Accounting theory 8


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Accounting theory 8

  1. 1. An overview of normative theories of accounting From Deegan, C. and Samkin, G., Financial Accounting. McGraw-Hill Irwin, New York & Kam, V. (1990), Accounting Theory, 2 nd edition, John Wiley & Sons, NY. Prepared By: Dewan Mahboob Hossain Assistant Professor; Department of Accounting & Information Systems; University of Dhaka; Dhaka; Bangladesh.
  2. 2. Conventional Accounting: Basic Concepts <ul><li>Conventional objectives of accounting: </li></ul><ul><li>With the growth of corporations, accounting information has taken greater significance. </li></ul><ul><li>Why? Separation of ownership and managers. </li></ul><ul><li>Absentee owners do not possess first hand knowledge of operations and conditions of the firm, and therefore, must depend heavily on accounting reports for information. </li></ul><ul><li>Also owners and creditors supply the funds to the business entities, they are considered ‘outsiders’ and have no access to the records and accounts of the entity. </li></ul><ul><li>Accountability, therefore, is crucial. </li></ul><ul><li>So, conventional accounting objective: focus on the stewardship function of managers. </li></ul>
  3. 3. Objectives of accounting <ul><li>Paton and Littleton (1940): </li></ul><ul><li>“ Corporation reports should rest upon the assumption that a fiduciary management is reporting to the absentee investors who have no independent means of learning how their representatives are discharging responsibilities”. </li></ul>
  4. 4. Normative accounting theories <ul><li>Accounting theories that seek to guide individuals in selecting the most appropriate accounting policies for given sets of circumstances. </li></ul><ul><li>Conceptual framework- example of normative theory. </li></ul>
  5. 5. Normative theories <ul><li>Normative theories are sometimes referred to as prescriptive theories as they seek to inform others about what practices should be followed to achieve particular outcomes. </li></ul><ul><li>For example, a normative accounting theory might prescribe how assets should be valued for financial statement purposes. </li></ul><ul><li>The prescriptions about what should be done might represent significant departure from current accounting practice. </li></ul><ul><li>For example, for many years, Raymond chambers promoted a theory prescribing that assets should be valued at market value – at a time when entities were predominantly using historical cost. </li></ul>
  6. 6. Normative accounting theories <ul><li>Dominant normative theories: </li></ul><ul><li>Historical Cost accounting </li></ul><ul><li>Current cost accounting; </li></ul><ul><li>Exit-price accounting; and </li></ul><ul><li>Deprival-value accounting. </li></ul>
  7. 7. Historical cost accounting: Why important? <ul><li>Historical cost is relevant in decision making. Cost to management is an investment, a calculated risk. So it should be the basis of judging. As managers make decisions concerning future commitments, they need data on past transactions. </li></ul><ul><li>Under historical cost accounting, a recording of the actual transactions is made and therefore, there is a supporting record of the figures of the financial statements. </li></ul>
  8. 8. Historical cost accounting: Why important? (contd….) <ul><li>3. Throughout history, F/S based on historical cost have been found to be useful. If those who make management and investment decisions had not found financial reports based on historical cost useful over the years, changes in accounting would long since have been made. </li></ul>
  9. 9. Historical cost accounting: Why important? (contd….) <ul><li>4. Accountants must guard the integrity of their data against internal modifications. Historical cost is less subject to manipulation. </li></ul><ul><li>5. The best understood concept of profit is the excess of selling price over historical cost. People understand this basic notion of business success. Historical cost is based on this idea of profit. </li></ul>
  10. 10. Historical cost accounting: Why important? (contd….) <ul><li>6. Changes in the market prices can be disclosed as supplementary data. Supplementary data on current prices are a practical and sufficient way of reporting. So, no need to change from historical cost accounting. </li></ul>
  11. 11. Historical cost accounting: limitations <ul><li>The role of accounting is to meet the needs of the users. The needs of users call for a forward looking position rather than a preoccupation with the past. Investors are also interested in knowing about the increases and decreases in the value of their investments as represented by the net assets of the company. </li></ul><ul><li>Historical cost overstates income in a time of rising prices and could lead to the unwitting reduction of capital. </li></ul>
  12. 12. Historical cost accounting: limitations <ul><li>3. One of the justifications for the utilization of historical cost is the going concern assumption. The high rate of business failures would make it difficult to build and evidential case for a projection of continuity. No business has ever continued ‘indefinitely’. Thus, it would more reasonable to assume cessation instead of continuity. </li></ul>
  13. 13. Current cost accounting <ul><li>A system of accounting that measures the value of their goods and services in terms of their current costs. </li></ul><ul><li>The general aim of this theory is to provide a calculation of income, that, after adjusting for changing prices, could be withdrawn from the entity while leaving the physical capital of the entity intact. </li></ul><ul><li>Such measures of income are often promoted as true measures of income. </li></ul>
  14. 14. Current cost accounting illustrated <ul><li>Suppose a company started the period with assets of $50,000. </li></ul><ul><li>Assume that there are no liabilities, so that equity also equals $50,000. </li></ul><ul><li>During the period, the business sells all of its assets for $70,000. </li></ul><ul><li>Under historical cost accounting the profit would be $20,000 and the closing equity would be $70,000, which would be matched by assets of $70,000 in the form of cash. </li></ul>
  15. 15. Current cost accounting illustrated <ul><li>If the $20,000 was withdrawn in the form of dividends, under historical cost accounting the owner’s equity in the business would remain the same as it was at the beginning of the period. </li></ul>
  16. 16. Current cost accounting illustrated <ul><li>If current cost accounting were adopted, the profit would not necessarily the same. </li></ul><ul><li>If because of rising prices, it cost $60,000 to replace the assets that were sold, under current cost accounting, the profit would be $10,000. </li></ul><ul><li>This is because $60,000 would need to be retained to keep the physical capital of the firm intact. </li></ul>
  17. 17. Current cost accounting illustrated <ul><li>The maintenance of the firm’s physical capital or the operating capacity is the central goal of current cost accounting. </li></ul><ul><li>Proponents of this normative theory argue that by valuing assets at their current cost a truer measure of profit is provided than is reflected by historical cost accounting. </li></ul>
  18. 18. Current cost accounting illustrated <ul><li>A criticism of current cost accounting is that it introduces an unacceptable amount of subjectivity into accounting process as some assets will not have a readily accessible current cost. </li></ul>
  19. 19. Exit price accounting <ul><li>Proposed by Australian researcher Raymond Chambers. </li></ul><ul><li>He labeled this theory as Continuously Contemporary Accounting (CoCoA). </li></ul><ul><li>This theory was principally developed between 1955 and 1965. </li></ul><ul><li>CoCoA: Normative theory that proposes an approach to accounting that relies on measuring the exit prices of the entity’s assets and liabilities. </li></ul>
  20. 20. Exit price accounting (contd..) <ul><li>This is a normative theory of accounting that prescribes that assets should be valued on the basis of exit prices and that financial statements should function to inform about organization’s capacity to adapt . </li></ul>
  21. 21. Exit price accounting (contd..) <ul><li>Key assumptions of CoCoA: </li></ul><ul><li>Firms exist to increase the wealth of their owners; </li></ul><ul><li>Successful operations depend on the organization’s ability to adapt to changing circumstances. </li></ul><ul><li>The capacity to adapt will be best reflected by the monetary value of the assets, liabilities and equities at balance date where the monetary value is based on the current exit or selling prices of the organization’s resources. </li></ul>
  22. 22. Capacity to adapt <ul><li>A measure, promoted by Chambers, tied to the cash that could be obtained if an entity sold its assets. </li></ul><ul><li>A central objective of accounting should be to provide information about an entity’s ability to adapt to changing circumstances - the capacity to adapt. </li></ul>
  23. 23. Exit price accounting (contd..) <ul><li>Chamber’s theory advocated that an entity’s balance sheet should base the value of all assets on their respective selling prices. </li></ul><ul><li>If an asset was not readily saleable (and therefore did not have a selling price), it did not contribute to an entity’s capacity to adapt to changing circumstances. </li></ul><ul><li>Further, the profit for a period should also be tied to changes in the current exit prices of the organization’s assets, and such as, profit as a measure should reflect changes in an organizations’ capacity to adapt. </li></ul>
  24. 24. Exit price accounting (contd..) <ul><li>CoCoA is often referred to as a ‘decision usefulness approach’ to accounting theory development. </li></ul><ul><li>According to CoCoA, organizations that cannot adapt are considered relatively more likely to fail. </li></ul><ul><li>The more liquid or saleable an organization’s assets, the greater was the perceived capacity to adapt. </li></ul>
  25. 25. Exit price accounting (contd..) <ul><li>Chamber recommended that all assets should be recorded at their current cash equivalent. </li></ul><ul><li>Current cash equivalents were represented by the amounts that would be expected to be generated by selling the assets. </li></ul><ul><li>The balance sheet should clearly reflect the expected net selling prices of all the entity’s assets – net selling prices would acknowledge any costs that would be incurred in making a sale. </li></ul>
  26. 26. Exit price accounting (contd..) <ul><li>Adaptive capital would be represented by the total net selling prices of the various assets, less the amount of liabilities. </li></ul><ul><li>Profit would reflect the change in the organization’s capacity to adapt that had occurred since the beginning of the period. </li></ul><ul><li>Because the valuation of assets will be done according to their current cash equivalents, depreciation expense would not be reflected in CoCoA. </li></ul>
  27. 27. Criticism of exit price accounting <ul><li>It does not consider the ‘value in use’ of assets. If an asset is retained, rather than sold, its value in use is likely to be greater than it current exit price. </li></ul><ul><li>In valuing assets at their perceived sales values, there is an implication that the firm intends to liquidate its assets. </li></ul>
  28. 28. Deprival-value accounting <ul><li>Recommended by the UK Sandilands committee in 1975. </li></ul><ul><li>It represents the amount of loss that might be incurred by an entity if it was deprived of the use of an asset and the associated economic benefits the asset generates. </li></ul>
  29. 29. Deprival-value accounting <ul><li>Criticisms: </li></ul><ul><li>Different valuation bases in one set of F/S </li></ul><ul><li>Valuation procedure would be costly and time consuming </li></ul><ul><li>It might not clear that which method will be used for which assets. </li></ul>