Lecture 7 Making Financial Reporting Decisions Critique of Positive Accounting Theories

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?

Lecture Overview Review of Modules 3 & 4 Module 5 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

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’

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)

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 agent’s 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

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

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

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

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

Review – Stakeholder Theory positive (managerial) branch stakeholder power is a function of the stakeholder’s 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

Critique of Positive Accounting Theories Module 5 Critique of Positive Accounting Theories (PAT, Legitimacy & Stakeholder)

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

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

Criticisms of PAT

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

‘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…

While Positive Accounting Theory doesn’t tell us how we should account, it does tell us what economic factors to consider when making financial reporting decisions.

Other Criticisms of PAT Slow / limited development Not ‘value free’ Scientifically flawed – hypotheses frequently not supported Results apply ‘on average’

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)

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

The usefulness of positive accounting theories and research results They are still useful!

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 we’ve got!

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)

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

Factors to consider when making financial reporting decisions Contracts of the company Assets of the company Information asymmetries Potential political costs Society’s expectations of the company Power of various stakeholders Impact on share price Impact on individual financial statement users

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

Introduction to Modules 6 & 7 Impacts of Financial Reporting Decisions

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?

Share prices Individuals You are here 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

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)

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

For Tutorials Required reading Self assessment questions 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