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TOPIC 1 : Introduction and Financial Regulatory (EVOLUTION OF DOUBLE-ENTRY BOOKKEEPING) ©NIRMALA (UITM SEGAMAT)...

TOPIC 1 : Introduction and Financial Regulatory (EVOLUTION OF DOUBLE-ENTRY BOOKKEEPING) ©NIRMALA (UITM SEGAMAT) EARLY HISTORY OF ACCOUNTING LUCA PACIOLI’S CONTRIBUTION (1445-1510) The history of accounting or accountancy is thousands of years old and can be traced to ancient civilizations = The use of Clay token. He is a mathematician introduced a double-entry bookkeeping and in 1494 (13th century) Post-Islamic era (circa 1400 years ago) Siagh accounting (similar to sub-ledgers) Many attempts have been done to locate the origin of double-entry bookkeeping. Some form of bookkeeping can be traced as far back as he published his book ‘Summa de Arithmetica Geometrica, Proportioni et Proportionalita’ published in evolved to “Five Books” which were used for book-keeping of main groups of to 3000BC. Venice (Everything about Arithmetic, Geometry and Proportion). accounts in the Ghajar era Accounting has its roots in the earliest history of civilization. Around 7,500 B.C., Mesopotamians began using clay token to represent The book was written based on his study on the common practices of merchants in Venice, Florence and Double-entry bookkeeping is at the centre of modern accounting and it was in Italy in goods, such as animals, tools, food items, or unit of grain. Milan (13th century) the fourteenth century that it was first introduced. Documents from ancient Mesopotamia show lists of expenditures, and goods received and traded. The development of accounting, With this early double entry bookkeeping system, merchants were able to maintain records to improve the At this time, Italy was an epicentre for trade and it was the merchants who introduced along with that of money and numbers, may be related to the taxation and trading activities of temples. efficiency of their business. a system of classification which rested on the principle of dual entries for all He describe the practices of double entry system that is debit and credit which is being used by the Italians. transactions. The emergence of complex business trade and agriculture was evident in many early civilizations which included: The terms Debit (adebeo) and Credit (credito) were used. By the fifteenth century they had begun to use accounting as a tool of management the Roman civilization (200BCE-400BCE) = with laws requiring taxpayers to prepare statements of their financial positions, and with civil Pacioli indicate that ‘all entries must be double entries… if u make one creditor you must make someone control. rights depending on the level of property declared by the citizens debtor’ Chaldean -Babylonian, Assyrian and Sumerian civilizations (2,000-3,000BCE) = the producers of the first organized government in the He also indicate that the purpose of book –keeping is to give trader without delay information as to his The ‘Italian method’ spread throughout Europe in the sixteenth and seventeenth world, some of the oldest written languages, and the oldest surviving business records assets and liabilities. centuries. Egyptian civilizations (1,000-3,000 BCE) = where scribes formed the “pivots on which the whole machinery of the treasury and the other The successful merchant, declares Pacioli, needs three things: sufficient cash or credit, good bookkeepers 16th century – specific journals for different type of transactions. departments turned” and an accounting system 16th to 17th centuries – practice of periodic financial statement and application of the Chinese civilization (3,000 BCE) = with government accounting playing a key and sophisticated role during the Chao dynasty :1122 - Pacioli suggested that not only the name of the buyer and seller should be recorded but also the description double entry system were expanded to other type of organizations. 256 BC of goods sold (weight, size, measurement, price and term of payment). 17th century – separate inventory account for different type of goods and the the Greek civilization (1-1,000 BCE) = where Zenon, a manager of the great estate of Appolonius , introduced in 256 BC an elaborate He also indicate the need of having periodic recording and closing of books. incorporation of East India Company where auditing, cost accounting and reliance on system of responsibility accounting Pacioli's System: Memorandum, Journal and Ledger concepts of continuality, periodicity and accruals are needed. The first 16 chapters of "De Computis" describe this basic system of books and accounts, while the 18th century – methods of treating fixed assets evolved (assets are carried forward at The presence of these forms of bookkeeping in the ancient world has been attributed to various factors, including: remaining 20 are devoted to specialized accounting issues of merchants. These include bank deposits and original cost, assets account are closed at the balance sheet date and revaluation of the invention of writing, withdrawals, brokered purchases, drafts, barter transactions, joint venture trading, expense disbursements fixed assets. the introduction of Arabic numerals and of the decimal system, and closing and balancing books. 19th century – depreciation of property, cost accounting and development of the diffusion of knowledge of algebra, Pacioli’s treatise (1494) = Double-entry accounting, Documenting process but not explaining basis for techniques of accounting for prepayments and accruals. the presence of inexpensive writing material, recording Mashayeki (2008) 19th – 20th centuries – development of funds statements the rise of literacy, Accounting records found 3600 years ago (Achaemenid era) shows records of payments, receipts of 20th century – complex issues such as EPS, accounting for business computations, the existence of a standard medium of exchange allotments, trade exchanges. Tax collections and expenditure. “Balance Sheets” inflations, long term leases and others.. THE BIRTH OF DOUBLE ENTRY ACCOUNTING What is an accounting The early development of accounting dates back to ancient Mesopotamia, and is closely related to developments in writing, counting = 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 and money and early auditing systems by the ancient Egyptians and Babylonians. money, transactions and event which are in part at least, of a financial character and interpreting the results of thereof However, many of these factors did not exists in ancient times, until the middle ages. A number of studies found that writing and arithmetic were among the important factors which contributed to the creation of double entry. Role of accounting The emergence of agriculture, trade and capital has also increased transactions which make the keeping of records and accounts inevitable. as a historical record - Provides a history of the managers’ stewardship of the owners’ as Communication-decision Information - Accounting reports are prepared to suit the resources. needs of users and this in turn, will impact the decision making behaviour of managers and A.C Littleton (1956), 7 factors that led to the creation of double entry bookkeeping. Measurement of the stewardship concept has evolved over time, in the following periods; investors. 1. The art of writing – A mechanism for making a permanent record in a common language Pure custodial period, Traditional custodial period and Asset-utilisation period (initiative in as a Magic - Viewed as a method of deceiving the users of reports. 2. Arithmetic – A means of computing the monetary details of the deal using the assets) As stated by Godfrey, Hodgson and Holmes (2003),....an accountant can perform sleight- 3. Private property – The power to change ownership because bookkeeping us concerned with recording details about property and as a Language - Accounting is perceived as the language of business. ofhand accounting tricks which can be compared to magician’s tricks. property rights To Hawes (1972), as a language, accounting has two components 1. Symbols – numerals Able to make the financial statements appear to be something they are not. 4. Money – The common denominator for exchanges that requires a transaction to record its monetary value and words and debits and credits are example of symbols unique to accounting. 2. Example - Enron used accounting techniques to disguise its loss-making investments. 5. Commerce – the interchange of goods on a widespread level, because purely local trading in small volumes would not create the sort of Grammatical rules – it refers to the general set of procedures used to create financial data. as Economic Goods - As costs are involved in producing accounting information, managers press of business Translate economic events and transactions into words and numbers that can be will often lobby for accounting standards that minimise information costs 6. Capital – wealth productively employed, because otherwise commerce will be trivial and credit would not exist communicated and understood by users of accounting reports Part of a wider information set which includes macroeconomic, political, taxation and other 7. Credit – the present use of future goods, because there would have been little impetus to record transactions completed on the spot Convey its financial performance, utilization of resources provided by various parties and specific information that affects the performance of the firm also details of past transactions that had been entered into Shareholders and creditors will lobby for accounting rules that enhance their ability or right as a intra-corporate Politics - reflects & supports the values and needs of special interest to control and monitor the conducts of the management group. information is formed and used as a resource in shaping company policies. as a Social Commodity - viewed as commodity resulted from economic activity Two Kinds of Double Entry used in decision making, as a way of enhancing and furthering the aim of management. accounting exists because specialized information is in demand and accountants are example - use accounting report to convince the management to increase resource willing and capable of producing it. Classification Causal allocation to it at the expense of other departments that appear less efficient. choice of accounting information may have an impact on the welfare of various group in Is aimed at maintaining the fundamental accounting Describe the cause and effect relationship between Standard Setting as Politics/ Political Process - Accounting standards are products of a society. equation that summaries the classification position increment and decrement political process rather than of an outcome of technical efficiency. there is a market for accounting information with its derived demand and supply. Debit portrays a classification and credit portrays another The value of increment offset by an equal value of decrement Often lobby for accounting standards to serve their own interest and select accounting as an Ideology & Exploitation - means of sustaining and legitimizing the current social, classification Example Dr Machine 20,000 Cr Account Payable 20,000 techniques that maximize their own utility. economic and political arrangements Example Dr Machine (Assets) Cr Account Payable (Liabilities) (Increase in debit of RM 20k offset by decrease of equal Example - managers support standards that lower taxes, reduce political and bookkeeping perceived as a myth, symbol and ritual that permits the creation of a symbolic order within (New assets acquired and new liabilities incurred) amount in credit side) costs and increase management compensation which social agents interact as a Mythology - Accounting system supports the concept of “professionalism” (used to an instruments of economic rationality and as a tool of a capitalistic system justify, rationalise and legitimise decisions that are made.) TOPIC 1 : Introduction and Financial Regulatory (THE DEVELOPMENT OF ACCOUNTING PRINCIPLES IN TOPIC 1 : Introduction and Financial Regulatory THE USA) ©NIRMALA (UITM SEGAMAT) (ACCOUNTING AND CAPITALISM) ©NIRMALA (UITM SEGAMAT) 1. MANAGEMENT CONTRIBUTION PHASE (1900-1933) Definition: an economic and political system in which a country's trade and industry are 2. INSTITUTION CONTRIBUTION PHASE (1933-1959) controlled by private owners for profit, rather than by the state synonyms: free enterprise, private The influence of management in the formulation of accounting principles arose enterprise, the free market; enterprise culture "the capitalism of emerging nations" from the increasing number of shareholders and the dominant economic Marked the creation and the increasing role of institutions on the development of accounting principles. In the late 18th century, capitalism emerge due to: role played by industrial corporations after 1900. The creation of the Securities and Exchange Commission (SEC) 1. the neglectfulness of middleclass officials in executing their duties, The diffusion of stock ownership gave management complete control over the In 1934 Congress created the SEC to administer various federal investment laws including the Securities Act of 1933 format and content of accounting disclosures. 2. the favouring of the merchants and the guilds. (regulates the issuance of securities in the interstate markets) and Securities Act of 1934 (regulates the trading of securities) The intervention of management may be characterized best by ad hoc solutions The SEC’s role in the development of accounting principles: Basic principle of capitalism: Economic initiative should come from individual rather than the to urgent problems and controversies Section 13 (b) of the 1934 Securities Exchange Act provides the SEC the authority to prescribe accounting ‘guidelines’ or government ‘forms’ for reports submitted to it. The consequences of the dependence on management initiative include: On April 25, 1938, the SEC sent a definitive message that unless the profession established a standard-setting body, the SEC 4 reasons explain role of double entry in economic expansion. 1. Given the pragmatic character of the solutions adopted, most accounting 1. Double entry contributed to new attitude toward economic life i.e the goal of substance are techniques lacked theoretical support. would use its mandate and develop accounting principles. replaced by capitalistic goal of profits 2. The focus was on the determination of taxable income and the minimization of income taxes. The approval by the AIA of “broad principles”. 2. The use of integrated system of interrelated accounts made it possible for entrepreneur to pursue 3. The techniques adopted were motivated by the desire to smooth earnings. George O. May, an Englishman, proposed that the AICPA begin a cooperative effort with the stock exchange committee in profit rationally. 4. Complex problems were avoided and expedient solutions were adopted. developing accounting standards. 3. Systematic bookkeeping- the duality technique (double entry), provide for check on accuracy. Its 5. Different firms adopted different accounting techniques for the same problem. Among other things, the committee proposed the first formal attempt to develop generally accepted accounting techniques, mechanization and objectivity contribute to an orderly and continue recording of business known as May’s “broad principles”. transactions. William Z. Ripley and J.M.B. Hoxley: argued for improvement in standards of They include: 4. The distinction between business and personal asset (separate entity), make the autonomous financial reporting. 1. That income accounts should not include unrealized profit, and expenses ordinarily chargeable against income should not be Adolph A. Berle and Gardiner C. Means: called for the protection of investors. existence of the enterprise charged against unrealized profit. The main players of the time: 2. That capital surplus (additional paid-in capital) should not be charged with amounts chargeable ordinarily to income. American Institute of Accountants (AIA) (In 1917 established a Board of Examiners to create a uniform CPA examination) 3. That earned surplus (or retained earnings) of a subsidiary company created prior to acquisition was not part of the RELEVANCE OF ACCOUNTING HISTORY consolidated earned surplus of the parent. The New York Stock Exchange (From 1900 required all corporations applying for listing to agree to publish annual financial statement.) 4. That dividends on treasury stock may not be credited to the company’s income. ITS IS IMPORTANT FROM THREE (3) PERSPECTIVES: Important issues and events : 5. That amounts receivable from officers, employees, and affiliated companies should be shown separately 1) Accounting Pedagogy = Accounting history is very helpful to a better understanding and Establishing realistic product costs to serve as basis for selling prices and 6. The new role of the Committee on Accounting Procedures appreciation of the field of accounting and its evolution as a social science. (Instructional theory) measuring management efficiency. In 1938, the Institute decided to empower the Committee on Accounting Procedure (CAP) to issue pronouncements. The rationale: No selling costs, interest charges or administrative expenses are included in the In 1938 – 1939 alone, CAP issued twelve Accounting Research Bulletins (ARBs) during that period continued to do so To educate profession members to appreciate intellectual heritage. factory overhead costs. during the war years. The growing effect on accounting theory of taxation of business income. To ensure all important advances in thought and major contribution to the literature are not lost 1946 – 1953, issued eighteen ARBs, with a strategy of eliminating questionable and suspect accounting practices, and The 1918 Act was the first to recognize the role of accounting procedures in the focusing on particular reporting problems. (because they are documented). determination of taxable income, which set the stage for the beginning of a Need to analyse and interpret historical development in accounting thought and practice so that harmonization between tax accounting and financial accounting. However, the period 1957 to 1959 was marked with an intensive criticism of the CAP for various reasons, including: today empiricist who conducted investigation has a complete and justified claim about the past. failure to give adequate hearings to financial executives and accounting practitioners; 2) Accounting Policy = Accounting history is instrumental to a better understanding of the 3. PROFESSIONAL CONTRIBUTION PHASE (1959 – 1973) failure to work on unpopular issues; accounting problems and their institutional contexts, as well as the formulation of public policy. (e.g failure to develop a comprehensive statement of basic accounting principles; tax accounting & policy) The AICPA accepted the recommendations to dissolve CAP and its research being in disagreement with the SEC, which was displeased by the CAP’s preference for the “current operating performance” 3) Accounting Practice = Accounting history could provide a better assessment of the existing department and established in 1959 the Accounting Principles Board (APB) and conception of income statement and by the failure of CAP to limit the alternatives available to the management. practice by a comparison of methods used in the past. the Accounting Research Division with the mission to advance the written expression of generally accepted accounting principles. In 1973, the Financial Accounting Standards Board was created to establish the Accounting has a history which is usually discussed in terms of one seminal event, the invention 4. POLITICIZATION PHASE (1973-PRESENT) and dissemination of the double-entry bookkeeping processes. Generally Accepted Accounting Principles, setting accounting standards in the U.S. The historical evolution of accounting provides clues and explanations of double-entry A situation created by the generally accepted view that accounting numbers affect economic behavior and, consequently, Between 1959 and 1973, the APB issued 31 Opinions dealing with controversial bookkeeping and the development of modern accounting. issues. that accounting rules should be established in the political arena. Horngren states: The history of accounting allows us to relate the past to what is practiced and to what ought to be The American Accounting Association also participated in the process through The setting of accounting standards is as much a product of political action as flawless logic or empirical findings. practiced. several research studies and attempts to develop an integrated statement of basic accounting theory. Why? Because the setting of standards is a social decision. Standards place restrictions on behavior; therefore, they must be It helps us to make a link between the historical state and both positive and normative states. accepted by the affected parties. The link supports the view within the full context of social, political, economic and temporal The APB was criticized for: Acceptance may be forced or voluntary, or some of both. In a democratic society, getting acceptance is an exceedingly environments limited controversial or ad hoc Opinions (APB 8 on pension accounting, APB 11 complicated process that requires skilful marketing in a political arena. on income tax allocation, APBs 2 and 4 on investment tax credit); LIMITATION OF ACCOUNTING HISTORY failing to solve problems of accounting for business combinations and goodwill. Since its inception, the FASB has adopted a deductive and a quasi-political approach to the formulation of accounting Historical inquiry could either be narrative or interpretative and is conditional and not definitive. principles. This approach can be seen through: It may be incomplete. The intervention of professional associations and agencies in the formulation of its effort to develop a theoretical framework or accounting institution, an accounting theory was spurred on by efforts to eliminate undesirable History may not reveal cause of an event as a certainty but can indicate probable factors affecting acknowledging the fact that the contribution of various interest groups that have emerge, is required for the “general” the event. techniques and to codify acceptable techniques. The problems associated with the dependence on such associations and agencies acceptance of new standards Historians ‘explanation and causal analysis’ begin with searches for patterns of development. 1930 - American Institute of Accountant (1887) & NYSE (Restore Public Confident) include the following: Attempts to proceed from determination (what happened) to a contingency (how it happened) The association and agencies did not rely on any established theoretical 1935 - American Accounting Association (AAA) (1916) (To expand research and development accounting principle and basis – judgmental process constrained by time. framework. practices) The authority of the statements was not clear-cut. 1937 - American Institute of Accountant changed to American Institute of CPA (AICPA) (Development of Accounting Theory) The existence of alternative treatments allowed flexibility in the choice of Establishment of Financial Accounting Standards Board (FASB) (1973) (Developing standards ) accounting techniques. TOPIC 1 : Introduction and Financial Regulatory (THE FINANCIAL REPORTING ENVIRONMENT IN MALAYSIA) ©NIRMALA (UITM SEGAMAT) DEVELOPMENT OF ACCOUNTING IN MALAYSIA STATUTORY REGULATIONS ON FINANCIAL ACCOUNTING AND REPORTING ACCOUNTING STANDARD IN MALAYSIA Prior to 1957 – Companies Ordinance (and amendments) of 1940, 1946, 1956. 1) The FRA 1997 6) Regulation by the Audit Oversight Board 1958 – Malaysian Institute of Certified Public Accountants (MICPA) was formed (as a company Before new financial reporting regime: Deals with compliance with approved accounting Established under Part 111A of SC Act 1993. limited by guarantee). = Regulates the practice of its members who carry the title of CPA. Professional accountancy bodies: standards of the MASB. The mission is to assist SC in overseeing the auditors of 1965 – Establishment of Companies Act, 1965. Companies ordinance were then repealed. MICPA and MIA, regulate only no 2) The Companies Act 2016 (approved in April 2016) public interest entities and to protect the interest of Contain Ninth Schedule (disclosure requirements). statutory power therefore, depends on Compliance with approved accounting standards investors by promoting confidence in the quality and 1967 – The Malaysian Institute of Accountants (MIA) was established under the Accountants True and fair value over ride reliability of audited FS of public interest entities. professional sanction for deterrent Act 1967. Compliance with other laws or authorities Requires all auditors of public interest entities to be The Approved Accounting Standards 1968 – MICPA issued first accounting guidance which dealt with specimen company accounts. Conflicts between the Act and approved registered. International Accounting Standards 1978 – MICPA was admitted as a member of International Accounting Standards Committee accounting standards Has statutory power to conduct inspections and monitor (IASs) adopted for operations in (IASC) and began adopting IAS. Four IASs (IASs 1 – 4) were adopted in that year alone. Accounting and other records to be kept programmes on registered auditors to assess the extent Malaysia 1984 – MICPA issued the first Malaysian Accounting Standard (MAS 1) on EPS. System of internal control of their compliance with recognized auditing and ethical Malaysian Accounting Standards 1985 – Companies Act 1965 was amended. New Ninth Schedule with more comprehensive Accounting periods of companies within the same standards, including compliance with accounting (MAS) disclosure requirements that includes the preparation of statement of source and application group standards. Under the new financial reporting regime: of funds. Director’s responsibility to prepare financial Empowered by SC Act to sanction any registered auditors Due process before 2004 1987 – Operation of MIA were activated. MIA began to issue accounting standards. statements for failure to comply with any provisions A policy of harmonization: MASB 1993 – Securities Commission were established. Public listed companies are required to show 3) The Companies Act 2016 7) Regulation by Bursa Malaysia Standard developed from the work of full disclosure requirements as required by SC’s. General requirements for FS A private sector body (self-regulatory body), incorporated IASC 1997 – Financial Reporting Foundation (FRF) and Malaysian Accounting Standard Board (MASB) Subsidiaries to be included in Consolidated FS under s15 of the CMSA 2007 to regulate companies listed MASB also issued technical was established under the Financial Reporting Act, 1997. Duty to lodge FS and reports with the Registrar on its Exchange. pronouncement 2012- Malaysian financial reporting standards converged to the International Financial Relief from requirements as to form and contents Does not have legal power to enforce compliance but has Due process after 2003 Reporting Standards (IFRS) issued by the IASB. IFRS’s issued by the IASB are/or simultaneously of FS and director's report power to delist, suspend or publicly reprimand errant Convergence: align standard with issued as Malaysian Financial Reporting Standards (MFRS) often with the same timeline. The no par value regime (significant feature of CA listed companies for any non-compliance with its those of the IASB April 2016- the Companies Bill 2015 was approved in Parliament introducing new Companies 2016) regulations. 2006: single set separated into two 1. Act 2016. = Key feature: requirement for reporting companies to comply with the accounting 4) The Income Tax Act It has the power to delist, suspend or publicly reprimand Financial Reporting Standards (FRS) 2. standards issued by MASB Mainly concerned with ascertaining of chargeable companies which did not adhere to its regulations. Private Entity Reporting Standards THE CURRENT FINANCIAL REPORTING REGIME income and tax payable Companies listed on Bursa Malaysia must comply with (PERS), 2015 become MPERS 5) Regulation by securities commission the Bursa Listing Requirements. Financial Reporting Act (FRA) 1997 = Act provides the enforcement authority to the standards Established under Securities Commission Act Provisions relating to financial accounting and reporting Feb 2006, MASB announced that private issued by MASB to be complied by all listed companies. 1993. on: Submission of Reports , Interim Reporting entities need not comply with FRSs, they Independent bodies were established: Main function: development of the capital market in Requirement were allowed to choose to apply PERS 1.Financial Reporting Foundation (FRF) – s 4(1) FRA Malaysia through the regulation and enforcement- 8) Regulation by Bank Negara Malaysia (accounting standard for private entity). To review the performance of the MASB securities industry. Issued 2 sets of guidelines on Financial Reporting Private entity is a company incorporated To be responsible for all financing arrangements for the operations of MASB Due diligence and professional responsibilities of practices of financial institutions established under the under CA 1965 that: To perform such other functions as MOF prescribed. corporate advisors, directors and management of Banking and Financial Institutions Act 1989: 1.Is not required to prepare any FS under 2.Malaysian Accounting Standard Board (MASB) – s7(1) FRA public company. BNM/GP3: Classification on Non-Performing Loans and any law administered by SC or BNM. To issue new accounting standard as approved accounting standard. Statutory power: compliance with its regulation and Provision for Substandard, Bad and Doubtful Debts; and 2.Is not a subsidiary or associate or To review, revise or adopt as approved accounting standards, existing accounting standards. compliance with approved accounting standards. Introduced in 1985 with objective to streamline the jointly controlled by an entity which is To issue statements of principles for financial reporting. Capital Market and Services Act 2007: requires method of income recognition and loan loss provisioning required to prepare any FS under any To undertake the development of possible accounting standards. To develop a CF for the company submit to SC (a) a copy of its audited BNM/GP8: Guidelines on Financial Reporting for Licensed law administered by SC or BNM. purpose of evaluating proposed accounting standards. annual accounts (b) interim and periodic financial Institutions Thus, private entities shall comply with To make such changes to the form and content of proposed accounting standards as it report Introduced in Dec 1988 with objective to standardize the format of financial reports for banks and finance either: MPERS in their entirety; or MFRS considers necessary. companies. in their entirety To perform such other functions as MOF prescribed.  TOPIC 1 : Introduction and Financial Regulatory (ACCOUNTING THEORY) ©NIRMALA (UITM SEGAMAT) Development in Accounting Theory Role of Accounting theory Nature of Theory Before 1400s - very little was written about the theory underlying the accounting practice. Main emphasis Accounting theory is a set of principles that describe, explain or predict The preparation of FR is dependent on management discretion and regulatory requirements. was on practices FR across countries differ due to internal and external factors such as company accounting practice. Theory is regarded as practice that advocates the 1494 - Luca Pacioli, a Franciscan monk, is generally associated with the introduction of double-entry usefulness of knowledge about a particular aspects of accounting to characteristics, BOD motivation, regulatory requirements and government intervention. With bookkeeping. He published a book describing the practice in Venice at the time with the purpose of “ giving regards to FA practices and financial reporting, in some cases, activities are explained and users. the trader without information as to his assets and liabilities." Pacioli's book was subsequently translated justified by relevant theories. into several languages contributing to the spread of the double-entry method throughout Europe. OBJECTIVES OF ACCOUNTING THEORY Oxford English Dictionary: A scheme or system of ideas or statements held as an explanation or account of a group of facts or phenomena 1450-1750 - This period is referred to as "pre-theory period “. Development in accounting were evaluation and explanation of accounting principles Heendriksen (1970) (as cited in Deegan, 2013) A coherent set of hypothetical, conceptual and concentrated on refining practices but not on systematic basis. Thus, developments were random and ill simplifying complex phenomena pragmatic principles forming the general framework or references for a field of inquiry defined, evolving as they were needed to justify particular practices solving problems created by different scenarios Theory and concepts are often used to underpin and/or support perceptions and/or thoughts 1750-1920s - This period saw the formalisation of existing practices in textbooks and teaching methods calculating the effect of an event on the future beforehand to a similar vein, a theory is constructed based in people’s perspectives, views and due to: predicting future events paradigm’s. a) Rapid expansion in technology, growth of business sectors and the construction of railroad networks in helping the investigation, explanation, and conclusion of an event A theory reflects a view that the elements of theory should logically combine together to US and UK. These increased the demand for detailed accounting information, for improved techniques provide an explanation or guidance in respect of certain phenomena. These elements include and for accounting practices such as depreciation of long-term assets and new finance PURPOSE OF ACCOUNTING THEORY among others: b) Taxation and government legislations regarding reporting requirements. Explain and predict accounting practice as it is. 1. A belief or principles that guides actions or behaviour (theories on motivating employees c) Government and corporate economic policy decisions based on accounting numbers. Provides basis for prediction and explanation of accounting behavior such as leadership theory, communication and interaction theory, Maslow’s theory) 1800-1955 - This period is referred to as the "general scientific period", The theories during the period were and event 2. An idea or set of ideas or perhaps assumptions that is intended to explain something (e.g. mainly concerned about the explanations of practice and the development of explanatory framework Justify existence of accounting profession and accountancy. agency theory, legitimacy theory) Theories developed based on real-world observation rather than solely on logic. However developent were Can be used as pedagogical devices to impart knowledge. 3. The set of principles on which a subject is based or of ideas that are suggested to explain a fact or event (e.g. economic theory) sporadic Evaluate current accounting practice and guide development of new 4. A conjecture or an opinion (e.g. autonomy theory, pecking order theory) 1956-1970s - This period is referred to as "normative period". The theories were concerned about accounting practice developing statements of ideal practice (the best accounting practice) and the basis for achieving such Accounting theory practices. Researchers were less concerned about what actually happen in practice and more concerned Why Accounting theories? about developing theories that prescribed what should happen. 1. All accounting is premised on theories A description, explanation or a prediction of accounting practice based on observations However, normative period drew to an end in early 1970s due to the following factors: Concepts of Materiality and/or logical reasoning. 1. normative theories were based on subjective opinion, which varied between individuals. Dissatisfaction Recognition Criteria Logical reasoning in the form of a set of broad principles that arised because these theories did not resolve the differences in opinion. Relevance 1. provide a general framework of reference by which accounting practice can be evaluated 2. normative theories could not be empirically tested because it was impossible to demonstrate Faithful Representation 2. guide the development of new practice and procedures. empirically what ought to be. Thus, it was unclear whether the theories had any strong foundation. The Conceptual Framework A theory could be based on numerous observations (inductive reasoning) or developed on the 1970-2000 - This period is referred to as "specific scientific theory" period or "positive era". Positive Measurement Bases basis of logic (deductive reasoning). Could be ‘positive’ or ‘normative’. accounting theories were developed to explain and predict accounting practices. 2. Studying theories of accounting exposes students to various issues, Theories can help people to: The benefit of positive accounting theories is that they enable regulators to assess the economic including: a) prescribe how (how assets should be valued for external reporting purposes) how elements of accounting should be measured consequences of various accounting practices they are considering. Hypotheses about reality were b) predict why (A manager’s decision on a accounting methods/approach in order to achieve developed and subsequently tested through observations of the reality. motivation for organisations to provide certain types of accounting his/her personal interest to gain profit/bonuses) However, the problem with these theories is that, for positive theorists, wealth maximisation became information c) seek to explain why (factors that influence a manager’s decision to disclose accounting information to external user the answer to every question-whatever the observed practice, could be construed as a means of motivation for individuals to support or lobby regulators for some d) prescribe (what type of accounting information should be provided in financial accounting maximising wealth. This has attracted criticisms regarding the biased fashion in which the positive accounting methods in preference to others reporting theorists dismiss alternative viewpoints the implications for organisations and their stakeholders if one For example, based on the 'bonus plan hypothesis', managers are wealth maximisers, even at the accounting method is chosen or mandated in preference to others Overview of Accounting Theory expense of shareholders. If a manager is remunerated partly with bonuses based on reported how and why the capital markets react to particular information accounting profits, he will have an incentive to use accounting policies that maximises reported profits whether there is a ‘true measure’ of income was developed to resolve problems as they arose – reactive in periods when he is likely to receive bonus. ad hoc approach This theory leads to the prediction (hypothesis) that managers who are remunerated via bonus plan use Characteristics of Accounting theory led to inconsistencies in practice (e.g. different depreciation methods ) profit-increasing accounting methods more than managers who are not remunerated via bonus plan 1. Guide research and organise its ideas (conceptual framework provides accounting standard setting = conceptual framework projects have not resolved 1980s-Present - Since late 1980s, there has been a resurgence in behavioural research. Behavioural basic principles so that the accounting standards more consistent) inconsistency in practice accounting theories focus on psychological and sociological influence on individuals in their use and/or 2. Support evidence gathered and provide a context for predictions (the Accounting theory is a modern concept compared to mathematics or physics preparation of accounting. manager may change the way (policies/ practices) they calculate items Even Pacioli’s treatise on double-entry accounting focused on documenting practice and did in the financial statement, in this circumstance, a theory can be used to For example, in the case of a bank loan manager who has had experiences with loans to firms that not explain the underlying theoretical basis for it support the manager’s actions for changing the accounting policies defaulted on their debt agreements because of poor cash flow, it is predicted that he will place more The development of accounting theory has been mostly unstructured. Chambers: based on the evidence gathered and analysed. Accounting has frequently been described as a body of practices which have been developed reliance on cash flow information in his assessment of the firm's "credit risk". On the other hand, if the bank loan manager has been involved with loans to firm that defaulted because of unprofitable 3. Explain empirical evidence (theory on revenue recognitions helps when in response to practical needs rather than by deliberate and systematic thinking operations, it is predicted that the manager will rely more on the reported profit or loss and earning the revenue should be included in FS) whether a theory is accepted depends on how: 1. well it explains and predicts reality prospects of the prospective barrowers. 4. Provide directions for new research (financial reporting failure, e.g. 2. well it is constructed both theoretically and empirically It is interesting to note that despite a growing popularity in the behavioural research, positive accounting Enron, WorldCom, Sathiyam) 3. acceptable its implications are still dominates the accounting research literature. 5. AT MUST BE: Logical , Structured (a Framework) and Evidenced  TOPIC 2 : Formulation and Verification of Accounting Theory © NIRMALA (UITM SEGAMAT) POSITIVE ACCOUNTING THEORY RELATIONSHIP IN THEORETICAL STRUCTURE SYNTACTIC AND SEMANTIC THEORIES Positivism or empiricism means testing or relating accounting TWO PERSPECTIVES ADOPTED BY PAT RESEARCH Good theory would have 3 aspects / elements, they’re consists of: Traditional historical cost accounting (HCA) has been theoretically interpreted as almost completely a syntactic theory hypotheses or theories back to experiences or facts of the real- 1) Efficiency perspective Semantic theory (ability to relate to the real world) Transactions recorded in vouchers, journals and ledgers of the business are the semantic input of the system. world. Researchers explain how contracting Syntactic theory (must be logical) They are manipulated based on premises and assumptions of HCA: inflation is not recorded and MV of assets & liabilities are Typical approach: Survey the opinion of financial analysts, bank mechanisms minimise agency costs of the firm Pragmatic theory (observation of accountant behavior in practice) ignored. officers & accountants on the usefulness of different inflation Known as ex ante perspective - mechanisms put Use double entry accounting & principle of HCA to calculate P&L and financial position. accounting methods in decision-making tasks (predict in place up front to minimise future agency and 1. SYNTACTIC The individual propositions are verified every time the statements are audited by checking the calculations and manipulations. bankruptcy/to buy or sell shares. contracting costs Syntactic or logical relationship, linking together with basic concept. However, the accounts are rarely audited specifically on pragmatic test – in terms of whether & how people will use them Based on scientific empirical methodology, relating or testing Managers select accounting methods which most Proper ordering of words and its affect on meaning (i.e. the rules of the CRITICISM accounting hypothesis. efficiently reflect underlying firm performance language employed). i. SEMANTIC CONTENT ONLY ON THE BASIS OF INPUT Focus on: Capital market research and Accounting policy choice PAT theorists argue that regulation forcing firms If the theory is written in English language, it concerns with the rules of ▪ There is no independent empirical operation to verify the calculated outputs, for example ‘income’ or ‘total assets’. These WHY POSITIVE ACCOUNTING THEORY? to use a particular accounting method imposes grammar. figures are not observed; they are simple summations of account balances, and the auditing process is, in essence, simply a ▪ A theory that is consistent with the existence of economic unwarranted costs and introduces inefficiencies recalculation. consequences. WHY POSITIVE ACCOUNTING THEORY? 2) Opportunistic perspective 2. SEMANTIC ▪ The auditing process verifies the inputs by examining underlying documents and checks mathematical calculations. ▪ Explain & Predict real world phenomenon and are tested Seeks to explain managers’ actions once Branch of linguistics However, it does not verify the final outputs. empirically. contracts are already in place. Concerns the literal meaning of words, phrases, & sentences. ii. HCA SYNTACTIC ELEMENT ▪ Based on scientific methodology using economic based empirical That is, particular accounting methods might Link the basic concepts of a theory to objects in the real world. ▪ The practice of summing several different money amounts assigned to specific assets (i.e., summing of cash held today with literature initially be selected for efficiency reasons, but cash paid for land 20 years ago, which the company still holds today). ▪ Enable theories a) to be refuted, b) to explain & predict, c) to once they have been negotiated/agreed, then 3. PRAGMATIC iii. INTERNAL INCONSISTENCY OF HCA rationalize accounting principles & d) to model connection managers will aim to utilise accounting choices in Concerns on the effect of words or symbols on people. ▪ Like the philosophy of doublethink. Doublethink means the power of holding two contradicting beliefs in one’s mind between accounting, firms and markets. a way that best serves their own interest. Nature of accounting is we are interested in HOW accounting concepts & the simultaneously and accepting both. ▪ Attempt to understand why accounting policies matter & predict Not possible to write complete contracts, so real-world corresponding events (or objects) AFFECT people’s behaviour. iv. IMPRECISION OF DEFINITION OF ACCOUNTING which accounting policies firms will choose. managers are assumed to opportunistically act to Accounting information must satisfy the information needs of users ▪ There are many imprecision of definitions in accounting. In terms of Popperian approach to science, many of the propositions CRITICISMS maximise own wealth. People react differently to the same information of conventional accounting are not falsifiable. i. Value laden prescriptions = PAT avoid making value laden Known as ex post perspective: considers ▪ All hypotheses proposed must be capable of falsification. If a hypothesis is not proposed or worded so that it is falsifiable, prescriptions opportunistic actions after the fact. PRAGMATIC THEORY then it is not informative and does not add to knowledge or progress in accounting. ii. Large scale = PAT use large-scale statistical research, remote from HC Accountants ARGUE that practitioners & their concerns. 1. DESCRIPTIVE PRAGMATIC APPROACH There is no requirement that accounting output should have any SEMANTIC content (correspond with current real-world events, Probably the oldest & most universal method of accounting theory transaction or values) WHY POSITIVE ACCOUNTING THEORY? ASSUMPTIONS NATURE construction. No requirement that it is to be subjected to falsification rules ▪ A theory that is consistent with the ❖ Efficient Capital Market Provide description of what Popular way of learning accountants' skills. DEFENCE OF HCA existence of economic consequences. ❖ A firm is a nexus of contracts accounting is Future accountants were trained by being apprenticed to a practicing The purpose of accounting is to allocate the HC of resource usage against revenue (EXPENSES vs REVENUE – the Matching WHY POSITIVE ACCOUNTING THEORY? ❖ Accounting is important in Descriptive, inferential & objective accountants. concept) ▪ Explain & Predict real world contract enforcement Objective of PAT is to explain & Inductive approach to accounting development. Assets, Liabilities & Owners’ Equity are residual from this process. They are not meant to measure or say anything about value phenomenon and are tested empirically. ❖ Accounting information is an predict accounting practice ▪ based on observed behavior of accountants or the financial situation. ▪ Based on scientific methodology using economic good A science to predict unobserved ▪ theory developed from how accountants act in certain situations economic based empirical literature ❖ Managers, investors, lenders are phenomena ▪ tested by observing whether accountants do act in the way the theory ▪ Enable theories a) to be refuted, b) to assumed to be rational & Analytic (logic), Semantic & suggests NORMATIVE THEORY explain & predict, c) to rationalize evaluative utility maximiser Pragmatic ▪ is an inductive approach accounting principles & d) to model ❖ Discretion to choose accounting Observable & Verifiable Prescribes what should happen, assuming a specified outcome FINANCIAL STATEMENTS SHOULD MEAN WHAT THEY connection between accounting, firms policies that maximize their Derived inductively from specific set CRITICISM should happen or ought to be SAY and markets. utility and firm value of observation i. Descriptive Pragmatic approach does not include analytical judgement of the ASSUMPTIONS 1. TRUE INCOME ▪ Attempt to understand why accounting quality of an accountant’s judgment. There is NO assessment of whether the a. Accounting should be a measurement system Focus on: Deriving single measure for assets and policies matter & predict which accountant report in the way he or she should. b. Profit & Value can be measured precisely Correct Profit figure accounting policies firms will choose. ii. Descriptive Pragmatic approach does not provide for accounting techniques c. Financial accounting is useful for making economic decisions However: no agreement on what constituted a true to be challenged; hence it does not allow for change. d. Markets are inefficient or can be fooled by creative accountants measure of value & profit. Most literature debates PHILOSOPHY STRENGTHS HYPOTHESES iii. Descriptive Pragmatic approach focuses attention on accountants’ behavior, e. Conventional accounting is inefficient on advantages & disadvantages of each system. o ECONOMIC FOCUS a) PAT perceive that theory should 1. BONUS PLAN HYPOTHESES = not on measuring attributes of the firm such as assets, liabilities & profits. In f. There is one unique profit measure 2. DECISION USEFULNESS o Focus on the cost & benefits of the be able to generate hypotheses Choose accounting policy that shift taking a descriptive pragmatic approach, we are not concerning ourselves CRITICISMS/LIMITATIONS The basic objective of accounting is to aid the alternative accounting methods, capable of falsification through reported earnings from future with the semantics (how theories correspond to real-world) of accounting i. Rarely subjected to empirical testing: - Cannot be tested by the decision-making process of certain users of regulations and accounting standards empirical testing. periods to the current period. Also phenomena. realism of their assumptions; - They can be judged only by their accounting reports by providing useful or relevant setting process; and b) PAT perceive that it is necessary called as ‘management predictive power accounting data. o The effect of reported financial to rationalize existing accounting compensation hypothesis” 2. PSYCHOLOGICAL PRAGMATIC APPROACH ii. NT not based on identified, empirical observations & methods Based on classical economic concepts of profits & statements on share prices. principles, which normative 2. POLITICAL COST HYPOTHESES = Observe users’ responses to the accountants’ output (Watts & Zimmerman, 1986). - ‘Valid prescription requires wealth or economic concept of rational decision o MORE SCIENTIFIC IN METHODOLOGY = theory did not attempt to do. Choose accounting policy that defer A reaction by the user is taken as evidence that the financial statements specification of both an objective & objective function’ making. Empirically explaining & predicting what c) PAT perceive that it is deemed reported earnings from current to contain relevant information and useful. iii. NT produces irrefutable prescriptions (Popper, 1968) - No amount Make adjustment to HC measures to account for occurs desirable that theory aim was to future periods. CRITICISM of empirical testing can prove a theory to be correct inflation or market value of assets. In essence, it is o CENTRAL IDEA IS TO DEVELOP explain & predict accounting 3. DEBT COVENANT HYPOTHESIS = i. Everyone react differently (illogical manner, preconditional response, not iv. Have NO use other than as an instrument for prediction measurement theories of accounting HYPOTHESES practices rather than supply Firm with prospect of violating reach when they should) to the financial information. ii. Therefore, we must rely on decision theories and testing them on large o Hypotheses about factors that prescriptions. accounting-based debt covenants samples of people, rather than concentrating on the responses of individuals. NORMATIVE VS POSITIVE influence the world of accounting d) PAT attempt to model would shift reported earnings from practices; and connection between accounting, future periods to current periods. Normative theories are prescriptive = Describe how accountant should behave to achieve an outcome that is judged to be right o To test the validity of these firms, markets & analyze The higher the firm’s debt/equity PRAGMATIC THEORY and good income hypotheses empirically. problems within an economic ratio, the more likely managers use This relation pertains to the effect of words or symbols on people Positive theories are descriptive, explanatory or predictive = Describe how people do behave regardless whether it is right, network. accounting methods that increase How accounting concept and their real world corresponding events or object explain why people behave in certain manner or predict how people will react/ do? income affect people’s behavior  BEHAVIOURAL THEORIES Derived from discipline such as psychology, sociology and organisational theories. Objectives is to TOPIC 2 : Formulation and Verification of Accounting Theory © NIRMALA (UITM SEGAMAT) discover why people behave as they do. According to Hofstedt and Kinard (1970), behavioural accounting research is defined as: “The study of the behaviour of accountants or the behaviour of non-accountants as they are influenced by accounting functions and reports” Encompasses: a. Judgement and decision making of accountants and auditors; CONTRACTING THEORY b. Influence of the output on users’ judgements and decisions making. Important of Behavioural accounting research : FIRM AND CONTRACT AGENCY THEORY i. Identifies how people use and process accounting information. Specifically, it examines the decision- Firms can be characterised as a nexus of contracts - between consumers of products and the making activities of the preparers, users and auditors of accounting information. suppliers of factors of production Agency theory was crucial to the development of PAT ii. Provides valuable insight into the ways of how different decisions are produced, processed and how Firms exist because they reduce contracting costs, Agency theory explained why the selection of particular accounting people react to particular items of accounting information and communication methods. o firms provide an efficient means of organising economic activity methods might matter iii. It can lead to training and increase in knowledge for accountants to improve their skills in information o ‘it costs less to transact (or contract) through central organization than to do so individually’ Focused on the relationships between principals and agents e.g. gathering, processing and communication.