INSTRUCTORS MANUAL TO:

Part 2: Theories of Accounting

Chapter 3

Theories of financial accounting

Review questions3.1The majority of financial accounting textbooks address the various rules embodied within accounting standards (as this book also does) but fail to consider such issues as:

What motivates management to adopt particular accounting methods when they have a choice between alternative approaches? Why do some organisations lobby in support of particular accounting methods whereas other organisations oppose the methods? What costs are likely to follow as a result of new accounting standards being released and are these costs likely to be equal for all stakeholders? What factors would motivate accounting regulators to favour introducing one method of accounting in preference to another? How will particular stakeholder groups respond to particular accounting disclosures?To consider or explore issues such as those identified essentially requires us to embrace particular accounting theories, such as those addressed in Chapter 3. Without exploring particular theories it would be difficult to provide considered answers to the above issues. In providing an overview of various theorieswhich is typically not what other financial accounting texts dothe author (as well as lecturers that have prescribed this chapter as part of the students required reading) believes that not only is it useful to discuss the requirements of the various accounting standards, but that it is important to provide frameworks within which to consider the implications of organisations making particular accounting disclosures, whether voluntarily or as a result of particular mandate. We also think it is useful to consider the various pressures, many of which are political in nature, that influence the accounting standard-setting environment.Of course, financial accounting could be studied without reading about theories of accounting. However, because the impact of financial accounting resonates throughout society we believe studying accounting theories provides readers with the necessary background to understand the possible implications of an organisation making particular disclosures. The theories overviewed in Chapter 3 also provide the basis for understanding the various pressures that drive organisations to make particular disclosures, even in the absence of disclosure requirements pertaining to particular transactions and events. By reading Chapter 3, together with the material in other chapters of this book, we believe that readers will gain a greater understanding of the implications of various accounting standards and other disclosure requirements.

3.2If it is assumed that individuals act in their own self-interest and seek to undertake actions which maximise their own wealth at the expense of others (as is assumed in Positive Accounting Theory (PAT) and various other theories from the economic literature), then it is possible that actions that are in the best interests of the manager may not always be in the best interests of other stakeholders, or the firm as a whole. From a PAT perspective, one way to alleviate this problem is to make the managers wealth dependent upon actions, which also would lead to a maximisation of the value of the firm. This is often referred to as an alignment of interests.

The types of management activities that may adversely affect the value of the firm would include perquisite consumption and/or the use of information acquired within the firm for the purposes of private gain. Mechanisms such as an efficiently operating labour market and efficiently devised remuneration plans should, according to PAT theorists, act to eliminate at least some of the actions by management that may not be in the interests of the firm. According to PAT, it is not possible to devise mechanisms that will fully remove the ability of management to undertake actions that are not in the interests of the organisation.

3.3To the extent that the output of the accounting system reflects the performance of the firm (and this will depend upon the appropriateness of the accounting techniques employed), then rewarding the manager in terms of the output of the accounting system should (assuming that self-interest is central to individual actions) motivate that manager to maximise the value of the firm. That is, we would attempt to align the interests of the manager and those of the owners of the firm.

In using the output of the accounting system, care must be taken to ensure that management is not short-run in focus (consider Healy 1985). Also, we must consider the fact that many investment strategies that are in the interests of the owners might not generate accounting profits for a number of years. If a manager was rewarded solely in terms of accounting profits then the manager may tend to focus on projects that generate profits in the near-term. This may be the case for managers approaching retirement, particularly if they are rewarded on the basis of accounting profits. For managers approaching retirement, there would be a potential horizon problem wherein the horizons of the managers are not the same as the horizon of the owners. Holders of equity capital would typically be concerned with the expected present value of all future cash flows, not just those in the short run.

It is common for managers to be rewarded in terms of a mix of both market-based (which are longer run in focus but suffer from the problem of market noise) and accounting-based performance measures.

3.4Management may pay excessive dividends to the owners, cause the firm to take on additional and perhaps excessive levels of debt, or use the firms resources to invest in very high-risk projects. Positive Accounting Theory would indeed argue that these actions would be taken to the extent that they have positive wealth implications for the managers involved. As stressed throughout the chapter, PAT assumes that managers are motivated by self-interest to undertake those actions that provide the greatest expected pay-offs to themselves.

Debt holders with a fixed claim would prefer the firm not to take on high-risk strategies. Hence, if a firm contractually agrees not to undertake activities that may expropriate the wealth of the debt-holders (and importantly, the managers agree to have their subsequent actions audited for compliance with the agreements), then the organisation may be able to attract funds at a lower cost than would otherwise be the case.

However, from a market-wide perspective, it is assumed that the market is indifferent to whether management contractually agrees, or does not agree, to minimise the activities, which may negatively affect the wealth of the debt holders. If a firm does not agree to such arrangements, then the market will price protect. That is, it will simply charge a higher rate of interest to compensate for the higher perceived risk.

3.5Corporate social reporting (CSR) can be defined as the reporting of information, both quantitative and qualitative, about the effects of the firms operations upon those within the society and upon the physical environment in which it operates. By its nature CSR shows an acceptance of the view that the users of financial statements extend beyond the shareholders, and include consumers, suppliers of factors of production including labour, particular interest groups and the public (that is, a broader group of stakeholders). Producers of CSR also indicate an acceptance that an organisation is accountable for more than just its financial performance. CSR could include, amongst other things, information about the firms interaction and effect upon the environment, employment policies, community projects and product safety issues. Most CSR reporting is undertaken in qualitative terms and is typically provided on a voluntary basis; that is, its disclosure is typically unregulated. This can be contrasted with financial reporting, which is heavily regulated. (An issue to consider: why do you think financial reporting is heavily regulated but social responsibility reporting is basically unregulated?)

Instructors should consider discussing possible motivations for management to voluntarily elect to provide such information. Do you think organisations are likely to voluntarily provide both positive and negative information about their social and environmental performance? Has there become an increased acceptance by corporate managers that they have an accountability for the social and environmental implications of their operations?

3.6Research within Australia and overseas indicates that many corporations do provide environmental information, but due to a lack of an accepted framework for reporting environmental information they typically provide this information in a variety of formats (which has implications if somebody is trying to compare the performance of different organisations). Traditionally, organisations failed to provide any negative information about their environmental performance, but in recent years organisations are producing reports that document various negative incidents, such as non-compliance with particular environmental standards, spills, employee accidents, and the like.

Different theoretical perspectives (for example, Positive Accounting Theory, Legitimacy Theory, Stakeholder Theory, Institutional Theory) can be used to provide possible explanations about why firms voluntarily present certain information. These theories provide different views as to why management provides such information. One argument may be that the community is concerned about environmental issues and hence, by providing good environmental news the firm may increase the community acceptance of its products, which ultimately will lead to increased profitability. Another argument may be that firms, particularly those in industries that are suspected of being environmentally unsound, feel a need to legitimise their existence, with this legitimising action taking the form, in part, of increased disclosure of the positive environmental attributes of the firm (consider Patten 1992).

In research undertaken by Deegan and Rankin (1996, referred to in this chapter of the text), a sample of companies that had been prosecuted by the Environmental Protection Authority for breaches of particular environmental laws disclosed significantly more positive environmental news in their financial statements than a matched sample (matched by size and industry) of firms that were not prosecuted for breaching any environmental regulations. Further, the amount of disclosure of positive environmental information increased significantly in the year of prosecution. Such results would be consistent with a legitimisation argument.

While there are a variety of approaches to social and environmental reporting (and sustainability reporting), many organisations have embraced the sustainability reporting guidelines released by the Global Reporting Initiative (GRI), which is now in its third version (G3.1). The GRI is discussed in Chapter 35. It is interesting to consider why some organisations have embraced the GRI guidelines, while many have not.

3.7It would seem to imply that the financial report users are considered to extend beyond shareholders and to include such parties as consumers, resources providers (inclusive of labour) as well as the general public; that is, there is an acceptance of a broad range of stakeholders. It would also seem to indicate an acceptance by management that it is accountable to, or perhaps dependent upon, the wider society in which it operates, and that it is accountable for various aspects of its performance (other than just financial performance).

3.8A debt covenant may be considered to be a clause or section of a larger debt contract negotiated between managers and the providers of debt capital and written for the purposes of controlling conflicts of interest between the debt holders and the managers of the firm. Debt covenants are frequently written in terms of accounting numbers. Such covenants may include debt-to-assets constraints, interest coverage clauses, and the like.

By having negotiated debt contracts in place, management will have agreed to restrict certain types of activities that may not have been in the interests of debt holders (for example, taking on excessive levels of debt). As a result, the firm may be able to attract funds at a lower cost than may otherwise be possible. (If this was not the expectation, then it would be unlikely that such restrictions would be accepted by management.) Of course, the debt contract would require that any agreements with management be monitored by an independent party for subsequent compliance.

3.9If we accept the perspectives provided by PAT then the goal would be to align the interests of the managers and the owners of the firm such that the actions of management which lead to an increase in management wealth will also lead to an increase in the wealth of the owners. That is, what is in the interests of the managers is also in the interest of the owners of the firm. (Remember, PAT assumes managers, and indeed all people, are driven by self-interest, which is typically assumed to be tied to wealth maximisation.) For example, if managers are given a bonus tied to accounting profits then they will act to increase profits (which in turn increases their bonus) and it would also be likely that an increase in profits would lead to favourable movements is share prices and dividend payments to owners.3.10(a)Two possibilities would be to put in place management compensation schemes and/or share and share option schemes. In putting in place such mechanisms, and if they are tied to accounting numbers, consideration needs to be given to how effectively accounting results reflect the performance of the firm and the manager. It would also be necessary to consider how noisy share prices are. That is, how much of the movement is influenced by market-wide, as opposed to firm-specific, factors. Also, incentive schemes will only work where the recipient believes that they are in a position to influence the particular performance indicator. As an example, it may be inappropriate to reward junior management on the basis of movements in share prices given their relative inability to influence the underlying price.

(b)Debt contracts may be put in place. Covenants within the contract may include such things as maximum allowed debt levels, maximum allowed dividend payments, required rates of return and restrictions on the types of activities that may be undertaken. It would be essential that an independent party be employed to monitor compliance with the negotiated agreements.

3.11The auditor acts to monitor the compliance of management with particular legislative and professional reporting requirements, and also perhaps with regard to privately negotiated accounting-based contractual arrangements. The value of the external auditor comes from the auditors independence. The auditor should provide an opinion on the financial statements, irrespective of whether it is, or is not, an opinion preferred by management. For many accounting disclosures there is a high degree of professional judgment necessary. Hence, the auditor will frequently have to arbitrate on the reasonableness of the accounting methods employed.

Instructors should emphasise the benefits that firms may derive from being audited, and that auditing existed well before regulatory requirements. With greater confidence being attributed to the financial statements (and this in part may be a function of the reputation of the auditor) a firm may be able to attract funds at lower cost, given that greater reliance can be placed on the financial reports.

3.12Many contracts written between the firm and the providers of managerial expertise, or the providers of debt capital, use the output of the accounting process in the contractual arrangement. For example, managers might be provided with a bonus tied to accounting profits or return on assets. Contracts with debt holders may include such things as debt-to-asset constraints or interest coverage clauses. Hence, if the accounting methods in use are changed then accounting numbers such as assets or profits may change, with potential cash flow consequences in relation to the contractual arrangements. Changes in cash flows will have implications for changes in the value of the organisation. When new accounting standards are issued there are often implications for various accounting-based contracts the firm might have negotiated (for example, a new measurement basis might cause assets to decrease in amount and this might mean that a debt to asset constraint is breaches and this could be costly for an organisation).

Of course, the contracts in place may stipulate the particular accounting methods to be used for the purposes of the contractual arrangements regardless of any changes that occur in accounting standards (this is referred to as frozen GAAP). However, the contracts cannot be expected to stipulate all accounting methods to be used in all circumstances, or for all transactions. To attempt to do so would be extremely expensive and, for practical purposes, impossible to do. Therefore there will always typically be scope for management to manipulate, to some extent, the cash flows associated with contracts based on accounting numbers. However, typically an auditor will review the accounting methods chosen and this will act to minimise the opportunistic basis of managements accounting choices. Also the manager would need to consider the possible costs that may result if the manager develops a reputation for being less than objective in their reporting function.

3.13 It is assumed within PAT that the value of the firm is a positive function of the expected present value of the firms future net cash flows. Because the firm would typically be party to many contractual agreements, which at least in part are tied to accounting numbers, and because the cash flows of these agreements might be tied to the accounting numbers, any change in accounting numbers may cause a change in cash flows. If the cash flows are expected to change, which may be the case when a new accounting standard (or exposure draft) is released, then this may have implications for the value of the firm.

As a further argument, it might be assumed that managers have selected the accounting methods that best reflect the financial performance of the entity. If they are no longer allowed to use accounting methods because of a new requirement that restricts the available accounting options, then there is a possibility that the new requirement is not as efficient in providing information about the performance of the organisation. From an efficiency perspective, this could have implications for the costs of attracting capital into the organisation.

3.14Political costs may be defined as costs or wealth transfers, which certain parties or groups external to the firm may be able to impose on the firm. Such parties may have no explicit contractual arrangements with the firm. For example, trade unions might be able to impose costs on the firm by instigating strikes or claims for wage increases. Particular interest or consumer groups may be able to impose costs on the firm by lobbying government to impose greater regulatory controls on the firm. Green groups may be able to impose costs on the firm by recommending product boycotts of those firms that do not comply with the green groups own environmental standards or expectations.

Where pushes for wage rises or reductions in prices of the firms goods and services seem to be related to the reported profitability of the firm, then the firm may adopt income decreasing strategies. This would, it is assumed, be successful on the basis that the parties imposing the costs do not adjust the financial statements to offset any changes in profits brought about by the changes in accounting methods employed.

Where firms are subject to scrutiny by such groups as environmental parties then they may elect to disclose additional qualitative information of a positive or favourable nature in the annual financial statements. This information may act to reduce the effects of the negative publicity being released by the particular interest groups.

3.15One argument may be that as the firm might already have in place many contracts tied to accounting numbers, and such contracts rely upon floating GAAP, then any change in accounting requirements may affect these arrangements and the associated cash flowsand hence, value of the firm.

Alternatively, management may believe that the accounting methods it uses are most efficient in disclosing managerial and firm performance (and possibly, for minimising the agency costs of the firm) and that by mandating a particular accounting technique (and thereby reducing the portfolio of possible techniques), inappropriate indicators of performance will be provided to account users.

Under PAT there is also the political cost hypothesis, which argues that if an organisation is subject to political scrutiny then the managers might prefer to use accounting methods that reduce reported profits. Therefore, if managers perceive that the organisation is subject to political costs then they might lobby for methods of accounting that are income reducing.

Because the accounting standards being used within Australia now emanate from the IASB, rather than being locally developed, the ability of local organisations to influence accounting standard setters has arguably declined relative to the situation wherein the AASB was responsible for developing Australian accounting standards.

3.16To the extent that this agreement is subsequently monitored for compliance by an independent auditor with a sound reputation, then by agreeing to restrict actions that may otherwise have been detrimental to the wealth of the debt holders, the firm should be able to attract funds at lower cost.

Instructors should briefly address the notion of price indifference, which suggests that the market as a whole will be indifferent to whether or not the firm agrees to restrict its set of possible activities. If the firm does not agree, it will simply be charged a higher rate. If it does agree to restrict its activities, it will be charged a lower rate. The market will relate the required return to the expected risk. Higher risk leads to a higher required rate of return. (Instructors might also wish to ask students their opinion of the efficiency of the market; for example, the market for debtmany of the arguments in PAT, and other economics-based theories, are based on the assumption of market efficiency.)

3.17As the textbook notes, according to Chambers, a central role of accounting should be to provide information about a reporting entitys capacity to adapt, which is a measure directly tied to the cash that would be obtained if an entity sold its assets. All things being equal, the greater the market value of the firms assets, the greater its capacity to adapt to changing circumstances. Companies that have highly specialised assets, which do not have a ready market, are deemed to have a low capacity to adapt. (A blast furnace is often used as an example of an asset that has minimal exit value and hence contributes little to an organisations capacity to adapt.) Chambers prescribes that all assets should be valued at their current cash equivalentsthe amount that would be expected to be generated by selling the assets. Within the Continuously Contemporary Accounting approach to asset valuation, assets that cannot be separately sold, such as goodwill, would be assessed as having zero value for financial statement purposes. Because Chambers argues that all assets should be valued on the same basis (at their exit values) it is argued that it is correct to add the values of all assets together. This can be contrasted to the common situation where various classes of assets are measured by way of different valuation approaches, but nevertheless a total for all assets is provided. (This is often referred to as the additivity problem.)

3.18 Positive Accounting Theory predicts that accountants (and, in fact, all individuals) will let self-interest dictate their various actions, including the selection of one accounting method in preference to another (a theoretical assumption that has been labelled as morally bankrupt by Gray, Owen and Adams (1996)). That is, financial statements will typically not be free from bias. If one was to believe this central assumption of PAT then one would probably consider that the characteristics prescribed in the IASB/AASB Conceptual Framework (for example, that information should be free from bias) are not achievable, and are perhaps quite nave. Self-interest and objectivity are mutually exclusive. Objectivity implies that the accounting method/treatment that best reflects the underlying transaction and circumstances will be chosen regardless of its implications for the preparers of the accounts. What must be remembered is that the view that all action is driven by self-interest is not a view that is universally accepted, hence we cannot, or perhaps should not, necessarily believe that all financial statements will not be objective reflections of the underlying transactions and events (although it would be nave not to believe that some financial statements will not be objectively prepared).

Instructors may wish to quiz students about whether the students believe that accountants are more likely to let self-interest or objectivity (or perhaps a combination of the two) rule the preparation of financial statements. Do their own views tie in with the assumptions made within PAT? Students might also consider whether students that are taught PAT, with little consideration of alternative theories, are more likely to let self-interest dictate their selection of accounting methods when they are ultimately employed as accountants than students that have not been exposed to PAT. That is, if students are taught that self-interest explains the choice of accounting methods (and indeed, all actions), will such teachings perpetuate the adoption of self-interest as the basis of accounting policy choice? That is, does teaching self interest-based predictions tend to lead to a self-fulfilling prophecy?3.19Positive Accounting Theory (which, in itself, is one example of a positive theory of accounting) seeks to explain and predict particular accounting-related phenomena, such as why managers might select a particular accounting method in preference to another. It does not seek to provide prescriptions, for example, to tell managers what accounting method should be chosen. On the other hand, normative theories of accounting seek to prescribe what should be done. For example, Chambers theory of accounting (CoCoA) prescribes that all assets should be valued at their current cash equivalents. This prescription is based on a view about what the objective of financial accounting is (for example, in CoCoA, one of the objectives of accounting is to provide information to enable financial statement readers to assess an organisations capacity to adapt).

3.20Agency costs of equity are those costs that arise as a result of delegating decision-making authority from the owner to the manager. These costs would include those related to the managers consumption of excessive perquisites or use of information acquired within the firm for personal gain (possibly because of information asymmetries). Agency costs of debt are those costs that arise as a result of the managers of a firm undertaking actions that benefit the firm at the expense of the debt holders. Such costs would include those associated with the firm taking on excessive levels of debt, paying excessive dividends, or investing in high-risk assets. All these actions would endanger the likelihood that the debt holders would receive the payments that are ultimately due to them.

It is not possible to put in place mechanisms to reduce all opportunistic actions. Not every action can be anticipated and it would be too expensive to write contracts that attempted to counter every opportunistic action that might be considered. Complete contracts are not possible.3.21If we were to accept the central assumption of PAT that all action is driven by self-interest then we would not expect a manager to provide objective financial statements. Such a manager would only prepare statements that appear to be objective to the extent that such a strategy provides a higher return than other potential strategies. As emphasised in Chapter 3, there are a number of alternative theories that could be used to explain why particular accounting methods are selected by the managers of an organisation. Whether researchers select one theory in preference to another to explain particular phenomena will be driven by a number of factors, including the researchers own values and beliefs. If a researcher was not prepared to accept that self-interest is a strong predictor of human behaviour then the researcher might not be prepared to adopt PAT (and vice versa).

3.22Accounting regulators need to consider the costs and benefits that might result if a particular accounting requirement is introduced. Indeed, the IASB Conceptual Framework states (paragraphs QC 35, 38 and 39):

QC35 Cost is a pervasive constraint on the information that can be provided by financial reporting. Reporting financial information imposes costs, and it is important that those costs are justified by the benefits of reporting that information.

QC38 In applying the cost constraint, the Board assesses whether the benefits of reporting particular information are likely to justify the costs incurred to provide and use that information. When applying the cost constraint in developing a proposed financial reporting standard, the Board seeks information from providers of financial information, users, auditors, academics and others about the expected nature and quantity of the benefits and costs of that standard. In most situations, assessments are based on a combination of quantitative and qualitative information.

QC39 Because of the inherent subjectivity, different individuals assessments of the costs and benefits of reporting particular items of financial information will vary. Therefore, the Board seeks to consider costs and benefits in relation to financial reporting generally, and not just in relation to individual reporting entities. That does not mean that assessments of costs and benefits always justify the same reporting requirements for all entities. Differences may be appropriate because of different sizes of entities, different ways of raising capital (publicly or privately), different users needs or other factors.

To the extent that Positive Accounting Theory can identify some of the implications that will follow the introduction of a particular accounting requirement then this may be useful information. Also, the accounting standard-setting process is very political with various individuals and organisations making submissions on proposed requirements. PAT could provide some insights into why particular parties may favour or oppose particular regulations and this might be useful to regulators when assessing the relative merit of the various submissions provided. Perhaps many submissions may be simply explained on the basis of self-interest and not on the basis of a desire to see improved accounting methods introduced.

3.23Basically, the social contract (also often referred to as a community licence to operate, or simply license to operate) is considered to be an implied contract that is constituted by the various expectations that are held by society as to how an organisation should conduct its operations. Failure to comply with these perceived expectations is considered to be detrimental to the ongoing operations of the organisation. In a sense, the organisation may find that its social contract is revoked. Shocker and Sethi (1974, p. 67) provide a useful definition of the social contract (see page 113 of the textbook). It is interesting to note that a number of Australian companies are publicly (for example, within their annual reports or in stand-alone environmental performance reports) using terms such as community licence to operate. As noted above, in essence, this is the same as what we refer to as the social contract. Such terminology has also become part of the vocabulary of Australian mining organisations and other industry bodies in recent decades. For example, the Group of 100 state in their 2008 document Sustainability Reporting: A Guide (p. 11) that one of the benefits of reporting is:Maintaining the licence to operatecompanies are increasingly recognising the link between ongoing business success and their ongoing licence to operate, especially in the resources sector where the concept of a social licence to operate has been central for some years. Communities and stakeholders are likely to be more supportive of companies that communicate openly and honestly about their management and performance in relation to environmental, social and economic factors.BHP Billiton Ltd made the following statements in its 2008 Sustainability Report:Our bottom line performance is, however, dependent upon ensuring access to resources and gaining and maintaining a licence to operate and grow.In another section of its report, entitled Gaining and Maintaining Our Licence to Operate and Grow BHP Billiton further states:

Access to resources is crucial to the sustainability of our business. Fundamental to achieving access to resources is effectively addressing heightened political and societal expectations related to the environmental and social aspects of our business.

Different managers will have different perceptions of what is in the social contract (or licence to operate), and some might get it wrong with potential consequences for the survival of the organisation. Further, as the notion of the social contract is based on community expectations, and as these expectations will change across time, management will also need to respond by altering particular behaviours. What was acceptable to the community at one point in time (or even in one place) may not be acceptable at a later time (or in another place) and management must be responsive to changing community concerns. This raises obvious issues for how managers actually determine community expectations, and how these expectations change across time.

3.24Institutional Theory would suggest that across time an organisations disclosure policies would tend to become similar to those employed by other organisations. The argument is that organisations that deviate from practices that are expectedincluding expected disclosure practiceswill potentially have problems gaining or retaining legitimacy. They will not be complying with the expectations of those parties on which they depend. As Dillard, Rigsby and Goodman (2004, p. 509) state:

By designing a formal structure that adheres to the norms and behaviour expectations in the extant environment, an organization demonstrates that it is acting on collectively valued purposes in a proper and adequate manner.

DiMaggio and Powell (1983) set out three different isomorphic processes (processes whereby institutional practices, such as reporting, adapt and change). These three isomorphic processes are referred to as coercive isomorphism, mimetic isomorphism and normative isomorphism. The first of these isomorphic processes, coercive isomorphism, arises when organisations change their institutional practices in response to pressure from stakeholders upon whom the organisation is dependent. In this respect an organisation will provide particular disclosures to address the concerns of stakeholders who have the greatest power over the organisation. The organisation is therefore coerced (in this case usually informally) by its influential (or powerful) stakeholders into adopting particular reporting practices. That is, the organisation is coerced into adapting its existing reporting practices (including the issues upon which it reports) to bring these into line with the expectations and demands of its powerful stakeholders (while possibly ignoring the expectations of less powerful stakeholders). Because powerful stakeholders might have similar expectations to those held for other organisations, there will tend to be conformity in the practices being adopted by different organisations. That is, institutional practices will tend to some form of uniformity.

The second isomorphic process specified by DiMaggio and Powell (1983) is mimetic isomorphism. This involves organisations seeking to emulate (perhaps copy or mimic) or improve upon the institutional practices of other organisations, often for reasons of competitive advantage in terms of legitimacy. As Unerman and Bennett (2004) explain in the context of a study investigating stakeholder dialogue in corporate social reporting: Some institutional theory studies have demonstrated a tendency for a number of organisations within a particular sector to adopt similar new policies and procedures as those adopted by other leading organisations in their sector. This process, referred to as mimetic isomorphism, is explained as being the result of attempts by managers of each organisation to maintain or enhance external stakeholders perceptions of the legitimacy of their organisation, because any organisation which failed (at a minimum) to follow innovative practices and procedures adopted by other organisations in the same sector would risk losing legitimacy in relation to the rest of the sector (Broadbent et al. 2001; Scott 1995). Drawing upon these observations, in the absence of any legislative intervention prescribing detailed mechanisms of debate, a key motivating force for many managers to introduce mechanisms allowing for greater equity in the determination of corporate responsibilities would therefore be their desire to maintain, or enhance, their own competitive advantage. They would strive to achieve this by implementing stakeholder dialogue mechanisms which their economically powerful stakeholders were likely to perceive as more effective than those used by their competitors. It is unlikely that these managers would readily embrace mechanisms designed to facilitate widespread participation in the determination of corporate responsibilities unless their economically powerful stakeholders expected the interests of economically marginalized stakeholders to be taken into account in this manner, and these managers are only likely to implement the minimum procedures which they feel their economically powerful stakeholders would consider acceptable.

The final isomorphic process explained by DiMaggio and Powell (1983) is normative isomorphism. This 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) 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, for example the culture and working practices developed within their workplace.

3.25There are two important dimensions within Institutional Theory. The first of these is termed isomorphism and the second is decoupling. Both can be of central relevance to explaining corporate reporting practices.

The term isomorphism is used extensively within Institutional Theory and is defined by DiMaggio and Powell (1983, p. 149) 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) at variance with other organisations might find that such differences will attract criticism. As Carpenter and Feroz (2001, p. 566) state:

DiMaggio and Powell (1983) label the process by which organizations tend to adopt the same structures and practices 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 organisation. DiMaggio and Powell (1983) set out three different isomorphic processes (processes whereby institutional practices such as voluntary corporate reporting adapt and change). These three isomorphic processes are referred to as coercive isomorphism, mimetic isomorphism and normative isomorphism.

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 from these formally sanctioned and publicly pronounced processes and practices. Thus, the actual practices can be decoupled from the institutionalised (apparent) practices. As Dillard, Rigsby and Goodman (2004, p. 510) put it:

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 organizations managerial and operational processes. Formal structure has much more to do with the presentation of an organizational-self than with the actual operations of the organization (Curruthers, 1996). 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 organizations formal management systems because they maintain appearances and thus confer legitimacy whether or not they directly facilitate economic efficiency.

3.26Yes, to the extent that the organisation is close to breaching the particular accounting-based contracts, and to the extent that any technical default will have negative implications for the wealth of the manager involved. Remember, PAT is based on the central assumption that all action is based upon wealth maximising self-interest.3.27 This really depends on ones perspectives about what motivates individual behaviour. This is a useful question to stimulate debate. If one was to accept that all behaviour is driven by self-interest, then the view that financial statements will be unbiased would probably be rejected. Regardless of ones philosophical perspective, to believe that all financial statements represent unbiased representations of what occurred would be unrealistic. Creative accounting does exist (and it is often highlighted after companies have collapsed). It is hoped, however, that creative accounting does not always exist! Further, to assume that all individual action is driven by self-interest, as PAT theorists do, is also arguably quite simplistic. However, we must remember that theories are, by necessity, simplifications of reality.

3.28 There are a number of theoretical arguments that might be used to explain what motivates regulators to introduce particular regulations. One perspective is that regulation is introduced for the benefit of society; that is, regulation is introduced in the public interest. This perspective, from public interest theory, assumes that regulators place the public interest before their own interest and hence this theory does not assume that self-interest motivates all action. Regulators introduce regulation if it is considered that the social benefits of the regulation exceed the social costs. (There are obviously many judgments to be made in undertaking such measurements and some of these could be quite controversial.)

Capture theory would argue, on the other hand, that whilst regulation might initially be put in place to serve the public interest, ultimately those people who are being regulated will capture the regulator (perhaps by becoming members of the regulatory body, or by influencing the regulator as a result of financial support). Following the capture the regulator will support regulations that benefit those parties that are subject to the regulation (and who captured the regulator), rather than making regulations for the public interest.

Economic interest theories of regulation assume, like PAT, that individual actions are motivated by self-interest. Under this perspective, regulation will be introduced to the extent that it benefits those people in charge of formulating the regulation. Under this perspective, the public interest does not play a part in regulatory decisions. Both the regulator and those lobbying the regulator are driven by private interests. If a lobby group has resources or power that can benefit the regulator then that lobby group is more likely to get favourable treatment and have their favoured regulation introduced (or unfavoured regulation removed).

3.29 Arguably, such a headline would not be the sort of publicity desired by ANZ. If ANZs profits were increasing at the same time it was charging high rates of interest on its credit cards then this would very likely be seen in a negative way by the community. (The media has often been known to highlight the relationship between high profits and high interest rates.) Such negative publicity could conceivably have negative implications for ANZs profits, although the profits might still remain at high levels.

There are various perspectives on how ANZ management might react. If high profits are likely to be used by government as a justification to legislate against high interest rates, then in anticipation of this it could be argued that ANZ would adopt income-decreasing strategies. (Such a perspective would be consistent with the political cost hypothesis of PAT.) If profits were lower then the level of argument might not be so intense in relation to the high interest rates.

If the community considers that ANZ is acting unjustly and not in compliance with its social contract, and ANZ perceives this to be the case, then the management might, consistent with legitimacy theory, undertake strategies to legitimise ANZs policies. It might decide to lower its interest rates to conform with public expectations and, importantly, it would need to notify the public of this action. Alternatively it might seek to inform the public that credit card rates need to be high because of the high associated risks (but we would probably question whether this tactic would work). Or, perhaps the organisation could try to deflect attention away from the high interest rates to other programs or initiatives it is involved with, such as some community-based programs. Question 33 (under Challenging questions) considers further specific issues in relation to this newspaper article.

There are many theories of accounting with various assumptions. Depending upon what theory is chosen then different predictions of managements actions will be generated. How or why we select between one theory and another will be dependent upon the world views of the researchers in question.

3.30(a)If we adopt a managerial perspective of stakeholder theory then it might be argued that the bank will only consider the concerns of a particular stakeholder group to the extent that the group has the power to influence the ongoing operations or survival of the organisation. If the banks operations are not particularly dependent upon the funds of the small business sector, or on the community support that they might receive, then it might elect to do little in regard to their concerns. However, perhaps the group has the ability to lobby other powerful stakeholder groups, such as the government or influential sections of the media. In such a case the threat that the other stakeholder groups might be sympathetic might cause the bank to consider the interests of the affected group. If we adopt a normative or ethical perspective of stakeholder theory then we might argue that the bank should consider the effects it has on all stakeholder groups, including those with limited power.(b) If the bank does not appear to be serving the interests of particular groups at the same time that it reports large profits then these profits might be used by groups, such as government, to justify the introduction of regulatory requirements to protect certain other groups, such as pensioners. Under the PAT perspective, the government will take action if the action is likely to serve its own political interests (perhaps by winning votes). Other groups, such as labour unions, might also take action for wage increases on the basis of the high profits. It is argued by Positive Accounting theorists that an organisation subject to such potential actions will adopt income-decreasing accounting methods so as to reduce its political vulnerability.

(c) Legitimacy Theory relies upon the notion of a social contract. If it looks as though the terms of this contract are being breached (and remember that the social contract is a theoretical construct so we cannot state specifically the terms of the contract) then the organisation will seek to implement strategies to bring legitimacy to the organisation. One way might be to simply conform with community perceptions and reduce staff turnover and bank closures. Do we think this is likely? Alternatively, through various public disclosures the bank might try to change community perceptions about bank closures and staffing requirements. The bank might also decide to use public disclosures to shift attention from bank closures and staffing to other attributes of the organisations performance, such as support for community-based projects, its employees, and so on. Whatever the strategy, under this theoretical perspective, if the bank perceives that there is a legitimacy gap (a gap between how the community believes the bank should be acting and how it believes the bank is acting) then to the extent that the bank perceives there is a legitimacy gap it will take actions to remove the gap. These strategies must involve public disclosures because even if the bank undertakes certain corrective strategies, if the community is unaware of them then there will be limited impact on perceptions of legitimacy.

3.31(a)General purpose financial statements may be used by a wide spectrum of users for the purpose of making various decisions. Hence, it would seem reasonable that directors should understand the contents of such statements if these statements are, in part, responsible for attracting funds into the organisation.

(b)Pursuant to corporations legislation, company directors are required to ensure that the statement of financial position, statement of cash flows, statement of changes in equity and statement of comprehensive income presented to shareholders are true and fair. Directors are also required to sign a Directors Declaration, which includes a statement that the company will be able to pay its debts as and when they fall due. It is difficult to understand how particular directors could sign any such statement, with conviction, in the absence of knowledge about the accounting process. The chief executive (who might also be a director) and chief financial officers of entities with securities listed on the Australian Securities Exchange are also required, pursuant to s. 295A(2) of the Corporations Act, to provide a written declaration to the board of directors that the annual financial statements are in accordance with the Corporations Act and accounting standards and that the financial statements present a true and fair view of the financial position and performance of the reporting entityIn the article presented, Mr Jones also stated that he was responsible for profitbut profit is an accounting concept that could not really be understood without a knowledge of the various rules and conventions inherent in financial accounting.

3.32(a)In the context of this article window dressing means that an organisation is opportunistically accounting for particular transactions, or creating new transactions, with the sole purpose of making the financial statements appear more favourable to readers than would be the case if the financial statements were prepared objectively. This would obviously be a direct departure from the primary qualitative characteristic of representational faithfulness as identified in the IASB Conceptual Framework.(b)Using Positive Accounting Theory, the managers of the bank might have tried to understate debt because the bank might have been close to breaching debt convents that included such restrictions as debt-to-asset constraints. If they disclosed the true amount of debt this might have caused the entity to go into technical default of a debt agreement, which could potentially have led to the (earlier) cessation of the business. This would have had negative wealth consequences for the managers involved.

(c)The main qualitative characteristic of the IASB Conceptual Framework that would have potentially been breached is representational faithfulness. Specifically, the financial statements would not have provided a fair or accurate reflection of the actual amount of debt being held within the organisation.

(d)Firms are probably more likely to engage in window dressing their financial statements when they have relatively high levels of debt rather than low levels of debt. Assuming the managers are driven by self-interestas PAT assumesthen if debt levels are rising there is a very real possibility that the entity might go into technical default of its borrowing agreements, and at the extreme, this might lead to the organisation being placed into receivership and management. This would not be favoured by managers who would probably lose their jobs, hence they would be predicted to try to keep the organisation operating as long as they can even though this might create even more costs across the community.

3.33(a)We can never be sure why an organisation undertakes a particular strategy. Different theories, such as those discussed in Chapter 3, might provide different insights. Perhaps some managers actually believed that they owed a duty to particular stakeholders to devise such a plan and therefore adopted the strategy because of ethical responsibilities. Alternatively, perhaps they thought that the profitability of the organisation was being influenced by the community concern and to alleviate some of this concern, and perhaps to reinstate some legitimacy, they developed a plan to tackle community concerns.

(b) Again, we cannot really be sure of the motivations and we can refer to different theories of regulation to provide us with some insights. If we adopt a public interest perspective of regulation then we might explain the governments actions on the basis that such actions are in the public interest, rather than in politicians self-interests. However, if we embrace particular economics-based theories of regulation, such as private interest theories of regulation, then politicians would take action to the extent that it serves their own interests; for example, bolsters their chances of re-election. Instructors might quiz the students about which theoretical perspectives they would be inclined to accept. Do we really think politicians would be driven by self-interest or do we accept their position that they serve the public interest?

(c) We cannot be sure, but the high profits do provide an excuse for people to argue that the banks can do more for the community and perhaps less for the shareholders and managers. The community would probably feel that it is not part of the social contract to have soaring profits while staff numbers are cut, branches are closed, and high fees are charged. There could be a view that the banks have a social responsibility that they simply are not fulfilling, yet they have the resources to be socially responsible. Advocates of PAT would argue that higher profits make the organisation a target of political scrutiny.

(d) Yet again, it depends upon our theoretical perspective. If profits are used as an excuse for governments to take action against an organisation, and if government believes that it can win votes by taking such action, then the banks might be advised to adopt income-reducing strategies. This would decrease the ability of the government to justify its action. However, if the management of the banks do not believe that the community or the government will react favourably to reduced profits then income-reducing strategies might not be adopted. What should be remembered is that reducing profits because of community concerns and the threat of government action is opportunistic conduct and would constitute creative accounting. If management and accountants believe that they should be objective, as our conceptual framework recommends, then they would not manipulate accounting profits to get their desired results. Of course, whether we believe that people act objectively will depend upon our own views about what motivates individual behaviour.

3.34(a) Companies would have preferred to treat the leases as operating leases rather than finance leases because by treating the leases as operating leases the entities would not show the lease as a liability and therefore their total debt would be lower. This could be significant if they have entered into debt contracts that restrict the total amount of debt they are permitted to have. In the early period of a lease the total costs on a finance lease (interest costs and depreciation of the leased asset) will tend to exceed the costs associated with an operating lease. Because various contracts will include accounting profits (such as interest coverage clauses in debt agreements, or profit sharing agreements within management remuneration plans), this will provide further incentives for managers to classify leases as operating leases rather than finance leases.

(b) A change in the accounting standard for leasing might cause organisations to breach covenants included within debt contracts because the new accounting standard might require further debt to be brought on to the statement of financial position and this additional debt might be sufficient to cause the organisation to breach covenants, such as debt to asset restrictions.

(c) A debt covenant that relies upon floating GAAP will be calculated on the basis of the accounting rules in place each time the covenant is calculated. By contrast a debt covenant that is calculated on the basis of fixed GAAP (also referred to as frozen GAAP), will be calculated on the basis of the accounting rules in place when the debt covenant was originally negotiated. There is less risk for a borrower with fixed GAAP arrangements because they will not be exposed to the risk of violating a debt covenant when accounting standards change.

(d) If management was lobbying on the basis of self-interest then organisations that are already close to breaching debt contracts (and therefore perhaps will violate debt covenants if additional debt is recognised) will be more likely to lobby against the accounting standard.

3.35Based on the information within the extract, the theory of regulation that appears to explain the apparent lack of controls or regulation to restrict problem gambling is Capture Theory. As a result of their support of local clubs and other organisations, gambling venues have attracted the support of many people within society, despite the hardship caused by issues such as problem gambling. Further, gambling organisations pay high levels of taxation and this tends to allow them to influence, or capture, government regulation on gambling. It would be hard to believe that the lack of regulation to combat problem gambling is in the public interest.3.36(a)The following hypotheses may be developed from PAT:i.Companies with management compensation linked to accounting profit are more likely to prefer to recognise research costs as an asset. (The rationale is to accelerate earning bonuses by deferring the recognition of expenses for research costs.) Obviously, once the accounting standard was introduced the organisations would not have this preferred option available to them.

ii.Managers of firms with high debt/equity ratios are more likely to prefer to recognise research costs as an asset. (Recognising research costs as an expense would reduce profit and equity, thus increasing the ratio and the likelihood of breaching an accounting-based covenant of a debt contract.)

iii.Companies with high political visibility are more likely to prefer to recognise research costs as an expense. (According to PAT the lower resulting profit will reduce political visibility and help to avoid political costs.)

(b)These hypotheses could be tested by examining the firm-specific characteristics of companies that responded to the exposure drafts about this change in the accounting standards. The researcher could compare attributes of those organisations (such as their reported profits, debt, the existence or non-existence of profit sharing schemes for managers) that lobbied for an accounting standard with those that lobbied against the standard. The hypotheses could also be tested using historical data from a period in which management had a choice between expensing or capitalising research expenditure.

3.37(a) and (b) The following three theories that attempt to explain the introduction of regulation were introduced within the chapter: Public Interest Theory, which holds that regulation is supplied in response to the demand of the public for the correction of inefficient or inequitable market practices (Posner 1974, p. 335)

Capture Theory, which posits that the regulated parties seek to take control of the regulatory process so that the resulting regulation is in their interests Economic Interest Group Theory of regulation (or Private Interest Theory), which suggests that different groups lobby in order to protect or promote their own economic interests and the regulation is viewed as a commodity which is subject to the forces of demand and supply. It also assumes that regulators and politicians select regulations or laws which provide the greatest economic benefits to themselves either directly, or indirectly.Students are likely to vary in opinion as to which theory is most descriptive of the phenomena described in the article.

There is evidence in the article that supports all three theories. That the government was proposing changes in response to concerns about accounting and auditing after the HIH collapse is consistent with Public Interest Theory. Further evidence is that the governments position gained strength after another corporate collapse, Enron.

The reference to self-regulation is consistent with Capture Theory, although it might not have been captured as auditing has traditionally been self-regulated in Australia. The intense lobbying, if viewed as an attempt to capture the new regulators, may be considered as consistent with that theory.

The Economic Interest Theory is also helpful in explaining the change in regulation and the responses by parties concerned. Examples include the plethora of announcements and submissions from regulators, accounting firms, companies and industry organisations.

3.38(a)From a Public Interest Theory perspective it might have been believed by government that market forces operate efficiently and therefore it is best for everyone in society for market forces to be left to freely operate, rather than imposing potentially costly regulation.(b)From a Capture Theory perspective, perhaps business leaderswho were opposed to any legislation being introducedhave people within the government who tend to support the interests of business. Certainly, within the government there are many people who formerly held senior business positions meaning that business interests might have captured government.

(c)From an Economic Interest Group Theory of regulation perspective, perhaps government considered they were less likely to lose electoral support (in the form of political donations and/or votes) as a result of not legislating particular social and environmental responsibilities within The Corporations Act relative to the alternative of introducing legislation. Under this perspective, politicians might choose those policies which will get them the most support, rather than selecting policies because they are in the public interest.Solutions Manual t/a Australian Financial Accounting 7e by Craig Deegan

Copyright 2012 McGraw-Hill Australia Pty Ltd

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