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

2. 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?

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

4. 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’

5. 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)

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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

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

13. 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

14. 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

15. Criticisms of PAT

16. 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

17. ‘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…

18. 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.

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

20. 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)

21. 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

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

23. 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!

24. 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)

25. 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

26. 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

27. 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

28. Introduction to Modules 6 & 7
Impacts of Financial Reporting Decisions

29. 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?

30. 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

31. 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)

32. 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

33. For Tutorials Required reading Self assessment questions
Text chapter 7, pp. 235 – 239
Text chapter 10, pp
Self assessment questions
Questions from module 5
Question 1 from module 6
Answers in tutorials