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Individual Assignment: Accounting Theory and Current Issue

Module Code: H16025

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Introduction

Accounting theory examines the various theories to understand the importance of accounting in

the process of decision making. Theoretically if there is no financial regulation then the methods

that are used to determine the accounting methods and the disclosure of financial information is

what accounting theory is. The accounting theory has both normative and positive theories in it

that deal with accounting. The theory also studies several current issues in accounting that have

surfaced and appears to be common in most accounting issues in different businesses. The

purpose of account theories and its place in current issues is to enable individuals to think

analytically and critically to integrate the knowledge in the work place environment.

(RMIT,2015)

Assignment Question 1

“The mere discovery of a problem is not sufficient to assure that the Financial Accounting

Standards Board will undertake its solution … There must be a suitably high likelihood that the

Board can resolve the issues in a manner that will be acceptable to the constituency—without

some prior sense of the likelihood that the Board members will be able to reach a consensus, it is

generally not advisable to undertake a formal project”.

The above is a quotation that has been taken from the book of Professor Miller which was

published in 1986. The quotation is from page 64. What Professor meant by the above mentioned

quotation is that identifying a problem is the audit process is no surety that a solution will be

found to the problem. The problem that is referred to in the above quotation is the problems that

emerge during an audit that is performed in a business entity.

What professor Miller tries to explain is that even if the issue is placed in front of the Financial

Accounting Standards Board there is no surety that the Board will take action or responsibility in

finding a solution to the problem. When a problem is presented to the Financial Accounting

Standards Board there must be reason to believe that the Board members will be able to

understand the problem collectively and create a solution to the problem by consensus, if

however the likelihood is not there then an individual or an audit firm should not take up a

project formally to try and find resolution though the Financial Accounting Standards Board.

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Financial Accounting Standards Board

The main responsibilities of the Board are to establish the financial accounting procedures for the

public companies and to improve the existing procedures that exist. The aim is to provide useful

information to the investors of companies so that the investments that the public makes are sound

investments that will provide financial returns to the investor. The Board is answerable only to

the Financial Accounting Foundation's Board of Trustees. The scope is to build independent

processes without any bias by taking the objective considerations of all stakeholders into account

but with the reality of a business environment it is only natural to accept the fact that neutrality

and representational faithfulness will not remain the same when confronted with public interest.

(FASB,2014)

The Neutrality and the Representational Faithfulness of Reports Generated

According to Professor Miller, constituency support is necessary before approached to

accounting techniques can be included in the Accounting Standards. Since the constituency

support is necessary then it does affect the neutrality of the members of the Financial Accounting

Standards Board cannot remain neutral and objective to the approaches that have been presented

to the Board, they have to rely on the constituency support to make it part of the Financial

Accounting Standards and create the procedure for uniform use of the accepted accounting

approach.(Edwards,2011)

The representational faithfulness of the approach is also affected as the Financial Accounting

Standards Board is not the only entity that can decide, the consensus has to be built within the

constituents, the Board members the business entities and also with the other organizations that

represent the financial accounting standards in different capacities. Some of the organizations

with which the Financial Accounting Standards Board has to build a consensus are: The

American Institute of Certified Public Accountants, The Governmental Standards Accounting

Board, The Securities & Exchange Commission, the American Accounting Association, The

Financial Executives Institute and the Institute of management Accountants (IMA).

Neutrality in accounting is the financial accounting and audit of business that is free from bias,

but there could also be deliberate bias of which Professor Miller talks about in the above quote.

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In most cases of financial accounting deliberate bias is sued by the management to cover up for

mistakes and fraudulent or illegal transactions that are running though the accounting records of

a business entity. The second type of bias in accounting that could affect the neutrality of the

accounting procedures when one type of system is favored because it has been traditionally sued

by the organization and is part of the organizational culture of the company. (AS,2015)

Representational Faithfulness has to do with the correct representation of facts and figures during

accounting and this generally is based on the conceptual premise of substance over form. When

placing a formal project in front of the Board there is no surety that there will not be any bias or

that the facts will be represented as they should be because the representation of facts will be

tailored to place weight behind the accounting approach that is being presented to the Board and

which the Board should look at favorable to gain constituent support and the consensus of other

accounting standards authorizes before it can resolve the issue.

Conclusion

Professor Miller is absolutely correct in showing that every business entity has its own vested

interests in the way the finances of an entity are accounted for. There are many aspects of the

workings of a entity that they may not like to place before the public or the government and yet

they are bound by codes of conduct that should be practiced, ethical standards that needs to be

practiced and the regulatory standards that must be complied with to avoid any type of legislative

violation of accounting practices. The draw back as to why it affects the neutrality and the

faithfulness of the representation of facts and figures is due to the vested interests and the need to

hold on to its stakeholders and investors.

Assignment Question 2

Introduction

Positive accounting theory has to do with accounting research possibilities to be able to study the

accounting practices in depth and to finds explanations that will allow accountants to predict the

financial accounting practices that are used in different business entities. It is slightly different

from normative accounting which tries to develop the best accounting standards that should be

used by the international business community.(Watts,Zimmerman,1986)

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Perspectives of Positive Accounting Theory

There are two basic types of positive accounting theory perspectives. One is the efficiency

perspective and the second one is the opportunistic perspective. This is a perspective that is sued

by the researchers to show how financial managers use different methods of accounting to place

their financial figures in the best possible light in the eyes of the stakeholders and the investors.

The purpose is to study and find the best accounting techniques that provide a true representation

of the financial condition of a business entity even if all the financial details are unavailable to

study and to audit. It finds pathways and loopholes by which the true financial performance of a

company can be seen despite cover ups.

The second type is the opportunistic perspective who holds the assumption that the financial

managers are only the agents for the principal business entity and therefore act in their own self

interest. This is true because, the professional career path of financial a manager depends on the

financial performance of the company in which they are working as financial managers.

(Watts,Zimmerman,1978)

The Quotation

The Watts, Zimmerman quote has been taken from the book Positive Accounting Theory which

was published in 1986. The quote has been taken from page 7 of the book and is quoted below

for reference.

As Watts and Zimmerman (1986, p. 7) state, Positive Accounting Theory ‘is concerned with

explaining [accounting] practice. It is designed to explain and predict which firms will and

which firms will not use a particular accounting method … but it says nothing as to which

method a firm should use’

The positive accounting theory tries to explain the accounting approaches of different business

entities without making any suggestions as to what should be the method that a business entity

should use to maximize its financial reporting standards and performance.(Christenson,1983)

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Watts and Zimmerman have focused on the relationship between the financial manager and the

owner or the financial manager (agents) and the debt capital providers. Their study deals with the

relationships that provide resources to a business entity.

The purpose is to put accounting methods into place that will lower the costs of hiring an agent

to perform the financial details of a business entity. There is no loyalty attached to the actions

because the motivation is increase the wealth of the business entity as the agents and the

principals are drive by self interest.

The assumption that Watts and Zimmerman refer to in the quote is that the organizations and

business entities are contractually bound to each person who works in the organization and who

work collectively to achieve the business goals of the entity. The cooperation that exists in an

organization stems only from the self interests of each of those individuals who are contractually

bound to the business goals of the organization.

The organization on the other hand provides good compensation packages and incentive to gain

this motivated cooperation from the employees who work in the organization.

Besides the agent cost the bonding cost is there also which is an expense for the accountants to

bond in the interests of the organization to provide the results that the principal wants out of

them for which they are being provided an excellent compensation package for their efforts and

expertise in accounting.

Under the Positive Account Theory it is assumed that the financial managers will be responsible

for creating the financial statements that place the organization in a good light and that the

financial statements will be monitored and audited.

The second assumption is that they will act in their own self interest to gain better prospects

within the organization and therefore will create the type of financial statements that will please

the stakeholders and the investors. There is a cost attached to auditing and this is known as the

monitoring costs.

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The theory according to Watts and Zimmerman also assumes that all the opportunistic actions

that are taken cannot be fully monitored or controlled by the contractual agreements that have

been made with the accountants and therefore there is no residual expense attached or else if all

activities could be controlled there would be a residual expense incurred by the organization.

The Agency relationship as illustrated in Illustration (1) makes it necessary for the self interest of

the agent and the self interest of the principal to be served which is why in many cases where the

contractual agreements are insufficient, the self interests of both the principal and the agents are

aligned.(Hossein,2011)

Illustration (1) Agency Relationship, Source: Hossein, 2011

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Conclusion

From the above facts that have been highlighted about the Positive Accounting Theory it does

appear that no codes of conduct of business ethics that are contrary to the self interests of the

business entity and its agents will be followed by the principal or the agents, it is also clear that

while the theory predicts what type of accounting method will be used by which type of entity , it

fails to mention the reason why a particular accounting method is being sued by a business entity

and its agents, therefore it is an abrogation for the academics to serve a self interested

community who will justify the means they use only if it serves their self interest. From the point

of abrogation of the academics’ duty one cannot contradict the statement made by Watts and

Zimmerman

References

Christenson, C. (1983), “The Methodology of Positive Accounting” The Accounting Review

(January), pp1–22

Edwards, H.(2011) Accounting Principles: A Business Perspective, Financial

Accounting ,Chapter 1 to 8 Pub: Textbook Equity Inc.

FASB(2014) Facts About FASB,www.fasb.org, retrieved on January 7th 2015

Hossein,(2011) An Overview of Positive Accounting Theory, Pub: McGraw-Hill, retrieved on

January 7th 2015

RMIT(2015) Financial Accounting Theory, www.shortcourses.remit.edu.au, retrieved on January

7th 2015

Watts, R. and Zimmerman, J. (1986), Positive Accounting Theory, Edgewood Cliffs, NJ:

Prentice Hall

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Watts, R. and Zimmerman, J. (1978)“Towards a Positive Theory of the Determination of

Accounting Standards,” The Accounting Review 53 (January), pp112–134.