FAR661 Topic 1 Accounting Theory PDF

WELCOME TO FAR661 Accounting: Theory and Emerging Issues SMA_UITM_PA_FAR661  TOPIC 1 Introduction to the Accounting Environment Part 1 HISTORY OF ACCOUNTING THEORY  What is an accounting The Committee on Terminology of the American Insti...

WELCOME TO FAR661 Accounting: Theory and Emerging Issues SMA_UITM_PA_FAR661  TOPIC 1 Introduction to the Accounting Environment Part 1 HISTORY OF ACCOUNTING THEORY  What is an accounting The Committee on Terminology of the American Institute of Certified Public Accountants defined accounting as “the art of recording, classifying, and summarizing in a significant manner and in terms of money, transactions and event which are in part at least, of a financial character and interpreting the results of thereof” SMA_UITM_PA_FAR661 Role of accounting Accounting as Communication - a historical record decision information a language an economic good Intra-corporate politics a social commodity standards setting as ideology and politics exploitation Mythology Magic SMA_UITM_PA_FAR661  Accounting as a historical record Provides a history of the managers’ stewardship of the owners’ resources. Measurement of the stewardship concept has evolved over time, in the following periods; 1. Pure custodial period 2. Traditional custodial period 3. Asset-utilisation period (initiative in using the assets) The first 2 periods – “ do as instructed “ – the direction of how assets should be used is determined by the owners. Period 3: Managers/ agent to use and provide initiative and insights on how the assets should be used- to meet the objective of -> to maximize the value of the assets, thus the value of the owners SMA_UITM_PA_FAR661 Accounting as a Language Accounting is perceived as the language of business. To Hawes (1972), as a language, accounting has two components 1. Symbols – numerals and words and debits and credits are example of symbols unique to accounting. 2. Grammatical rules – it refers to the general set of procedures used to create financial data. ▪ Translate economic events and transactions into words and numbers that can be communicated and understood by users of accounting reports ▪ Convey its financial performance, utilization of resources provided by various parties and also details of past transactions that had been entered into SMA_UITM_PA_FAR661 Accounting as a intra-corporate Politics reflects & supports the values and needs of special interest group. information is formed and used as a resource in shaping company policies. used in decision making, as a way of enhancing and furthering the aim of management. example - use accounting report to convince the management to increase resource allocation to it at the expense of other departments that appear less efficient. SMA_UITM_PA_FAR661  Accounting Standard Setting as Politics/ Political Process ▪ Accounting standards are products of a political process rather than of an outcome of technical efficiency. ▪ Often lobby for accounting standards to serve their own interest and select accounting techniques that maximize their own utility. ▪ Example - managers support standards that lower taxes, reduce political and bookkeeping costs and increase management compensation SMA_UITM_PA_FAR661 Accounting as a Mythology Accounting system supports the concept of “professionalism” - used to justify, rationalise and legitimise decisions that are made. Accounting reports are prepared to suit the needs of users and this in turn, will impact the decision making behaviour of managers and investors. SMA_UITM_PA_FAR661 Accounting as a Magic ▪ Viewed as a method of deceiving the users of reports. ▪ As stated by Godfrey, Hodgson and Holmes (2003),....an accountant can perform sleight-of- hand accounting tricks which can be compared to magician’s tricks. ▪ Able to make the financial statements appear to be something they are not. ▪ Example - Enron used accounting techniques to disguise its loss-making investments. SMA_UITM_PA_FAR661 Accounting as Economic Goods ▪ Part of a wider information set which includes macroeconomic, political, taxation and other specific information that affects the performance of the firm. ▪ As costs are involved in producing accounting information, managers will often lobby for accounting standards that minimise information costs. ▪ Shareholders and creditors will lobby for accounting rules that enhance their ability or right to control and monitor the conducts of the management. SMA_UITM_PA_FAR661 Accounting as a Social Commodity viewed as commodity resulted from economic activity. accounting exists because specialized information is in demand and accountants are willing and capable of producing it. choice of accounting information may have an impact on the welfare of various group in society. there is a market for accounting information with its derived demand and supply. SMA_UITM_PA_FAR661 Accounting as an Ideology & Exploitation perceived as an ideological (as a means of sustaining and legitimizing the current social, economic and political arrangements perceived as a myth, symbol and ritual that permits the creation of a symbolic order within which social agents interact an instruments of economic rationality and as a tool of a capitalistic system SMA_UITM_PA_FAR661 Overview of Accounting Theory What is a theory? Hendriksen’s definition: …the coherent set of hypothetical, conceptual and pragmatic principles forming the general framework of reference for a field of inquiry. SMA_UITM_PA_FAR661 Overview of Accounting Theory What is an accounting theory? Hendriksen’s definition: …logical reasoning in the form of a set of broad principles that provide a general framework of reference by which accounting practice can be evaluated and guide the development of new practices and procedures. SMA_UITM_PA_FAR661 Overview of Accounting Theory was developed to resolve problems as they arose – reactive ad hoc approach led to inconsistencies in practice e.g. different depreciation methods accounting standard setting conceptual framework projects have not resolved inconsistency in practice SMA_UITM_PA_FAR661 Overview of Accounting Theory Accounting theory is a modern concept compared to mathematics or physics Even Pacioli’s treatise on double-entry accounting focused on documenting practice and did not explain the underlying theoretical basis for it The development of accounting theory has been mostly unstructured. Chambers: Accounting has frequently been described as a body of practices which have been developed in response to practical needs rather than by deliberate and systematic thinking SMA_UITM_PA_FAR661 Overview of Accounting Theory whether a theory is accepted depends on how: well it explains and predicts reality well it is constructed both theoretically and empirically acceptable its implications are SMA_UITM_PA_FAR661 SMA_UITM_PA_FAR661 Development in Accounting Theory SMA_UITM_PA_FAR661 SMA_UITM_PA_FAR661 SMA_UITM_PA_FAR661 …….Who is Luca Pacioli? Pacioli is often associated with the introduction of double-entry bookkeeping. In 1494 he published the book Summa de Arithmetica, Geometria, Proportioni et Proportionalita. His work described double-entry bookkeeping and reflected the trading practices of Venice, known as ‘the Method of Venice’ or ‘the Italian method’. He did not invent double-entry bookkeeping but rather made a record of what was happening in Italy at the time. His books were translated into several languages and so the Italian Method spread throughout Europe. SMA_UITM_PA_FAR661 What did Luca Pacioli write? The terms Debit (adebeo) and Credit (credito) were used. He explained that three books are used in the ‘Italian method’: a memorandum, a journal and a ledger. He said, ‘All entries … have to be double entries, that is, if you make one creditor, you must make someone debtor’. He advised the computation of periodic profits and the closing of the books. ‘It is always good to close the books each year, especially if you are in a partnership with others. Frequent accounting makes for long friendship’. SMA_UITM_PA_FAR661 Evolution of double-entry bookkeeping Pacioli’s treatise (1494) Double-entry accounting Documenting process but not explaining basis for recording Mashayeki (2008) Accounting records found 3600 years ago (Achaemenid era) shows records of payments, receipts of allotments, trade exchanges. Tax collections and expenditure. “Balance Sheets” Post-Islamic era (circa 1400 years ago) Siagh accounting (similar to sub-ledgers) evolved to “Five Books” which were used for book-keeping of main groups of accounts in the Ghajar era. SMA_UITM_PA_FAR661 Evolution of double-entry bookkeeping Double-entry bookkeeping is at the centre of modern accounting and it was in Italy in the fourteenth century that it was first introduced. At this time, Italy was an epicentre for trade and it was the merchants who introduced a system of classification which rested on the principle of dual entries for all transactions. By the fifteenth century they had begun to use accounting as a tool of management control. SMA_UITM_PA_FAR661  Evolution of double-entry bookkeeping The ‘Italian method’ spread throughout Europe in the sixteenth and seventeenth centuries. 16th Century The introduction of specific journals. The practice of periodic financial statement. 17th Century Continuing development of the practice of periodic financial statement. The use of separate inventory accounts for different types of goods. Growth of the corporation and the Industrial Revolution and, as a result, accounting acquires a better status. SMA_UITM_PA_FAR661 Evolution of double-entry bookkeeping 18th Century Three methods of treating fixed assets: Asset is carried forward at original cost. Asset account is closed at balancing date and carried forward as the account balance. Asset is revalued, upwards or downwards. 19th Century Depreciating property was accounted. Cost accounting emerged. Techniques of accounting for prepayments and accruals. Development of funds’ statements. SMA_UITM_PA_FAR661 Evolution of double-entry bookkeeping The 20th century saw the development of accounting methods for complex issues. th 20 Century Computation of earnings per share. Accounting for business combinations Accounting for inflation. Accounting for long-term leases. Accounting for pensions. Accounting for new products of financial engineering. SMA_UITM_PA_FAR661 Two Kinds of Double Entry Classification Causal Is aimed at maintaining the Describe the cause and effect fundamental accounting equation that relationship between increment and summaries the classification position decrement Debit portrays a classification and credit The value of increment offset by an portrays another classification equal value of decrement Example Example Dr Machine (Assets) Dr Machine 20,000 Cr Account Payable (Liabilities) Cr Account Payable 20,000 (New assets acquired and new liabilities (Increase in debit of RM 20k offset by incurred) decrease of equal amount in credit side) SMA_UITM_PA_FAR661  TOPIC 1 Introduction to the Accounting Environment Part 2 The Financial Reporting Environment -Malaysia -overview of development in accounting concepts and principles SMA/UITM/PA 1 Malaysia’s Perspective SMA/UITM/PA 2 Financial Reporting Environment Regulators/ Legislative bodies and Enforcement Authorities Purpose Reducing information disparity Protecting public interest Concerns Standards setting Corporations/ Preparers Monitoring and Enforcement of Financial Statements (Through Companies Act Purpose and through its prescribed Public and Investor relations schedules. Compliance with (communicating Financial and stock exchange authorities operating performance) etc) Concern Maintenance Legal risks Confidentiality Users/ Capital Markets Purpose Decision Making Concerns Relevance and Reliability SMA/UITM/PA 3  4 SMA/UITM/PA Accounting Development in Malaysia Prior to 1957 – Companies Ordinance (and amendments) of 1940, 1946, 1956. 1958 – Malaysian Association of Certifies Public Accountants (MACPA) was formed. 1965 – Establishment of Companies Act, 1965. Companies ordinance were then repealed. Contain Ninth Schedule (disclosure requirements). 1967 – The Malaysian Institute of Accountants (MIA) was established under the Accountant Act, 1968 – MACPA issued first accounting guidance SMA/UITM/PA 5 Accounting Development in Malaysia 1968 – MACPA issued first accounting guidance which dealt with specimen company accounts. 1978 – MACPA was admitted as a member of International Accounting Standards Committee (IASC) and began adopting IAS. 1984 – MACPA issued the first Malaysian Accounting Standard. 1985 – Companies Act 1965 was amended. New Ninth Schedule with more comprehensive disclosure requirements that includes the preparation of statement of source and application of funds SMA/UITM/PA 6 Accounting Development in Malaysia 1987 – Operation of MIA were activated. MIA began issuing accounting standards. 1993 – Securities Commission was established. Public listed companies are required to show full disclosure requirements as required by SC’s. 1997 – Financial Reporting Foundation (FRF) and Malaysian Accounting Standard Board (MASB) was established under the Financial Reporting Act, 1997 SMA/UITM/PA 7  Development of accounting concepts and principles The development of accounting practices over the 20th century have been identified by theorists: 1. Management contribution phase. 2. Institution contribution phase. 3. Professional contribution phase. 4. Overt politicization phase. SMA_UITM_PA_FAR661  …(A):Management contribution phase (1900-33) Arose from the increasing number of shareholders and the dominant economic roles played by industrial corporation after 1900 The diffusion of share ownership led to more pronounced separation of ownership (the shareholders) from the control(managers) of the organization. Impact; gave management more or less complete control over the format or contents of accounting disclosure. SMA_UITM_PA_FAR661..Management contribution phase (1900-33) There are five consequences of the dependence on management initiative: 1. Practices lacked theoretical support. 2. The focus was on the determination of taxable income and minimization of income taxes. 3. There was a desire to smooth earnings. 4. They avoided complex problems, and adopted expedient solutions. 5. There was no consistency as different firms adopted different accounting techniques for the same problem. SMA_UITM_PA_FAR661  …….Management contribution phase (1900-33) Some of the Issues arose/ debate 1. Improvement in standards of financial reporting 2. Protection of investors 3. Agree to publish annual financial statements 4. Question of accounting for interest cost 5. Calculation of taxable income on the basis of cash receipts and disbursements SMA_UITM_PA_FAR661 …(B): Institution contribution phase (1933-46) The creation and increasing role of institutions in the development of accounting principles In the United States, the developments included; 1. the creation of the Securities and Exchange Commission (SEC) in 1934 2. the approval by the American Institute of Accountants (AIA) of ‘six rules or principles’ 3. the new role of the Committee on Accounting Procedures. (Refer page 6&7 text book) SMA_UITM_PA_FAR661 …(C):Professional contribution phase (1959-73) Discontent with the Committee on Accounting Procedure (CAP) was expressed by the president of the AICPA. “ how successful we have been in narrowing areas of difference and inconsistency in the preparation and presentation of financial information” A Special Committee on Research Program was set up and proposed the dissolution of the CAP and its research department. The AICPA accepted the recommendations of the Committee and established the Accounting Principles Board (APB) and the Accounting Research Division. - Criticized and dissatisfaction ? SMA_UITM_PA_FAR661  D:Overt politicization phase (1973-present) Adoption of a more deductive approach (Normative theory) as well as an ever-increasing politicization of the standard-setting process. Generally accepted view: accounting numbers affect economic behavior and, consequently, accounting rules should be established in the political arena. The FASB’s and IASB’s conduct is to develop a theoretical framework and the general acceptance of new standards. SMA_UITM_PA_FAR661 …(D): Overt politicization phase (1973-present) The process of formulating accounting standards is becoming political; for instance: The US Senate Subcommittee released a report entitled The Accounting Establishment. Known as the Metcalf Report, it charged that the United States’ ‘big eight’ accounting firms monopolies the auditing of large corporations and control the standard-setting process. The passing of the Sarbanes-Oxley Act in 2002, also known as the Public Company Accounting Reform and Investor Protection Act of 2002, Sarbox or SOX. SMA_UITM_PA_FAR661  Academic and professional developments in accounting theory have tended to take different approaches Academic research focuses on capital markets, agency theory and behavioural aspects The profession has sought a more normative approach – what accounting practices should be adopted SMA_UITM_PA_FAR661  Conceptual framework – resurrected in 1980s states the nature and purpose of financial reporting Establishes criteria for deciding between alternative accounting practices SACs 1–4 SMA_UITM_PA_FAR661  Conceptual framework – Recent Developments Joint project between IASB & FASB International harmonisation of accounting practices through a single consistent set of international financial reporting standards (IFRS) SMA_UITM_PA_FAR661  The conceptual framework underpinning the IFRS favours a move toward accounting practices that provide information for enhancing decision making by investors and others recognising all gains and losses in the accounting periods in which they occur measurement using exit values SMA_UITM_PA_FAR661  The importance of accounting history (USE OF PPP) Pedagogy – to a better understanding and appreciation of the field of accounting and its evolution as a social science. (Instructional theory) Policy – instrumental to a better understanding of the accounting problems and the institutional contexts as well as the formulation of public policy (e.g tax accounting & policy) Practice – provide a better assessment of existing practices by comparing with the methods used in the past. SMA_UITM_PA_FAR661  Relevance of accounting history Accounting has a history which is usually discussed in terms of one seminal event, the invention and dissemination of the double-entry bookkeeping processes. The historical evolution of accounting provides clues and explanations of double-entry bookkeeping and the development of modern accounting. The history of accounting allows us to relate the past to what is practiced and to what ought to be practiced. It helps us to make a link between the historical state and both positive and normative states. The link supports the view within the full context of social, political, economic and temporal environments. SMA_UITM_PA_FAR661 Limitations of Accounting History Historical inquiry could either be narrative or interpretative and is conditional and not definitive – It may be incomplete. History may not reveal cause of an event as a certainty but can indicate probable factors affecting the event. Historians ‘explanation and causal analysis’ begin with searches for patterns of development – Attempts to proceed from determination (what happened) to a contingency (how it happened) basis – judgmental process constrained by time SMA_UITM_PA_FAR661 THE END SMA_UITM_PA_FAR661