Question 1: (10 marks – approx 20 minutes) From a critical perspective, can fina

Question

Question 1: (10 marks – approx 20 minutes)
From a critical perspective, can financial statements ever be considered objective or neutral? Explain your answer.
Question 2: (10 marks – approx 20 minutes)
Assume that XYZ Company Ltd decides to undertake an upward revaluation of its non-current assets just prior to year end of the financial year, the effects being that the total assets of the company increases, as does the total shareholders’ equity.
(a) Explain the decision of management to undertake an asset revaluation in terms of the debt hypothesis of Positive Accounting Theory (5 marks).
(b) Explain the decision of management to undertake an asset revaluation in terms of the management compensation hypothesis of Positive Accounting Theory (5 marks).
Question 3: (10 marks – approx 20 minutes)
Identify and explain the perceived benefits that flow from the decision that a country will adopt the International Financial Reporting Standards (IFRS).
Question 4: (10 marks – approx 20 minutes)
Compare and contrast the development and evaluation of positive accounting theories with normative accounting theories.

Explanation / Answer

From a critical perspective, can financial statements ever be considered objective orneutral? Explain you answer.

From a critical perspective, financial statements would probably never be considered asobjective or neutral. Critical theorists consider that accounting serves to maintain the interestsof those individuals with financial capital. Accounting is seen as a means of constructing andlegitimising particular social orders. Arguments are also provided that those responsible forregulating accounting, and those involved in accounting research, act to sustain current socialorders as such individuals typically benefit from the existing systems. So, while regulators (forexample government) may look as though they are putting in place rules or mechanisms tofurther the interests of particular disadvantaged groups, in essence, the government isprobably only attempting to legitimise the current social system. Merino and Neimark (1982,p.49) relate this view to the development of Securities Acts in the United States. They contendthat ‘the securities acts were designed to maintain the ideological, social and, economicstatus quowhile restoring confidence in the existing system and its institutions’. This view isalso held by Puxty. He argues (1986, p.87)

:financial information is legislated by the governing body of society (the state)which is closely linked to the interests of the dominant power group in society(Offe & Ronge, 1982; Miliband, 1969, 1983) and regulated either by agencies ofthat state or by institutions such as exist within societies like the United Kingdom,United States, and Australia that are linked to the needs of the dominant powergroup in partnership with the state apparatus.

2 (a) Explain the decision of management to undertake an asset revaluation in terms of the debt hypothesis of Positive Accounting Theory

The debt/equity hypothesis predicts that the higher the firm’s debt/equity (or debt/asset) ratio,the more likely managers will use accounting methods that increase income (increase assets)and thereby decrease the likelihood that an entity would breach any debt covenants that mightexist.

If Kahuna Company Ltd undertook and an upward revaluation just prior to year end the debthypothesis would suggest that perhaps the company was close to breaching a debt covenantand the revaluation was required to reduce the likelihood of a technical default of the debtagreement.

(b) Explain the decision of management to undertake an asset revaluation in terms of the management compensation hypothesis of Positive Accounting Theory.

The debt/equity hypothesis predicts that the higher the firm’s debt/equity(or debt/asset) ratio, the more likely managers will use accountingmethods that increase income (increase assets) and thereby decrease thelikelihood that an entity would breach any debt covenants that mightexist.If Kahuna Company Ltd undertook and an upward revaluation justprior to year end the debt hypothesis would suggest that perhaps thecompany was close to breaching a debt covenant and the revaluationwas required to reduce the likelihood of a technical default of the debtagreement.(b)The management compensation (or bonus plan) hypothesis predictsthat managers of firms with bonus plans (tied to reported income) aremore likely to use accounting methods that increase current periodreported income. To determine whether the act of undertaking anupward asset revaluation is consistent with the management

compensation hypothesis we need to establish whether an upwardrevaluation has the implication of increasing reported profits.If we undertake an upward revaluation and the assets are depreciable,then this will increase the depreciable base of the assets leading to anincrease in depreciation expense and therefore a reduction in profits.Further, the upward revaluation will result in a credit to revaluationsurplus, rather than being treated as part of profits. Also, any gain onsale of a non-current asset will be reduced as a result of a revaluationincrement (the gain on sale being the difference between the fair valueof the consideration less the carrying amount of the asset). Hence, theeffect of an upward revaluation is to decrease reported profits despitethe fact that the revaluation acts to increase the net assets of the entity.Therefore, an upward revaluation cannot be explained by themanagement compensation hypothesis. If we accept that PAT providessound predictions or explanation of accounting choices then perhapsthe firm was close to breaching a debt covenant and the benefits tomanagers of avoiding the breach more than offset the potentiallynegative impacts on management compensation (also, the firm mayhave been subject to political costs and an upward revaluation mayhave been part of a portfolio of accounting choices used to reducereported income and therefore the possibility of political costs beingimposed)

3. Identify and explain the perceived benefits that flow from the decision that a country will adopt the International Financial Reporting Standards (IFRS).

1.      The first factor is that IFRS promise more accurate, timely and comprehensive financial statement information that is relevant to the national standards. And the information provided by financial statements prepared under IFRS tends to be more understandable for investors as they can understand the financial statement without the necessity of other sources which makes investors more informed

2.     This also helps new or small investors by making the reporting standards simpler and better quality as it puts small and new investors in the same position with other professional investors as it was impossible under the previous reporting standards. This also helps to reduce the risk for new or small investors while trading as professional investors can not take advantage due to the simple to understand nature of financial statements.

3.     Due to harmonization and standardization of reporting standards under IFRS, the investors do not need to pay for processing and adjusting the financial statements to be able to understand them, thus eliminating the fees of analysts. Therefore, IFRS reduces the cost for investors.

4.     Reducing international differences in reporting standards by applying IFRS, in a sense removes a cross border takeovers and acquisitions by investors.

Based on information mentioned above, it can be assumed that because higher information quality reduces both the risk to investors from buying and owning shares and the risk to less informed investors due to wrong selection due to lack of understanding, it should lead to reduction in firms cost of equity capital.

4 ) Compare and contrast the development and evaluation of positive accounting theories with normative accounting theories.

A positive 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. E.g. A positive theory of accounting may yield a prediction that, if certain conditions are met, then particular accounting practice will be observed.

Positive theories can initially be developed through some form of deductive (logical) reasoning. Their success in explaining or predicting particular phenomena will then typically be assessed based on observation –that is, observing how the theory’s predictions corresponded with the observed facts.

Positive Accounting Theory is developed by Watts and Zimmerman, which seeks to predict and explain why managers elect to adopt particular accounting methods in preference to others. The theory relied in great part of work undertaken in the fields of economics, and central to the development of Positive Accounting Theory was the acceptance of economics based ‘rational economic person assumption”.

That is the assumption that an accountant are primarily motivated by self-interest, and that the particular accounting method selected will be dependent on certain conditions.

Factors - FAT

However, PAT does not seek to tell us that what is being done in practice is the most efficient or equitable process.

While positive theories tend to be based on empirical observation, there are other theories based not on observation but rather on what the researcher believes should occur in particular circumstances. Theories that prescribe particular actions are called normative theory.

For example, Chambers Continuously contemporary accounting describes how financial accounting should be undertaken. It is prescriptive and central to this theory is a view that most useful information about an organization’s assets for the purpose of economic decision is information about their current cash equivalent.

Normative theories of accounting are not necessarily based on observation and therefore cannot (or should not) be evaluated on whether they reflect actual accounting practice.

The conceptual framework of accounting is an example of a normative theory of accounting. Relying on various assumptions about the types or attributes of information useful for decision making, The CFA provides guidance on how assets, liabilities, expenses, income and equity should be defined, when they should be recognized, and ultimately how they should be measured.

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