CH-1-4 An Introduction to Accounting Theory – Accounting Theory: Conceptual Issues in a Political and Economic Environment : Book Guide

This Document Contains Chapters 1 to 4 Chapter 1: An Introduction to Accounting Theory CHAPTER HIGHLIGHTS The chapter is concerned with what accounting theory is and where it fits within the “structure” of financial accounting. The definition of accounting theory used in this chapter is broad and complements the objectives of the text. Theory itself helps to explain and predict phenomena that exist in a given field, and this likewise holds true in accounting. In accounting, theory can be developed in response to needs arising from practice, including concepts such as realization and matching. However, as an “infrastructure” has developed in financial accounting, theory is formulated in a more institutionalized way by means of the research process. Along with political factors and economic conditions, accounting theory contributes to the standard-setting process. The process of developing standards or making rules is itself largely a deductive process and is certainly concerned with accounting theory. The relationship of theory to measurement is very important. While some see measurement as closely related to but separate from theory (as we did in earlier editions), its importance relative to theory is so great that we now consider it to be part of theory. Measurement is the assignment of numbers to the attributes or properties of objects being measured. The different types of measurements and the quality or “goodness” of measurements are examined. The latter embodies (1) the usefulness of the measurement, illustrated here in a predictive context but showing up later in an assessment mode and (2) verifiability or objectivity, which is the degree of consensus among measurers in the statistical sense. The various valuation models are presented in Appendix 1-A. The models come under the scope of accounting theory. In addition, the different models are mentioned in several theory chapters. QUESTIONS Q-1 What does the term “social reality” mean and why are accounting and accounting theory important examples of it? The term social reality pertains to the measurement of social phenomena and the use of these measurements. The measurements may be representationally faithful (low in bias) and have a high degree of objectivity (verifiability). Or the opposite for either or both of these qualities may be the case. The important thing to grasp, however, is that important consequences stem from the measurement, whether they are “good” or “bad.” For example, an excellent year in terms of income could cause management to be highly rated by shareholders and other interested parties, resulting in high management bonuses, or provide increased dividends to shareholders. All of this could occur even though income is a “construct”: not a “real” factor but a conceptual artifact. This example shows why accounting is an important area relative to social reality measurements and constructs. Hopefully, accounting theory can improve the fairness and usefulness of these measurements. This Document Contains Chapters 1 to 4 Q-2 Why do the value choices (entry value, exit value, and historical cost) fall within the domain of accounting theory? These are examples of different concepts involved with measuring income which have different underlying purposes. These different purposes—which affect social reality—are discussed in the appendix. Q-3 Of the three inputs to the accounting policy-making function, which do you think is the most important? Of the three inputs (economic conditions, political factors, and accounting theory) to the policy- making function, economic conditions is clearly the most important input. Economic conditions can easily influence the accounting theory track as well as the policy-making function. Inflation, for example, in the USA during the 1970s and 80s triggered a significant amount of theoretical work. Theory responded to the actual economic environment. Another prominent example of the influence economic conditions has is the merger and acquisition wave of the 1960s, which lead to APB Opinion Nos. 16 and 17. Many other standards have also been triggered by economic conditions. Q-4 How can political factors be an input into accounting policy-making if the latter is concerned with governing and making the rules for financial accounting? Those who are affected by the rules will usually try to influence what those rules will be. The investment tax credit provides an excellent example. When APB Opinion No. 2 did not allow flow through, lobbying led to APB Opinion No. 4, which did allow immediate recognition in income of investment tax credits. The stock option battles of the 1990’s (and continuing today) is another example of the political process and its effect on rule-making. From a predictive standpoint, we are concerned with how and why political factors play a role in the standard- setting process. Q-5 Is accounting theory, as the term is defined in this text, exclusively developed and refined through the research process? Absolutely not. Many concepts such as conservatism and revenue recognition arose on a “common law” type of basis. They were responses to particular problems. Research has, of course, dealt with these issues. Any attempt to leave these concepts outside of the definition of accounting theory would make the subject matter of accounting theory artificial and incomplete Q-6 What type of measurement is the measurement of objectivity in Equation (1.1): nominal, ordinal, interval, or ratio scale? It is ordinal, due to the squaring effect on each individual deviation from the mean. The zero point, however, is unique. Hence, there would be perfect consensus among measurers. It would mean that each individual measurement would be the same for all measurers. Q-7 The measurement process itself is quite ordinary and routine in virtually all situations. Comment on this statement. This is not necessarily the case. Measurements can be extremely complex. For example, measuring the temperature of the earth’s atmosphere is extremely difficult. The increasing temperature has led both to the hypothesis of the greenhouse effect and to the theory that the warming global temperatures are simply a fluctuation, a naturally occurring variation. Measuring the success of a man’s life can be perplexing. How does accumulation of Bill Gates’ monetary wealth compare with the accomplishments of Ghandi, Nelson Mandela, or Wolfgang Amadeus Mozart? What does one actually measure to determine success? Measurements in accounting are significantly less complex, but should not be taken lightly. For example, determining the replacement cost or exit value of a firm’s machinery and equipment is not an easy task. Determining net income or earnings during a specified period of time may be more complicated that it appears to be on the surface. Q-8 Can assessment measures be used for predictive purposes? Though an assessment measure concerns an attribute or characteristic of an object at the present time, it could be used as a surrogate for a prediction measure if none exists. For example, the best indicator of the current ratio of a firm in a year may be the current ratio today, if budgets have not been prepared. Q-9 A great deal of interest is generated each week during the college football and college basketball seasons by the ratings of the teams by the Associated Press and United Press International. Sports writers or coaches are polled on what they believe are the top 25 teams in the country. Weightings are assigned (25 points for each first place vote, 24 for each second place vote, . . . one for each 25th place vote) and the results are tabulated. The results appear as a weekly listing of the top 25 teams in the nation. Do you think that these polls illustrate the process of measurement? Discuss. An argument can be made that a number is assigned to a team on the basis of a property that might be called the “goodness” or “strength” of a team. However, these measurements do not have a great deal of precision. How good a team is relative to other teams is a property or quality that is extremely intangible compared to other measurements such as median weight of interior linemen, average speed of running backs per 100 meters, etc. Unquestionably, the measurements are indirect. The qualifications of the measurers are also open to question. Do sportswriters really “know” football? Constraints are also present because the voters may have seen very few teams and they may also have regional biases. The numbering scale used is basically ordinal because 1 is considered to be better than 2, which is better than 3. However, the “goodness” of the interval between rankings is not uniform. For example, a voter may feel it is a virtual “toss-up” between 1 and 2, both of which he considers to be vastly superior to 3. As a result, the aggregating process is open to serious question. It is also not clear whether the pollsters are making assessment or prediction measures. The measures would be prediction measures if the voter presumes that 1 would beat 2 if they played the following week. We suspect, however, that an assessment measure is being made. The property being assessed is the team’s record to date. Hence, a team with a 6-0-0 record is usually ranked higher than a team with a 5-0-1 record. Q-10 Accounting practitioners have criticized some proposed accounting standards on the grounds that they would be difficult to implement because of measurement problems. They therefore conclude that the underlying theory is inappropriate. Assuming that the critics are correct about the implementational difficulties, would you agree with their thinking? Discuss. This question brings together the relationship among theory, policy, and practice. It also brings up Larson’s warning of the necessity to differentiate between theory and measurement even though we believe that Larson’s statement is too strong. Hence, even though the practitioners may be correct about the measurement process recommended by the proposed standard, it does not necessarily mean that the underlying theory is inappropriate. Some theories may indeed lead to dead ends in terms of implementation. More time may also need to be taken to make the measurements operational. Q-11 Some individuals believe that valuation methods proposed by a standard-setting body such as FASB should be based on those measurement procedures having the highest degree of objectivity as defined by Equation (1.1). Thus, some assets might be valued on the basis of replacement cost and others on net realizable value. Do you see any problems with this proposal? Discuss. The problem here is basically the opposite of that presented in question 10. In this case, part of the measurement problem might be solved, but at the cost of sacrificing the theoretical base. Hence, the cart is put before the horse, conceptually speaking. However, there are other measurement problems presented by this proposal. It is questionable whether replacement cost dollars and net realizable value dollars can be meaningfully added together, even if computed for the same point in time (this is the problem of additivity). Moreover, if firms were given latitude to employ valuation methods for their various balance sheet items that were more objective in their own particular cases, there could well be a major problem of lack of comparability in the resulting financial statements between and among firms. Q-12 What type of measurement scale (nominal, ordinal, interval, or ratio scale) is being used in the following situations? a. Musical scales b. Insurance risk classes for automobile insurance c. Numbering of pages in a book d. A grocery scale e. A grocery scale deliberately set 10 pounds too high f. Assignment of students to advisers, based on major a. Musical scales, Interval, there is no natural zero tonal point. b. Insurance risk classes for automobile insurance: Ordinal, Class 1 is “better” than Class 2 to the extent that people have had fewer accidents. However, within classes people do not have uniform accident records, and the “accident interval” between classes is not totally uniform. c. Numbering of pages in a book: Interval (possibly nominal). d. A grocery scale: Ratio. e. A grocery scale deliberately set 10 pounds too high: Interval — In effect, the “zero” point is set at 10 pounds, but interval differences remain constant. f. Assignment of students to advisers, based on major: Nominal Q-13 If general price-level adjustment is concerned with the change over time of the purchasing power of the monetary unit, why is it not considered to be a current value approach? Current value approaches (replacement cost and exit value) are concerned with questions such as what would it cost to replace an asset today with the same type of asset in the same condition or how much would an asset sell for if it were sold today. General price-level adjustment attempts to restate historical cost of assets in terms of the contemporary purchasing power of the money expended. Q-14 How do entry- and exit-value approaches differ? As noted previously, entry value (replacement cost) concerns the cost of replacing an asset already owned in markets in which the asset is generally acquired by the firm. Exit value is the price the firm could get for the asset less costs of getting rid of the asset (e.g., removal costs, transportation). Exit value is generally lower than replacement cost because of restricted access to the market, disposal costs, and the possibility of “the perception of a lemon” on the part of prospective buyers. Q-15 Why is discounted cash flow extremely difficult to implement in the accounts? The difficulty relates to measurement. Which discount rate should be used, how far in the future should one go, and how should one estimate cash flows? In addition, many assets contribute jointly to generating future cash flows. Problems of separating the cash flows for valuation purposes are virtually impossible to solve. Q-16 How do measurement and calculation in accounting differ from each other? Give three examples of each. Measurement in accounting is concerned with determining real economic phenomena such as current values (entry and exit values) and discounted cash flows. Calculations are simply mechanistic assignments of the monetary unit to accounting categories. The word calculation is very similar to allocation as developed by Arthur Thomas (see Chapter 8). Calculations thus abound under historical costing. Some examples would be inventory amounts determined by LIFO, FIFO, or weighted average; depreciation calculations; and marketable securities carried at cost. Measurements would include inventories and marketable securities when carried at market; acquisition of inventories and fixed assets in general (but only at the acquisition point) as well as assets acquired in a purchase type business combination; and the carrying of accounts receivable (net) at net realizable value. Q-17 Are issues of costliness and timeliness as they pertain to accounting standards part of accounting theory? Costliness and timeliness are part of accounting theory (refer to Statement of Financial Accounting Concepts No. 2 and No. 8 of the conceptual framework). Benefits of a standard should exceed their costs. Thus it could be too costly to improve the accuracy (representational faithfulness of a particular measurement of a desired characteristic of an asset). The same pertains to timeliness. A more accurate measurement requires more time, but the delay necessary to attain the increased accuracy makes the more accurate measurement less useful. Q-18 Do you think that changes brought about in accounting standards by failures of publicly traded companies such as Enron should be classified under political factors or economic decisions? Support your position. We classify these as political factors. The inability to draft workable rules to bring special purpose entities (SPE) to the balance sheet is definitely political in nature. Q-19 Political factors are an adverse influence on the accounting standard-setting function. Discuss this statement. This is tough issue. Prior to the Enron, WorldCom, etc. scandals we would have said that to get firms to buy into the standard-setting process, those who must work to apply the standards should have input to the process. We still believe this, however, we now know that skeptical eyes and ears are important necessities when reviewing interested party inputs. Trust with a skeptical eye. Q-20 Did the 21st century begin on January 1, 2000? By popular acclamation the 21st Century began on January 1, 2000. Since there was no year zero, each century ends with a year ending with an even hundred or a thousand. This question is a good example of a social reality—the effect of the odometer turning over—overcoming measurement theory. Q-21 Do you think that the color-coded terrorist threat system instituted by the Department of Homeland Security involves a measurement system? Explain. Absolutely. Different colors refer to different degrees of danger. It would be an ordinal-type scale because the difference in degrees of danger between color codings is not uniform. For example, the highest point on the scale indicates that a terrorist attack is virtually imminent. This is a large step above the next level on the scale. Q-22 Since the FASB makes the standards that are used by business and industry, they make accounting theory. Comment on this statement. FASB uses accounting theory when developing accounting standards, but it does not make it. Does an aircraft manufacturer make aerodynamic theory when producing a new airplane or does it use specific theories to help design and produce a high quality product? CASES, PROBLEMS, AND WRITING ASSIGNMENTS 1. Assume that three accountants have been selected to measure the income of a firm under two different income measurement systems. The results for the first income system (M1) were incomes of $3,000, $2,600, and $2,200. Under the second system (M2), results were $5,000, $4,000, and $3,000. Assume that users of accounting data believe that dividends of a year are equal to 75 percent of income determined by M1 for the previous year. Users also believe that dividends of a year are equal to 60 percent of income determined by M2 for the previous year. Actual dividends for the year following the income measurements were $3,000. Determine the objectivity and bias of each of the two measurement systems for the year under consideration. On the basis of your examination, which of the two systems would you prefer? Designating the three accountants as A1 . . . A3 and using Equation (1.1) for measuring objectivity, we get: M1 (xi – x )2 A1 (3,000 – 2,600)2 = 160,000 A2 (2,600 – 2,600)2 = 0 A3 (2,200 – 2,600)2 = 160,000 $320,000 ÷ 3 = 106,667 M2 (xi – x )2 A1 (5,000 – 4,000)2 = 1,000,000 A2 (4,000 – 4,000)2 = 0 A3 (3,000 – 4,000)2 = 1,000,000 $2,000,000 ÷ 3 = 666,667 To arrive at the bias present in the measures, solve for what income should be in the first period ( I*j1 ) in terms of user decision models from Equation (1.2): M1 M2 Dj2 = f(.75 I*j1 ) Dj2 = f(.60 I*j1 ) $3,000 = .75 I*j1 $3,000 = .60 I*j1 $4,000 = I*j1 $5,000 = I*j1 Now solve for bias by using Equation (1.3): B = ( x – x*)2 i: M1 (2,600 – 4,000)2 = 1,960,000 M2 (4,000 – 5,000)2 = 1,000,000 Combining the two measures that are additive to arrive at an overall measure of reliability, we have: M1 M2 R = V + B R = V + B $2,066,667 = $106,667 + $1,960,000; $1,666,667 = $666,667 + $1,000,000 M2 appears to have more reliability than M1. M2’s poorer objectivity is more than offset by its better predictive power in this example. These numbers give a quantitative grasp of objectivity and bias, but one cannot claim that M1 is approximately six times more objective than M2 or that M1 has twice as much bias as M2. Standard deviation might have been used for objectivity, in which case the objectivity ratio would come down to less than 3 to 1. Hence, the measures can give a comparative ordering for reliability—but that is all. 2. J & J Enterprises is formed on December 31, 2000. At that point it buys one asset costing $2,487. The asset has a three-year life with no salvage value and is expected to generate cash flows of $1,000 on December 31 in the years 2001, 2002, and 2003. Actual results are exactly the same as plan. Depreciation is the firm’s only expense. All income is to be distributed as dividends on the three dates mentioned. Other information: The price index stands at 100 on December 31, 2000. It goes up to 104 and 108 on January 1, 2002 and 2003, respectively. Net realizable value of the asset on December 31 in the years 2001, 2002, and 2003 is $1,500, $600, and 0, respectively. Replacement cost for a new asset of the same type is $2,700, $3,000, and $3,300 on the last day of the year in 2001, 2002, and 2003, respectively. Revenue is $1,000 per year and the internal rate of return is 10% and all cash flows are received (and distributed) on December 31. Required: Income statements for the years 2001, 2002, and 2003 under: Historical costing General price-level adjustment Exit valuation Replacement cost Discounted cash flows 2.1 Historical costing: 2001 2002 2003 Total Revenue $1,000 $1,000 $1,000 $3,000 Depreciation 829 829 829 2,487 Net Income $ 171 $ 171 $ 171 $513 2.2 General price level adjustment: 2001 2002 2003 Total Revenue $1,000 $1,000 $1,000 $3,000 Depreciation 829 862a 895b 2,586 Operating Income $ 171 $ 138 $ 105 $ 414 Purchasing Power Loss — 33c 66d 99 Net Income $ 171 $ 105 $ 39 $ 315 a $829 × 1.04 = 862 b $829 × 1.08 = 895 c $829 × [(1.04 – 1.00)/1.00] = $33 ($829 represents the firm’s cash holding on January 1, 2002) d $1,724 × [(1.08 – 1.04)/1.04] = $66 2.3 Exit valuation:e 2001 2002 2003 Total Revenue $1,000 $1,000 $1,000 $3,000 Depreciation 987 900 600 2,487 Net Income $ 13 $ 100 $ 400 $513 2.4 Replacement cost:e 2001 2002 2003 Total Revenue $1,000 $1,000 $1,000 $3,000 Depreciation 900 1,000 1,100 3,000 Net Income $ 100 $ 0 $100 $ 0 e Purchasing power gains and losses might be computed but are omitted for simplicity here 2.5 Discounted cash flows:f 2001 2002 2003 Total Revenue $1,000 $1,000 $1,000 $3,000 Depreciation 751 826 909 2,486 Net Income $ 249 $ 174 $91 $514 f The problem was structured so that the asset has a 10% internal rate of return 3. Objectivity (also called “verifiability”) and bias (usefulness) are two extremely important characteristics of accounting. Discuss each of the following situations in terms of how you believe they would impact upon objectivity and bias. The latest standard on troubled debt restructuring, SFAS No. 114, calls for newly restructured receivables to be discounted at the original or historical discount rate. Two board members disagreed with the majority position because they thought the discount rate should be the current discount rate, given the terms of the note and the borrower’s credit standing. SFAS No. 115 requires marketable equity securities to be carried at fair value (market value). Its predecessor, SFAS No. 12, required marketable equity securities to be carried at lower-of-cost-or-market. Assume that a new standard would allow only FIFO in inventory and cost of goods sold accounting with weighted average and LIFO being eliminated (you may ignore income tax effects). This situation shows how even a minimum exposure to “accounting theory” can sharpen reasoning power. Other examples of the type illustrated here can be easily generated. The original historical rate would be more verifiable since it is precisely determinable, whereas the current rate would not be exact but should be restricted to a very narrow range. The current discount rate should be more useful because its use would help to determine the current value of the restructured debt. On balance, we agree with the dissenters. Verifiability problems with the current discount rate should be quite small. While conservatism in accounting should not be totally thrown out, we believe that it is relied on too heavily. We believe that SFAS No. 115 has an absolute advantage in value terms over SFAS No. 12. Historical cost is not particularly useful for decision-making purposes. The consistent use of fair value is more useful, we believe, than lower-of-cost-or-market. If anything, verifiability should be better under SFAS No. 115 than SFAS No. 12, since one value is involved rather than two under lower-of-cost-or-market. The new standard would be more verifiable since only one calculation is allowed rather than two. Relative to usefulness, the usual argument might arise: LIFO is “better” in the income statement because costs used up are more current and thus give a better “matching,” but LIFO would be less useful on the balance sheet. Since neither of these calculations has an absolute advantage over the other, we would opt for the exclusive use of FIFO. In addition to being more verifiable, only one method would be less ambiguous for users. While the advantage is not absolute, we believe it is clearly in favor of FIFO only. 4. Accounting theory has several different definitions and approaches. Using Hendriksen and van Breda (1992, Chapter 1) and Belkaoui (1993, Chapter 3), list and briefly discuss these definitions and approaches. From the perspective of a professional accountant, evaluate these approaches in terms of their usefulness. Chapter 1 in Hendriksen and van Breda is devoted to accounting theory. Accounting theory is not defined until the conclusion of the chapter on page 21. Using Webster’s Dictionary as a background, accounting theory is defined as a “. . . coherent set of hypothetical, conceptual, and pragmatic principles forming a general frame of reference . . . ,” which is fairly close to the definition used here. The chapter talks about different “approaches” to theory, including tax, legal, ethical, economic, behavioral, and structural, hence, different frames of reference would evidently apply to each of these approaches. This entire framework is then related to philosophy of science issues such as the use of language involving pragmatics, semantics, and syntatics and theory as reasoning involving deductive and inductive approaches. Chapter 3 in Belkaoui is devoted to accounting theory, which is defined as “. . . a set of interrelated constructs (concepts), definitions, and propositions that present a systematic view of phenomena . . . with the purpose of explaining and predicting the phenomena.” His “approaches” then include pragmatic versus theoretical approaches with the latter mirroring the Hendriksen and van Breda approaches by covering deductive, inductive, ethical, sociological, economic, and eclectic approaches. We suspect that for both books, as well as this one, defining accounting theory has been a difficult task. The whole question of what do we know and how do we know it (and know that we know it) is an extremely interesting area. Epistemology is as important for accounting as for other disciplines. 5. What theoretical issues are involved in Statement of Financial Accounting Standards No. 2 which calls for expensing research and development costs? SFAS No. 2, Accounting for Research and Development Costs, issued in 1974, establishes standards of financial accounting for research and development (R&D) costs. It requires that R&D costs be expensed when incurred. It also requires a company to disclose in its financial statements the amount of R&D that it charges to expense. Theoretical issues relate to: measurability (how to measure future benefits of R&D expenditures, especially given the associated uncertainties) and matching (recognizing costs as expenses on a cause and effect basis). 6. Read “The Margins of Accounting” by Peter Miller in “The European Accounting Review (Volume 7, Number 4, 1998). What is Miller’s main point? Discuss the examples he uses to illustrate his main point including those pertaining to management accounting. What do you think the significance of his article is for understanding accounting? This 17-page reading is available through the EBSCO library database. Miller argues that practices at the margins of accounting today may be at the core in the future and vice-versa. “accounting innovation is not the preserve of any single group.” His examples include cost accounting and nonfinancial measures. This article emphasizes how accounting has developed in relation to “localized concerns and issues,” much like medicine and law. It implies that accounting will change, evolve as time passes and environmental factors vary. CRITICAL THINKING AND ANALYSIS 1. Is accounting theory really necessary for the making of accounting rules? Discuss. This question should hopefully shake students up. We doubt that a sophisticated answer that might arise when students have finished Chapter 4 suggesting that regulation, in some views, is unnecessary—will arise. Even prior to the appearance of any standard-setting agency, unifying themes such as realization and matching arose. In today's extremely complex environment, it is difficult to imagine financial accounting operating without a standard-setting body and that body operating without some type of conceptual (theoretical) guidelines since issues such as who the users are and what their information needs are, costs and benefits of different alternatives, verifiability issues, attaining comparability, and increasing information symmetry are all issues which must be considered by standard setters. 2. Every fall U.S. News and World Report comes out with a much awaited ranking of American colleges and universities (you may have even used it yourself). While there has been much criticism of the methodology that the magazine employs as well as some “fudging” of the numbers by universities in their response to the questionnaire, this report represents what the chapter calls a “social reality.” What is meant by “social reality” and why does this college and university ranking provide a good analogy for accounting? From Question 1: The term social reality pertains to the measurement of social phenomena and the use of these measurements. The measurements may be representationally faithful (low in bias) and have a high degree of objectivity (verifiability). Or the opposite for either or both of these qualities may be the case. The important thing to grasp, however, is that important consequences stem from the measurement, whether they are “good” or “bad.” For example, an excellent year in terms of income could cause management to be highly rated by shareholders and other interested parties, resulting in high management bonuses, or provide increased dividends to shareholders. All of this could occur even though income is a “construct”: not a “real” factor but a conceptual artifact. This is a particularly interesting application because the U.S. News & World Report survey is well known and widely used. It may well help many students in terms of narrowing down colleges and universities that they would be interested in by giving various “bottom line” summaries of the schools. Yet we might well ask how “good” and how meaningful these numbers are. Unquestionably, they influence actions. We know of college administrators who would “kill” to improve their ratings. 3. Accounting rule making should only be concerned with information for investors and creditors. Discuss. This is a good discussion question. You may want to also ask your students to determine who the two primary standards-setting bodies (FASB and IASB) identify as their primary customers of standards. Should the customers be all those using the information for making economic decisions or more limited to only one audience (e.g., investors, creditors, the entity alone)? Where do current and past employees fall in this investor-creditor classification? How about communities? Taxing authorities? Environmental regulatory agencies? This is a critical question, “Exactly, who is the customer?” Chapter 2: Accounting Theory and Accounting Research CHAPTER HIGHLIGHTS The chapter provides the student an appreciation for the contribution of research to the general growth of our knowledge about accounting. It shows how accounting research affects the standard-setting process in financial accounting. The chapter focuses on the roles of deductive and inductive reasoning and how they relate to financial accounting. It is also important to stress that these methods are complementary and not an either/or orientation. It is important to stress that empirical research generally looks at fairly small, manageable types of questions. It thus can provide input to the standard-setting process. Making accounting rules, however, must still be seen as a normative function. The chapter also stresses that empirical research cannot be value-free. Values are embedded in the questions that are asked and the parameters that are used in attempting to measure phenomena. Given the rise of formal approaches to theory and a concern for the process of measurement discussed in Chapter 1, the question arises as to whether accounting is an art or a science. A science might be defined as a discipline or area where considerable measurement problems exist. In the physical and natural sciences, there should be a high degree of consensus among measurers. This will be less the case in the social sciences simply because of the variability of human behavior. Nevertheless, they should come under the domain of science. Accounting could certainly move closer to the science realm as a result of the rise of scientific method and the concern for measurement. The chapter also briefly discusses accounting research directions or trends. These are expanded throughout the text. The chapter closes with a look at the question, stemming from Kuhn, concerning whether a “scientific revolution” is occurring in accounting. At this time, the answer appears to be a fairly clear “maybe.” The included PowerPoint, revolutions and paradigms.ppt, references an article from The Wall Street Journal, that suggests the beginnings of a paradigm shift. QUESTIONS Q-1 Do you think that the work of a policy-making organization such as the FASB or the SEC is normative (value-judgment oriented) or positive (oriented toward value-free rules)? Discuss. It is unquestionably normative because judgments must be made in accordance with objectives or other criteria. While a standard-setting group may attempt to be neutral, it usually must decide among different positions, each of which will have its adherents. A standard-setting organization may use empirical research (which attempts to be descriptive or positive) as part of its input into the standard-setting process. Ijiri used the term “policy science” to describe financial accounting. Q-2 An individual who was appraising accounting education had the following premises (assumptions): • Accounting professors used to do more consulting with accounting practitioners than they do today. • Accounting professors have become more interested in research that is abstract and not necessarily practical. He, therefore, concluded that accounting students are not as well prepared to enter the accounting profession as they used to be. Which type of reasoning was the individual using? What is your assessment of his conclusion? The individual used deductive reasoning. The conclusion was not warranted from the premises because accounting professors generally teach “what is” as opposed to what research may say or imply. Q-3 In 1936 the United States was still suffering from the Great Depression. During the presidential election campaign, an extensive survey of voter attitudes was undertaken to find out whether the public preferred the incumbent, Franklin Delano Roosevelt, or the challenger, Alf Landon. The sample was gathered randomly from telephone book listings throughout the country. A preference was found for Alf Landon; however, Roosevelt won re-election by a huge landslide. What type of research was being conducted? Why do you think it failed to make an accurate prediction? The method employed is inductive (empirical). The research failed because in 1936 a representative sample could not be gathered solely from people who had telephones because large segments of the population did not have telephones. The magazine (The Literary Digest) in fact failed as a result of its prediction that Landon would win; Franklin Delano Roosevelt won in a landslide. Interestingly, at about the same time pundits predicted that a telephone in every U.S. home was an impossibility. The reason being that the female population was insufficient to run the manual switchboards. Q-4 In accounting, deductive approaches are generally normative. Why do you think this is the case? As long as there is a value judgment or normative type of premise in the system, the results must be normative. If the premises (assumptions or postulates) are purely descriptive, it is highly likely that the conclusions derived from the system will be trivial. Therefore, the real issue is one of how acceptable any normative premises can be made. Q-5 A frequent argument is that inductive reasoning is value-free because it simply investigates empirical evidence. Yet some charge that it is not value-free. What do you think is the basis for this charge? As long as there are choices to be made, then research cannot be value-free. The choice of what one examines (question A versus question B) entails a value judgment. Parameters used in the research require value judgments. Furthermore, assumptions that may not even be stated are evidence that value judgments are being employed (the assumption that economic systems tend to move toward equilibrium is a value judgment, for example). Q-6 Several years ago an author stated that corporate income could be scientifically ascertained, but any type of adjustment for inflation would be pure folly because measurements would tend to become very subjective. Do you agree with the author’s appraisal? Comment in detail. The question pertains to an actual article that appeared in the early 1950s. The word “scientifically” was not defined in the article, so it is difficult to know what the author meant. The word was, however, undoubtedly being used to create an impression. The author appeared to be willing to sacrifice more economic reality (“faithful representation,” as it would now be called) because of a presumed lack of objectivity in measurement. The position was not unreasonable, but the real issues were hidden because of the way the author phrased his belief. Q-7 Of the four disciplines in the following list, which do you think qualify as sciences and which do not? State your reasons very carefully. Law Medicine Cosmetology Accountancy Cosmetology (barbers and beauticians) is concerned with a relatively frivolous subject matter; hence, it should not qualify. While law uses a system of precedence and deductive reasoning, the judge (not to mention the jury) ultimately employs judgments in making decisions. The lawyers, of course, have vested interests. Measurement is not directly applied except in a crude ordinal fashion. As the chapter states, accounting is moving somewhat toward the realm of science. Policy-making in accounting may use the results of research, but it is not a scientific endeavor itself. Medicine might fall into the category of an “applied science,” because the results of scientific endeavor are used for particular purposes. There is a fair analogy between accounting and medicine, but accounting is certainly far cruder at this time. Q-8 Several occupations within two of the aforementioned disciplines are listed here. Which do you think come closest to being scientific? Accounting researcher Chief accountant for an industrial firm Medical researcher Doctor (general practitioner) The accounting researcher and the medical researcher obviously come closest to being scientists, insofar as their work should be value-free (though this is not totally possible). They should be using formal research techniques to attempt to shed light on unanswered questions. Significant measurement problems are also present in work of this sort. Other researchers should arrive with similar results when they employ the same methods the original researchers used. However, replications should more easily come up in medical science than in accounting, because accounting is a social science where measurement pertains to human beings and their actions, choices, and values, and disagreement at basic research levels tends to be present. The chief accountant and the general practitioner are using or applying the results of science as opposed to being scientists themselves. As a result, they fall more into the line of being professionals. Furthermore, the chief accountant undoubtedly is not neutral in his work: he is concerned with making his firm look as good as possible. The doctor should be concerned with maximizing the health of his patients as opposed to maximizing his or her own wealth. Q-9 What are some of the pitfalls of empirical research? There are many pitfalls. Sample size relative to the universe being examined should be large enough to draw an inference with minimal chance of an incorrect conclusion. The parameters selected should be reasonable: for example what do we mean by “large firms” and “small firms.” Does the evidence that we examine really pertain to the hypothesis selected? Thus the presumed relationship between general price level adjusted income and reported historical cost income may or may not indicate something relative to a firm’s self perception of whether it may be subject to anti-trust action or other types of pressure if it is deemed to be large. We should also be careful of data manipulation possibilities: Watts and Zimmerman themselves determined the general price level adjusted incomes of the firms examined. It goes without saying that appropriate statistical tests and methods should be used. Q-10 If Watts and Zimmerman are correct that managers of very large firms oppose accounting standards that would raise their income and favor those that would lower it, what policy implications would this have for a standard-setting organization such as the FASB? Managers of very large firms might fear possibilities such as antitrust action, excess-profits taxes, and adverse public opinion, which could unfavorably affect sales and profits. These same possibilities could affect FASB’s deliberations. Since one of the hallmarks of FASB deliberations is due process—listening to those who would be affected by accounting standards—it would be useful to understand firms’ motivations. If the FASB knows a lobbying firm’s intentions, it helps the FASB maintain its neutrality. Q-11 What is the major difference in orientation between positive accounting theory and more overtly normative theories, such as the valuation approaches discussed in Chapter 1? The valuation approaches in Chapter 1 can each be viewed as a system. The choice of a valuation system (replacement cost over exit values, for example) is based on the value judgments (no pun intended) of advocates. Positive accounting theorists are making implicit value judgments in their examination and analysis of evidence. The questions and issues to be examined involve value judgments, as does the evidence examined (responses to FASB exposure drafts, income of firms, security prices, how FASB members vote, etc.), and parameters and statistical methods utilized (confidence intervals, regression analysis, ANOVA, and MANOVA). Q-12 For a discipline to become a science, the results of experiments and research must be exact. Do you agree with this statement? Discuss. Not necessarily. Science involves complicated questions of measurement. At other times, there may be disagreement relative to hypotheses. Nevertheless, science is an open process that uses agreed-upon methods of measurement, so that over the long run, agreement begins to appear in terms of measuring and interpreting phenomena. During the process of working out solutions to problems, strong disagreement does occur. On rare occasions, a scientific revolution may occur and questions are addressed in new and unique ways until general agreement once again occurs. Q-13 Why, in practical terms, is it impossible to separate deductive and inductive approaches to theoretical reasoning? Inductive work usually contains basic assumptions that are accepted without any further questioning. Deductive work usually contains assumptions based upon real-world referents that have been subject to at least a crude form of induction. The methods are cooperative rather than exclusive relative to each other in their operations. Q-14 What is the relationship among scientific method, accounting research, and accounting policy making? Accounting research is an important input to the accounting policy-making process. Most research today uses formal methods of deriving generalizations (deductive or inductive approaches). The scientific method is, therefore, a formalized means for carrying out research. Q-15 What are the two principal underlying assumptions of agency theory (positive accounting research)? Critique their role in constructing a theory of accounting. The two principal assumptions are that individuals act in their own best interest and that the firm is the locus or nexus of many competing types of contractual relationships. The former is virtually true by definition while the latter (which is, of course, dependent upon the former) is an interesting assumption that is the cornerstone of the agency theory literature in accounting. There can be other views of the enterprise, such as Chambers’ coalition view. This points out, once again, that positive research simply cannot shake off its normative underpinnings. Q-16 The “uncertainty principle” of the famous physicist, Werner Heisenberg, states that physical phenomena cannot be precisely measured because the very act of measuring affects the phenomenon being measured. Which of the directions of accounting research discussed in the chapter does Heisenberg’s uncertainty principle relate to most closely? The “uncertainty principle” clearly relates most closely to critical accounting. Critical accounting believes that by investigating a topic we literally help to shape the reality that we are investigating. It argues that there is an “observer effect.” Other research approaches see a “reality” that investigators do not directly affect. Q-17 Why do you think the term “deprival value” was used to name a specific type of replacement cost? Deprival value tries literally to measure the cost to the firm of not having (being deprived of) the particular asset. Q-18 Of the following decision-model advocates discussed in the chapter (Chambers, Sterling, Solomons, Bell, and Ijiri), which one stands out as most unlike the others? Ijiri stands out because he is an advocate of historical cost adjusted for the change in the general price level. He chooses this approach because the prime purpose of financial statements, as he argues, is accountability. The other individuals advocate various types of current value systems. Q-19 What is the difference between “accounting theory” and “accounting research? Accounting research is an active process, the results of which can add to the “store” of accounting theory. This difference is very closely related to the economic concepts of “flows” (accounting research) and “stocks” (accounting theory). Q-20 Why does the decision-model orientation to research accord more closely with the standard-setting function than any of the other research directions? The decision-model orientation attempts to prescribe valuation approaches on a "global" basis: exit value or entry value for example. If either of these approaches were instituted, the FASB would be involved with deriving rules for the selected valuation method. None of the other research approaches gets this close to the standard-setting process. Q-21 If there has been a paradigm shift (scientific revolution) in accounting research, but not in accounting practice, what may this signifiy? It may indicate that accounting research and accounting practice are not in synchronization with each other. In the move toward empirical research in accounting (a paradigm shift in accounting research), one research problem which may have been overemphasized were studies of market efficiency. Practitioners (including financial analysts) were not carried away by this research (Chapter 8). In our opinion, practitioners were largely correct in this and other areas of research. However, research and practice may now be becoming more attuned to each other. For example, research on earnings management (chapter 12) may become very useful for standard-setters. Q-22 In accounting behavioral research, student subjects have been frequently used as proxies for real-world decision makers. Does this lead to any potential problems? Using student subjects as proxies for real-world decision makers may lead to findings that may not generalize to the population. The students may have different values, analytical abilities, priorities, and life experiences that distinguish them from the real-world individuals making decisions. This is always a consideration when designing research projects and is usually identified as a limitation at article-end. Q-23 Why do you think that ethnographic research (footnote 65) would be difficult to apply to organizations such as the SEC and FASB? Ethnography is a social science research method. Data collection consists of interviews, observations, and document reviews over an extended period of time, usually years or perhaps decades. Its roots are in anthropology and the social sciences, so an ethnography of the FASB or SEC would be akin to living with the natives. The synthesis of data collected result in a descriptive narrative, a portrait of the subject. In most business programs the current tenure paradigm is not compatible with the time required to gather data for an ethnography. The time required to produce high quality case studies is likely to be as close to an ethnography that we can expect. CASES, PROBLEMS, AND WRITING ASSIGNMENTS 1. Agency theory takes the view that the corporation is the locus or nexus of many competing and conflicting interests. List as many of these conflicting groups as you can and discuss in detail the nature of their conflicts with other groups. Among the conflicting groups would be management, auditors, shareholders, creditors, labor, and government. Management desires to maximize its own income through bonus arrangements (which may mean that cash flows are diverted from shareholders) and will probably desire lower reported income if it fears government antitrust action, excess-profits taxes, or simply adverse public opinion. Shareholders generally want high cash dividends and price appreciation on their shares (the latter is at least perceived to stem from higher reported income). Auditors want to maximize their income and minimize their risk. They prefer to avoid what might be perceived to be subjective judgments, hence, they have not favored rendering opinions on earnings forecasts, even if this might be very beneficial to users. They also prefer detailed standards in order to avoid pressure from management, which wants its own interpretation of standards. Creditors desire protection to maximize the probability of receiving interest and repayment of principal. Therefore, they desire protection from the possibility of shareholders “stripping” the firm through excessive dividends. This is often done by means of debt covenants in bond contracts, which may prevent payment of dividends if they are violated (maintenance of a maximum debt-to-equity ratio, for example). Management does not want bond covenants violated because of the potential adverse effect upon security prices. Labor wants to maximize its wage return relative to the previous three groups. Government would certainly like to maximize tax collections from the other groups without creating unrest, minimize labor-management turmoil, and minimize harmful business actions such as polluting the environment. 2. Using the article by Colin Lyas (“Philosophers and Accountants”) in Philosophy (January 1984, pp. 99–110), discuss and compare Sterling’s scientific approach to standard setting with the judicial or jurisprudential approach of Stamp. Lyas’s article is not particularly difficult to understand and dovetails neatly with the discussion in the chapter of the various directions in accounting research. Notice also that Lyas immediately refers to the public misperception of accounting as unambiguously objective and clear-cut in a similar fashion to the opening paragraph of Chapter 1 of this text. Lyas sees Sterling as being in the “objectivist” school, whereby values exist separate and apart from those who are measuring them. From this viewpoint, Sterling would be in the same boat as agency theorists, a prospect that would not particularly please him. Lyas also sees Sterling’s position in favor of exit values as a “judgment” rather than a scientific hypothesis. Perhaps the key point is why exit values take precedence over replacement cost or entry values and how would we decide on whether the numbers that we do generate have a high enough degree of verifiability, as discussed in Chapter 1. Perhaps Sterling’s answer to which system to choose lies in his article entitled “Relevant Financial Reporting in an Age of Price Changes,” Journal of Accountancy, February 1975, pp. 42-51. Lyas raises basic questions such as who should have access to what information, a relativist orientation which would, to this extent at least, put Stamp in the camp of the critical accountants. Therefore, given values that are tentative and questions of who should have access to what information, Lyas is much more comfortable with Stamp’s judgmental approach, which Lyas sees as being very compatible with a legalistic approach. It should also be mentioned that Stamp very definitely has a broad accountability approach to accounting information: many groups have a stake in accounting information, not just investors and creditors. Finally, the legalist approach of Stamp would not, in Lyas’s (and Stamp’s) view, lead to a total degree of arbitrariness in choice among accounting methods and other financial reporting. CRITICAL THINKING AND ANALYSIS 1. How can accounting move more toward becoming a science rather than an art? Discuss. One method would be to eliminate arbitrary choices among accounting methods in generally similar event situations (LIFO versus FIFO although income taxes are a problem here, different depreciation methods, and moving towards principles based accounting standards such as requiring all long-term leases to be capitalized). Measuring real phenomena would help move accounting towards being a science. Even if current value systems might not be easily implemented, there are still factors where more realistic measures might be used. For example, with troubled debt restructuring, we still use the historical rate for discounting rather than the current rate. The latter should be able to be estimated with a fairly high degree of accuracy. Hence we gain usefulness with only a very small "giving up" of verifiability, a fairly clear-cut trade-off. To accomplish a movement toward measuring real phenomena, we may have to let go of conservatism. CHAPTER HIGHLIGHTS Accounting practice prior to 1930 was unregulated, and the procedures used by various enterprises generally were confidential. During the 1920s, the American public began to invest in corporate business far more extensively than in the past; however, it was not until the stock market crash of 1929 that investors began to question the accounting and reporting practices in use. A brief history of accounting in the United States prior to 1930 provides an overview and background. The New York Stock Exchange (NYSE) became very concerned because listed companies were using various undisclosed accounting procedures. A cooperative effort between the NYSE and the AICPA resulted in the first real effort to develop accounting principles. The organizations agreed that corporations should be allowed to follow any accounting procedures they deemed appropriate as long as those procedures were disclosed and were considered acceptable. Five broad accounting principles were then agreed upon by the AICPA and NYSE. The SEC came into existence in 1934 and was (is) empowered to prescribe accounting principles. It decided that self-regulation by the accounting profession was in the public’s best interest. That position has remained unchanged for about 80 years; however, on many occasions the U.S. profession has come close to losing its self-regulatory status. In recent years, accounting scandals have severely affected its independence; it is experiencing more governmental oversight, but less influence from organizations seeking preferential accounting standards. In 1933, the AICPA formed the Special Committee on Development of Accounting Principles, but this committee accomplished very little and was subsequently replaced by the Committee on Accounting Procedures (CAP) in 1936. The CAP did very little until 1938. At that time, the SEC issued an ultimatum that either the accounting profession must establish standards or the SEC itself would establish them. The CAP saw the need for a conceptual framework but felt that the time to develop one did not exist. Consequently, it embarked on a standard-setting mechanism that has been called the “brushfire” approach. Although the CAP was criticized, it did make significant contributions to accounting practice, and many of its pronouncements are still applicable. Perhaps its major contributions were that it established standard-setting in the private sector. The Accounting Principles Board (APB) was designed to overcome the major deficiency of the CAP. It was to operate on a dual approach: first by the establishment of a conceptual framework and then by the deductive development of accounting standards. Unfortunately, the attempt at a conceptual framework was a failure, and in a very short time the APB found itself in the same position as the CAP. In the APB’s relatively short life (1959-1973), it made two very significant steps forward. First, it issued APB Statement 4, which has served as groundwork for the Trueblood Committee report and the FASB’s conceptual framework project. Second, it greatly expanded the due process procedures for establishing accounting standards. The APB was the first to experiment with discussion memorandums, exposure drafts, and the general use of its constituency. The APB’s ultimate failure, however, was due to its inability to develop a deductive approach and the lack of independence of its members. Chapter 3: Development of the Institutional Structure of Financial Accounting The Financial Accounting Standards Board (FASB), as an independent body from industry, was seen as a last chance to keep accounting standard setting out of the public sector. The initial charge to the FASB was to establish standards of financial accounting and reporting in the most efficient and complete manner possible. In that light, it decided that a conceptual framework in the long run is an absolute necessity. Consequently, much of the FASB’s resources were devoted to developing a conceptual framework, one that required multiple decades to develop. The FASB uses research in the development of accounting standards more than any of its predecessors. Although the FASB has been under constant attack, almost from its inception, it appears to have weathered the storm and will, most likely, remain in some form of existence for the immediate future. However, its role will likely differ. Sarbanes-Oxley of 2002 required that the SEC review principles-based accounting for application to U.S. issuing companies. Today, the FASB and IASB are pursuing convergence of their respective accounting standards (result of the Norwalk Agreement of 2002 and the subsequent conceptual framework project). Assuming that the convergence projects are successful, the need for redundant standards-setting bodies arises. This suggests that the most serious threat to the FASB may come from an external standards- setting body (IASB), not from the public sector. 100+ countries have adopted IASB standards to some extent; this makes it very difficult to argue that U.S. GAAP should be the world’s Lone Ranger of accounting. The challenge when IFRSs are adopted, not just converged with U.S. GAAP, will be to find new roles for the FASB. Structures are must easier to build than to dismantle. An additional threat, albeit small, comes from the AICPA. Since the PCAOB now has responsibility for major portions of what the AICPA did pre-SOX, the AICPA appears to be searching for its new role. For a while the AICPA adopted “baby GAAP” as its project to review separate standards for smaller companies, a project that should have been left to the official standards-setting body, the FASB. The FAF formed the Private Company Council (PCC) in response to concerns related to non-public company requests for separate standards. Rather than create two separate standards setting bodies, FASB is the single standards setting board in the United States. PCC is an advisory body to the FASB on standards, taking a private company perspective. Note that a separate Microsoft PowerPoint file is available on Sarbanes-Oxley, one that you may want to review or lecture on at some point in the course. SOX provides for funding through accounting support fees for FASB, a point that makes its independence from industry and its funding significantly stronger than IASB’s. This will likely be something to be resolved before the U.S. will actually adopt IFRSs, if it does. Public accounting firms are emerging from the crisis created by joint and several liability. At the federal level since the Private Securities Litigation Reform Act of 1995, liability is largely restricted to proportionate liability which restricts damages to the defendant's proportionate share of the damages. QUESTIONS Q-1 How did the APB pave the way for the FASB? The APB’s biggest contribution to the FASB was the due process procedures for the establishment of accounting standards. The APB initiated the use of discussion memorandums, public hearings, and exposure drafts, all of which have become standard procedures for the FASB. Q-2 In what ways does the FASB differ most markedly from its two predecessors? Perhaps the FASB’s biggest difference is its independence. The FASB, unlike its two predecessors, is independent from and not part of the AICPA. All board members must maintain complete independence. This not only applies to other employment arrangements, but also to investments. There must be no conflict, real or apparent, between the members’ private interest and the public interest. Financial independence from CPA firms and industry (attained from assessment of accounting support fees from companies issuing financial statements, SOX) reduces the appearance of undue influence from specific interests. Another important difference is the FASB’s commitment to research. Q-3 What is the weakness of Grady’s approach in arriving at principles in ARS 7? The primary weakness is that Grady codified existing pronouncements and then tried to derive the profession’s existing structure of principles. The study blended inductive and deductive approaches because it took the existing pronouncements and then attempted to deduce accounting principles from the body of accepted pronouncements. Q-4 Do you think that the nonbinding status of the FASB’s statements of financial accounting concepts (like that of APB Statement 4) is a good idea or not? The purpose of SFACs is not to establish accounting standards but to set forth the fundamentals on which financial accounting and reporting standards will be based. The FASB itself is likely to be the major user of SFACs and thus the most direct beneficiary of the guidance provided by them. The problem with the nonbinding status of the SFACs, however, is that they can simply be ignored, as has occurred in a significant number of cases. Q-5 Discuss the significance of the SEC’s ASR 150. ASR 150 represented the first time that the SEC formally recognized that accounting standards set in the private sector had substantial authoritative support. It said that SFASs and Interpretations will be considered by the SEC as having substantial authoritative support, and practices contrary to such FASB promulgations will be considered to have no such support. Q-6 What has been the SEC’s role in the evolution of the rule-making process? How has that role changed since the passage of SOX? The SEC’s role in the evolution of the rule-making process has been as a behind-the-scenes observer. It has played a definite role in practically all standards, but has chosen to take a low profile in most situations. The SEC has chosen to pursue the low profile role because it has been assumed to be best for the profession as a whole. By staying out of the limelight, the SEC may also be maximizing its life span and survival. SOX has further strengthened the SEC’s authority. The PCAOB has responsibility for oversight of the audit and accounting functions (formerly AICPA’s responsibility), but the SEC has final approval on any policies, standards, etc. that it might propose. The FASB no longer receives its funding from corporate donations, increasing its independence from industry influence. Now, the SEC provides FASB’s funding by budget approval, so it is now more closely controlled by this regulatory body. Additionally, in 2007 the SEC and FAF agreed that the SEC would have input to board appointments. So, the FASB is now seen as a quasi-governmental body. Q-7 What were the politics that led to the demise of both the CAP and the APB? The “politics” that led to the demise of both the CAP and the APB was the SEC’s belief that both groups were unable to work effectively due to their lack of independence. The members of both groups were only part-time standard setters and full-time practicing accountants with various vested interests regarding certain accounting standards. Q-8 “The FASB’s standard-setting procedure is a fairly narrow, cut-and-dried approach to developing accounting standards.” Evaluate this statement. The FASB’s standard setting procedure/process is anything but “cut and dried.” While there is an overall sequence of steps involved, the consultations and politicking can be quite extensive. Refer to the Johnson and Swieringa article discussed in the chapter on SFAS No. 115 on marketable securities, certainly not one of the more complex and extensive standards. Two even better examples might be income tax allocation (SFAS No. 109) and stock options which resulted only in a disclosure standard. The work involved in both of these cases took years to play out with much vigorous discussion, debate, and politicking. Q-9 Should constituents have input into the FASB decisions, or should the FASB neutrally and independently set standards? Using constituents’ input and acting neutrally and independently are not mutually exclusive. Without question, the FASB should neutrally and independently set standards; however, it must consider its constituents’ input or its standards will not be accepted. One of the FASB’s biggest jobs is to obtain a consensus of the constituents on standards it promulgates. However, current conditions indicate a decline of influence by constituents, but it is still important to get their input. Q-10 Explain how the role and form of research used by the APB and FASB differ. The initial role of research used by the APB was to develop postulates and principles. That role, however, quickly changed to one of completely examining certain narrow subjects, goodwill, for example. The APB then used that research as a basis of its deliberations. The FASB uses research in the same manner, but has expanded the role extensively. It also uses research to determine the expected economic consequences of many proposed SFASs as well as the real economic consequences of its recently issued SFASs. Q-11 What is the importance of the FAF and FASAC to the success of the FASB? The FAF elects members to the Board of Trustees, whose responsibility is to select FASB members and perform the oversight role. The FASAC’s role is to advise the FASB on its operating and project plans, agenda and priorities, and appointment of task forces as well as on all major technical issues. FASAC’s influence will probably decline given the SEC’s increasing role. Note that now the SEC participates in board appoints; this is a significant change. Q-12 The three attempts at standard setting in the private sector (CAP, APB, and FASB) have all dealt with the need for a theoretical foundation. Why were the CAP and the APB unsuccessful at this endeavor? The CAP never really attempted to develop a theoretical foundation. Although it recognized the need for one, it did not believe that it could afford the time commitment. The APB attempted to develop a theoretical foundation by commissioning ARSs 1 and 3; but the accounting profession rejected both of those ARSs. APB Statement 4 was mildly successful in developing a theoretical foundation, but it neither had authoritative support nor went far enough. The short answer as to why the CAP and APB failed to develop a theoretical foundation is that they “put out fires,” focused their efforts on short-term successes versus the work required to assure long-term progress. Q-13 Can any overall trend be detected in FASB pronouncements? Explain and cite examples to substantiate your opinion. At one time there was an attempt to “clean up” the balance sheet by expensing items such as research and development costs (SFAS No. 2) and development stage enterprises (SFAS No. 7). There is, however, a movement toward current values with marketable securities (SFAS No. 115), derivatives (SFAS No. 133), and even impaired assets (SFAS No. 121 and 144) although this is a “lower-of” type of valuation. The FASB-IASB convergence project will likely result in increased fair value approaches, an asset-liability view. SOX actually required a review of principles-based accounting for U.S. standards, so this approach is likely in the future. The U.S. Congress now requires that the FASB and SEC report annually on progress towards adopting principles-based accounting and increased transparency in financial reporting. Q-14 In terms of financial reporting in the future, do you expect greater refinement of measurements appearing in the body of the financial statements or increasing disclosure with less effort directed toward refinement of measurements? In the foreseeable future, if the recent past is any indication, accounting standards probably will be directed more toward increasing disclosure with less effort on refinement of measurement. This is not necessarily acceptance by the FASB of the efficient-markets hypothesis, but rather the practicality of establishing accounting standards. It is easier to obtain a consensus on disclosure than on changing the measurement of items that appear on financial statements. Of course, stock options is an important counter-example, although disclosure is the final result! Q-15 How has Sarbanes-Oxley of 2002 affected FASB’s jurisdiction and independence? Sarbanes-Oxley places more emphasis on auditing because the Auditing Standards board of the AICPA will no longer be setting auditing standards. Pressure will also be placed on the public accounting firms and corporate officers to sign off on their financials. The beneficial changes affecting the FASB is that financing will come from assessments on public companies and accountants, but not contributions of companies politicking for their self-interest. However, the FASB is more of a quasi-governmental body. On balance, FASB should be more indpependent from industry influence, particularly as it works with the International Accounting Standards Board on “convergence.” Q-16 In late 1990s, the “Wyden Amendment” was stricken from the Crime Bill passed by Congress. The amendment would have required reporting by auditors on internal controls. Letters sent by FEI members opposing the amendment were instrumental in its defeat. The AICPA supported the amendment. From an agency theory perspective, why do you think the AICPA supported the amendment and the FEI was against it? Explain The AICPA supported the Wyden Amendment because its members would have generated more auditing fees from reporting on internal controls. The FEI was against it because the firms, represented by its members, would be paying the increased fees to the public accounting firms. The politics and positions were to be expected. Q-17 “Since the FASB is independent from the AICPA, the latter is no longer concerned with standard setting and related issues.” Evaluate this statement. This is not true; the AICPA is still interested in standard setting. Its members must understand the standards and audit their implementation by industry. Auditors are concerned with the implementation of the standards. AcSEC plays an important liaison role as well as issuing SOPs and Industry Accounting Guides. In addition, the AICPA works with the International Accounting Standards Board at the international level (Chapter 10). However, the AICPA, on balance, will be losing influence. Q-18 What is the relationship between the National Commission on Fraudulent Financial Reporting and Private Securities Litigation Reform Act of 1995? The activities of the National Commission on Fraudulent Financial Reporting were instrumental in helping to draft and pass the Private Securities Litigation and Reform Act of 1995. Q-19 What is the difference between joint and severable liability and proportionate liability? Joint and several liability can result in a guilty party being stuck with more than its proportionate share of the damages if other guilty parties do not have the financial means to pay their share of the damages. Proportionate liability restricts each defendant's damages to their proportionate share thereof. CASES, PROBLEMS, AND WRITING ASSIGNMENTS 1. During its long tenure, the CAP produced a total of 51 ARBs. While the CAP was in existence, another committee, the Committee on Terminology of the American Institute of Accountants (the previous name of the AICPA), prepared certain definitions. Assess their definitions of assets and liabilities (see Chapter 11 for the definitions). Do you see any problems with one committee preparing rules and another making definitions? Read Chapter 15 of ARB 43 on unamortized discount, issue cost, and redemption premium on bonds refunded. Why do you think these issues concerned the committee? What were the two acceptable alternatives for dealing with the costs of any issue? Why would the definition of assets be helpful in analyzing a situation of this type? Are there any other situations that might be somewhat analogous to the bond redemption situation? The definitions of assets and liabilities contained in the terminology bulletin are of little value to standard setters. They do not provide any discussion of the characteristics or attributes of assets and liabilities that would help standard setters determine what is an asset or liability. Basically, the definitions say that if an item doesn’t belong on the income statement, it must go on the balance sheet. The problem with one committee preparing rules and another preparing definitions is that the former must use those definitions; if its members do not agree on the definitions (because they did not write them), an impasse occurs and it becomes extremely difficult to issue sound rules. 2. Read Chapter 15 of ARB 43 on unamortized discount, issue cost, and redemption premium on bonds refunded. Why do you think these issues concerned the committee? What were the two acceptable alternatives for dealing with the costs of any issue? Why would the definition of assets be helpful in analyzing a situation of this type? Are there any other situations that might be somewhat analogous to the bond redemption situation? Make sure you check availability of ARB 43 to the students before assigning this case. Accounting for unamortized discount, issue cost, and redemption premium was an issue because the amounts involved very frequently are significant and the alternative accounting practices that existed affected financial statements significantly. The object was to eliminate alternatives in order to obtain uniformity. Unfortunately, the CAP was not successful because of a lack of good asset and liability definitions. Therefore, it was acceptable to write-off immediately all such costs, or to defer and amortize over a period shorter than the remaining life of the old issue. Under SFAS No. 4, all costs of early extinguishment of debt are considered to be extraordinary items (they may not, however, be infrequent). At least the FASB allows only one treatment in comparison to the two allowed by the CAP. Whether the redemption premium, which is a true opportunity cost, should be distinguished from the sunk costs—unamortized premium or discount and issuance costs—is an interesting question. Expense versus capitalization questions also involve the investment tax credit and research and development costs. A situation analogous to the opportunity cost nature of the redemption premium involves tearing down costs of old buildings located on land that has been acquired for development. 3. Read “FASB Response to SEC Study on Arrangements with Off-Balance Sheet Implications, Special Purpose Entities, and Transparency of Filings by Issuers” (Feb 2006, available on FASB’s website). Ask how would you frame the tenor of the FASB’s response. To what extent does it agree with the SEC’s study? The FASB acknowledges that it was not asked to respond to the SEC’s report, a reminder that the SEC, not the FASB, has statutory authority to set accounting standards. This omission by the SEC to ask FASB for its feedback is a not so subtle indicator of who is in the driver’s seat. There is consensus that to improve accounting standards the emphasis must be on reducing complexity, improving transparency, and pursuing principles-based accounting standards. 4. Five so-called broad principles of accounting were prepared by the AICPA’s Special Committee on Cooperation with the Stock Exchange and approved by the NYSE’s Committee on Stock List in 1932. They were to be followed by all firms listed on the exchange. Subsequently, these principles (along with a sixth item) were codified as Chapter 1 of ARB 43 and two principles from ARS 7 are available in the text. Terms such as principles of accounting have been used frequently since 1932. Describe what you think the principles might be. Do any of the principles coming from ARB 43, Chapter 1, or ARS 7 qualify as principles as you have construed them? How similar are these two partial groups of principles? Accounting principles are fairly broad in nature and few in number. In general, they specify how accountants should approach recognition and measurement of transactions and events that affect the financial position and results of operations of enterprises. Examples include the historical cost principle, the revenue recognition principle, the matching principle, and the full disclosure principle. The principles coming from ARB 43 and ARS 7 generally are more narrow than accounting principles as defined. The "principles" prepared by the AICPA's Special Committee on Cooperation with the Stock Exchange are quite specific and appear to be more in the nature of rules rather than principles. Notice, however, in principle (a) we do have the underpinning for part of the revenue recognition principle (as the word "principle" was defined in the chapter. These principles also have the flavor of being definitions: principle (b) defines the nature of capital surplus (paid-in-capital). The two principles from ARS 7 are also definitional in nature. CRITICAL THINKING AND ANALYSIS 1. Why have management consulting operations created problems for the public accounting industry? How has SOX affected these problems? Consulting activities overshadowed auditing services in CPA firms during the 1990s. When consulting fees exceeded audit fees, the audit firm’s independence came into question. The audit firm’s independence became impaired, if not in fact, at a minimum in appearance. This breaching of the "Chinese Wall" did and can create some very difficult problems for auditors relative to the consulting services of their firms. SOX placed restrictions on the consulting-auditing services that a single audit firm can provide a client. 2. The FASB and AICPA are considering the addition of “baby GAAP” for private companies. Take a position and argue why two GAAPs should or should not exist? “Baby GAAP” is essentially a more simple GAAP for private companies. The argument for this second GAAP is that it is too costly for a private (and likely smaller company) to implement the GAAP standards for imposed on a publicly traded company. On the other hand, why should an economic activity be accounted for in multiple ways depending on the type ownership of the company. A transaction is a transaction is a transaction. Right? Also, two GAAPs means that auditors will need to develop expertise in two GAAPs, increasing the cost to audit. Perhaps FASB needs to consider the structure of standards to allow for ease of understanding and implementation. Perhaps the PCC advisory role will help from this perspective. 3. What role should the AICPA assume in the possible development of “baby GAAP” standards? We have a standards setting body, the FASB. The AICPA should allow it to function as that body, provide input to projects and standards. However, the AICPA should not attempt to lead or develop new standards, even though it has significant capacity to fill since SOX sent so much of its work to the PCAOB. The SEC submitted to Congress its Study Pursuant to Section 108(d) of the Sarbanes-Oxley Act of 2002 on the Adoption by the United States Financial Reporting System of a Principles-Based Accounting System in July 2003. One of its recommendations was that the FASB should be the only organization setting authoritative accounting guidance in the United States. The FASB responded a year later and agreed with the SEC. That is how the PCC came into being in 2012. Chapter 4: The Economics of Financial Reporting Regulation CHAPTER HIGHLIGHTS In recent years, the regulatory nature of accounting policy making has become a prominent topic in both academic and professional accounting literature. The purpose of this chapter is to expose students to the two extreme sets of arguments: those that favor free markets, and those that favor regulatory intervention. By looking at both sets of arguments, students should become more sensitive to the regulation issue, and realize that regulation creates both benefits and costs. These benefits and costs are hard to measure, and it is sometimes hard to identify on whom they fall. Most economists believe it is not possible to optimally allocate society’s resources under regulation (Arrow’s Impossibility Theorem). What one is left with, then, is the far less ambitious task of simply assuring that there is a net benefit from regulation (benefits exceed costs). If the text has a philosophical stance on regulation, it leans toward regulation but with the need to justify it more than has occurred in the past. This means carefully assessing the benefits and costs of accounting regulation. The second part of the chapter explains the political nature of regulatory decision making. Students should understand the “self-interest” principle in a regulatory environment. The self- interest principle is applicable to (1) accounting regulators (FASB and the SEC) and (2) the constituency groups affected by accounting regulation. These latter groups include preparers, auditors, interpreters, and users of accounting reports. Traditional self-interest theories of regulation (capture theory and life-cycle theory) seem less applicable to accounting than to other areas. This is probably due to the public-good nature of accounting information compared to private property rights created by conventional regulation (e.g., transportation routes in the airline transportation industry). Finally, “economic consequences” has become a vogue term in accounting literature. Basically, it refers to the effect of accounting standards and reports upon the decision-making behavior of preparers and users. Economic consequences can be viewed as part of what is called the political economy of accounting. Simply put, the argument is that any choice of financial reporting systems, from laissez faire to complete regulation, makes some people better off and others worse off. It is thus difficult for standard setting to maintain neutrality. The FASB indeed has an extremely difficult task requiring exquisite balance: promulgating standards for the benefit of investors and creditors but within the context of benefits (to users) exceeding the costs of providing information. The codificational outlook discussed by Gaa provides a philosophical justification for standard setting by an organization such as the FASB. Finally, Sarbanes-Oxley of 2002 (SOX), by establishing the PCAOB and providing FASB funding from non-taxpayer accounting support fees, has reduced self-regulation by the accounting profession. This signals significant changes for several years to come. QUESTIONS Q-1 What are the arguments favoring regulation of financial reporting? The arguments for regulation are in two groups: those relating to market failures and those relating to social goals. It can be argued that private incentives for financial reporting do not work because (1) firms are monopoly suppliers of information, (2) reporting sometimes fails to signal corporate fraud or bankruptcy, and (3) the public-good nature of accounting information leads to underproduction (underreporting) in a free market. In terms of social goals, the arguments are cast in terms of information symmetry and comparability. Q-2 What are the arguments against regulation of financial reporting? The arguments against regulation focus on the incentives to report voluntarily. Agency theory can be used to argue for reporting incentives between managers and owners. The competitive nature of capital markets and the concept of “corporate signaling” are used to argue for public reporting incentives. Finally, it is argued that nonpublic information could be privately purchased if demanded. Q-3 Why is it difficult to evaluate the regulation question? The free-market position cannot be easily researched (empirically) because the market is regulated. Benefits and costs of regulation are extremely difficult to identify and measure. As a result, the arguments, both for and against regulation, have been largely deductive in nature. Q-4 Why does accounting information have some features of a public good? What are the implications for information production in both unregulated and regulated markets? A public good is one that is characterized by non-rival consumption; that is, it can be consumed without reducing the opportunity for consumption by others. In one sense, an accounting report can be read without reducing the information available to subsequent readers. However, the usefulness of the information is highly related to time. Reading a 1980 report in 1984 may convey the same message in both years, but the opportunity to use the information passes quickly (if the efficient-markets hypothesis is correct). Finally, public goods are under produced in free markets due to externalities and overproduced in regulated markets due to the free-rider problem. This is a paradox of regulation. Q-5 Why can’t optimal regulation be determined? If optimal accounting regulation cannot be determined, how can a regulatory body such as the SEC or FASB make good decisions? Arrow argues (in the Impossibility Theorem) that optimal regulation (resource allocation decisions) cannot be determined because individual preferences are not additive across individuals. Therefore, one cannot determine if regulation is economically desirable. So, the decision to regulate is achieved through imperfect preference revelation in the form of voting. Given a democratic mandate for regulation, a regulatory agency should at least try to achieve a net social benefit. Even here, determining costs and benefits is difficult due to measurement obstacles. Q-6 A distinction was made in the chapter between two types of regulation: (a) the refinement and standardization of financial statements and (b) expanded disclosure. Why is the distinction important in evaluating the regulation question? Refinement and standardization is probably more aesthetically pleasing because it is within the body of the statements themselves and should lead to increased comparability. The emphasis upon disclosure, particularly within the framework of a presumably efficient market with free riders using the information, can easily lead to steeply escalated production costs. Q-7 Who pays for accounting regulation and who benefits? These are important but unanswered questions, at least in terms of accounting research. From a self-interest viewpoint, auditors and financial intermediaries benefit from regulation because new work is created by new regulation. Users benefit to the extent that information is useful. Costs are incurred by producers of information (firms), but are probably passed to consumers. The costs of regulatory agencies are borne by society as a whole in the case of the SEC, and the private sector in the case of the FASB (primarily accounting firms and large corporations). Q-8 Can accounting standards and policy making be neutral? In what sense is neutrality really important? Neutrality is not possible in the sense that someone benefits from regulation, and someone pays the costs. Regulation creates wealth transfers. However, neutrality is at least conceptually possible in the sense of providing information that is useful for investors and creditors within a benefits exceeding costs (of production) framework. The FASB has an extremely difficult balancing act to maintain. Q-9 Arrow (1963) warns that public participation and a consensual approach to social issues can lead to democratic paralysis; that is, to a failure to act due to an inability to agree on goals or objectives. How did such a situation lead to the demise of the APB (review Chapter 3)? Why is the FASB faring somewhat better? The rejection of ARS 1 and ARS 3 by the accounting profession was a failure due to inability to agree on goals. While the APB did have some successes (pension and income tax allocation, for example), the APB floundered once again on the issue of business combinations and goodwill. The APB opened up the process of standard setting through public hearings and discussion memorandums. While these are important and necessary steps which were picked up by the FASB. The paradox is that these steps can lead to democratic paralysis: a general lengthening of the time that it takes to draft and complete standards. Of marginal benefit is the fact that the FASB has managed to get a conceptual framework in place, a process which was also accompanied by democratic paralysis (see Chapter 7). Q-10 Horngren (1973) argues that accounting policies are a social decision and a matter of public interest. Evaluate this statement. The decision to regulate is a social decision because it affects society’s allocation of resources. Therefore, accounting regulation falls in the domain of public policy. Laissez faire is also a “policy” decision inasmuch as it too affects society’s allocation of resources. Q-11 Horngren (1973) believes that accounting standards must be marketed by regulatory bodies. By this he means that affected parties need to be sold on the benefits of standards. How is this concept consistent with the nature of regulation? Regulatory theories suggest that regulators are motivated to make their constituents happy in order to enhance the position of the regulator. The essence of Horngren’s position is that the self-interest of accounting regulators is best served by making the constituency want the regulation. Horngren implies a normative aspect (it “should” be this way), which is harder to defend. Q-12 It was suggested many years ago that a court should be created to resolve disputes in accounting. In what ways does the FASB function as an accounting court? In what ways is it different? The due-process nature of regulatory decision making is adapted from the legal system. There is an obvious parallel between a judge and a regulator; both are presumed to be impartial arbiters. An important difference, though, is the absence of a body of law and precedents in accounting on which to base decisions. As a result, regulatory decision making is far more open-ended and the criteria more subjective. Q-13 What benefit is the conceptual framework project to the FASB if (a) there is no way of determining optimal accounting regulation and (b) regulatory decision making is a political process? Perhaps the best way of characterizing it is to liken it to the United States Constitution, as providing a frame of reference or departing point for analyzing policy issues. However, just as the Constitution has not prevented “bad” laws (e.g., the Jim Crow laws after the Civil War) or “bad” interpretations of the laws by courts, the FASB’s conceptual framework will not prevent bad accounting policy making, nor will it ensure that ephemeral and illusive quality of neutrality (see also question 14 below). The codificational justification by Gaa (1988) discussed in the chapter (and also in Chapter 6) is quite helpful in defending standard setting by organizations such as the FASB as well as both conceptual framework. Q-14 What is the relationship between public goods and free riders? Is accounting a public good? Free riders are those individuals who capture the benefits of public goods without paying for those benefits. Public goods are goods that are not used up even though individuals have derived benefits from them. Yes, accounting’s financial statements are public goods. Q-15 What is Pareto optimality? Why would adherence to it minimize accounting standard setting? Pareto optimality refers to social situations where the benefit of one group or individual cannot be improved without hurting other groups or individuals. The problem with applying Pareto optimality to accounting standard setting is that each position of standards represents a unique Pareto optimal point. Any new standard or change in standards will adversely affect some individual or groups. This also includes preparers who must pay for the cost of preparing new standards or disclosures. Q-16 How do agency theory and the codificational viewpoint differ in assumptions about the behavior of individuals? Under the agency theory view, individuals act in their own best interest. The problem with this assumption is that it is tautological. The codificational view is more process-oriented than agency theory. While individuals do operate in their own best interest, the standard setting process is a rational process and individuals involved with the regulatory process will more or less try to carry out the assigned tasks of the organization (which may well be in their own best interest). This does not, of course, guarantee optimal standards, but an evolutionary and rational process. Q-17 Why does codification presume a democratic setting? Codification, which is essentially a rational process with a diffusion of power, can only occur in a democratic society. The process is also evolutionary in nature. Codification is inconceivable in societies that are other than democratic. Q-18 The social goals underlying accounting regulation are information symmetry and comparability. Why are these goals complementary? These are complementary because we not only want as much comparability between firms as possible, but we also want all users to have this information. It may well be impossible to maximize comparability without maximizing information symmetry. Q-19 Would a regular quarterly announcement of earnings-per-share which is “good” be an example of signaling? What about early adoption of a new accounting standard that would reduce income? Regular reporting of information such as quarterly announcements of earnings-per-share would not be considered to be signalling. However, early adoption of a standard, particularly one that would lower income such as SFAS No. 106, would be an example of signalling. The firm, in effect, appears to be saying that it is in such good shape that it can afford to take an income "hit" early on. Q-20 If accounting were not regulated, we would not be facing the difficult problems that have arisen as a result of Enron and other corporate auditing failures. Do you agree with this statement? Explain. Absolutely not! Enron arose out of pure greed. Enron, WorldCom, and others arose because individuals tried to “game the system.” The problem would have been as bad – if not worse – if we had no regulation. This is evidenced by the overwhelming vote in favor of SOX passage in 2002. Despite SOX’s continued criticism, major components of this law are being emulated country-by-country. Q-21 Evaluate Ronen’s financial statement insurance proposal. Ronen, Joshua (2002). “Policy Reforms in the Aftermath of Accounting Scandals,” Journal of Accounting and Public Policy 21, no. 3: 281–286. The key point about Ronen’s proposal is that the insurance company selects and pays the auditor. By putting the insurance company between the firm and the auditor, a dangerous moral hazard interface is eliminated. Q-22 Under financial statement insurance why would the relation between the firm and its auditor and investors bear a slight resemblance to the relationship between Saddam Hussein and the weapons inspectors from the United Nations in 2002 and 2003? The auditors’ role would be somewhat similar to the weapons inspectors and the firm would be similar to Iraq or, if you like, Saddam Hussein. The financial statement insurance proposal would certainly make the auditors stronger. The interesting question – which is now history – is whether Hans Blix led a strong or a weak inspection regime. Q-23 What is due process in financial accounting standard-setting? Due process refers to the bringing into the process all of those who are affected by it, standard setting in this case. Obviously this makes the standard-setting process longer and more complex. Q-24 Why do companies, even those with “bad news,” have an incentive to disclose financial reporting information? While “bad news” is no fun, it gets everything into the open. Not announcing would certainly add to the volatility of the security price. Of course one of the problems today is firms trying to get around uncertainly by “cooking the books.” The self preservation instincts of individuals may conflict with the firm’s incentives to disclose. Q-25 Does the ability to swiftly-and at no cost-download music files convert this music from a private good to a public good? Yes. Files can be shared at no cost resulting in an inability by the artist and the public to restrict use of the product to those who actually purchased it. CASES, PROBLEMS, AND WRITING ASSIGNMENTS 1. What is the relationship among agency theory, economic consequences, and signalling? Explain in depth There is a close connection between agency theory and economic consequences. An underlying assumption of agency theory is that the firm is a locus or nexus among competing groups: management tries to maximize its compensation at a cost to shareholders of money that might have gone into dividends, bondholders likewise want to get their interest and principal and not be jeopardized by excessive dividends to shareholders hence debt covenants protecting bondholders as part of the bond indenture, for example. Economic consequences, the idea that accounting standards can benefit some groups at the expense of others would be complementary to agency theory. Signalling appears to be directed primarily toward one group: shareholders and prospective shareholders so it would neither be in agreement or disagreement with agency theory and economic consequences. However, it is seen as complementary to agency theory in terms of being an instrument making accounting regulation unnecessary. Agency theory gives rise to the idea that management can maximize its welfare by keeping relations with shareholders and others on a good basis by means of techniques such as having audits comply with generally accepted accounting principles. In a complementary fashion signalling would help to make regulation unnecessary because it would lead to voluntarily sharing information with shareholders—even if the news is bad—in light of competitive capital markets. 2. Benston (1982, p. 102), in an analysis of corporate social accounting and reporting (CSAR), says: “The social responsibility of accountants can be expressed by their forebearing from social responsibility accounting.” However, in a critique of Benston’s analysis, Schreuder and Ramanathan (1984, p. 414) state: The comments . . . do not purport to convey the message that there is no value at all in analyzing the potential of CSAR from a shareholder perspective and proceeding from the (implicit) assumption of perfect and complete markets. We do, however, wish to point out that this may not be the most appropriate perspective as (1) CSAR is addressed toward a more inclusive group of stakeholders and (2) one of its main objectives is to include in the accounting system those aspects of corporate behavior that are decidedly not handled well by the market. Therefore, the perspective implied in Benston’s analysis is of very limited value at best. Required: CSAR assumes there is a legitimate interest or “stake” in the corporation beyond the stockholders’ interests, and that these other stakeholders’ interests are not well served by traditional financial statements. Therefore, it follows that within a broad political economy of accounting, CSAR is an important policy-making issue. Critically evaluate this proposition and indicate your agreement or disagreement and the underlying reasons for your position. This case is intended to raise serious questions about the “primacy” of the FASB’s primary user group of investors/creditors. Lip service is paid to the existence of other stakeholders, but with a wave of the magic wand their interests are reduced to and equated with investors/creditors. A wider accountability beyond investors and creditors is a distinct possibility and is examined in later chapters. One difference between the United States and other Western countries is the issue of the broadness of the stakeholder group. We contend that the focus could be broadened somewhat from investors and creditors without making the problems of the FASB any worse than they are. Of course, the conceptual framework would need to be broadened from the perspective of investors and creditors to a wider primary user group. The FASB and IASB’s current convergence project (initiated in 2004) on the conceptual framework will likely move toward a more inclusive user group definition. 3. Discuss the economic consequences issues that are present in each of the following transaction situations. SFAS No. 13 allows lease contracts to be set up so that the transaction can usually be set up as an operating lease rather than a capital lease. When SFAS No. 19 was passed, medium-sized petroleum exploration firms campaigned hard to set it aside. SFAS No. 19 would have allowed successful efforts only, whereas the lobbying firms wanted an unrestricted choice between full costing and successful efforts. A securities industry group objected to part of APB Opinion No. 10, which would have required that all convertible debt be broken down into debt and equity portions at the time of issue. The debt portion (bonds payable plus premium or minus discount) would be booked at the effective rate without the conversion privilege with the equity portion credited to paid-in capital. The industry group was pleased by APB Opinion No. 14, which did not break out the equity portion of convertible debt except if detachable stock warrants were issued. Why was the securities industry group (which represented investment bankers who floated large loans for industry) unhappy with Opinion No. 10 and pleased with Opinion No. 14? SFAS No. 87 does not show the full pension obligation or liability in the balance sheet (although a “minimum” liability may be present). SFAS No. 96 made it much more difficult to recognize deferred tax assets as opposed to deferred tax liability (a more even-handed treatment was used in recognizing deferred tax assets and liabilities in SFAS No. 109, which superceded SFAS No. 96). The FASB tried to include the cost of stock options as an expense but they were prevented from doing so by vociferous opposition from the business community, although it now is going to happen under SFAS No. 123R. This allows for a “better” measurement of debt-equity ratios from the perspective of shareholders—less of a problem of violating debt covenants—hence making it easier to pay dividends. Shareholders thus benefit from the ability to more easily receive dividends, which can work to the detriment of the firm’s bondholders. SFAS No. 19 would have lowered the income of firms using full costing. These were generally medium-sized firms. The claim was that the lower income under successful efforts would raise the cost of borrowing to firms that were using full costing. Of course, efficient-market advocates would say that the market should be able to see behind the income difference between the two methods, but the lower debt-equity ratio that would result under successful efforts could indeed more easily threaten violation of debt covenants. This could affect potential dividend payments and could, therefore, raise the cost of capital (see Chapter 8). Of course, this latter effect could also lower the cost of debt capital, since it would be better protected, but that also depends upon players in the market understanding this issue. Use of one method—successful efforts—rather than two methods might also benefit users of financial statements, who would not have the problem of reconciling incomes for different firms using different methods. Use of one method would also improve verifiability. Zeff (1978) discusses this situation. It appears that the crux of the problem under the break-out of debt and equity is that by assigning some of the credit to equity, the resulting lower carrying value of debt would raise the effective rate of interest (as opposed to no break-out of equity) and also lower the level of income by either reducing the premium or increasing the discount (as opposed to no break-out of equity). The securities industry group may therefore have thought that convertible debt raised through their auspices had a higher cost than, in their opinion, it really had. Assume that a ten-year $1,000,000 convertible debt issue is sold at par. Coupon rate is 10%, and $100,000 is assigned to equity (which would now create a $100,000 discount). Straight-line amortization is used. Entries for the first year would be: Cash 1,000,000 Discount on bonds 100,000 Bonds payable 1,000,000 Paid-in capital 100,000 Interest expense 110,000 Cash 100,000 Discount on bonds 10,000 No break-out of equity would leave the interest expense at $100,000. The discount would also lower the carrying cost of the debt which would also raise the effective interest rate. SFAS No. 87 results, in most cases, in keeping debt off the balance sheet which benefits debt- equity ratios which are often used as debt covenants in bond indentures. Hence it favors stockholders over bondholders. SFAS No. 96 would have had a detrimental effect on debt-equity ratios and would likewise have resulted in lower income when deferred tax assets were not recognized. Hence it would have been beneficial for bondholders over stockholders. The lower income which would have resulted in some cases (where deferred tax assets would not have been recognized) might have resulted in lower security prices. This is a now classic example of trying to keep a cost off of the income statement in order to make income higher and cost of capital lower. It also presumably enables start-up companies to avoid spending much larger outlays for managerial compensation. See Chapter 11 for more on stock options. 4. Although a recent study by Barton and Waymire indicates that there are incentives for higher quality financial information under unregulated financial reporting, why is this finding not an effective one in support of unregulated financial reporting? References: Barton, Jan and G. Waymire (2004). “Investor Protection Under Unregulated Financial Reporting,” Journal of Accounting and Economics (December 2004), pp. 65-116. Leftwich, Richard, (2004). “Discussion of: ‘Investor Protection Under Unregulated Financial Reporting’ (by Jan Barton and Gregory Waymire).” Journal of Accounting and Economics (December 2004), pp. 117-128. Barton and Waymire conclude that firms with higher quality financial reporting experienced substantially lower price declines when stock prices dropped in October 1929. With each accounting scandal prompting increased regulation over the last 70+ years, the markets have responded favorably and flourished. It is difficult to convincingly show that the markets would have been even better without the increased regulation. 5. Etzioni (2009) argues that the 2008 financial crisis points towards widespread regulatory capture resulting in special interests benefiting from the capture. Rather than pursue more or less regulation, Etzioni argues for capture-proof regulations. Evaluate Etzioni’s proposals. Etzioni, Amitai (July 2009). “The Capture Theory of Regulations–Revisited,” Society, 319–323. Etzioni suggests that what is needed is a way to make regulations stronger, more capture-proof. “This requires, first of all, greatly restricting the role of private money in public life, mainly through reforming campaign-finance laws. Unless this change is adopted, regulations will continue to be captured on a large scale and will continue to serve special interests rather thanthe public at large.” The student response should include the feasibility of keeping private money out of the democratic process. CRITICAL THINKING AND ANALYSIS 1. Evaluate the costs and benefits of the accounting standard-setting process (versus an unregulated environment). This question spans the entire chapter. Repeating the arguments from the beginning of the chapter should not be sufficient but it is most likely necessary. Balancing the pros and cons is probably important. The social goals of improving comparability and increasing information symmetry are, we believe, extremely important goals which can only be brought about through regulation. Nevertheless, the bottom line will undoubtedly result in a costs versus benefits analysis. Despite the many problems such as democratic paralysis, inability to attain social optimums, making some people and groups worse off, as well as the politics resulting from the standard setting process, we believe that the benefits of standard setting are greater than the costs. There's no question that it is a close call. 2. How might the “capture” of auditors by auditees be mitigated? Capture theory argues that the group being regulated eventually comes to use the regulatory process to promote its own self interest. One approach to responding to the question would address the long-term relationship between the audit firm (auditor) and its client (auditee). Perhaps the relationship with an individual regulatory body (audit firm in this case) could be periodically changed to restart the clock, so to speak. For example, Brazil requires that public companies periodically rotate audit firms, not just audit partners. This limits the ability of time to affect the audit-client relationship, keeping it professional rather than too friendly. What would be the effect of mandated audit firm rotations every 5-10 years in the USA? The idea of the cost-benefit should arise. Sarbanes-Oxley of 2002 (SOX) requires audit partner rotations every five years, not audit firm rotations; will this mitigate the capture? Another approach would be to view the question from a financial influence perspective. SOX took the approach that restricting consulting activities by the audit firm issuing the audit opinion would mitigate the capture of auditors by auditees. This removes the non-audit related fees from the process of issuing an audit opinion. This move towards greater independence of the auditor (real and perceived) could also be achieved by assigning the audit responsibilities to the public sector. Also, consider that if a single client represents a significant percentage of the audit firm’s revenues, the potential loss of a client due to an unfavorable audit opinion. A good class discussion might result if you approach the question from increasing the integrity of individual accountants. If we in the accounting profession are persons of unquestionable integrity, would we ever be “captured” by an auditee? Is this a realistic approach? If so, ask how the educational system might be used to produce accounting professionals with more integrity. 3. Ball (2009) evokes the question of responsibility for the rash of accounting scandals in the 2000s. What actions do you propose to address the problem, if you agree that one exists? Ball, Ray (May 2009). “Market and Political/Regulatory Perspectives on the Recent Accounting Standards,” Journal of Accounting Research, 277–323. This is a thought provoking question. Ball views responsibility for recent accounting scandals from multiple perspectives, arguing for and against specific views. This should be a good classroom discussion after students have thoroughly read the article. Solution Manual for Accounting Theory: Conceptual Issues in a Political and Economic Environment Harry I. Wolk, James L. Dodd, John J. Rozycki 9781483375021, 9781412991698