accounting questions project

1. Why would an energy firm be inclined to manage profits downwards in a financial

year following a steep rise in gas and electricity charges to UK households? Use an

accounting theory to explain the phenomenon.

An energy firm would be inclined to manage profits downwards in order to keep its

earnings down keeping in mind the political cost hypothesis. According to this theory,

the managers are induced to keep the profits low to stay out of political attention.

Also, reduction of reported income is hypothesised to reduce the possibility that

people will argue that the organisation is exploiting other parties. That is why firms

likely to adopt accounting methods to reduce profits to lower political scrutiny. The

political cost accounting theory explains this phenomenon.

According to that theory large firms rather than small firms are more likely to use

accounting choices that reduce current period reported profits. They do this because

size is a proxy variable for political attention. Bigger the size of firm, bigger political

attention it is bound to get. It is believed in this theory that reduction of reported

income is hypothesised to reduce the possibility that people will argue that the

organisation is exploiting other parties. Reporting higher profits could lead to ‘political

cost’ for companies. These costs are resulting from political attention from

government, lobby groups etc. Most commonly, these firms are directed at larger

firms which is an indication of market power. Sometimes politicians may also scrutiny

firms that report good profits due to following reasons:

Politicians know that highly profitable companies could be unpopular with

members of constituency. So they might want to keep a tab on those

companies.

Politicians could win votes by taking actions against the companies. For that

the action may be either in public interest even though in own interest.

They may rely on reported profits to justify actions. If the firms are reporting

low profits then they may not have a basis for taking any actions on the

company. It’s like an incentive for firms to reduce reported profits

Reporting higher profits may result in increased taxes, increased wage claims, product

boycotts etc. The amount of tax a company pays is based on the firm’s earnings.

Therefore, firm is likely to adopt accounting methods to reduce profits to lower tax

liability.

Another big advantage of reporting lower profits is that the investors are always

looking to get more dividends and the companies are looking to keep the maximum

possible, with them for meeting any future contingency. So, by reporting lower

profits, the company does not have to shell huge money in paying as dividends. The

increase in price may be due to a spike in demand as compared to supply or sudden

rise in production cost, which might not stay for long as being a regulated utility the

regulator would intervene and stabilize the costs for general public.

2. Why do preparers of financial statements seem to prefer historic cost to

replacement cost or fair value? Discuss the advantages and disadvantages of the

various asset valuation models in your answer.

Historical cost accounting is a traditional method of accounting which takes the assets

and liabilities being reported at their historical cost. It is done by assuming the value

of product has not changes since the purchase of product. Although widely criticised

for its inaccuracy, historical cost is one of the most widely used accounting system in

finance. Following are the reasons why people prefer historical cost over fair value

while preparing financial statements:

There are many values that we come across while preparing accounting

statements, but historical cost is one of the most utilized values.

The historical costs can be verified, as there are recorded documents to support

the value. On the other hand, the replacement cost or fair values are

assumption, which are not backed by any document.

Historical cost accounting is widely recognized by many accountants because of

its objective nature, as it is backed by transactions that have already been

completed.

Unlike Historical cost method, Replacement cost or fair value methods are

subjective in nature. Only estimated assumptions are made to arrive at a

valuation. So no two analysts would arrive at an identical value.

Although the replacement cost or fair value methods represent the current

values for any asset and historical method may not be good estimator of current

asset value. But the historical cost method definitely negates the possibility of a

steep rise in asset prices or fall in prices due to any macro or micro economic

factors.

For valuing a business there are many different methods available. It is important for

the valuation specialist to look at all the pros and cons of a particular valuation model

before doing valuation. The various advantages and disadvantages of valuation

models are discussed below:

Historical cost valuation: In historical cost valuation, the assets are recorded at their

acquired cost. Once the useful life on asset is determined, the firm then depreciates

the value of asset throughout its useful life. This depreciation is done to show the

reduced value based on usage and asset life. The main advantage of using this method

is that we can verify the historical cost of assets. Also historical cost is conservative

approach as it does not post gains until they are realized.

The main disadvantage of this method is that at times of inflation in the markets and

the purchasing prices go up, at that movement the balance sheet would not resemble

any proximity to the current asset values. It would eventually lead to the depreciation

being understated leads to overstatement of net income and thus more income tax to

be paid.

Net realizable value or fair value: Fair values or NRV refers to the values of assets and

liabilities at the end of accounting period. It is the value that an asset would fetch

being sold in the market at the end of accounting period minus the cost of selling. The

main advantage of this method is that it displays an actual value of a business and this

can be a huge advantage to the investors and seekers of financial information. In

contrast to the historic cost method, the fair values can be compared as it is based on

asset characteristics rather than company characteristics.

The main problem with this method is that it is difficult to obtain the ‘correct’ value of

any asset. Also while reporting assets at their fair value they needs to be recognizing

the gains and losses in income statement. Also there is lack of evidence to support the

fair value, since it is based on assumptions only and every analyst has its own set of

assumption to reach to a value.

Replacement cost or entry value: Replacement cost is often confused with fair value.

Replacement cost refers to the cost for which an asset would be replaced at a current

date whereas the fair value refers to the proceeds an asset would get in current price

levels minus the sales costs. The main advantage of replacement cost accounting is

that it is relevant for decision making. The firm can decide on replacing the assets

based on their replacement costs and allow the users of financial information accurate

current information.

The major disadvantages of this method are similar to the ones in fair value method.

It is difficult to find a correct replacement cost in case of second hand market and

secondly the residual value of damaged assets needs to be estimated and that again is

a subjective task. This creates difficulty in correct estimation as the replacement cost

of an asset may be reduced by the residual cost of asset being replaced. This method

can only be useful for short term decision making process as the values depend on the

current market values and they are subject to change.

Future discounted cash flows: This method assumes the value of any asset or an entity

is dependent upon the future cash flows being discounted to the current period to

reach net present value. Here the assumptions are the cash flows, time period of cash

flows and the required rate of return or the discount rate. The main advantage of this

method is that is captures a lot of fundamental drivers (such as cost of equity, WACC,

growth rate, inflation etc.), which may not be captured by any other method. DCF can

also be used as a sanity check to arrive at the present value calculated by some other

method and match the two values.

The major disadvantage of DCF valuation is the cash flows can never be anticipated

with certainty. And even if the cash flows can be estimated with confidence, it is

difficult to segregate and allocate the resulting net inflows and outflows to individual

asset to find their values. Another disadvantage is that there is a lot of assumption

that goes into this model and each one can have a significant impact on valuation.

3. How do the assumptions of capital market research and behavioural accounting

research differ with respect to human behaviour?

The assumptions of capital market research and behavioural accounting research

states that the market operates efficiently. If at any point of time, the stock price

deviates from its fundamental price the market forces of demand and supply would

force the stock price back to its fundamental price, leaving no-scope for arbitrage

opportunity. Whereas the assumptions of human behaviour says that markets move

due to human behaviour and it is dependent on different assumption such as

confirmation and hindsight bias, herd behaviour, gambler’s fallacy, overconfidence

etc.

Capital market theories explain that effective managerial strategies reflected in

positive share price movements. Whereas human behaviour assumptions explain that

the price movements is not only the result of effective decisions but psychological and

emotional factors as well. It explains that intelligence is most commonly overruled by

emotions in main decision making. On the other hand, most people tend to fear regret

and hence many will make every effort to try and avoid anything that can cause

regret. If an investor detects the potential of regret in an investment (for instance

having a close friend who gambled in an investment that did not pay off), it is likely

that the individual will be deterred from such a venture.

These theories also have a number of differences which are hereby highlighted. The

first and most striking difference is the manner in which concepts and models vary

respectively. As a direct consequence of differences in the technicalities associated

with the carrying out of human behaviour and capital market and behavioural

accounting practices, the crucial models as well as the vital models inevitably vary

accordingly.

Based on experimental research carried out, there are indications that behavioural

accounting leans towards the most use of mathematical or statistical methods when

compared to human behaviour. This is true to expectations because accounting duties

often deal with tables and figures.

In addition, in behavioural accounting only the attitudes of those concerned with

accounting field are covered whereas in the case of human behaviour, one goes

deeper to find psychology that is influencing attitudes in markets, corporates as well

as amongst individuals. Furthermore, human behaviour lays emphasis on the effects

the biases of an investor have on the behaviour of financial markets. In the scenario

involving behavioural accounting, one narrows down their focus to the results of

managerial biases on accounting and reporting issues (Marnet, 2008).

In a nutshell, the differences outlined above are just but divergent ways of providing

effective information to help in the process of making decisions that is associated with

investment and accounting matters. In the end everything is geared towards the

achievement of a collective goal of economics in totality.

4. Discuss the statement “All accounting research is interdisciplinary.” Illustrate your

answer with a range of accounting theories.

The statement “all accounting research is interdisciplinary” means that accounting

research doesn’t only focus on the field of accounting, but attempts to explain

managerial actions through other disciplines too, for instance social sciences,

economics, etc. The systems-oriented theories have their origins in the political

economy theory. The political, social and institutional framework is important to be

analysed since all economic activity takes place in such a context. Managerial actions

can be defined using a number of theories such as PAT as well as system oriented

theories. The managerial discretionary behaviour is differently in PAT as well as

system-oriented theories. Pat explains that all individual action is driven by self-

interest i.e. individuals will act in an opportunistic manner to increase their wealth.

Whereas the system oriented theories explain that the management should manage

the organisation for the benefit of all stakeholders.

As per positive accounting theories, the management is driven by the economic

aspects of the firm, whereas the system oriented theories are based on social context

and explain that managerial decisions are based on notion of political economy, i.e.,

“the social, political and economic framework within which human life takes place”.

Positive accounting theories try to explain that the managers focus on short term

horizon and base their decision on that only. In other words, they are less concerned

about the longevity of the company and want to generate short term cash flows,

which would impact their bonuses and remuneration. They would also try to delay

upgrades to equipment’s and reduce research and development expenditure. As per

the ethical branch of stakeholder theory, the all stakeholders have the right to be

treated fairly by an organisation. It says that firm is a vehicle for coordinating

stakeholder interests.

PAT theories are based on economic theories that of maximising profits and reducing

cost. Most theories now focus on the economic impact of an accounting decision or

disclosure. Not only that, but the CSR theory takes into account the implications of a

social act on shareholders’ wealth, firm’s reputation and overall well-being of the

society. The CSR theories explain the different usage of CSR reporting against different

benefits perceived by the companies doing that. The majority of them are doing it to

focus on the embedding sound corporate governance and ethics systems throughout

all levels of an organisation while the others focus on having an improved

management of risk through enhanced management systems and performance

monitoring.

Thus, we can say that the accounting research does not focus on just one discipline

rather combined as number of disciplines to explain one particular theory. The

activities that take place in any company are required to be analysed from various

perspectives and describe the accounting theories in social, political and institutional

milieu.

5.

a. Discuss the main differences between PAT and systems-oriented theories with

respect to explaining managerial discretionary behaviour.

PATs explain and predict accounting/financial reporting practice. System oriented

theories prescribe how an item should be accounted for or how/when it should be

disclosed. Both are positive theories in the sense that they seek to explain and/or

predict corporate behaviour rather than prescribe how organisations should behave

(normative/prescriptive theories). However, they are different from PAT in following

basis:

◦ Disciplinary origins

◦ Assumptions of human behaviour and

◦ Relationship between firm and society (social context)

The managerial discretionary behaviour is differently in PAT as well as system-

oriented theories. PAT explains that all individual action is driven by self-interest i.e.

individuals will act in an opportunistic manner to increase their wealth. As per

positive accounting theories, the management is driven by the economic aspects of

the firm. Positive accounting theories try to explain that the managers focus on short

term horizon and base their decision on that only. In other words, they are less

concerned about the longevity of the company and want to generate short term

cash flows, which would impact their bonuses and remuneration. They would also

try to delay upgrades to equipment’s and reduce research and development

expenditure. As per the ethical branch of stakeholder theory, the all stakeholders

have the right to be treated fairly by an organisation. It says that firm is a vehicle for

coordinating stakeholder interests. PAT explains that managerial decisions are taken

as considering relationship between firm and outside parties as a nexus (network) of

contracts. The mangers take rational decisions based on Strategic action with the

aim of maximising rewards and minimising costs. PAT explains that there is a

managerial need to find best possible means to attain one’s end using appropriate

reasons.

On the other hand, system oriented theories consider the relationship between

firms and outside parties is seen as a ‘social contract’ and managerial discretionary

behaviour is based on this assumption only. System-oriented theories say manager’s

decision making is bounded rationality, irrationality, emotion. whereas system-

oriented theories say that the manager’s decisions are motivated by ideals, values,

morals, tradition, habit, or emotion. Whereas the system oriented theories explain

that the management should manage the organisation for the benefit of all

stakeholders. System oriented theories are based on social context and explain that

managerial decisions are based on notion of political economy, i.e., “the social,

political and economic framework within which human life takes place”. We can say

that systems-oriented theories provide alternative to Positive Accounting Theory.

Since, they originate in sociology. Both regard the organisation as a part of the

broader social system in which economic, social and political aspects are

intertwined.

b. Use three accounting theories to explain why Starbucks sends its UK

employees to work on coffee plantations in Africa.

The reason why Starbucks sends its UK employees to work on coffee plantations in

Africa can be explained using three different accounting theories:

Explanation using Positive accounting theory

The action taken by Starbucks to send its employees to work on coffee plantations in

Africa can be explained using the PAT. PAT explains the relationship between

Starbucks (entity) and its UK employees (managerial labour). This is a managerial

contract. So, it is bound on the employees that the managerial decisions are taken

care by them. Bonus plan hypothesis can be used here: the managers might be doing

this in self-interest to increase their bonuses, as well as bonuses of UK employees

too, of being stationed out-of-town. According to bonus plan hypothesis, managers

of firms with bonus plans are more likely to use accounting methods that increase

current period income. This theory is also called as management compensation

hypothesis. Actions like this would increases the present value of bonuses paid to

management.

Explanation using system oriented theories

According to the system oriented theories, the organisation is assumed to be

influenced by, and in turn, to have influence on the society in which it operates. In

this case, Starbucks wants its staff to feel emotionally connected to the work they

do, systems-oriented theories can be used to explain why Starbucks took this action

which is not so usual or rational and seems to be based on emotions and social

values, as a reputed brand like Starbucks should have employees who are extremely

devoted and excited about their work. Since, Starbucks gets its raw coffee needs

from Africa; it can be their way to show respect towards the African society. The

society allows the organisation to continue operations to the extent that it meets

their expectations. The organisation may find it difficult to obtain the necessary

support and resources to continue operations.

Explanation using CSR theories

The relationship between Starbucks and the community in Africa is encompassed in

a social contract. This is an attempt at corporate social responsibility, explained by

CSR theory. This was not a legal, economic or technical requirement that Starbucks

had to fulfil. It would lead to maximisation of shareholders wealth, in terms of good

reputation in the market and thus a strengthening of the agency contract between

the firm and the shareholders. This can also be a part of their sustainability

development program, so as to attract the workforce from Africa and retaining

competent staff by demonstrating an organisation is focused on values and its long-

term existence.

6. Outline the arguments of the free market perspective with respect to the regulation

of accounting. Do their arguments still hold after the financial crisis?

The regulations of accounting are rules that have been developed by an independent

authoritative body that has been given the power to govern how we are to prepare

financial statements. Free market economic system advocates free market economic

system with minimal government intervention. According to free market prospective,

the market for information is efficient. Free market perspective says that accounting

information should be treated like other goods, with demand and supply forces should

be allowed to operate to generate an optimal supply. It believes that accounting

information is a free good and users generally do not bear any cost of these. As a

result, free goods are produced as a result of regulation.

Regulations tend to reduce the choice of accounting methods that may be used.

Organisations are prohibited from using accounting methods which most efficiently

reflects their particular performance and position E.g., PPE historic cost vs. fair value.

As a result, it impacts on the efficiency with which firms can inform the market about

its operations. There are four arguments that support the free market respective:

Private economic based incentives

Market for managers

Market for corporate takeovers

Market for lemons

Private economic based incentives: This argument assumes that managers will

operate business for own benefit and this is expected by shareholders and debt

holders. Therefore, in interests of management to enter contracts with shareholders

and debt holders to constrain managers’ actions. Contracts often based on

accounting information. So, the organisations that are not producing information will

be penalised by higher costs of capital. The theory states that the organisations are

best placed to determine what information should be produced. It is dependent on

parties involved and assets in place. Imposing regulation restricting available set of

accounting methods decreases efficiency of contracting. It also assumed auditing will

take place in absence of regulation - reduces risk to external stakeholders.

Market for managers: This argument says that managers’ previous performance

impacts on remuneration they can command in future. So, in absence of regulation

assumed managers encouraged to adopt strategies to maximise value of firm

(provides favourable view of own performance). This also includes providing optimal

amount of accounting information. The assumptions underlying this argument are:

Managerial labour market operates efficiently

Information about past performance known by prospective employers and

will be impounded in future salaries

Capital market is efficient

Effective managerial strategies reflected in positive share price movements

Markets for corporate takeovers: This argument highlights that under-performing

organisations will be taken over by another entity with the existing management

team subsequently replaced. Therefore managers would be motivated to maximise

firm value. Thus they need information to be produced to minimise cost of capital

thereby increasing firm value. This argument assumes managers know marginal cost

and marginal benefits of information. So, the need for regulation is fulfilled by the

fear of corporate takeover.

Market for lemons: This argument advocates the fact that capital markets require

information and any organisation that fails to provide information will be punished

by the market. The organization might have to pay higher cost of capital. Markets

view no information in the same light as bad information. So, market may make the

assessment that silence implies the organisation has bad news to disclose. Therefore

managers motivated to disclose both good and bad news. This argument assumes

that the market knows that managers have news to disclose. It may not always be a

realistic assumption (as has been seen with many apparently unforeseen accounting

failures such as Lehman Brothers, Enron). If knowledge of non-disclosure

subsequently becomes available market are expected to react at that stage

After the financial crisis, the theories are criticized by many experts. They are of the

view that financial regulation is needed as economic issues cannot be investigated in

the absence of considering the political, social and institutional framework within

which economic activity takes place. Compliance with accounting standards usually

seen to indicate financial statements are ‘true and fair. Users may not be aware that

financial reports are the outcome of various political pressures. Also, absence of

accounting regulation can have economic consequences. Should regulators consider

preparers’ views given that standards are designed to limit what preparers do? Is

what the question is today?

Use different accounting theories in answering your chosen questions.

7.

a. Use the criteria proposed by Deegan & Unerman (2011, Chapter 1) to evaluate

Positive Accounting Theory (PAT).

Deegan & Unernab in 2011 proposed criteria to evaluate PAT. The criteria seek to

predict and explain particular phenomena (as opposed to prescribing particular

activity) are classified as positive research and the associated theories are referred to

as positive theories.

The criteria Deegan & Unerman use to evaluate is that: A positive accounting theory

begins with some assumption(s) and, through logical deduction, enables some

prediction(s) to be made about the way things will be. If the prediction is sufficiently

accurate when tested against observations of reality, then the story is regarded as

having provided an explanation of why things are as they are.

For example, a positive accounting theory may yield a prediction that, if certain

conditions are met, then company may be underreporting their earnings. In

economics, a positive theory of prices may yield a prediction that, if certain conditions

are met, then rapidly rising prices will be observed. Similarly, a positive theory of

accounting may yield a prediction that, if certain conditions are met, then particular

accounting practices will be observed.

b. How does the notion of ‘political economy’ differ from the economic focus of

Positive Accounting Theory?

PAT, as developed by Watts and Zimmerman and others, is based on the central

economic-based assumption that all individuals’ action is derived by self-interest and

that individuals will act in an opportunistic manner to the extent that the actions will

increase their wealth. An assumption is that ‘self-interest” drives all individual actions.

On the same premise, PAT predicts that organization will seek to put in place

mechanisms that align the interests of the managers of the firm (agent) with the

interests of the owners of the firm (the principal). Political economy on the other hand

Political economy was the original term used for studying production and trade, and

their relations with law, custom, and government, as well as with the distribution of

national income and wealth.

Although PAT has an economic focus to explain the behaviour of individuals: that is

Manager, investors, lender and other individuals are rational, evaluative utility

maximize. Political economy deals with explaining that for allocation of the resources

in any particular society, politics was used to provide the people.

Political economy is the study of the relationships between individuals and society,

and more specifically, the relationships between citizens and states whereas the

economic focus of PAT explains the relationships between the human beings and their

choice of decisions. An example of difference in notion of political economy and

economic focus of PAT is that it examines a range of relationships between the entity

and Suppliers of equity capital (owners), Managerial labour (management), Debt

capital (lenders or debt holders) whereas political economy deals with the relationship

of politics with the division of resources among the stakeholders.

8. “Exit-value accounting … has a tendency to “rough” the expenses and income … This

… is the basis for objections to reporting it. Some use the derisive term “yo-yo

profits” to express this objection” (Sterling 1979: 200). Discuss Sterling’s statement

with respect to the advantages and disadvantages of three asset valuation

approaches.

The statement above states that the exit value accounting makes the incomes and

expenses appear uneven. It is indicated by Sterling in the above statement, there has

been mixed reactions about the three valuation systems and so far no valuation

system has been regarded as best and without any disadvantages. We are discussing

each valuation approach has its own set of advantages and disadvantages which are

discussed below:

Exit or fair value: Fair or exit values valuation refers to the values of assets and

liabilities at the end of accounting period. It is the value that an asset would fetch

being sold in the market at the end of accounting period minus the cost of selling. The

main advantage of this method is that it displays an actual value of a business and this

can be a huge advantage to the investors and seekers of financial information. In

contrast to the historic cost method, the fair values can be compared as it is based on

asset characteristics rather than company characteristics.

The main problem with this method is that it is difficult to obtain the ‘correct’ value of

any asset. Also while reporting assets at their fair value they needs to be recognizing

the gains and losses in income statement. Also there is lack of evidence to support the

fair value, since it is based on assumptions only and every analyst has its own set of

assumption to reach to a value.











be paid.














9. How do you expect Adidas and Nike to respond to the following press release by

Greenpeace? Use two accounting theories to discuss your answer:

“Greenpeace activists displayed a banner with the message "Detox" at the main

entrance of both the world's largest Adidas store and a nearby Nike store today in

Beijing, calling on the sportswear giants to remove toxic chemicals from their supply

chains and from their products. The demand comes as the result of a year-long

Greenpeace investigation into toxic water pollution in China” (13 July 2011).

Adidas and Nike are global companies and hold responsibility for CSR activities. The

firms may say that it’s not their responsibility to take care of supply chains and their

products as they do not own their factories or supply channel, they just own brands

and focus on their marketing. As a result these firms must act in such a way that they

are doing development using the social resources, so it is their responsibility to give it

back to the society, what they are using.

There are ethical theories built behind this, which focus on what is the right thing for

companies to do to achieve a good society. These are:

Ethical (normative) branch of stakeholder theory

Sustainable development

Ethical branch of stakeholder theory states that all stakeholders have the right to be

treated fairly by an organisation be it the shareholders or the society. The issues of

stakeholder power are not directly relevant. Management should manage the

organisation for the benefit of all stakeholders. Each group merits consideration in its

own right. It states that the stakeholders have a right to be provided with information,

even if that information is not used by them. Where interests conflict, business

managed to attain optimal balance among them. Each group merits consideration in

its own right.

The ethical theories of sustainable development explain that the firms should

participate encouragingly in sustainable development. Sustainable development refers

to development that meets the needs of the present without compromising the ability

of future generations to meet their own needs. This theory originally focused only on

environmental factors, but now it considers both social and environmental factors.

10. :

a. Why is there such a variety of accounting theories? b. Give examples of theories and

explain how they differ.

In any theory there is a display of organized way of thinking about a subject.

Accounting theories are statements of concepts and their interrelationships that show

how and/or why a phenomenon occurs. There are a variety of accounting theories

because that they make sense to the world and communicate understanding to

others. Accounting theories help to summarize the information making it easier for

people to interpret. Since the theories always try to explain with reasons, the logic

that is underlying behind a particular practise. Generally accepted accounting

principles are widely accepted and hence, they cannot be changed completely for

one’s interest. With the help of accounting theories, it is possible to re-module and

reforms these principles to suit the needs of any changed society or economy. The

accounting theories are required so that we can make better predictions and decisions

if we get the contradictions out of our thinking, if we consider what is known on the

many sides of the issue.

Various accounting theories can be:

Regulatory theories: Regulatory theories comment on rules that have been

developed by an independent authoritative body that has been given the power

to govern how we are to prepare financial statements. Regulation theories

explain: Why regulation is put in place and which parties benefit from

regulation, Why particular accounting standards are in place and not others,

Accounting standards are not necessarily ‘best’ standards but result of lobbying

& compromise.

Positive accounting theories: Positive accounting theories are aimed at

explaining and predicting accounting practice rather than prescribing particular

practices. Begins with assumption(s), and through logical deduction enables

prediction(s) to be made. Predictions are sufficiently accurate when tested

against observations of reality; they are regarded as having provided

explanation of why things are as they are.

Asset valuation theories: These are also known as normative theories. Their

main argument is to describe a variety of methods that can be used to assigning

a value to any particular asset. It is done by comparing various valuation

methods and selecting the best one depending upon the type of business and

usage of reporting. Various valuation methods are: Historical accounting, Entry

value accounting, exit value accounting, discounted cash flow etc.

b. How do normative, positive, and critical theories differ? Give examples of each.

On a broader perspective, the theories can be divided into three types i.e. normative,

positive, and critical theories. The theories differ on the basis of their usage. These

are:

Descriptive theories: Descriptive theories are the ones that describe what

people do. This is based on the common practise. It is carried on using a top-

bottom approach, applying a logic that hold true over a range of domain. The

main advantage of description theories is that they are accepted by majority of

people. Although they do not involve a critical evaluation of facts and nor do

they allow for change. For example: Whenever there are clouds, it would rain.

Since, there are clouds today; it can be deduced that it will rain today.

Prescriptive or normative theories: Prescriptive theories explain what the people

should do. It is based on assumption that there is always a best way to do a task.

The main advantage of this theory is that it can improve processed and the way

they are performed. The disadvantage is that it assumes only one best way is

possible, whereas there can be more than one. For example: Prescribing

accounting theories for fixed assets. Theory can say that fair value accounting is

the best method for the same.

Predictive or positive theories: These theories deal with explaining reasons for

people’s behaviour and predicting future behaviour. It can help to deduct, how a

change in particular thing can affect the other thing. Begins with assumption(s),

and through logical deduction enables prediction(s) to be made. Predictions are

sufficiently accurate when tested against observations of reality; they are

regarded as having provided explanation of why things are as they are. For

example: It is assumed that companies having similar characteristics would

revalue their assets. Looking into the characteristics of companies that do

revaluation, one can deduct the characteristic of companies that do revaluation.

Thereafter one can tell if a company would revalue its asset or not just by

looking at the characteristics.

Theories can be differentiated on following key points:

Point of

difference

Descriptive theories Prescriptive (normative)

theories

Predictive (positive) theories

Main theme Descriptive theories

say “what is”

Prescriptive theories say

“what should be”

Explanatory, predictive “why

it is” “what will happen”

What it explains Explains the already

known facts

Explains the already known

facts to deduct a best way

Explains why the things

happen and what affect it

could have on future

Degree of effort

required

Easy to deduce Easy to deduce but requires

in-depth analysis to select

the best way

Requires lot of assumption

and in-depth analysis

11. Discuss the statement that the typical investor can be termed homo heuristics rather

than homo economics.

Heuristics are efficient cognitive processes that ignore information. In contrast to the

widely held view that less processing reduces accuracy, the study of heuristics shows

that less information, computation, and time can in fact improve accuracy. Homo

economics on the other hand, is the concept in many economic theories of humans as

rational and narrowly self-interested actors who have the ability to make judgments

toward their subjectively defined ends. Using these rational assessments, homo

economics attempts to maximize utility as a consumer and economic profit as a

producer.

It clearly emerges that in real life people do not always make rational decisions based

on established preferences and complete information. In many ways their behaviour

thus contradicts the homo economics model. Much of the behaviour observed is

caused through people trying to cope with the complexity of the world around them

by approximating, because collating and evaluating all the factors of relevance to a

decision overtaxes their mental processing capacity. As a rule these approximation

methods deliver serviceable results, but they often also lead to distorted perceptions

and systematic flaws.

A typical investor can be termed as homo heuristic since homo economics acts as an

actor with too great of an understanding of macroeconomics and economic

forecasting in his decision making. They stress uncertainty and bounded rationality in

the making of economic decisions, rather than relying on the rational man who is fully

informed of all circumstances impinging on his decisions. They argue that perfect

knowledge never exists, which means that all economic activity implies risk. Austrian

economists rather prefer to use as a model tool the homo heuristics. These days, the

investors are not much focused on the technical and fundamental analysis of stocks

while picking them up, rather they focus on selective information such as company

management and future projects to do their decision making. Gone are the times

when a typical investor would spend months tracking a stock before making a buy or

sell decision. Nowadays, these decisions are made quick and will the help of

technology, there is lot more ease to the brain of typical investor.

12.

a. What are the arguments in favour of using fair value to measure items included in

the financial statements? What are the arguments against the use of fair value?

In accounting and economics, fair value is one of the widely used accounting

approaches. In order to estimate a potential market price of an asset, service or

goods. In fair value accounting, the values of assets and costs can change with respect

to change in market prices. Major advantages of fair value accounting are:

Accurate valuation: To the users of financial information, fair value accounting

provides accurate valuation on the assets and liabilities. This means that with an

increase or decrease in price of an asset or liability, the balance sheet represents

its actual amount. This is done by marking up the value of asset or liability to its

market value and it represents the actual amount that would be received if the

asset is sold or actual amount to be paid for liability.

Reduced net income: When a company is using fair value accounting and the

company’s asset value decreases, at that time the company is able to report

reduces net income. It can also be reported at the time when the fair value of

liabilities increase. Since, the amount of tax a company would pay depends upon

its net income, reporting lower net income can be advantageous to company in

a way that they would have to pay fewer taxes. It also benefits the company in

one other way. Lower net income also leads to reduction in equity of the

company and hence the company has less money to be worried about. It means

less money goes out for dividends and less bonuses for employees.

Investor benefits: While the investors are rational to look for information about

the company before investing, the fair value accounting method provides a clear

picture about the actual health of a company. So, when it comes to analyzing

the investment option, this valuation proves handy to investors. The companies

are required to disclose changes in the form of footnotes. These footnotes allow

the investors a way of examining the health of a company and make their

decision.

Comparable: Fair values of assets and liabilities can be comparable with other

companies’ assets. It is because the fair value of any asset depends upon its

characteristics rather than the characteristics of the company. It is important

because in case of other methods, say historical cost method, the value of assets

are reported at their acquisition cost. It may be possible that at a same time,

same asset may be acquired by different companies at different values. So, it

would create a difficulty in comparing the assets.

Although in many countries including US, the fair value method is considered gold

standard, yet there are many critics of this method and they list out some

disadvantages of this method. The main arguments against this method are that it is

difficult to obtain the ‘correct’ value of any asset. Also while reporting assets at their

fair value they needs to be recognizing the gains and losses in income statement. Also

there is lack of evidence to support the fair value, since it is based on assumptions

only and every analyst has its own set of assumption to reach to a value. The objective

of financial statements is to provide the end users with inputs to assess the final value

of the asset, whereas the fair value method is supplying them with a ‘fair’ value

already. This creates a kind of circularity in the process and hence is not very good

estimate.

Adopting fair value accounting ignores one of the basic concepts of accounting i.e.

going concern concept. As it values the asset on the exit date, it assumes the value of

asset that it could be sold for. It also creates difficulty in knowing the value of certain

unique assets, whose market does not exist. It can be objectified only if the market of

this product exists and takes a subjective estimate. The fair values are made on the

basis of market prices, these market prices are nothing but the expectations of buyers

and sellers, and hence is not bound to be correct.

b. Explain the advantages and disadvantages of three different approaches to asset

valuation.

Following are the advantages and disadvantages of three most widely used valuation

approaches:











be paid.

Replacement cost or entry value: Replacement cost is often confused with fair value.

Replacement cost refers to the cost for which an asset would be replaced at a current

date whereas the fair value refers to the proceeds an asset would get in current price

levels minus the sales costs. While replacement cost deals with primary market for an

asset (sometimes second hand market too), fair value deals virtually with secondary

market to sell as asset or liability. This is one the oldest methods of accounting, used

very less currently. The main advantage of replacement cost accounting is that it is

relevant for decision making. The firm can decide on replacing the assets based on

their replacement costs and allow the users of financial information accurate current

information.

The major disadvantages of this method are similar to the ones in fair value method.

First it is difficult to find a correct replacement cost in case of second hand market and

secondly the residual value of damaged assets needs to be estimated and that again is

a subjective task. This would create the difference is correct estimation as the

replacement cost of an asset may be reduced by the residual cost of asset being

replaced. This method can only be useful for short term decision making process as

the values depend on the current market values and they are subject to change.














13. “If an accounting change that does not affect taxes is costly and has no other effect

on firm value, why do managers make those changes?” (Watts and Zimmerman).

Use insights from Positive Accounting Theory to explain this phenomenon.

Positive accounting theory explains and predicts accounting policy choice of various

firms. The theory helps us to understand the reasons as to why do firms select

particular accounting methods in favour of others. It also helps in answering why do

managers lobby regulators in regard to particular accounting methods. Positive

Accounting Theory is concerned with explaining accounting practice. It is designed to

explain and predict which firms will and which firms will not use a particular method,

but it says nothing as to which method a firm should use.

The theory works by examining the range of relationships between the companies and

owners, managers and creditors. It explains a number of differences that occur among

these three and possible actions to overcome the differences. Since, the question talks

about accounting policy change, it is important to understand that accounting policies

forms one of the major components of both manager remuneration and lending

contracts. As a result management makes judgement to make a range of accounting

decision on a daily basis. The actions of managers are assumed to be a part of actions

to maximize their own wealth. They do this based on a rational economic person

assumption.

Positive accounting theory presents three hypotheses on which managers base their

accounting choices:

Bonus hypothesis

Debt hypothesis

Political cost hypothesis

Insights from bonus hypothesis: A manager being a rational human being works

towards maximising his/her wealth. For that managers are more likely to use

accounting methods that increase current period income. This is also called

management compensation hypothesis. This action increases the present value of

bonuses paid to management. The managers have incentive to manipulate

earnings, as it would affect their short term rewards.

Insights from Debt hypothesis: It can be inferred from this hypothesis is that

higher the firm’s debt/equity ratio, the more likely managers use accounting

methods that increase current period income. This hypothesis is also called

debt/equity hypothesis. The higher the debt/equity ratio, the closer the firm is to

the constraints in debt covenants and covenant violation results in costs of

technical default. So in order to avoid this situation, mangers increase their

earnings while reporting.

Insights from Political cost hypothesis: Political cost theory can be used to learn

reasons managers are induced to keep the profits low to stay out of political

attention. Also, reduction of reported income is hypothesised to reduce the

possibility that people will argue that the organisation is exploiting other parties.

That is why firms likely to adopt accounting methods to reduce profits to lower

political scrutiny. The political cost accounting theory explains this phenomenon.

Positive accounting theory also explains choice of capitalization vs. expensing

decision that mangers make. It explains that managers on compensation contracts

which have bonuses tied to a current measure of entity performance would prefer to

capitalise costs, hence would want to report earnings upwards. Those entities which

have lending agreements with a leverage covenant would prefer to capitalise costs

to manage earnings upwards. Entities in the public eye would prefer to expense

costs to be able manage earnings downwards.

accounting questions project

Economy & Finance