to attend to the expectations of
  particular (powerful) stakeholders

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Review Stakeholder Theory

• positive (managerial) branch
• stakeholder power is a function of the
  stakeholders degree of control over resources
  required by the organisation
• Information, including financial accounting and
  social performance information, is a major
  element employed to manage stakeholders

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Module 5

• Critique of Positive Accounting Theories
• (PAT, Legitimacy Stakeholder)

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What is a critique?

• A critical essay or analysis
• Critical thinking involves questioning everything
  that you hear or read
• The critiquing of claims can alter our ways of
  understanding the world
• Both strengths and weaknesses are considered

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Importance of critiquing in relation to studying
this unit

• All theories and related research have
  limitations
• Sometimes related to underlying assumptions
• These should be understood and kept in mind when
  using them to guide financial reporting decisions
• More informed (better) decision making will be
  the result

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Criticisms of PAT
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Assumptions Underlying PAT

• Everything can be explained in terms of utility
  maximisation (self-interest)
• Promotes a morally bankrupt view of the world
  (Gray, Owen and Adams, 1996)
• Utility maximisation does not necessarily relate
  to wealth maximisation (ignores some costs such
  as social costs)
• However, wealth maximisation appears to be a
  reasonable assumption when explaining corporate
  decisions

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Failure of PAT

• Positive accounting theory does not provide
  prescriptions for how we should account
• How to account is an important issue for
  practicing accountants and accounting regulators
• However, we know that standard setting is a
  political /social process rather than a matter of
  deriving a set of ideals
• And

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While Positive Accounting Theory doesnt tell us
how we should account, it does tell us what
economic factors to consider when making
financial reporting decisions.
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Other Criticisms of PAT

• Slow / limited development
• Not value free
• Scientifically flawed hypotheses frequently not
  supported
• Results apply on average

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Criticisms of Legitimacy and Stakeholder Theories

• Limited application to many financial reporting
  decisions
• Eg. Expense vs. capitalise, accounting method
  choices, disclosure vs. recognition
• Usefulness relates mainly to unaudited
  disclosures
• Not value free
• Pursuit of profits is the only moral obligation
  of business (Den Uyl, 1984)

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Criticisms of Legitimacy and Stakeholder Theories

• Legitimacy theory too broad, why is it important
  to be legitimate?
• Empirical tests often involve counting the number
  of pictures and words (lacks statistical rigour
  compared to PAT)
• PAT remains as the dominant paradigm in relation
  to financial reporting

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The usefulness of positive accounting theories
and research results

• They are still useful!

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In support of positive accounting theories

• Positive accounting theories provide some useful
  explanations and predictions for accounting and
  disclosure practice
• Empirical support for the predicted hypotheses
  gives credibility to the theories
• Growing body of evidence to support theories
• Theories are simplifications of reality, and all
  suffer limitations
• These theories are the best that weve got!

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Using positive accounting theories in practice

• Before applying positive accounting theories in
  practice, you should be aware of their
  limitations
• Remember, the theories are based on assumptions
  and these may not hold in reality
• Also, before relying on particular research
  results, the validity of the results must be
  assessed (critique them)

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Strengths of positive accounting theories

• Provide a useful framework for making financial
  reporting decisions
• Helps to predict the effects of changes to
  accounting regulation
• Useful in relation to the future development of
  accounting regulations
• Indicates the factors to consider when making
  financial reporting decisions

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Factors to consider when making financial
reporting decisions

• Contracts of the company
• Assets of the company
• Information asymmetries
• Potential political costs
• Societys expectations of the company
• Power of various stakeholders
• Impact on share price
• Impact on individual financial statement users

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The usefulness of normative accounting theories

• Examples are the ethical branch of stakeholder
  theory and the Conceptual Framework
• Provide an ideal to work towards
• A starting point for standard setters
• However we should not expect final accounting
  standards to fully reflect these ideals due to
  the process being political

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Introduction to Modules 6 7

• Impacts of Financial Reporting Decisions

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The Impacts of Financial Reporting Decisions

• Modules 6 7 deal with research into the impacts
  of financial reporting decisions

How do my financial reporting decisions impact
on the decisions of financial statement users?
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Financial Reporting Decisions
Regulated Financial Reporting Decisions
Unregulated Financial Reporting Decisions
Making Financial Reporting Decisions
The Impact of Financial Reporting Decisions
You are here
Social Determinants Of Financial Reporting
Contracting Determinants of Financial Reporting
Share prices
Individuals
Critique of PAT
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Impacts of Financial Reporting Decisions

• There are two ways to assess the impacts of
  financial reporting decisions
• Determine what impact the release of information
  had on share price? (capital markets research)
• Determine the impact of the information on the
  decisions of individual information users
  (behavioural research)

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Comparison of Behavioural and Capital Markets
Research

• Both examine the impact of financial reporting
  decision on users of the info.
• Capital markets research assesses the aggregate
  effect, while behavioural research assesses the
  effect on individuals
• Capital markets research includes only investors,
  while behavioural research examines other types
  of financial statement users
• Capital markets research assesses WHETHER the
  information is used, while behavioural research
  can asses HOW the information is used

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For Tutorials

• Required reading
• Text chapter 7, pp. 235 239
• Text chapter 10, pp. 358 - 359
• Self assessment questions
• Questions 1 - 5 from module 5
• Question 1 from module 6
• Answers in tutorials