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Lecture 2

AYB311 - Lecture 2 Notes

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LECTURE 2 – INTRODUCTION TO ACCOUNTING THEORY Accounting  Building blocks o Debits o Credits  Not changed for centuries o Now varied and complicated  More global  Cited as ‘language of business’ Financial Accounting  Regular reporting o Financial position and performance o Financial statements  External users – this is the only information which they recieve Accounting Theory  Viewed as a ‘practical’ discipline o How to apply accounting rules o Using computerised accounting programs o Limited theory in the past o Needed to provide basis for decisions as business became more complex and more frequent  Thus, conceptual framework  Current attempt to merge GAAP with ISFRS What theory is ?  Dictionary definitions focus on notions of o Beliefs or principles o Ideas o Explanation o Opinion Accounting theory means ...  ‘a description, explanation or a prediction *of accounting practice based+ on observations and/or logical reasoning’ o Prediction not always needed  ‘Logical reasons in the form of a set of broad principles that (1) provide a general framework of reference by which practice can be evaluated and (2) guide the development of new practice and procedures’ o Preferred definition Why is theory needed?  Providing an explanation of what is happening  Helping us predict what will happen  Provide solutions to problems  Competing theories Why is theory needed in an accounting context? o Describe and explain current accounting practice  Eg capital market theory – how share prices react to accounting information o Predicting accounting practice  Eg. Agency theory – how managers may respond to particular accounting practices o Providing principles to guide decision making eg when or under what circumstances should an asset be recognised o Identification of problems Types of theories  Theories are often placed into two categories: o Positive …  ‘What is’ o Normative …  ‘What should happen’ Positive  Describe what is actually happening  Explain what is happening  Make predictions about what will happen o often framed as a hypothesis o which is tested to help decide whether the theory is correct Normative  What should happen, or What ‘ought to be’  Prescriptions or recommendations  With the aim to achieve some goal or objective o More research done on the positive theory Evaluating and testing theories  Financial accounting o Alternative theories about how items should be measured  Number of reasons theories might be accepted without ‘first hand’ or direct knowledge o Examining the logical construction o Considering the evidence Falsification  The rational way to use observation to test a theory is not to try to find observations that confirm the theory but to search for instances that do not fit with the theory, which disprove it Relationship between theory and research  Empirical research  Associated with both positive and normative theories  Based on observation or experience  Exploratory, descriptive, investigative or causal  Research can come before theory  Research can come after theory Research of or about accounting  Role of accounting o Is accounting useful in making investment decisions  Response of share prices to the release of accounting information o Is accountability more important than decision usefulness as the main purpose for accounting  Critical accounting  A critical understanding of the role of accounting processes and practices and the accounting profession in the functioning of society and organisations with an intention to use that understanding to engage (where appropriate) in changing these processes practices and the profession (Laughlin 1999, p.73). Research in accounting o Considers questions such as  What measurement models should be used  What information should be disclosed  Is it necessary to disclose director remuneration  What is the impact of specific accounting policies What is contracting theory?  Attempts to explain and predict the incentives for and economic consequences from the adoption of alternative accounting policies  Including o the demand for accounting information o motivations for accounting changes o lobbying behaviour on accounting regulation o share price reaction to accounting changes Agency theory  A principal-agent relationship arises from separation of ownership and management  The 2 major principal-agent relationships are between: (1) shareholders and managers (2) debtholders and shareholders  It is assumed that in (2) managers act in the interest of shareholders Information Asymmetry and Moral Hazard  Inherent in an agency situation is the information asymmetry problem of moral hazard  Typically it is assumed that (1) the agent has access to superior information (manager) (2) the principal cannot observe the agent’s behaviour (shareholder) (3) the agent uses this position to maximise the agent's self interest at the expense of the principal Agency Costs  Two types of agency costs (in the absence of agency resolution mechanisms) o Agency costs of equity o Agency costs of debt Factors Mitigating Agency Costs of Equity  Management compensation (bonus) plans  Managerial labour market o external & internal  Auditing o external & internal  Corporate governance practices & policies o audit committees, independent
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