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Lecture 7 Making Financial Reporting Decisions Critique of Positive Accounting Theories


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Title: Lecture 7 Making Financial Reporting Decisions Critique of Positive Accounting Theories

Lecture 7 Making Financial Reporting Decisions
Critique of Positive Accounting Theories
Making Financial Reporting Decisions
  • Modules 3, 4 5 deal with theoretical frameworks
    related to making financial reporting decisions

How do I make financial reporting decisions?
Lecture Overview
  • Review of Modules 3 4
  • Positive Accounting Theory (PAT)
  • Legitimacy Theory
  • Stakeholder Theory
  • Module 5
  • Criticisms of positive accounting theories (5.1 -
  • Usefulness of theories and research results (5.4)
  • Intro to Modules 6 7
  • Two ways to evaluate the impacts of financial
    reporting decisions

Review - positive accounting theory (PAT)
  • Major focus is on stewardship role of accounting
  • Looks at reasons underlying financial reporting
  • Emphasis on relationship between financial
    reporting decisions and contracts, particularly
    management compensation contracts and loan
    agreements (debt contracts)
  • Based on agency theory

Review - Agency Theory
  • Conflicts of interest give rise to agency costs
  • Contracts are used to reduce these conflicts of
    interest (bonding) - contract terms sometimes
    rely on accounting information
  • Firms prepare audited accounting reports to
    facilitate monitoring of these contracts
    (stewardship role of accounting)

Review - Implications for financial reporting
  • Because contracts are used to bond the agent to
    the principal, and financial statement
    information is often used to monitor the agents
    compliance with these contracts
  • Agents have incentives to present the financial
    statements in a way that ensures the best outcome
    under the contracts
  • Therefore, contracts need to be considered when
    making financial reporting decisions

Review Legitimacy Theory
  • Organisations seek to ensure they operate within
    the bounds and norms of their respective
  • relies upon the notion of a social contract
  • Represents the implicit and explicit expectations
    that society has about how the organisation
    should conduct its operations

Review Legitimacy Theory
  • Legitimacy Theory proposes a relationship between
    corporate disclosure and community expectations
  • Consider implications of not meeting social
    contract when making financial reporting
  • may lead to sanctions such as legal restrictions
    on operations, limited resources provided, or
    reduced demand for products

Review Legitimacy Theory
  • Disclosures form part of the portfolio of
    strategies undertaken to bring legitimacy to or
    maintain legitimacy of the organisation
  • Increase in environmental disclosures
  • Over time
  • Following social incidents or environmental
  • Disclosures mostly positive

Review Stakeholder Theory
  • Definition of stakeholders is very broad
  • Two branches of Stakeholder Theory
  • ethical (moral) or normative branch
  • Management should be accountable to all
  • positive (managerial) branch
  • Attempts to explain when corporate management
    will be likely to attend to the expectations of
    particular (powerful) stakeholders

Review Stakeholder Theory
  • positive (managerial) branch
  • stakeholder power is a function of the
    stakeholders degree of control over resources
    required by the organisation
  • Information, including financial accounting and
    social performance information, is a major
    element employed to manage stakeholders

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

What is a critique?
  • A critical essay or analysis
  • Critical thinking involves questioning everything
    that you hear or read
  • The critiquing of claims can alter our ways of
    understanding the world
  • Both strengths and weaknesses are considered

Importance of critiquing in relation to studying
this unit
  • All theories and related research have
  • Sometimes related to underlying assumptions
  • These should be understood and kept in mind when
    using them to guide financial reporting decisions
  • More informed (better) decision making will be
    the result

Criticisms of PAT
Assumptions Underlying PAT
  • Everything can be explained in terms of utility
    maximisation (self-interest)
  • Promotes a morally bankrupt view of the world
    (Gray, Owen and Adams, 1996)
  • Utility maximisation does not necessarily relate
    to wealth maximisation (ignores some costs such
    as social costs)
  • However, wealth maximisation appears to be a
    reasonable assumption when explaining corporate

Failure of PAT
  • Positive accounting theory does not provide
    prescriptions for how we should account
  • How to account is an important issue for
    practicing accountants and accounting regulators
  • However, we know that standard setting is a
    political /social process rather than a matter of
    deriving a set of ideals
  • And

While Positive Accounting Theory doesnt tell us
how we should account, it does tell us what
economic factors to consider when making
financial reporting decisions.
Other Criticisms of PAT
  • Slow / limited development
  • Not value free
  • Scientifically flawed hypotheses frequently not
  • Results apply on average

Criticisms of Legitimacy and Stakeholder Theories
  • Limited application to many financial reporting
  • Eg. Expense vs. capitalise, accounting method
    choices, disclosure vs. recognition
  • Usefulness relates mainly to unaudited
  • Not value free
  • Pursuit of profits is the only moral obligation
    of business (Den Uyl, 1984)

Criticisms of Legitimacy and Stakeholder Theories
  • Legitimacy theory too broad, why is it important
    to be legitimate?
  • Empirical tests often involve counting the number
    of pictures and words (lacks statistical rigour
    compared to PAT)
  • PAT remains as the dominant paradigm in relation
    to financial reporting

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

In support of positive accounting theories
  • Positive accounting theories provide some useful
    explanations and predictions for accounting and
    disclosure practice
  • Empirical support for the predicted hypotheses
    gives credibility to the theories
  • Growing body of evidence to support theories
  • Theories are simplifications of reality, and all
    suffer limitations
  • These theories are the best that weve got!

Using positive accounting theories in practice
  • Before applying positive accounting theories in
    practice, you should be aware of their
  • Remember, the theories are based on assumptions
    and these may not hold in reality
  • Also, before relying on particular research
    results, the validity of the results must be
    assessed (critique them)

Strengths of positive accounting theories
  • Provide a useful framework for making financial
    reporting decisions
  • Helps to predict the effects of changes to
    accounting regulation
  • Useful in relation to the future development of
    accounting regulations
  • Indicates the factors to consider when making
    financial reporting decisions

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

The usefulness of normative accounting theories
  • Examples are the ethical branch of stakeholder
    theory and the Conceptual Framework
  • Provide an ideal to work towards
  • A starting point for standard setters
  • However we should not expect final accounting
    standards to fully reflect these ideals due to
    the process being political

Introduction to Modules 6 7
  • Impacts of Financial Reporting Decisions

The Impacts of Financial Reporting Decisions
  • Modules 6 7 deal with research into the impacts
    of financial reporting decisions

How do my financial reporting decisions impact
on the decisions of financial statement users?
Financial Reporting Decisions
Regulated Financial Reporting Decisions
Unregulated Financial Reporting Decisions
Making Financial Reporting Decisions
The Impact of Financial Reporting Decisions
You are here
Social Determinants Of Financial Reporting
Contracting Determinants of Financial Reporting
Share prices
Critique of PAT
Impacts of Financial Reporting Decisions
  • There are two ways to assess the impacts of
    financial reporting decisions
  • Determine what impact the release of information
    had on share price? (capital markets research)
  • Determine the impact of the information on the
    decisions of individual information users
    (behavioural research)

Comparison of Behavioural and Capital Markets
  • Both examine the impact of financial reporting
    decision on users of the info.
  • Capital markets research assesses the aggregate
    effect, while behavioural research assesses the
    effect on individuals
  • Capital markets research includes only investors,
    while behavioural research examines other types
    of financial statement users
  • Capital markets research assesses WHETHER the
    information is used, while behavioural research
    can asses HOW the information is used

For Tutorials
  • Required reading
  • Text chapter 7, pp. 235 239
  • Text chapter 10, pp. 358 - 359
  • Self assessment questions
  • Questions 1 - 5 from module 5
  • Question 1 from module 6
  • Answers in tutorials
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