Accounting Theory and Application – final exam review

Week 1
Chapter 1: Introduction
Key terms and concepts: Theory, Accounting theory, Normative theory, Positive theory, Behavioural
theory, Conceptual framework, IFRS
1. Overview of Accounting theory
(1) What is a theory: (Hendriksen’s definition) …the coherent set of hypothetical, conceptual and
pragmatic principles forming the general framework of reference for a field of inquiry
(2) What is an accounting theory: …logical reasoning in the form of a set of broad principles that
1) Provide a general framework of reference by which accounting practice can be evaluated and
2) Guide the development of new practices and procedures
(3) Whether a theory is accepted depends on how 1) well it explains and predict reality; 2) well it is
constructed both theoretically and empirically; 3) acceptable its implications are
(4) Accounting theory is a modern concept compared to mathematics or physics
(5) Even Pacioli’s treatise on double-entry accounting focused on documenting practice and did not
explain the underlying theoretical basis for it
(6) Chambers: accounting has frequently been described as a body of practices which have been
developed in response to practical needs rather than by deliberate and systematic thinking
(7) Was developed to resolve problems as they arose – reactive; Ad hoc approach
(8) Led to inconsistencies in practice e.g. different depreciation methods
(9) Accounting standard setting: conceptual framework projects have not resolved inconsistency in
practice
2. Pre-theory (1400s – 1800)
(1) Goldberg: no theory of accounting was devised from the time of Pacioli down to the opening of the
19th century
3. Pragmatic accounting (1800 – 1955)
(1) The ‘general scientific period’: 1) based on empirical observation of practice; 2) provided an
explanation of accounting practice; 3) focused on the existing ‘viewpoint’ of accounting
4. Normative accounting (1956 – 1970)
(1) Sought to establish ‘norms’ for the best accounting practice; focused on what should be (the ideal)
vs. what is
(2) Degenerated into battles between competing viewpoint
(3) Two groups dominated: 1) conceptual framework proponents; 2) critics of historical cost
(4) Factors prompting the demise of the normative period include
1) The unlikelihood of one particular normative theory being generally accepted
2) The application of financial economic principles; the availability of empirical data and new
testing methods
(5) The major criticism of normative theories were: 1) they do not necessarily involve empirical
hypothesis testing; 2) they are based on value judgements
5. Positive accounting (1950 to the present day)
(1) A shift to a new form of empiricism called ‘positive theory’; had its origins in the ‘general scientific
period’
(2) It seeks to explain the accounting practices being observed; objective is to explain and predict
accounting practice
(3) It helps predict the reactions of ‘players’, to the actions of managers and to reported accounting
information
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(4) Major deficiencies are

1) ‘Wealth maximisation’ has become the answer to explain all accounting practices and reported
information
2) It relies excessively on agency theory and dubious assumptions about the efficiency of markets
(5) Behavioural research
1) Concerned with the sociological implications of accounting numbers/the associated actions of
‘key players’
2) Emerged in the 1950s; despite growing acceptance since the 1980s, positive accounting theory
still dominates
6. Recent developments
(1) Academic and professional developments in accounting theory have tended to take different
approaches
(2) Academic research focuses on capital markets, agency theory and behavioural aspects
(3) The profession has sought a more normative approach – what accounting practices should be adopted
(4) Conceptual framework – resurrected in 1980s: 1) states the nature and purpose of financial reporting;
2) established criteria for deciding between alternative accounting practices; 3) SACs 1-4
(5) Conceptual framework – recent developments
1) Joint project between IASB and FASB
2) International harmonisation of accounting practices through a single consistent set of
international financial reporting standards (IFRS)
(6) The conceptual framework underpinning the IFRS favours a move toward
1) Accounting practices that provide information for enhancing decision making by investors and
others
2) Recognising all gains and losses in the accounting periods in which they occur
3) Measurement using exit values

Chapter 2: Accounting Theory Construction

Key terms and concepts: Descriptive pragmatic approach, Psychological pragmatic approach, Syntactic
and semantic approach, Historical cost accounting, Normative theories, Positive theories, Scientific
approach to theory, Naturalistic approach to theory, Auditing theory
1. Pragmatic theories
(1) Descriptive pragmatic approach
1) Based on observed behaviour of accountants; theory developed from how accountants act in
certain situations
2) Tested by observing whether accountants do act in the way the theory suggests; is an inductive
approach
(2) Criticisms of descriptive pragmatic approach
1) Does not consider the quality of an accountant’s action; not provide for accounting practices to
be challenged
2) Focused on accountants’ behaviour not on measuring the attributes of the firm
(3) Psychological pragmatic approach
1) Theory depends on observations of the reactions of users to the accountants’ outputs
2) A reaction is taken as evidence that the outputs are useful and contain relevant information
(4) Criticisms of the psychological pragmatic approach: some users 1) may react in an illogical manner;
2) might have a preconditioned response; 3) may not react when they should
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(5) Theories are therefore tested using large samples of people

2. Syntactic and semantic theories
(1) Semantic inputs are the transactions and exchanges recorded in vouchers, journals and ledgers
(2) The inputs are then manipulated on the basis of the premises and assumptions of historical cost
accounting
(3) Criticised because there is no independent empirical verification of the calculated output
(4) The outputs may be criticised for poor syntax inaccurate e.g. different types of monetary measures
added together
(5) The outputs may be syntactically accurate but nevertheless be valueless due to a lack of semantic
accuracy (a lack of correspondence with real-world events, transactions or values)
(6) Historic cost accounting may produce ‘accurate outputs but which nevertheless have little or no
utility
(7) That is, they are not useful for economic decision making except to verify accounting entries
3. Normative theories
(1) 1950s and 1960s ‘golden age’: 1) policy recommendation; 2) what should be; 3) concentrated on
deriving – true income/practices that enhance decision-usefulness; 4) based on analytic and
empirical propositions; 5) financial statements should mean what they say
(2) True income: 1) a single measure for assets; 2) a unique and correct profit figure
(3) Decision usefulness: the basic objective of accounting is to aid the decision-making process of
certain ‘users’ of accounting reports by providing useful accounting data
(4) The decision process: accounting system of company XPrediction model of userDecision model
of user
4. Positive theories
(1) Expanded during the 1970s; based on ‘experiences’ or ‘facts’ of the real world
(2) Explain the reasons for current practice; predict the role of accounting information in decision-
making
(3) The main difference between normative and positive theories is that: 1) normative theories are
prescriptive; 2) positive theories are descriptive, explanatory or predictive
5. Different perspectives
(1) Scientific approach: 1) has an inherent assumption that the world to be researched is an objective
reality; 2) is carried out by incremental hypotheses; 3) has an implied assumption that a good theory
holds under circumstances that are constant across firms, industries and time
(2) Criticism of the scientific method: 1) large-scale statistical research tends to lump everything
together; 2) it is conducted in environments that are often remote from the world of or the concerns
of accountants
(3) Naturalistic approach: 1) implies that there are no preconceived assumptions or theories; 2) focuses
on firm-special real-world problems
(4) Alternative ways of looking at the world
CATEGORY ASSUMPTION
a) Reality as a concrete structure
b) Reality as a concrete process
c) Reality as a contextual field of
information
d) Reality as a symbolic discourse

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e) Reality as a social construction

f) Reality as projection of human
imagination
6. Scientific approach applied to accounting
(1) Misconceptions of purpose: 1) make scientists out pf accounting practitioners; 2) researchers =
practitioners; 3) the desire for ‘absolute truth’
(2) The scientific method does not claim to provide ‘truth’; it attempts to provide persuasive evidence
which may describe, explain or predict
7. Issue for auditing theory construction
(1) Auditing is a verification process that is applied to the accounting inputs and processes
(2) Auditors provide an opinion on: 1) whether the financial statements accord with the applicable
reporting framework; 2) whether the statements give a true and fair view
(3) The normative era of accounting coincided with a normative approach of auditing theory
(4) The positive era of accounting has led to a positive approach to auditing theory

Week 2
Chapter 3: Applying Theory to Accounting Regulation
Key terms and concepts: Efficient markets, Agency relationships, Public interest, Regulatory capture,
Private interest, Political process, Regulatory framework, Accounting and auditing standards
1. The theories of regulation relevant to accounting and auditing
(1) Managers have incentives to voluntarily provide accounting information, so why do we observe the
regulation of financial reporting? Explanations are provided by: theory of efficient markets, agency
theory, theories of regulation
2. Theory of efficient market
(1) The forces of supply and demand influence market behaviour and help keep markets efficient
(2) This applies to the market for accounting information and should determine what accounting data
should be supplied and what accounting practices should be used to prepare it
(3) The market for accounting data is not efficient; the ‘free-rider’ problem distorts the market
(4) Users cannot agree on what they want; accountants cannot agree on procedures
(5) Firms must produce comparable data; the government must therefore intervene
3. Agency theory
(1) The demand for accounting information: 1) for stewardship purposes; 2) for decision-making
purposes
(2) A framework in which to study the relationship between those who provide accounting information
(e.g. a manager) and those who use it (e.g. a shareholder or creditor)
(3) Because of imbalances between data suppliers and data users, uncertainty and risk exist
(4) Resources and risk are likely to be misallocated between the parties
(5) To the extent the market mechanism is inefficient, accounting regulation is required to reduce
inefficient and inequitable outcomes
4. Theories of regulation: public interest theory, regulatory capture theory, private interest theory
5. Public interest theory
(1) Government regulation is required in the ‘public interest’ whenever there is market failure
(inefficiency) due to: 1) lack of competition; 2) barriers to entry; 3) information asymmetry; 4)
public-good products

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(2) Governments intervene: 1) to get votes; 2) because public interest groups demand intervention; 3)
because they are neutral arbiters
6. Regulatory capture theory
(1) The public interest is not protected because those being regulated come to control or dominate the
regulator
(2) The regulated protect or increase their wealth
(3) Assume the regulator has no independent role to play but is simply an arbiter between battling
interest groups
(4) Professional accounting bodies or the corporate sector seek to control the setting of accounting
standards
7. Private interest theory
(1) Governments are not independent arbiters; but are rationally self-interested; they seek re-election
(2) They will ‘sell’ their power to coerce or transfer wealth to those most likely to achieve their re-
election (if they are elected officials) or increase their wealth (if they are appointed officials) or both
8. Standard setting as a political process
(1) Standard setting is a political process because it can affect many conflicting and self-interested
groups
(2) The regulator must make a political choice; the regulator must have a mandate to make social choice
(3) The recognition of doubtful debts can affect entities differently
9. The elements of a regulatory framework are: 1) statutory requirements; 2) corporate governance; 3)
auditors and oversight; 4) independent enforcement bodies
10. Corporate governance
(1) (Davis) The structures, processes and institutions within and around organisations that allocate power
and resource control among participants
(2) Supranational and national bodies have issued corporate governance recommendations

Week 3
Topic 3: The Conceptual Framework and Accounting Standard Setting
 Chapter 2 & 3: Contemporary issues in accounting by Rankin et al
1. The role of a conceptual framework: a group of ideas or principles used to plan or decide something
(1) It is a normative theory; it is prescribes the basic principles that are to be followed in preparing
financial statements
(2) It is a coherent system of concepts, which are guidelines to the accounting standards used for
financial reporting
2. Conceptual framework vs. Accounting standards
(1) The conceptual framework is designed to provide guidance and apply to a wide range of decisions
(2) Accounting standards: 1) specific requirements for a particular area; 2) may go beyond the
framework; 3) are mandatory; 4) sometimes conflict with the framework
3. Purpose, objective and underlying assumption
(1) The conceptual framework states that it is concerned with general purpose financial reports: these
are financial reports intended to meet the needs of users who are not in a position to require an entity
to prepare reports tailored to their particular information needs; not special purpose financial reports
(2) Proposed definition of a reporting entity: a reporting entity is a circumscribed area of economic
activities whose financial information has the potential to be useful to existing and potential equity
investors, lenders, and other creditors who cannot directly obtain the information they need in
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making decisions about providing resources to the entity and in assessing whether the management
and the governing board of that entity have made efficient and effective use of the resources
provided
(3) Focus on economic events and transactions, not legal form; designed for ‘for-profit’ entities
(4) Does not actually set out which entities must prepare General Purpose financial Reports: this is a
matter for individual countries to decide at law
4. The objective of financial reporting
(1) The conceptual framework: the objective of general purpose financial reporting is to provide
financial information about the reporting entity that is useful to existing and potential investors,
lenders and other creditors in making decisions about providing resources to the entity. Those
decisions involve buying, selling or holding equity and debt instruments, and providing or settling
loans and other forms of credit
(2) Financial statement should provide information that is useful to users in making decisions: 1) help
predict the future; 2) provide feedback on previous decisions; 3) accountability and stewardship
(3) The conceptual framework identifies the following users: existing and potential investors, lenders,
other creditors
(4) Very limited list when compare with previous framework
5. Underlying assumption
(1) The conceptual framework: the financial statements are normally prepared on the assumption that an
entity is a going concern and will continue in operation for the foreseeable future
(2) Affects recognition and measurement
6. Qualitative characteristics of useful financial information
(1) There is a hierarchy of qualitative characteristics: fundamental, enhancing
(2) To be useful for decision making: 1) information must have both of the two fundamental
characteristics; 2) the enhancing characteristics are not essential, but can improve the usefulness of
the information
7. Fundamental qualitative characteristics
(1) Relevance: 1) aim to ensure that only useful information is included; 2) materiality
(2) Faithful representation: what is shown corresponds to the actual events and transactions that are
being represented; three key elements – complete depiction, neutrality, freedom for error
8. Enhancing qualitative characteristics
(1) Comparability: achieved with consistent measurement and presentation of items over time and
between entities
(2) Verifiability: information can be supported or confirmed so that users are confident in relying on it
(3) Timeliness: users need information on a timely basis
(4) Understandability: financial reports are prepared for users who: 1) have reasonable knowledge of
business and economic activities, and 2) will conduct a diligent review and analysis of the
information
9. Recognition criteria
(1) Recognition is the process of incorporating an item in the balance sheet or income statement… It
involves depiction of the item in words and by a monetary amount and the inclusion of that amount
in the balance sheet or income statement totals
(2) Two tests for recognition: probability, measurability
10. Probability
(1) An element should be recognised if: it is probable that any future economic benefit associated with
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the item will flow to or from the entity

(2) Probability criteria is met if ‘the event of more likely than not to occur’
11. The benefits of a conceptual framework
(1) Technical benefits
1) Improve the practice of accounting and to provide a basis for answers to specific accounting
questions
2) It is stated that the conceptual framework does this in two ways: a) by providing a basis and
guidance for those who set the specific accounting rules; b) by helping individuals involved in
preparing or auditing or using financial statements
(2) Political benefits: prevent political interference in setting accounting standards – accounting
information has significant real-world affect
(3) Professional benefits: protect the professional status of accounting and accountants
12. Problems and criticisms of conceptual framework
(1) It is ambiguous: 1) the principles are too vague; 2) too much room for alternative interpretations
(2) It is descriptive not prescriptive: 1) the conceptual framework simply describes current accounting
practice; 2) should be prescriptive (normative) and try to improve practice
(3) The concept of faithful representation is inappropriate
1) Realistic view: financial statements… Are representationally faithful to the extent that they
provide an objective picture of an entity’s resources and obligations
2) Materialist view: although the underlying events and transactions do exist the accounting
measures that are reported and created by accountants and do not exist independently of them
13. Rule-based vs. Principles-based standards
(1) Rule-based standards: sets of detailed rules that must be followed when preparing financial
statements
(2) Principles-based standards: based on a conceptual framework that provides a broad basis for
accountants to follow – the focus is on economic substance of a transaction, engaging the
professional judgement and expertise of those preparing financial statements
14. Disadvantages of rules-based standards
(1) Can be very complex; organisations can structure transactions to circumvent unfavourable reporting
(2) Standards are likely to be incomplete or even obsolete by the time they are issued
(3) Manipulated compliance with rules makes auditing more difficult
15. Advantages of principles-based standards
(1) Are simpler; they supply broad guidelines that can be applied to many situations
(2) They improve the representational faithfulness of financial statements
(3) They allow accountants to use their professional judgement
(4) Evidence suggests that managers are less likely to attempt earnings management
16. Disadvantages of principles-based standards
(1) Managers may select treatments that do not reflect the underlying economic substance
(2) The judgement and choice involved in many of the decisions mean that comparability among
financial statements may be reduced
Tutorial 3
1. What is the difference between a conceptual framework and accounting standards?
(1) The conceptual framework provides high level concepts such as definitions of elements of financial
statements, qualitative characteristics, definition of the objective of general purpose financial
reporting. Standards apply the concepts in specific situations — for example, accounting for
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financial instruments, leases and inventory

(2) The standards setters base new accounting standards, and amendments to old, on the conceptual
framework
(3) Standards take precedence in the event of conflict as the Conceptual Framework. In Australia, the
Conceptual Framework does not have legal force for reporting entities subject to the Corporations
Law; accounting standards do. However, concepts from the conceptual framework are now included
in all new and reissued accounting standards. Therefore, application of such embedded concepts is
mandatory because these are included in accounting standards
2. Outline the technical benefits of a conceptual framework. What problems could occur if accounting
standards were set without a conceptual framework?
The technical benefits relate to improving how financial reporting works – either though improving
quality, or accounting practice, via improving understanding. The Conceptual Framework outlines these
under its purpose section
(1) To assist the Board in the development of future IFRSs and its review of existing IFRS
(2) To assist the Board in promoting harmonisation of regulations, accounting standards and procedures
relating to the presentation of financial statements by providing a basis for reducing the number of
alternative accounting treatments permitted by IFRSs
(3) To assist national standard-setting bodies in developing national standards
(4) To assist preparers of financial statements in applying IFRSs and in dealing with topics that have yet
to firm the subject of an IFRS
(5) To assist auditors in forming an opinion on whether financial statements comply with IFRSs
(6) To assist users of financial statements in interpreting the information contained in financial
statements prepared in compliance with IFRS, and
(7) To provide those who are interested in the work of the IASB with information about its approach to
the formulation of IFRSs
The problems that could occur if standards set without a conceptual framework is
(1) Inconsistencies between standards if different concepts/principles used to develop different
accounting standards
(2) Time frame for developing standards could be longer as would need to debate underlying
principles/concepts each time new standard developed/changed
3. What does the IASB Framework describe as the basic objective of accounting? What are its
implications?
Stewardship looks primarily to the past, asking the question: What happened? Decision making looks to
consequences in the future, asking the question: What will happen? A decision-making approach sees
accounting information as inputs for the decision-making prediction models of users. If so, then we are
concerned about what kind of accounting information is relevant to decision makers. Some believe that
current value is implied. Also that statement of financial position accounts and their amounts are as
important as those in the income statement. Traditional accounting emphasises income
4. What type of information do you think is useful for shareholders, lenders and creditors? Is this the type
of information that is currently provided?
Useful information is both relevant and reliable. Presumably, it is also ‘fair’.
Adopting a narrow perspective, useful information provides a basis for investors and creditors to assess
the amount, timing and uncertainty of future cash flows for themselves based on the expected cash flows
of the firm. Such a basis is provided by information concerning the profitability and financial condition
of the firm. In turn, this information is presently reported in the statement of financial performance or the
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statement of financial position, and the statement of changes in financial position. For the latter, many
believe a cash flow statement is especially pertinent.
Taking a broader view, useful information helps to efficiently allocate capital in the economy.
5. Explain the advantages and disadvantages of principle-based and rule-based standards
The focus of principle based standards is on an underlying principle or principles. They require that the
principle be interpreted by financial statement preparers and auditors. They do not set out what preparers
are to do in a step by step manner. Rather, they provide guidance to be interpreted and applied in an
appropriate manner. They are more flexible, as they allow companies to apply the principles in a way
that is appropriate for their situation and business, in order to convey useful information for decision
making.
Rule-based standards include detailed directions about actions required by preparers. They are more
specific than principle-based standards, and may include ‘bright line’ thresholds such as “greater than
50%”. Rule based standards tend to be longer and more complicated, with more amendments, as
standard setters try to cover all situations in which the rules apply.
Specific rules are easier to follow and enforce so are favoured by some preparers, auditors and
regulators. However, one problem with rule based standards is that rules can be “worked around” to give
a result which is technically in compliance with the rules but does not meet the overarching objective of
the standard (the substance over form debate). It is possible to comply with the substance of a rule based
standard while not complying with its form. For example, leases which are in substance finance leases
are structured to meet the tests for operating leases so that they can be shown as operating rather than
financial leases in the financial statements.
6. Identify the qualitative characteristics of financial information in the conceptual framework. How are
these related to the objectives of general purpose financial reports?
The Conceptual Framework states that
QC 1. The qualitative characteristics of useful financial information discussed in this chapter identify
the types of information that are likely to be most useful to the existing and potential investors, lenders
and other creditors for making decisions about the reporting entity on the basis of information in its
financial report (financial information)
QC4. If financial information is to be useful, it must be relevant and faithfully represents what it
purports to represent. The usefulness of financial information is enhanced if it is comparable,
verifiable, timely and understandable.
So the rule of qualitative characteristics is to ensure that information provided to users has these qualities
as they will help ensure that the information is useful to users. This is directly related to the objective of
general purpose financial reports, which in the Conceptual Framework, is to provide information that is
useful to range of users in making decisions.
The Conceptual Framework identifies 2 fundamental qualitative characteristics: relevance and faithful
representation. To be useful information must have both of these. As the Conceptual Framework states:
QC 17. Information must be both relevant and faithfully represented if it is to be useful. Neither a
faithful representation of an irrelevant phenomenon nor an unfaithful representation of a relevant
phenomenon helps users make good decisions.
It also identifies a number of enhancing qualitative characteristics (comparability, verifiability, timeliness
and understandability) which increase the usefulness of information, each of these qualitative
characteristics is outlined in the Conceptual Framework and these outlines link each qualitative
characteristic with the usefulness and use of information by users.

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Contemporary Issue 2.2 New Lease Accounting to Have Big Impact

1. Consider the definitions of an asset and liability in the Conceptual Framework. Would a 5-year lease for
land meet these definitions?
An asset is a resource controlled by the entity as a result of past events and from which future economic
benefits are expected to flow to the entity: 1) future economic benefits would be the right to use the
assets (and the revenue/benefits that you obtain from using the land; 2) control would be established as
given the contract the lessee can obtain the benefits from sing the asset (that assets do not need to be
owned; 3) past event – would be lease contract that gave rise to lessee having right of use of asset and
controlling and accessing benefits
A liability is a present obligation of the entity arising from past events, the settlement of which is
expected to result in an outflow from the entity of resources embodying economic benefits: 1) the future
outflow of economic benefits/ resources would be the meeting of lease payments); 2) present obligation
– under leasing contract would assume have legal obligation to make payments; 3) past event – would be
lease contract that gave rise to obligation
Given the land has an indefinite life a 5 year lease of land would be classified as an operating lease and
would not give rise to an asset or liability. Under the proposed leasing standard this would change and an
asset and a liability would be recognised.
2. The extract discusses the fact that these changes reflect the way in which accounting is moving – that is,
towards putting all assets and liabilities on the balance sheet. What reasons could there be for this move?
Given the identified impact on key company ratios, do you believe this approach is justified?
Reasons towards the move towards putting all assets and liabilities on the balance sheet would be:
(1) Based on principles & objectives of financial reporting: To be consistent with the conceptual
framework all items that meet the definition and recognition criteria of assets and liabilities should
be included on the balance sheet. Also to be complete and so representationally faithful would argue
that need to include all elements. Surely information about the assets and liabilities of an entity
would be relevant to users.
(2) Improves comparability as does not distinguish on form or arbitrary rules but reflects economic
substance. For example, under current lease accounting 2 entities could have identical items of land –
one entity owns and one leases (as operating lease). The different accounting treatment would result
in one entity including an asset but the leasing one not. This would distort rations such as return on
assets etc. and make comparison difficult.
(3) Reduce opportunities to structure transactions on order to reflect a particular financial position (this
could include maintaining certain ratios). If all assets and liabilities meeting the recognition criteria
are required to be included on the balance sheet then this limits the ability of entities to choose or
plan transactions to avoid including these on their balance sheet or in particular to ‘hide’
obligations/ /commitments. Under the current leasing arrangements company may decide to lease
land rather than purchase (even those costs and commitments may be relatively equal) as leasing will
avoid the recognition of the lease liability and asset. It could be argued that the use of special purpose
entities by Enron which were not required to be included on the balance sheet and were used to hide
debt is an example of structuring transactions to reflect a particular financial position.
Clearly including all assets and liabilities on the balance sheet would impact on key financial ratios.
Whilst it could be argued that this could disadvantage some companies. However an alternative
argument is that if all assets and liabilities are included then this provides a more complete and
representationally faithful view of the financial position and hence the ratios are more ‘accurate’ and
useful.
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Case Study 4.3 Revisiting the Conceptual framework

1. Explain why principles-based standards require a conceptual framework
The aim of principles-based standards is to build on previously agreed upon principles, which do not
have to debate each time when a standard is being developed. For example, if definitions of elements are
agreed upon, they can be used in standards and not debated again. This approach aims to increase
consistency among standards and to reduce time taken in their formulation. Principle based standards
rely on the existence of underlying principles which can be used so that detailed rules do not have to be
provided. The conceptual framework provides a source of principles which can be used in accounting
standards. For example, if the conceptual framework provided an agreed approach to measurement e.g.
measure all assets and liabilities at fair value, then it would provide a principle which could be applied in
standards. The existence of a principle would make it easier and quicker to develop standards.
2. Why is it important that the IASB and FASB share a common conceptual framework?
A study by the SEC has recommended that US standards be more principles based. Therefore, additional
work on the principles underpinning the standards, that is, the principles contained in the conceptual
framework, is needed. The IASB/FASB convergence project has created a need to converge the bodies’
conceptual frameworks. Since standards are based on underlying conceptual frameworks, it is necessary
to achieve convergence of standards.
3. It is suggested that several parties can benefit from a conceptual framework. Do you consider that a
conceptual framework is more important for some parties than others? Explain your reasoning.
Standard setters are the major beneficiary of a sound conceptual framework. It allows them to develop
their standards based on agreed upon principles. The article states that the IASB and FASB base their
accounting standards to a large part on the foundations of objectives, characteristics, definitions, and
criteria set forth in their respective conceptual frameworks. Further, it states that principles-based
standards must be rooted in fundamental concepts that constitute a framework which is ‘sound,
comprehensive and internally consistent’. Thus the conceptual framework is important to achieving the
goals of setting high quality accounting standards and converging US GAAP and IFRS.
However, the conceptual framework can also be of assistance to preparers of financial statements. It can
provide guidance in relation to the interpretation of existing financial statements and on matters which
are not covered by existing standards. Auditors can also benefit from the guidance in the framework in
forming their opinions. Finally, the Framework may assist users in interpreting the financial information
provided.
4. What is meant by a ‘cross-cutting’ issue? Suggest some possible examples of cross-cutting issues
Cross cutting issues are those which relate to more than one standard. That is, the issue comes up when
various standards are being considered. Examples are the definition and recognition criteria for assets,
liabilities and equity. Revenue recognition matters and financial instruments are other examples. In
addition, measurement is a problem area. For example, standard setters have not found an obvious way
to decide when to value items at historical cost and when fair or market value should be used.

Week 4
Topic 4: Accounting Measurement Systems
 Chapter 6 – Accounting Theory & Chapter 4 – Contemporary issues in accounting
1. Historic cost accounting
(1) Separation of ownership and control: information asymmetry
(2) Most critical objective of accounting is accountability – stewardship (conservatism)
(3) Income statement is paramount: 1) transaction based; 2) revenue recognition; 3) matching; 4) profit
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measurement
2. Criticisms: objective of accounting
(1) Stewardship is only a secondary object
(2) Providing the decision making needs of users is the primary objective, historic cost data is a failure
in this regard
(3) Historic cost information is: 1) not objective; 2) can be easily manipulated; 3) does not maintain the
entity’s capital
3. Criticisms: information for decision making: 1) is irrelevant when evaluating past decisions; 2) produced
only flawed measures of profit; 3) after acquisition, historic cost data is fictional; connected to
inconsequential measures of capital
4. Criticisms: basis of historic cost
(1) The going concern assumption does not justify the used of historic cost accounting
1) Many business fail; not business continue indefinitely doing only or at all what they are presently
doing
2) All businesses, except those presently existing, cease operations
(2) All businesses have alternatives and choices going forward
5. Criticisms: matching: 1) a practical impossible; 2) totally arbitrary; 3) the balance sheet is important; 4)
volatility and smoothing; 5) resulted in non-assets being classified as assets and non-liabilities being
classified as liabilities
6. Criticisms: notions of investor needs: 1) distorts and conceals; 2) its goals are ill-conceived; 3) creative
accounting is commonplace; 4) incentives to produce misleading data; 5) today, investors pay little
attention to historic cost accounting data about a firm
7. Objective of current cost accounting
(1) CCA values assets as their current market buying price and profit is determined using matching
expense allocations based on the current cost to buy
(2) Profit is more precisely defined as the change in capital over the accounting period
(3) Managers are better able to evaluate their past decisions , better use the firm’s resources to maximise
future profits
(4) Shareholders, investors and others are able to make better allocations of their resources
(5) Managers will examine
1) The current operating profit: the excess of the current value of the output sold over the current
cost of the related input
2) Realisable cost savings: increases in the current cost of assets held – 1) holding gains/losses; 2)
realised/un-
8. Financial vs. Physical capital: holding gains are included/excluded in profit under financial
capital/physical capital
9. Arguments for and against current cost: 1) recognition principles – violates the conservatism principle –
but actual phenomena; 2) objectivity of current cost – lacks objectivity; 3) technological change –
appears to ignore advances
10. More specific criticisms
(1) Advocates of historic cost accounting: violates the realisation principle; subjectivity in increase
(2) Comparisons of the results with historic cost: industry variations
(3) Advocates of exit price
1) The logical expression of opportunity cost is the current selling price; additivity problem exists
2) The arbitrary allocation of expenses is still a problem issue; irrelevant to most business decisions
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3) Number of reasons for an asset having value to business; physical capital concept fraught with
weaknesses
11. Exit price accounting
(1) Exit price = selling price = fair market value; represents clean surplus accounting
(2) Has two major departures from historic accounting
1) The values of non-monetary assets are selling prices and any changes are included in profit as
unrealised gains
2) Changes in the general purchasing power of money affect both financial capital and profits
(3) The income statement explains all of the differences existing between the opening and closing
balance sheets
12. Objective of accounting
(1) Objective = data for adaptive decision making; the assumption is that the business world is dynamic
and business must adapt to survive
(2) Firms and those associated with them go into markets to take advantages of opportunities as they
arise
(3) The ability to engage in market transactions in revealed by net financial position (net current market
value)
(4) Ultimately all accounting information users are interested in cash and cash equivalent values
(5) In the final analysis, economic survival and performance of a firm depends on the amount of cash it
can command
(6) Chambers: …the single financial property which is uniformly relevant at a point of time for all
possible future actions in markets in the market selling price or realisable price of any all goods held
13. Arguments for exit price accounting
(1) Provides useful information; to be relevant, information must be useful in the decision models of
data users
(2) Provides relevant and reliable information: one way to determine profit that is superior to all others –
profit is the difference between capital at two points in time exclusive of additional investments by
and distributions to owners
(3) The present selling price is the only item for information that is relevant to all decisions
(4) Additivity
1) If we use different measurement systems then no practical or commercial meaning can be
deduced from the aggregate; exit price accounting does not have the problem
2) Even if we use historic cost accounting as the sole measurement system, the jumble of historic
costs on different dates means we cannot put any meaning on the calculation of net assets or
profit
(5) Allocation: the financial statements are allocated free
(6) Reality: 1) every disclosed amount refers to a present, actual market price; 2) exchangeability
(7) Objectivity: market prices are relatively more objective than most believe
(8) A measure of risk: can indicate the financial risk of purchasing an asset
14. Argument against exit price accounting
(1) Profit concept: 1) does not provide a meaningful concept of profit; 2) the critical event does not
relate to the performance of the firm; 3) does not produce realistic financial reports
(2) Additivity: violates the principle of exclusion of anticipatory calculation that it claims to reject
(3) The valuation of liabilities: valuing liabilities at face value and not market value is internally
inconsistent
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(4) Current cost or exit price: at what stage of the operating cycle should exit price dominate asset
valuation?
15. Value in use vs. Value in exchange
(1) Similar when markets are liquid and efficient; they are complements not substitutes
(2) There are factors common to both: 1) market prices are more relevant for decision making; 2)
additivity and reliability are prime requirements; 3) historic cost accounting has too many defects
(3) Value in use assesses long term survival (solvency), value in exchange assess the ability to adapt in
the short term
16. Fair value: current market entry price, current market selling price, historic cost and discounted future
cash flows
17. Measurement bases: historic cost, fair value, current cost, present value, deprival value – essentially the
loss that would be suffered if an entity was deprived of the asset
18. Future directions on measurement
(1) Measurement is an important part of the IASB Conceptual Framework Project
(2) Approaches tentatively considered: 1) actual or estimated current prices; 2) actual past entry prices
with adjustment; 3) prescribed computations or calculations based on discounted or undiscounted
estimated of future cash flows
19. Decision criteria and influence on choice of measurement approach
(1) Potential users of the financial statements: what will provide the most decision useful information
(2) Practical considerations: 1) is it possible to calculate; 2) cost vs. benefit
(3) Managements motivations and objectives: 1) short-term/long-term; 2) impact on incentives; 3)
reputational impact
20. Current measurement challenges: water assets
(1) Water accounting standards are being developed in serval countries, with no single body taking
responsibility for international standards; water is a limited natural resource which needs to be
managed, measured and reported
(2) Measurement and valuation: 1) wide range of stakeholders; 2) how should value be determined; 3)
water quality and recognition
Tutorial 4
1. According to the historical cost system, what are the objective of accounting and the role of profit? What
criticisms are made of profit calculated under the historical cost system?
Stewardship is emphasised as the objective of accounting in traditional historical theory – enunciated by
Paton and Littleton. Accountability to equity holders is primary. Owners and creditors are considered to
be especially interested in what the firm (management) has done with the funds they have entrusted to it.
Therefore, information should be provided to give an accounting of the performance of the firm in using
the funds from a creditor’s point of view. Hence conservatism is required in valuation. Determining ‘net
worth’ to owners is not of primary importance.
Critics say that stewardship is too narrow an interpretation of the objective of accounting. The
stewardship emphasis causes a preoccupation with the past. Users want information for decision making,
which calls for a ‘forward looking’ position. This is now the principles based approach championed by
the IASB for international accounting standards.
Because accountability and stewardship is emphasised, the belief is that equity holders are primarily
interested in the results of the use of their funds. Thus an emphasis on flows and hence to earnings as the
primary statement; the statement of financial performance is more important than the statement of
financial position. After all, the objective of the firm is to make a profit a concept that is embedded in
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business. The balance sheet (now statement of financial position) is a link between two statements of
financial performance. It is a repository of unamortised historical costs.
Critics charge that we claim the balance sheet is a statement of financial position; but, in effect, historical
theory downplays this interpretation. We should be more serious about making the statement of financial
position a meaningful statement, one that fits the claims we make about it. Useful information for
decision making implies that the statement of financial position items should be as important as the
income statement items. Current values would be more relevant.
2. Would market value-adjusted statements be more ‘decision useful’ than those prepared applying
historical cost measures? Would using current market values reduce the number of decisions required to
prepare financial statements?
This of course very much depends on the decision proposed. If the decision was related to protecting
creditors producing conservative accounting reports to monitor managers’ compensation then the answer
is no. If financial statements were determined to aid decision making by investors then the answer is
probably more positive. Edwards and Bell also argue that a current cost system is also appropriate as a
management accounting system.
Using current market values requires a more complex accounting system and more decisions to be made
in preparing reports.
3. Explain the difference between financial capital and physical capital
The financial capital concept is the traditional view. It keeps track of capital in terms of the dollar
amount invested in the company. A return on financial capital means that there is an excess of the dollar
amount of capital at the end compared with the dollar amount of capital at the beginning, excluding the
effect of transactions with owners. In other words, there has been an increase in the value of money
capital.
The physical capital concept looks at capital in terms of its physical aspect, and then translates it into
dollars. Usually, the physical aspect relates to the firm’s producing capacity. A return on physical capital
results only if the physical productive capacity at the end of the period exceeds the physical productive
capacity at the beginning of the period, excluding effects of transactions with owners. Only current cost
is relevant for a physical capital view.
The main difference between the two is the placement of price changes of non-monetary assets and long-
term debt during the period. Under the financial capital view, these price changes are included in profit
as holding gains/losses. Under the physical capital view, these are placed directly into shareholders’
equity as a capital maintenance adjustment.
4. Explain the concept of ‘adaptive behaviour’ of the firm by Chambers, and how ‘financial position’
relates to it
Chambers sees the firm as an adaptive entity engaged in buying and selling goods and services. The
notion of adaptive behaviour implies a continual attempt to adjust to the environment for the sake of
survival. Through its managers, the firm is aware of the expectations of the interested parties associated
with it (for example, owners, customers, employees, creditors). A condition of a firm’s existence is that
expectations of all interested parties are satisfied, at least to a greater degree than the satisfaction
perceived in alternative courses of action. Ultimately, they are interested in cash receipts to themselves
due to their association with the firm.
To continue in business, a firm must have the capability to engage in transactions. This capability is
revealed by its financial position. This relates to the firm’s capability to go into the market with cash for
the purpose of adapting itself to present conditions. In the last analysis, the survival of the firm depends
on the amount of cash it can command. Adaptive behaviour, therefore, calls for knowledge of the cash
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and current cash equivalents of the firm’s net assets at any particular time.
5. Why is Chambers critical of the notion of ‘value in use’?
Chambers says value in use is basically a calculated amount of a present expectation. It represents
beliefs about the future, not facts about the present. It is personal to the owner or firm, and therefore it is
subjective. On the other hand, market value is determined by the market, and therefore is objective.
Market value represents a firm’s capability to buy things and pay its debts, as of a given date. Market
value is seen to be necessary for an evaluation of the financial position of a firm.
6. Explain the concept of ‘fair value’ as defined in IAS 16/AASB 116 and outline benefits to financial
statement users of continually revaluing assets to their current value
This standard relates to tangible assets - property, plant and equipment. First, fair value accounting has a
commercial focus and is generally interpreted as current market price accounting or else some form of
discounted present value. General guidance is to use a market price if markets are reliable or discounted
present value if they are not or the asset/liability is not traded. However, what market price is appropriate
is not always spelt out. Some guidance is provided but one may use a cost model or a revaluation model.
7. Explain the arguments for and against using historical cost as a measurement base
Key argument for historical cost include: 1) most objective measurement approach - amounts are
determined based on actual transactions; 2) clear audit trail – amounts can usually be proven by
documentation
Arguments against historical cost accounting
(1) The assumption that the purchasing power of the dollar remains constant is simplistic and flawed
(2) Information generated through historical costs accounting suffers from the ‘additivity problem’—it is
argued that it makes little sense to add together the costs of assets acquired in different time periods
(3) Relies on arbitrary cost allocations which may have little correspondence to the actual changes in an
asset’s values
(4) Can lead to an overstatement of profits in times of rising prices and this overstatement can cause a
reduction in the operating capacity of the entity because an excess amount of dividends might be
distributed
(5) Historical cost accounting data is of limited relevance to current decisions
(6) Assists an organisation to manipulate its profits given that the decision to dispose of a non-current
asset can directly lead to the recognition of gains on disposal, even though those gains actually
related to prior periods. The decision to sell an asset might be made in an effort to offset other losses
that will be recorded

Week 5
Chapter 7: Assets
1. Assets defined
(1) IASB (AASB) Framework: an asset is a resource controlled by the entity as a result of past events
and from which future economic benefits are expected to flow to the entity
(2) Three essential characteristics: 1) future economic benefits; 2) control by an entity; 3) past event
2. Future economic benefits
(1) Are the potential to contribute, either directly or indirectly, to the flow of cash and cash equivalents
to the entity: profit seeking entity, not-for-profit entity
(2) Relate to economic resources: scarcity, utility; an asset is something that exists now
(3) Has the capability of rendering service or benefit currently or in the future
(4) Distinguish between the object, such as a building or machine, and the service or benefit embodied in
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it
3. Control by entity: 1) the economic benefit must be controlled by the entity; 2) an entity’s right to use or
control an asset is never absolute; 3) ownership is often concurrent with control, but it is not an essential
characteristic of an asset; 4) does not rely on legal enforceability
4. Past events: 1) control as a result of a past event; 2) planned assets are excluded; 3) event can be
interpreted in different ways – executory contracts
5. Asset recognition
(1) The extent and timing of the recognition of assets is important because it can have economic
consequences for preparers and users of financial statements
(2) Recognising assets on the balance sheet involves recognition rules: conventions and authoritative
pronouncements
(3) Recognition criteria: 1) the future economic benefits must be probable; 2) the asset must be capable
of being measured reliably
6. How to calculate fair value measurement – various valuation techniques
(1) The market approach: 1) observable price; 2) actual transaction data
(2) The income approach: conversion of future amounts – cash flows/earnings: to a single discounted
present amount
(3) The cost approach: amount currently would be required to replace its service capacity (current
replacement cost)
(4) The valuation must emphasise market inputs: assumptions and data that market participants would
use in their estimates of fair value
(5) Three hierarchical levels for the input
1) Level 1: quoted prices for identical items in active markets, without adjustment
2) Level 2: quoted prices for similar items in active markets, adjusted as appropriate for differences
3) Level 3: estimated fair value using multiple valuation techniques consistent with the market,
income and cost
7. Issue for auditors – they need to
(1) Understand the client firm’s processes and relevant controls for determining fair value
(2) Make a judgement on whether the client firm’s measurement methods and assumptions are
appropriate and likely to provide a reasonable basis for the fair value measurement
(3) Appreciate management’s potential biases and likely error: incentives
Tutorial 5
1. What attributes must something possess in order to be defined as an asset? Why? What are the asset
recognition rules?
For something to be defined as an asset, it must possess the following attributes: 1) future economic
benefits or service will flow to the entity from it; 2) it must be controlled by the entity; 3) it must be the
result of a past transaction/event
These attributes ensure that whatever is defined as an asset is of economic value to the entity and is an
asset of the entity itself rather than some other organisation that controls it.
Recognition criteria: 1) the future economic benefits must be probable; 2) the asset must be capable of
being measured reliably
2. The framework defines assets, liabilities and equity by reference to economic benefits
a. What are the economic benefits that would be assets for Alex Corp, a government business enterprise
that constructs the physical infrastructure for the city of Huntersville?
An economic benefit is ‘scarce’ and has ‘utility’. Utility pertains to the future economic benefits or
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services. Because the resource is scarce and has future benefits, it has economic value in generating
future cash flows (including reducing future cash outflows). Alex Corp — a government business
enterprise constructing physical infrastructure for the city of Huntersville — would have assets
comprising productivity resources to build the infrastructure (that is, equipment) and claims to
receive money associated with contracts and money. If Alex Corp retains ownership of the
infrastructure assets and they are leased to the city of Huntersville, the infrastructure assets provide
economic resources to Alex Corp (that is, lease receipts) and constitute assets.
b. Must economic benefits re revenue-generating, or can parks, roads or statues provide economic
benefits?
Examples of economic benefits include:
(1) Cash inflows from sales of products produced by an entity using resources such as raw materials,
equipment, patents, or contractual rights to the use of resources of other entities
(2) Money; claims to receive money; ownership interested in other enterprises
Monuments, parks and/or roads provide service potential to the authorities providing and
maintaining them because they enable those authorities to pursue their objectives. To the extent that
the monuments, parks, and/or roads generate inflows (e.g. indirectly from increased rates or
donations, etc.) or reduce outflows of cash, (e.g. because other community resources do not need to
be acquired in their stead) they contribute economic benefits.
3. The framework definition of assets required future economic benefits to be controlled by an entity before
they can be regarded as an asset. How does ownership differ from control? Which criterion (ownership
or control) do you think should be applied in defining assets? Why?
The term ‘ownership’ means different things to different people. Ownership is usually associated with
legal ownership or entitlement. For accounting purposes, the criterion to meet the asset definition is that
the entity controls the future economic benefits. The term ‘control’ is associated with the right to regulate
access to, and use of, the future economic benefits. This implies that the entity has a legal or
moral/equitable right to receive the benefits.
4. According to the Framework, assets do not exist unless they result from past transactions or events.
Determining whether a past transaction or event has occurred to give rise to an asset is not always
straightforward. Explain the past transaction or event that triggers the existence of the following assets
a. Accounts receivable – sale of the product or service; Prepaid insurance – purchase of the insurance
policy
b. Inventory of work-in-process – production activity; Inventory of raw materials – purchase of the
inventory
c. Finance lease of manufacturing equipment – the signing of the lease agreement; or if the equipment
is to be constructed, when the construction is completed
d. Goodwill – the purchase of a company (purchased goodwill); the activity/activities generating
reputation (internally generated goodwill, which is not recognised, anyway)
5. Are the following assets? If so, whose assets, and why?
a. Member of the Australian hockey team
Human resources arguably meet the definition of assets of the Australian government, or the
Australian Institute of Sport (depending upon whether it is accepted that they can be controlled to act
in the interests of the reporting entity). However, even if they are regarded as meeting the definition,
because of the difficulty of placing a value on them they are not recognised.
b. A 9-month lease agreement to rent a business office
Operating lease: for the lessee (tenant), the future benefits that he or she has control over are the
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benefits under a contract specifying the rights to benefits, e.g. the right to use a motor vehicle for a
month. According to AASB 117, there is no intent by the lessor to transfer substantially all
ownership benefits and risks to the lessee. Nonetheless, once a contract is in place there is a right to
control the inflow of economic benefits, and an obligation to pay for them. As such, both an asset
and a liability do exist under the Framework definitions
c. Expenditure on research and development
Research and development: AASB 138 does not allow intangible assets arising from research phase
to be recognised by the firm paying for the R&D, as the existence of intangible assets that will
generate future economic benefits cannot be demonstrated. AASB 138 only allows intangible assets
arising from development to be recognised if the technical feasibility of the product or process that
they relate to has been demonstrated, and there is a clear indication of a future market for the
product; or if the item is to be used internally, its usefulness can be demonstrated. Students should
debate whether the R&D is controllable by an organisation and gives rise to economic benefits.
d. An unsigned, documented contractual agreement to build specialised equipment for a client
An unsigned contract: there is no basis for believing future economic benefits exist. Because the
contract has not been signed, it is possible that the buyer (client) may get out of the contract. The law
does not recognise a sale for custom-made goods unless performance has begun. In this case, the
contract for performance has not even been signed. There is no asset.
e. A building bequeathed to a firm
Bequest: an asset does not need to have a cost. The land is now under the control of the company, it
has future benefits, and it arose from a past transaction (the donation). Therefore, by definition it is
an asset. The company should record it at fair market value.
f. A 5-year option to acquire property, where the option was purchased by the company a year ago
Option: At the time the option is purchased, it should be considered an asset of the holder. It gives
the company the right to purchase the building and therefore has future benefit. If the building is
actually purchased, whether the option should be considered part of the cost of the building is
another issue. It can be argued that the option was purchased as part of an integrated plan to acquire
an appropriate building, and therefore it is part of the cost of the building. On the other hand, does
the purchase of the option make the building more valuable than the actual bargained price of the
building? If the option lapses, it should be expensed,
Additional Questions
A. What is the three-level of fair value accounting and give examples each. Discuss the advantages and
disadvantages of fair value of accounting.
The use of fair value provides relevant information for decision making.
Disadvantages:
(1) Fair values are not available for all assets. In some cases, fair values have to be estimated. Therefore
they are costly to obtain and are subjective. In the case of some financial instruments standard
setters require the use of mathematical models to calculate the hypothetical market price
(2) Fair values may be misleading when they are based on estimation. Fair values may be subject to
intentional and unintentional measurement error
(3) Small changes in the assumptions and predictions used in the models can change the value of an
item
(4) Fair value re-measurements introduce volatility into the accounts, which may influence investors’
views
B. Explain and discuss the arguments for and against the use of historical cost for the measurement of
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tangible assets
Arguments for historical cost accounting:
(1) Information generated by the historical cost accounting system seems to be demanded by the market
whereas various studies have indicated that price level adjusted information is not in great demand
(2) It is a generally accepted accounting system, hence maintaining its use will not lead to drastic
changes in accounting practice, which in turn could cause a variety of social and economic
consequences
(3) People are used to preparing and reading historical cost accounting reports, hence there is no need to
re-educate them about the strengths and limitations of historical cost accounting
Arguments against historical cost accounting:
(1) The assumption that the purchasing power of the dollar remains constant is simplistic and flawed
(2) Information generated through historical costs accounting suffers from the ‘additivity problem’—it
is argued that it makes little sense to add together the costs of assets acquired in different time
periods
(3) Historical cost accounting relies upon arbitrary cost allocations (for example, in relation to
depreciation) which may have little correspondence to the actual changes in an asset’s values
(4) Historical cost accounting can lead to an overstatement of profits in times of rising prices and this
overstatement can cause a reduction in the operating capacity of the entity because an excess amount
of dividends might be distributed (because historical cost accounting relies upon a financial capital
maintenance perspective)
(5) Historical cost accounting data is of limited relevance to current decisions
(6) Historical cost accounting assists an organisation to manipulate its profits given that the decision to
dispose of a non-current asset can directly lead to the recognition of gains on disposal, even though
those gains actually related to prior periods. The decision to sell an asset might be made in an effort
to offset other losses that will be recorded
Case Study 7.1: Heritage Assets
1. In what ways are heritage assets similar to the assets of for-profit entities and in what ways are they
different?
The definition can be applied to assets held by for-profit businesses but it is difficult to apply to many
heritage assets because of the special features of these assets. The custodial entity may manage and care
for a park, but it cannot sell it. Art galleries can buy and sell assets, but purchases are scrutinised by
external stakeholders.
Is there a past event? The purchase of a painting is a past event, but the creation of the Great Barrier
Reef is an event possibly beyond the scope of accounting.
Do future economic benefits flow to the entity? Art galleries often do not charge for admission to view
collections. Parks may charge admission, but to contribute to costs rather than make a profit. Heritage
assets are often not held to make future economic benefit but rather have social, psychological and
community benefits. Students should discuss the difficulty of applying concepts of ‘future economic
benefit’ to heritage assets.
2. Is it appropriate to recognise a heritage asset in the financial statements of the entity which has custody
of and responsibility for the asset?
In many cases such assets are held for social, political and community reasons rather than economic
reasons. Future economic benefits are unlikely in many cases as the assets are not held for the purpose of
wealth creation.
Further, future benefits (of any kind) are difficult to measure with any reliability in relation to heritage
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assets which are often unique (one of a kind) and thus lacking in a market value. Where market values
are available, such as for works of art or buildings, they are may not be relevant to stakeholders since the
assets are not held for trading or sale
3. Are there users for the information about the value of heritage assets?
The collection must be valued for insurance purposes and that insurance is necessary to protect the asset.
Since a value is available it should be communicated to stakeholders, to assess the stewardship of
management in maintaining, protecting and expanding the community asset.
It has been suggested that “businesses manage what they measure.” Should not-for-profit entities also
measure their assets as part of an accountability and stewardship process? While there is some merit in
this argument, it should be noted that heritage assets are not held to generate income in a manner similar
to the assets of commercial enterprises.
4. Can a financial value be assigned to a heritage asset?
It can be argued that heritage assets are priceless, that they belong to future generations, that they are not
for sale and market values or financial values are academic and meaningless. It would appear that for
many heritage assets financial value in no way represents their ‘real’ value or future value. Some assets
have no ‘market value’ because they are unique and irreplaceable. The value of the assets is determined
by reference to community values and may vary according to the stakeholders consulted. There may not
be agreement about the financial value or even the social or cultural value. For example, we can
determine both a purchase price and a current market value for Jackson Pollack’s Blue Poles owned by
the Australian National Gallery. However, does the financial value represent the value of the painting to
the community? Is the increase in financial value over the time it has been owned related to ‘income’ for
the community? The answers to these question is likely to be no and can be discussed with students to
explore the relevance of financial values to determining worth of heritage assets.

Week 6
Chapter 8: Liabilities and Owners’ Equity
Key terms/concepts: Liabilities, Owners’ equity, Proprietary theory, Entity theory, Definitions, Recognition
criteria – probable, reliable, Present obligation, Past transaction, Measurement/fair value, Provisions and
contingencies, Rights of the parties, Economic substance, Concept of capital, Debt vs. equity, extinguishing
debt and employee shares, Issues for auditor
1. Proprietary theory
(1) Proprietorship = net worth of owners = capital; P = A – L; the objective of accounting is to determine
the net worth
(2) Profit is the increase in net worth, include 1) operating profit; 2) changes in the values of assets
(3) With the advent of the company the theory has proved inadequate as a basis for explaining company
accounting
1) Developed when businesses were smaller; a company is separate from its owner; no longer so
relevant
2) A company is legal entity in its own right; shareholders rely on managers for information
2. Entity theory
(1) Inadequacies in proprietary theory led to the entity theory; formulated to address separate legal status
of company
(2) The company is viewed as a separate entity with its own identity
1) Separation of owners and managers; accounting views the entity as an operating unit
2) Accounting principles and procedures not formulated in terms of an ownership interest
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3) Can also be applied in proprietorships, partnerships and not-for-profit organisations

(3) The objective of accounting may be either stewardship or accountability: 1) entity seen as being in
business for itself; 2) interested in its own survival; 3) sees owners as outsider; 4) reports to owners
to meet legal requirements and maintain good relationships with them
(4) Focus on the assets; assets are resources controlled by the entity; liabilities are obligations of the
entity
(5) Profit increases net assets and accrues to the entity; the owners only have a residual claim on the net
assets of entity
(6) Both proprietary and entity theories are still influential in practice
1) Entity theory: 1) conventional accounting theory based on it; 2) financial reports reflect it
2) Proprietary theory: 1) interest charges are an expense; 2) dividends are a distribution of profit
3. Liabilities defined
(1) IASB Framework: a present obligation of the entity arising from past events, the settlement of which
is expected to result in an outflow from the entity of resources embodying economic benefits
(2) Present obligations: 1) the actual sacrifices are yet to be made; 2) obligation is already present; 3)
planned obligation include if to an external party; 3) legal enforceability; 4) settlement of liability in
various ways; 5) equitable and constructive obligations
(3) Past transaction: ensures that only present liabilities are recorded and not future ones
4. Liability recognition
(1) Recognition criteria
1) Ability to measure the value of the liability: 1) normally the nominal amount; 2) if period longer
than 12- months, based on the present value of expected future cash flows
2) Use of the conservatism principle: at what point is the entity too conservative
(2) IASB Framework: a liability should be recognised if
1) It is probable that any future economic benefit associated with the items will flow to or from the
entity; and
2) The item has a cost or value that can be measured with reliability
5. Provisions and contingencies
(1) Provisions and contingencies occur when there is a blurring between present and future obligations
(2) Liabilities and provisions are recognised only when there is a present obligation probable/can be
reliably measured
(3) Contingent liabilities do not meet these criteria – notes
6. Owners’ equity
(1) Framework: the residual interest in the assets of the entity after deduction of its liabilities
(2) Essential features: 1) rights of the parties; 2) economic substance of the arrangement
Tutorial 6
1. With respect to the proprietary theory
a. What is the objective of the firm?
The firm essentially is the proprietor. It is simply the proprietor’s instrument to achieve his or her
purpose, which is to increase his or her wealth. Income represents the increase in the wealth of the
proprietor in a given period.
b. How important is the concept of ‘stewardship’?
Stewardship is relatively unimportant, because accountability to outside parties is not critical. The
proprietor is, in effect, the firm, and therefore is in a privileged position to know what is happening.
Liabilities are usually short term, and therefore there is no need to give a continual accounting to
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creditors.
c. What are the relationship between assets/liabilities and the owner?
The assets are ‘owned’ by the owner, and the liabilities are ‘owed’ by the owner. This shows that
there is no separation between the firm and the owner. In the accounting equation, P stands for the
net worth of the owner.
d. How would you define revenue, expenses, profit?
Revenue is the increase in proprietorship; expense is the decrease in proprietorship; and profit is the
net effect of proprietorship, excluding additional investments and withdrawals by the owner.
Revenue and expense accounts are truly subsidiary accounts of P. They have the same algebraic
characteristic as ‘net worth’ — increases in net worth are credits and decreases in net worth are
debits. The proprietary theory focuses on P in viewing income. Revenues and expenses are caused by
the decisions and actions of the proprietor. The profit of the firm belongs to the proprietor and that is
why P is affected in the accounting equation.
e. What are three effects on current practice?
The following are examples of the effect of the proprietary theory on accounting practice:
(1) Dividends paid are a distribution of earnings, not an expense; and interest charges are an expense
(2) In a sole proprietorship or partnership, salaries to owners who work in the firm are not
considered an expense of the business. The reason is that the firm and the owner are not separate
entities; they are the same
(3) The equity method for long-term investments focuses on the proprietary interest of the investor
company in the invested company
(4) The parent company theory for consolidating financial statements views the parent as ‘owning’
the subsidiary Minority interest is considered an ‘outside’ claim, and logically should therefore
be a liability on the consolidated statement of financial position
(5) The pooling of interests method for business combinations emphasises the uniting (pooling) of
the owners’ interests of the two combining companies
(6) Common terms used reveal the proprietary interests of owners are: book value per share,
earnings per share and income to shareholders
(7) The use of the consumer price index for general price level adjustments shows that the
‘consumer desires’ of owners are considered; The financial capital view is pertinent to owners
f. What are the theory’s limitations?
The proprietary theory does not accord with the realities of the large corporation. The law recognises
the corporation as a separate entity, distinct from the owners. The corporation — not the shareholders
— owns (controls) the assets, and is liable for the debts. For the large corporation, withdrawals of
cash or other assets by shareholders cannot be made without running afoul of the law. This shows
that the ownership rights of shareholders are limited. Accountability to shareholders is significant;
otherwise, shareholders have no knowledge of the status and operations of the business. The
assumptions of the proprietary theory are not relevant to the shareholders of large firms.
2. With respect to the entity theory
a. What are the reasons for concentrating on the entity as a unit of accountability rather than the
proprietor?
Emphasis is on the entity, because in the 20th century the separation of owners from management in
the corporate form of business is common. Shareholders of large corporations have little power to
make decisions for the company. The corporation, the entity, has a life of its own. It is therefore more
realistic to view the entity as the unit of accountability — that is, to see the accounting process from
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the point of view of the entity.

b. What is the objective of accounting?
Stewardship or accountability to equity-holders is of primary significance. The entity needs to
account to those who have supplied funds (shareholders and creditors). There are two views of entity
theory, but both stress accountability to equity-holders. The conventional view emphasises
stewardship because equity-holders are seen as ‘associates’ in business. The newer view focuses on
stewardship because of legal, contractual requirements, and also to maintain good relations with
equity-holders in the event of the company needing more funds.
c. How important is the concept of ‘net worth’?
The net worth of the owner is not a meaningful concept, because the owner is not recognised as such
but as an equity-holder, a provider of funds. So-called owners are not seen as having the power to
make decisions for the firm. The net assets belong to the entity. However, net worth can be a
meaningful concept. An argument can be made that the entity needs to know the worth of its net
assets for its own purposes.
d. What is the reason for modifying the accounting equation to Assets = Equities?
The reason is that the entity is the focus of attention, and therefore creditors and owners are seen
simply as those who supplied the funds to the entity. Their financial interest in the company is
‘equities’ — claims on the assets. Thus, they are seen as equity-holders. Their relationship with the
company is a contractual one.
e. On what side of the equation in (d) would retain profits appear?
Paton and Littleton argue that the shareholders have a contractual residual claim on the assets, and it
is for this reason that income is placed in the retained earnings account. Shareholders get the
leftovers after the creditors have been paid, in the event of liquidation of the company. The newer
view of entity theory sees retained earnings as the firm’s equity or investment in it
f. Why is there a stress on profit determination?
Profit is stressed for two reasons
(1) Profit is what equity-holders are interested in, because it represents the results of their
investment
(2) The firm is in business to make a profit — profit is essential to the firm’s survival
g. How do the concepts of revenues, expenses and profits differ from the proprietary theory? What
about interest charges, dividends and income tax?
Revenue is the inflow of assets (increase in total assets) due to the events undertaken by the firm
with regard to its output. Under the proprietary theory, revenue is the increase in proprietorship.
Expense is the decrease in assets or increase of liabilities due to the consumption of assets and
services by the firm to generate current revenue. Under proprietary theory, expense is the decrease in
proprietorship.
For both the entity and proprietary theories, profit is the difference between revenues and expenses.
Entity theory, however, emphasises the left side of the accounting equation (assets), whereas the
proprietary theory concentrates on the right side (proprietorship). Entity theory focuses on what the
entity does, its performance; whereas proprietary theory focuses on the effect on proprietorship.
For traditional entity theory, interest charges, dividends and income taxes should be distributions of
earnings. The theory considers these as payments to the equity-holders for the use of their funds. Of
course, the government does not provide funds as the others, but provides intangible services such as
protection from foreign powers. The newer version of entity theory sees interest charges, dividends
and income taxes as payments to ‘outsiders’, and therefore they are expenses.
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h. What are three effects on current practices?

Although conventional accounting theory subscribes to entity theory, the theory has had little effect
on actual practice. The reason is that the theory was formulated in the 20th century, and many current
practices were devised since the time of the Italian city–states and are based on the proprietary
theory. The following show the effect of the entity theory on practice:
(1) The physical capital view is in consonance with the entity theory
(2) Salaries to corporate employees who are also shareholders are expenses, because the company is
a separate, distinct entity from the holders
(3) In consolidating financial statements, an entity theoretical approach can be taken. Instead of
concentrating on the proprietary interest of the parent (parent company theory), entity theory
sees the consolidation from the point of view of the consolidated entity
(4) The use of profit and cost centres for internal purposes is based on entity theory. The centre is
seen as an individual entity
3. Liabilities are all ‘obligations’ under the Framework definition of liabilities. What is an obligation, and
why does the Framework rely heavily on it in the definition?
A liability is a present obligation to act or perform in a certain way. An obligation is a duty; a
responsibility or requirement. It may be legally enforceable in the courts or simply ‘equitable’ or
‘constructive’. The Framework definition emphasises the future sacrifice, but it should be remembered
that a liability exists now — it is also a presently existing requirement.
4. If a liability is a present obligation, does that mean that a legally enforceable claim must exist before a
liability exists?
A liability need not be legally enforceable. According to the Framework for the Preparation and
Presentation of Financial Statements, it may be equitable or constructive. Most liabilities are legal
liabilities, but company policy of a ‘moral obligation’ may give rise to a recordable liability as long as
the intent is to transfer assets or render a service to settle the obligation. The past transaction or event is
not as clear for non-legal liabilities as for legal liabilities, and thus may be more difficult to recognise.
For such liabilities, the future sacrifices cannot be avoided without significant penalty, such as a decrease
in employee morale. Interpreting the meaning of significant penalty is a matter of opinion.
5. Hunter Ltd is attempting to bring its accounts in line with Australian accounting standards and
statements of accounting concepts. Advise the accountant of Hunter Ltd whether a liability exists in each
of the following cases and, if so, what the liability is
a. The company is being sued for injuries sustained by an employee who claimed that the workplace
steps he fell down were unsafe. The outcome of the lawsuit is highly uncertain
Contingent liabilities are not recorded, but are disclosed. A decision must be made on whether these
items are ‘straight’ liabilities or contingent liabilities. This decision is based on two criteria: (1) it is
probable that a liability has been incurred; and (2) the amount can be estimated reliably.
In this case, there is no liability. According to the Framework for the Preparation and Presentation of
Financial Statements,, the event must make it ‘probable’ that a liability has been incurred and the
amount must be ‘estimable’. These two conditions are not met.
b. An order for raw materials has been placed with the firm’s regular supplier
No liability. The pertinent event is not placing an order but receiving title to the goods. When title
passes, then a purchase has been made, and accounts payable is recorded.
c. There is a signed contract for the construction by Suzanna Ltd of a major item of plant for Hunter
Ltd
Unclear. Until there is performance, there is nothing to record as no party has an obligation under the
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contract until there is some performance under that contract. On the other hand, if signing the
contract has created that legal obligation, then a liability and an equal asset should be recorded — the
event is the signing of the contract and the passing of some form of consideration that creates rights
and obligations under the contract.
d. The firm has unsecured notes of $1,000,000 outstanding. Interest is payable 6-monthly in June and
December. It is now August
Interest payable for two months. Accrued interest is to be recorded. The event is the passing of time;
the company is using the money that was borrowed each day.
e. At the end of the year, half of the firm’s employees have non-vested sick leave owing
No liability exists for the non-vested rights. The following four conditions can be considered for the
recording of an accrued liability for sick pay:
(1) The sick pay is based on services already rendered
(2) Rights to sick pay are vested or ‘accumulated’ (earned but unused)
(3) Payment is probable
(4) The amount can be reasonably estimated
If sick pay benefits vest, an accrual should be made. If they ‘accumulate’ but do not vest, accrual is
not required.
Case Study 8.1 – Disclosure of Environmental Liability
1. The article states that the US standard setter FASB requires companies to record provision in relation to
environmental costs of retiring an asset (‘to reserve environmental liabilities’) if its fair value could be
reasonably estimated. How do you think companies would go about estimating such a provision?
To estimate a provision for the cost of retiring an asset the company would engage suitably qualified
personnel to estimate the cost of removing and disposing the materials of which the asset was
constructed. Next they would estimate the costs involved in restoring the land on which the asset was
based. The date that the costs are expected to be incurred would be determined. Cost accountants would
work with these predicted future expenses to estimate the present value of the outflows and to arrive at
the amount of the provision to be recognised in the accounts.
2. What aspects of the requirements were used by US companies to defer recognition of a liability? Why
would companies want to do this?
The US requirement stated that a provision was to be recorded in the accounts if its amount could be
reliably estimated. Some companies responded by stating that they could not reliably estimate costs and
therefore they avoided recognition of the provision.
A reduction in profit and an increase in liabilities which result from recognising a provision may not be
viewed favourably by managers because of the impact on share price, financial ratios and remuneration.
Students should consider the incentives at play behind decisions to record (recognise) an item in the
accounts or to disclose information.
3. In what ways does the recognition of the liability in relation to future restoration activity affect (a) net
profit and cash flow in the current year and future years; and (b) liabilities in the current and future
years?
A provision for restoration involves the following journal entry to initially raised the provision
(1) Year 1 Dr Restoration expense
(2) Year 1 Cr Provision for restoration
It reduces profit (by creating a restoration expense) but not cash flow in the year it is recorded. It
increases liabilities in the year it is recorded. In the future when the liability is settled, the following
journal entry is recorded
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(1) Year X Dr Provision for restoration

(2) Year X Cr Cash
There is no effect on profit but there is an outflow of cash for the amount of the restoration expense. At
this time the liability is reduced. The entries are basic accrual accounting. Students should refer to
discussion in the chapter about IAS 37 and the limitations on the use of provisions.
4. The article refers to changes in disclosure requirements relating to environmental liabilities in many
countries around the world. How important is it that companies recognise the liability? To what extent is
disclosure about the liability sufficient?
Ideally, accounting measures transactions and reports information which is useful for decision making.
One argument is that as long as information is disclosed, users can factor it into their decision making.
That is, disclosure is sufficient for competent users. As long as they are aware of the amount and timing
of the expected outflow of future economic benefits they can include it in their models predicting cash
flows and profit and make informed decisions. Recognition of the amount in the accounts is not
necessary.
However, the counter argument is that less attention is given to note disclosure by users and auditors
compared to when items are recognised. Potentially, users could miss the information if it is not
recognised in the accounts and they focus on amount recognised in the accounts. One view is that
companies may give lower importance to amounts which are disclosed (not recognised). When an
amount must be recognised, it has economic consequences which will ensure that managers give close
attention to the management of the underlying item. That is, if amounts are included in the accounts,
managers will endeavour to make accurate assessments of these amounts. Remember that accounting is a
means of holding managers accountable and recognition of liabilities is a more effective way of doing
this than simply disclosing an item. In addition, research shows that auditors apply stricter tests and
closer scrutiny to amounts which are recognised compared to those which are disclosed.

Week 7
Chapter 9: Revenue
Key terms and concepts: Revenue, Behavioural view of revenue; Earning process; Criteria for revenue
recognition; Point of sales; Fair value; Sales of goods and the rendering of services
1. Revenue defined in AASB Framework: income is increases in economic benefits during the accounting
period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases
in equity, other than those relating to contributions from equity participants.
2. Behavioural view of revenue
(1) Revenues are the result of firm activities; net accomplishment of firm: 1) revenue = accomplishment;
2) expense = effort; 3) matching results in profit = net accomplishment
(2) A point of recognition must be determined: 1) critical event; 2) accrual throughout earnings process
3. Criteria for revenue recognition
(1) Devising an ideaMaking purchasesReceipt of orders before commencing
productionCommencing productionProgressively throughout productionCompletion of
productionReceipt of orders after completing productionDelivery of goods to
customersReceipt of cash
(2) Recognition criteria are based on the desire for both relevant and reliable accounting information: 1)
measurability of asset value; 2) existence of a transaction; 3) substantial completion of the earning
process
4. Revenue measurement
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(1) Framework provides 2 criteria for revenue recognition

1) It is probable that any future economic benefit associated with the item will flow to or from the
entity
2) The item has a cost or value that can be measured with reliability
(2) IAS 18/AASB 118 Revenue: is to be measured at the fair value of the consideration received or
receivable
5. Sale of goods
(1) The sale point is generally the most appropriate point to measure and record revenue as all three
criteria are met
(2) The sale point is when the product is delivered or the services are rendered, or when title passes to
the customer
6. Exceptions to sales basis
(1) Revenue recognised during production: e.g. construction contracts
(2) Revenue recognised at the end of the production: production is the critical event and the sale is
assured
(3) Revenue recognised when cash is received after the sale is made: instalment method and the cost
recover method
7. Development in revenue recognition and measurement
(1) Resulting changes in emphasis
1) Revenue is recognised when it arise: changes emphasis from realisation to timeliness
2) Revenue can result from the changes in asset and liability values and from holding assets: re-
measurements
3) Revenue recognition and measurement reflect fair value; measurement should be reliable
(2) Tentative agreement that two criteria must be met to recognise revenue
1) A change in assets or liabilities must have occurred: the element criterion
2) The change in assets or liabilities can be appropriately (reliably) measured: the measurement
criterion
8. Financial statement presentation – tentative conclusions
(1) An all-inclusive, single income statement where all changes to assets and liabilities will be disclosed
(2) Realisation is not the basis for inclusion of items
(3) Separate disclosure of performance (income flows) and re-measurement (valuation adjustments)

Chapter 10: Expenses

Key terms and concepts: Expenses; Definitions; Economic benefits; Recognition criteria; Probable and
reliable; Expense measurement; Matching; Allocation of expenses; Associating cause and effect; Systematic
and rational allocation; Immediate recognition; Criticisms of allocations; Conservatism
1. Expenses defined
(1) Framework: expenses are decreases in economic benefits during the accounting period in the form of
outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other
than those relating to distributions to equity participants
(2) To make a definition of expenses operational, it must be associated with a physical activities of the
entity – something it does: sales and production generate revenue and the using up of goods and
services in support of those functions causes expenses to occur
2. Expense recognition
(1) An expense is recognised if
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1) It is probable that any future economic benefit associated with the item will flow to or from the
entity; and,
2) The item has a cost or value that can be measured with reliability: 1) prudence and neutrality; 2)
freedom from material error and bias, represent faithfully
(2) The decrease in future economic benefits relates to a decrease in an asset or an increase in a liability:
recognition of an expense occur simultaneously with the recognition of an increase in a liability or a
decrease in assets
3. Allocation of expenses
(1) Revenue = accomplishment; expense = effort; for any given period, matching revenue and expenses
yields net accomplishment (periodic profit)
(2) Most of the problems of profit determination have to do with expense allocation and matching
(3) The accountant must decide
1) Whether a cost pertains to future revenues and therefore should be deferred
2) Whether a cost pertains to current revenues, thus should be written-off against revenue in the
current period
3) Whether a cost, although incurred and not yet paid, is related to current revenue and thus should
be accrued
(4) The matching process involves the simultaneous or combines recognition of revenues and expenses
that result directly and jointly from the same transactions or other events
(5) Three basic methods of matching: 1) associating cause and effect; 2) systematic and rational
allocation; 3) immediate recognition
4. Criticisms of allocations
(1) The doctrine of conservatism means that expenses, losses and liabilities are recognised as soon as
possible, even if evidence for them is weak; the allocations (matching) process is an essential part of
accounting practice
(2) Asymmetrical treatment of revenue and expenses create a conservative bias and misleading financial
statements
(3) Personal incentives may influence managers’ judgement in the allocations process
(4) The process has made the balance sheet secondary to the income statement; the balance sheet has
become a repository for unexpired costs; most of what accountants put in accounting reports is
‘rubbish’
(5) The allocation problem: (Thomas) allocation in accounting do not meet the following criteria – 1)
additivity, 2) unambiguity; 3) defensibility
(6) Allocations are defended by accountants on two grounds
1) A given input provides services in the current and future periods and the cost allocation pattern
reflects the cost of the services received in the given periods
2) Allocated data serves a useful purpose because readers of accounting reports, which include
allocated data, find them useful
(7) But, allocations are ‘incorrigible’ – Thomas
1) They are not capable of verification or refutation by objective, empirical means
2) The patterns of allocation do not exist in the real-world; they exist only in the minds of
accountants
3) An input’s individual contribution to the output cannot be known because all the inputs interact
with each other to generate an output
4) Empirical studies do not demonstrate that allocations are useful
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Tutorial 7
1. What is revenue? Is it an object or an event?
Revenue is defined in AASB 118 as follows: Revenue is the gross inflow of economic benefits during
the period arising in the course of the ordinary activities of an entity when those inflows result in
increases in equity, other than increases relating to contributions from equity participants.
The definition implies that revenue is an event (an increase or flow), not an object. Revenue applies
definitely to value, which is monetary. Although assets are economic objects, revenue relates to
enhancement in value of the assets.
2. What is the difference between revenue and gains? How does definition of ‘income’ treat revenue and
gains?
The AASB framework defines income as including both revenue and gains. Thus the Framework makes
no conceptual distinction between revenue and gain. Both are consistent with the concept of income as
something which increase assets (an inflow or enhancement) or decreases liabilities with a resulting
increases in equity. Gains are included in income because they represent future economic benefits
flowing to the entity. They may or may not arise from ordinary operations of the entity, while revenue is
defined as arising from ordinary operations. It should be noted that gains may also include unrealised
gains.
3. What are the differences between general criteria for revenue recognition and revenue recognition
principles contained in AASB 118 Revenue?
The revenue recognition principles contained in IAS 18/AASB 118. IAS 18/AASB 118 recognition rules
are formulated around the concept of a probable inflow of future economic benefits and reliable
measurement of such an inflow. Therefore, the first general criterion (measurability of asset value) forms
part of IAS 18/AASB 118 as reliable measurements is a recognition criterion. The existence of a
transaction (second criterion) is specifically mentioned in para 20 and forms part of the discussion in
IAS 18/AASB 118. Substantial completion of the earning process is not specifically mentioned in para
14, 20 and 29. However, completion of the earnings process underpins these paragraphs. For example, a
sale occurs when the significant risks and rewards of ownership have transferred. This implies
substantial completion of the earnings process. Similarly in the rendering of services, recognition
depends on the extent to which the transaction is complete. Also for interest royalties and dividends, the
process of earning the item is discussed. For example, interest is recorded as it is earned based on the
effective interest method.
4. What is the significance of ‘title passing’ in determining whether a sale has taken place?
Legally, title passing is part of the meaning of a sale of a good. In accounting, we use this aspect of a
sale to determine in many cases that a sale has taken place. But it is used as a guideline only, not a
requirement. Economic substance is more important than legal form. For this reason, accounting looks
more at the transfer of significant risks and rewards of ownership in the sale of goods rather than the
passing of legal title.
5. When should revenue be recognised for the following businesses?
a. A soft-drink manufacturer – when the soft drinks are delivered to the customers
b. A legal firm – when services are rendered (after the last act is performed)
c. A theatre that sells season tickets to musical productions – after the musical production is performed.
In most cases, refunds are not given to those who do not show up (no-shows)
d. A magazine publisher producing monthly titles – when the magazines are delivered. For advertising
revenue, when the advertising appears in the magazine
e. A good-mining company – either at end of production (after the gold is mined) or at time of sale. A
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gold mining company has a choice of using end of production or sale basis for revenue recognition
f. A farmer who grows wheat – either at end of production or at time of sale. A wheat farmer has a
choice between end of production
g. A company which sells houses on an instalment plan; term of payment extending to 20 years; buyers
assume all risks of ownership; buyers pay a deposit of 25% of the sales price – it seems the full
accrual method (sales basis) can be used. The main points are collectability and the degree of
continuing involvement of the seller
h. A contractor building a bridge for the government – percentage of completion method or completed
contract method can be used
Problems – chapter 10
1. How is cash outflow of an entity related to expense?
In the ideal case, liabilities are payables whose value is the present value of the future cash outflow of
the firm, and expenses are the increase in value of the liabilities. This shows that expenses relate to cash
payments. In other words, eventually all expenses are paid in cash. In the real world of uncertainty,
expenses are related to the using up of assets and services in the operations of the business. The assets
and services are paid for at some time. Under accrual accounting, the payment may be made before the
use of the asset or service or at the same time or after. In this sense, we can say that expenses are paid in
cash at some point(s) in the life of the firm.
2. What is the ‘monetary event’ associated with the notion of expense? How is the ‘using up of goods or
services’ related to expense?
The monetary event is the increase in the value of liabilities (or shareholders’ equity) or the decrease in
the value of the assets. The monetary event relates to the abstract portion of the definition of an expense
— that is, that part which relates to the accounting equation. The reason why the monetary event occurs
is that the firm does something to make it happen. In particular, the firm uses goods (assets) and services.
The using up of goods and services refers to the real-world part of the definition of expense.
3. What is the difference between expense and loss? How does the AASB Framework apply to expenses
and losses?
In the AASB Framework, expenses are defined as follows: Expenses are decreases in economic benefits
during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities
that result in decreases in equity, other than those relating to distributions to equity participants.
Expenses arise in the course of the ordinary activities. They usually take the form of an outflow or
depletion of assets such as cash and cash equivalents, inventory, property, plant and equipment.
Expenses encompass losses as well as expenses which arise in the course of ordinary activities of the
entity. Losses may or may not arise in the course of ordinary activities of the entity. However, the
Framework states that losses represent decreases in economic benefits and are therefore not different in
nature from other expenses. Therefore they are not regarded as a separate element.
4. Name the three basic methods of matching. Given an example of each. How do they align with the
expense recognition criteria outlined in the AASB Framework?
The three basic principles of matching are:
(1) Cause and effect: cost of goods sold, sales commissions, salaries and wages, certain selling costs
(2) Systematic and relational allocation: depreciation, amortisation, depletion, insurance
(3) Immediate recognition: R&D, advertising, utilities
Some expense can be said to be due to cause and effect and are immediately recognised.
The AASB Framework focuses on the recognition criteria more than on matching. The two criteria for
the recognition of expenses are stated as followed.
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An item that meets the definition of an element should be recognised if:

(1) It is probable that any future economic benefit associated with the item will flow to or from the
entity; and
(2) The item has a cost or value that can be measured with reliability
For an expense to be recognised in the financial statements, it must meet both of the recognition criteria.
These criteria imply that any matching of expenses and revenue is limited by the extent to which the
recognition criteria are met. Therefore, under the Framework expenses should be matched to the period
in which the asset expiry or liability increase occurs rather than being matched against the revenues that
they have contributed to earning. The recognition criteria relate to the outflow of service potential or
future benefits having occurred, and the need for the amount to be reliably measurable. The application
of the matching concept under the Framework does not allow the recognition of items in the balance
sheet which do not meet the definition of assets and liabilities.
However, the matching concept underpins accrual accounting. Therefore, the Framework recognises the
matching concept which states ‘Expenses are recognised in the income statement on the basis of a direct
association between the costs incurred and the earning of specific items of income’. The matching
process involves the simultaneous or combined recognition of revenues and expenses that result directly
and jointly from the same transactions or other events. For example, the various components of expense
making up the cost of goods sold are recognised at the same time as the income derived from the sale of
the goods.
5. Determine whether an asset or expense should be charged for the following, and state your reasons
a. Cost of removing two small machines to make way for a larger new machine
It depends. If the estimated salvage value of the two small machines had taken into consideration
expected costs of removal so that a net salvage value was used in the calculation of depreciation,
then the present cost of removal is an expense. If not, then the cost would be capitalised to the new
machinery.
b. Cost of repairing a floor damaged when a new machine was dropped while being unloaded
Expense. The cost of repairing the floor is not a ‘necessary’ expenditure to acquire the machine or to
put the machine in operating condition. The cost is due to carelessness.
c. Cost of a new calculator, $48 – Expense. The amount is not material.
d. Cost of major repairs to equipment. The need for repair was discovered immediately after
acquisition. There is no warranty on the equipment
Expense. The company should have inspected the equipment more carefully before purchase. If the
need had been discovered, presumably the purchase price would have been reduced to account for
the necessary repair.

Week 8
Chapter 11: Positive Theory of Accounting Policy and Earnings Management
1. Early demand for theory
(1) capital markets research tried to explain the effects of accounting: was ultimately inconclusive and
inconsistent
(2) This research relied upon the EMH – ultimately there were too many departures
(3) Led to the development of a positive theory of accounting policy choice
2. Contracting theory
(1) The firm is seen as a ‘nexus’ of contractual relationships
(2) The firm is seem as an efficient way of organising economic activity to reduce contracting costs: 1)
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equity (management) contracts (an agency contract); 2) debt contracts (an agency contract)
3. Agency theory
(1) An agency contract is one where one party (the principal) engages another (the agent) to act on their
behalf: e.g. where there is a separation of management and ownership
(2) Both parties are utility maximisers
1) Agent may therefore act from self-interest: divergence of interests is the agency problem
2) Contracts incorporating accounting numbers can be used to align the interests of both parties
(3) Monitoring costs: the cost of monitoring the agent’s behaviour; initially borne by the principal but
passed on to the agent through an adjustment to their remuneration (price protection) – auditing
cost, operating rules…
(4) Bonding costs: the cost borne by the agent as a result of them taking action to align their interests
with those of the principal: 1) providing more regular financial reports (a cost to the manager in
terms of time and effort); 2) constraints on their activities…
(5) The agent incur bonding costs in order to reduce the monitoring costs they eventually bear
(6) Agents stop spending on bonding costs when the marginal cost equals the marginal reduction in the
monitoring cost
(7) Residual loss: associated with not being able to fully align the interests of the agent with those of the
principal
(8) Ex post settling up – (ex post = at the end of each period)
1) Agent’s future remuneration based on observed agent performance
2) The principal changes the remuneration to be paid to the agent to align it with their performance
4. Price protection and shareholder/manager agency problems
(1) Risk aversion: managers prefer less risk than do shareholders – 1) different degrees of diversification
affecting risk; 2) limited liability accorded to shareholders
(2) Dividend-retention: managers prefer to pay out less of the profits as dividends than shareholders
prefer – 1) pay their remuneration; 2) empire building
(3) Horizon: managers have a shorter time horizon with respect to their association with the firm than do
shareholders
1) Shareholders are interested in future cash flows
2) Managers have a time horizon only as long as they intend to remain with the firm
(4) Contracting can be used to reduce the severity of these problems: manager remuneration is usually
tied to firm performance in some way to motivate managers to act in the shareholders’ interest
1) Performance can be related to accounting numbers such as sales, profits, return on assets, net
asset growth etc.
2) Performance can be related to the firm’s share price
5. Shareholder- debtholder agency problems
(1) Firm value is the value of debt plus the value of equity
(2) The value of equity can be increased by: 1) either increasing the value of the firm (efficient
contracting); or 2) transferring wealth away from debtholders (opportunistic behaviour)
(3) Varieties of opportunistic behaviour
1) Excessive dividend payments
a. Reduces the asset base securing the debt; the debt become mispriced; reduces the value of the
debt
b. Shareholders have received cash but limited liability protects them from being personally
liable for the debts of the firm in the event of bankruptcy
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2) Asset substitution
a. Firm invests in higher risk projects to benefit shareholders: 1) no benefit to debtholders; 2)
but do share in possible losses
b. Shareholders are able to diversify and have limited liability; debt become mispriced
3) Underinvestment: in some circumstances, shareholders have incentives not to undertake positive
NPV projects because to do would increase the funds available to the debtholders but not to the
shareholders
4) Claim dilution: 1) occurs when the firm issues debt of a higher priority than the debt already on
issue; decrease the relative security and value of the existing debt
(4) Lenders will price protect: through interest rates, the withholding of funds and the length of the loan
(5) The interests of shareholders can be bonded to those of debtholders via restrictions in lending
agreements
6. Ex post opportunism vs. ex ante efficient contracting
(1) Ex post opportunism: occurs when, once a contract is in place, agents take actions that transfer
wealth from principals to themselves
(2) Ex ante (before contracts are finalised) efficient contracting: occurs when agents take actions that
maximise the amount of wealth available to distribute between principals and agents
7. Evidence that managers use accounting numbers to: 1) counter political pressure; 2) gain political
advantages; 3) set management targets related to remuneration; 4) minimise breaching debt covenants; 5)
provide dividend constraints; 6) constrain management manipulation
8. Evaluating the theory
(1) Mixed support for positive accounting theory
(2) Two categories of major criticism
1) Methodological and statistical criticism: empirical evidence is weak and inconclusive
2) Philosophical criticism
a. Contrary to its claims, it is laden with value judgements; positivism is no longer taken
seriously
b. Focuses on human behaviour and not the behaviour and measurement of accounting entities
9. Earning management
(1) Occurs when managers use judgment or discretion within GAAP, or structure transactions, to affect
the information in financial reports
(2) The purpose is to influence users’ perceptions of financial statements about the firm’s underlying
economic performance or to influence outcomes that contractually depend on reported accounting
numbers
10. Examples of earnings management
(1) If financial information is used in determining bonus payments, managers may have an incentive to
arrive at the financial results necessary to achieve the bonus
(2) A firm at risk of breaching a loan covenant has an incentive to manipulate financial information to
avoid the breach
(3) Management artificially manipulates earnings to produce a steadily growing profit stream
11. Managers might choose accounting methods that reduce current period reported earnings in order to: 1)
avoid political costs; 2) to smooth income trends in a high profit year; 3) signal shareholders there are
reduced earnings in the future
Tutorial 8
1. What is the difference between normative and positive accounting theory? Give examples of each
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Positive accounting theory (PAT) is concerned with explaining and predicting current accounting
practices. This means that the focus is on understanding and explaining the techniques and methods that
accountants currently use and why we have ended up with the conventional historical cost accounting
system. Examples of PAT include:
(1) Explaining why firms select specific accounting policies
(2) Predicting which firms will oppose new or revised accounting rules
(3) Explaining share price reactions associated with accounting information releases
This approach can be compared with normative accounting theories that dismiss conventional historical
cost accounting as being meaningless or not decision useful and prescribe the use of more ‘useful’
systems of accounting (usually) based on inflation adjustments. Examples of normative theories include:
(1) Specification of the preferred measurement system; defining elements of financial statements
(2) Theories as to the objective of general purpose financial reporting
2. Why is meant by the term ‘earning management’? What are the incentives for managers to manage
earnings?
Earnings management occurs when managers use judgment or discretion within GAAP, or structure
transactions, to affect the information in financial reports. The purpose of earnings management is to
influence users’ perceptions of financial statements about the firm’s underlying economic performance
or to influence outcomes that contractually depend on reported accounting numbers.
Earnings management may be undertaken so that a firm reports a smooth income stream rather than a
volatile one. The practice of earnings management may potentially affect transparency of the underlying
economic reality of a firm’s financial performance or position. Consequently, investors’ decisions with
respect to the allocation of resources may be affected, with adverse consequences. Earnings management
may be used to disguise declining operating performance to protect share price to ‘ensure their stock
based compensation remains valuable’ and to allow capital raising on favourable terms.
3. Why might managers choose accounting methods that increase current period reported earning?
Managers might choose accounting methods that increase current period reported earnings in order to
increase their remuneration. Normally managers’ remuneration is tied with accounting numbers, such as
profits, as a benchmark in determining how shareholders compensate them for their performance.
Therefore, managers tend to choose accounting methods that result in increased profits so that they can
maximise their remuneration. In addition, increased current period reported earnings usually will give
positive signal to the market. If the investors believe the signal, the firm’s share price will increase and
both shareholders and managers will benefit as well (the purpose of managers is to maximise
shareholders’ wealth). Shareholders will benefit from capital gains, whereas managers will get more
remuneration as some components of their remuneration are determined by the firm’s share price.
4. What is the debt hypothesis? Explain the logic (theory) underpinning it
The debt hypothesis predicts that as a firm’s leverage (that is, proportion of debt relative to the firm’s
assets) increases, managers will select accounting procedures that shift reported profits from future
periods to the present period. The theory underpinning the debt hypothesis comes from agency theory
where managers (acting on behalf of shareholders) have incentives to transfer wealth away from debt
holders to shareholders. In other words, they have incentives to decrease the value of debt so that
residual equity increases in value. Recognising this incentive, debt contracts often include covenants
whereby firms covenant to not allow their debt to exceed a certain percentage of total assets or total
tangible assets. This is intended to ensure that there is sufficient equity to buffer the value of debt if
assets lose value and/or the firm makes future losses.
As the firm’s leverage increases and the firm gets closer to breaching its debt covenants, managers have
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incentives to ensure that the firm does not violate its debt covenants. Therefore, managers would choose
accounting methods that increase assets or decrease liabilities in order to reduce the reported leverage.
5. Why might manager’s interest differ from those of shareholders? What can shareholders do to ensure
that they do not suffer financially because managers’ interests differ from their own?
Managers’ interests might differ from shareholders’ interests due to the separation of ownership and
control. As managers generally have zero or a small ownership in the firm, they do not bear the costs of
any dysfunctional behaviour. If the firm suffers from any loss due to their action, the shareholders would
bear the loss, while managers still receive their salaries. To ensure that shareholders do not suffer
financially because managers’ interests differ from their own, shareholders can:
(1) Price-protect against managers’ dysfunctional behaviours: price protection is the way the principals
protect themselves against bearing agency costs by paying management compensation according to
the level of monitoring costs expected. That is, the principal initially will incur monitoring costs to
monitor agents’ behaviours, but then adjust the agents’ remuneration accordingly so the agents
ultimately will bear the costs.
(2) Align managers’ interests with their interests: this can be done by remunerating managers on the
basis of share-price movements, or using share-based compensation to increase managers’
ownership of the firm. As managers’ ownership increases, the more likely it is that their interests
will align with shareholders’ interests
6. Explain the three types of agency costs and their relationships to each other in the context of debt/equity
contracts
The three types of agency costs are: monitoring/bonding costs and residual loss
Monitoring costs are the costs of monitoring the agent’s performance. Initially, they are borne by the
principal to monitor the agent). For example, shareholders or lenders could appoint an outside
accounting firm to investigate the manager’s performance in managing the financial affairs of the firm.
Being rational, the shareholders or lenders would reduce the remuneration to the agent by an amount that
increases as monitoring costs increase. In the case of a shareholder–manager agency relationship, the
manager’s remuneration will be reduced by the monitoring costs incurred by the shareholders. In the
case of a lending contract, the lender (principal) will impose higher costs on the agent (management
acting on behalf of shareholders) by demanding lower interest rates or other lending terms that are
favourable to the lender. Either way, costs are incurred initially by the principal, but are then passed on
to the agent.
The agent, as an insider who has access to information about his or her performance, is deemed to be a
wealth-maximiser. Therefore, they are likely to bond their actions to align them with the interests of the
manager. The agent will incur bonding costs to the limit whereby the marginal cost of bonding equals the
marginal cost of monitoring that is imposed by the principal. As such, bonding costs are incurred by the
agent.
Generally it is not possible to eliminate all agent behaviour that is inconsistent with principals’ interests.
The cost of this remaining behaviour is known as residual loss. The residual loss is borne by the
principal in the first instance. However, if the principal anticipates the level of residual loss that
eventuates, the residual loss will be priced into the agency contract. For example, the residual loss could
be ‘charged back’ via reductions in the amount of management remuneration or the interest rate on debt
in the case of shareholder–manager contracts and lending contracts respectively. The extent to which the
principal or the agent bears the residual loss depends on the completeness of the ‘pricing’ in ex post
settling up or ex ante price protection.
7. Bonus plans are used to reduce the agency costs of equity. Describe the agency relationship giving rise to
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the agency cost of equity and explain how bonus plan scan reduce particular types of agency problems
The separation of ownership and control means that managers can act in their own interests, which may
be contrary to the interests of shareholders. This can be broken down into a number of specific
difficulties:
(1) Risk aversion problem. Managers prefer less risk than shareholders because their human capital is
tied to the firm. They prefer to diversify their own risk rather than maximising the value of the firm
through higher risk projects.
(2) Dividend retention problem. Managers prefer to pay out less of the firm’s earnings in dividends in
order to pay for their own perquisites.
(3) Horizon problem. Managers are only interested in cash flows affecting their remuneration for the
period they remain with the firm, whereas shareholders have a long-term interest in the firm’s cash
flows because share prices equal the present value of shareholders’ expectations of all future cash
flows.
Bonus schemes can reduce these problems by tying the manager’s remuneration to an index of the firm’s
performance that has a high correlation with the value of the firm. This aligns managers’ and
shareholders’ interests by tying managerial compensation to performance ex ante without the need to
rely on ex post mechanisms, such as renegotiating salary. Remuneration can also be tied to dividend
payout ratios or to options or share bonus schemes. It is likely that a bonus plan will reward managers
only after they have achieved an ‘expected’ level of firm profits for a period — then the remuneration
will increase as profitability increases, thereby providing incentives for managers to increase their
bonuses by increasing firm profitability. There may also be a ceiling on the amount of bonus paid to
managers, to reflect the fact that profits can sometimes be increased to artificially high levels by actions
that are not in the shareholders’ long-term interests.
8. Explain the main agency cost of debt, and how debt contracts can be designed to reduce those costs. In
particular, explain how accounting specifications within the contacts can be sued to reduce the agency
problem
The main agency problems involved in debtholder-shareholder relationships are:
(1) Excessive dividend payments. This lowers the value of debt because it reduces available funds to
service the debt. It transfers wealth from within the firm, where it is available to lenders, to the
shareholders.
(2) Claim dilution. When further debt is issued, this makes the original debt riskier and lowers its value
to the original debtholders.
(3) Asset substitution. When debt is issued that reflects (and subsequently projects) a particular risk, a
higher risk is undertaken.
(4) Underinvestment. This occurs when management or shareholders reject desirable positive NPV
projects on the grounds that most of the benefits accrue to debt holders.
Debt covenants can be structured to restrict conflicts by bonding managers and shareholders to act in the
interest of creditors, such as:
(1) Covenants to restrict the production-investment opportunities of the firm (asset substitution and
underinvestment)
(2) Covenants restricting dividend policy to a function of net income; bonding covenants
(3) Covenants restraining financing policy, usually expressed as gearing ratios
Accounting would play a primary role if the above covenants were expressed in terms of accounting
numbers. Whittred and Zimmer (1986) and Stokes and Tay (1988) found that debt covenants in Australia
were mainly expressed in the form of accounting numbers.
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9. Why might managers choose accounting methods that reduce current period reported earnings?
Managers might choose accounting methods that reduce current period reported earnings in order to
avoid political costs. Alternatively, managers might reduce current period reported earnings if high
earnings are considered to be an indication of a mature industry, and the government might then remove
tariff or subsidies that protect the industry.
Other reasons why managers might choose accounting methods that reduce current period reporting
include:
(1) To smooth income trends in a high profit year (saving this period to boost the next periods’ reported
earnings)
(2) To ‘take a bath’ by reducing profits this year in order to have higher profits next year, when earnings
might be sufficiently high to earn a performance-based bonus for the manager
(3) To signal to shareholders that there are reduced earnings in the future (rather than have future profits
suddenly slump, the signal might be gentler to shareholders)
(4) To warn of bad news early so that management mitigates the likelihood that shareholders or others
will litigate against them for misleading their investment or other decisions with high reported
earnings
10. Explain the efficiency perspective and opportunistic perspective of Positive Accounting theory. Why is
one considered to be ex post and the other ex-ante?
The efficiency perspective takes the view that contractual arrangements will be designed to reduce future
conflicts of interest (and associated agency costs) between various individuals involved in the operations
of an organisation. Well-designed contracts are expected to reduce future transaction costs. By reducing
future costs, well-designed contracts can have the effect of increasing the value of an organisation.
Because the contractual arrangements are designed to reduce future conflicts they are considered to be
introduced on an ex ante (up-front) basis. Many of the contractual arrangements use the output of the
accounting system (such as rewarding managers on the basis of a share of profits, or utilising debt to
asset ratios in debt contracts).
The opportunistic perspective relies upon the assumption that individuals are always motivated by their
own self-interest (at the possible expense of others) and once they enter contractual arrangements they
will subsequently capitalise upon any flexibility within the contracts to cause any related pay-offs to be
more favourable to themselves (again, at the expense of others). Because it is not practical to attempt to
write ‘complete contracts’, there will always tend to be some degree of flexibility in most agreements
and it is anticipated that the opportunistic manager will uncover such flexibility. In relation to the
selection of accounting methods, independent external auditors will frequently be used to ensure that the
accounting methods adopted by managers appear to be reasonable and in accordance with generally
accepted accounting practice. Because the opportunistic behaviours frequently occur after transactions
have been negotiated (after the fact) the actions are described as occurring on an ex post basis.

Week 9
Chapter 12: Capital Market Research
1. Philosophy of positive accounting theory
(1) Seeks to explain and predict accounting practice; seeks to explain how and why capital markets react
to accounting reports; does so by observing practice – empirical evidence; has an economic focus
(2) Explanation means providing reasons for observed practice: e.g. why do firms continue to use
historic cost
(3) Prediction means that the theory predicts unobserved phenomena
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(4) Positive theory is based on assumptions about the behaviour of individuals

1) Assumes investors and financial accounting users and preparers are rational utility maximisers
2) Rejects arguments based on anecdotal evidence and naive acceptance of political or academic
prescription
2. Strengths of positive theory
(1) Positive hypotheses are capable of falsification by empirical research
(2) Provides an understanding of how the world works rather than prescribing how it should work
1) Obtain an understanding about how value-relevant accounting numbers are for share prices
2) Attempt to understand the connection between accounting information, managers, firms and
markets, and analysis those relationships
3. Dissatisfaction with prescriptive standards: 1) normative standards; 2) prescriptions not based upon
identified, empirical observations or methods; 3) theories are not falsifiable; 4) do not explain and
predict accounting practice; 5) do not assess existing accounting practices
4. Scope of positive accounting theory: two stages of development
(1) Capital market research: into the impact of accounting and the behaviour of capital markets
1) Did not explain accounting practice; efficient markets hypothesis (EMH); capital asset pricing
model
2) Investigated connection between the accounting data and share prices/returns
(2) Sought to explaining and predict practices across firm: 1) ex post opportunism; 2) ex ante efficient
contracting
5. Capital market research and the efficient market hypothesis
(1) Two types of capital market research
1) The impact of the release of accounting information on share returns
2) The effects of changes in accounting policy on share prices; most research in these areas relies
upon the EMH
(2) Efficient market: one ‘in which prices fully reflect available information’
(3) 3 forms of information efficiency: 1) weak form (past price information); 2) semi-strong form
(publicly available information); 3) strong form (all information – public and private)
(4) Capital markets research in accounting assume semi-strong form efficiency
(5) Financial statements and other disclosures from part of the information set that is publicly available
(6) Based on dubious assumptions
1) There are no transaction costs in trading securities; information is available cost-free to all
market participants
2) There is agreement on the implications of current informationthe current price /distributions of
future prices
(7) Market efficiency simply means that share prices reflect the aggregate impact of all relevant
information, and do so in an unbiased and rapid manner
6. Market model
(1) Derives from CAPM; used to estimate abnormal returns on shares when profits announced; share
prices and returns are affected by both market-wide and firm-specific events; market-wide events
must first be controlled for
(2) Based on dubious assumptions
1) Investors are risk averse; returns are normally distributed and investors select their portfolios on
this basis
2) Investors have homogeneous expectations; market are complete – 1) all participants are price
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takers; 2) there are no transaction costs; 3) there are no taxes; 4) there are rational expectations
by investors
7. Impact of accounting profit announcements on share prices
(1) Ball and Brown (1968): 1) seminal work in positive accounting and financial literature; 2) tested the
usefulness of historical cost profit figure to investment decisions; 3) if the historical cost profit figure
is useful the share price will react
(2) Ball and Brown (1968) results: most of the information contained in the earnings announcement (85-
90%) was anticipated by investors; 2) evidence of information content at time of historical cost
earnings announcement
(3) Magnitude; information asymmetry and firm size; magnitude of profit releases from other firms;
volatility
(4) Profit release event studies showed that accounting profit does capture a portion of the information
set that is reflected in security returns; annual accounting figures are not timely
(5) The evidence also shows that competing sources of information pre-empted the information in
annual profits by about 75-85 per cent; led to another approach – association studies
8. Association studies and earnings response coefficient
(1) Earnings response coefficient (ERC): the objective is to test the impact of accounting variables and a
wider information set that is reflected in securities returns over a longer period
9. Methodological issues
(1) To argue that the results of the research are supportive of EMH and that the form of accounting is not
that important for valuation purpose derives, in part, from the fact that the EMH is assumed to be
descriptively valid
(2) This assumption may not be warranted; there is increasing evidence that markets can be fooled by
accounting no.
(3) No attempt to discriminate EMH from competing hypothesis
1) Mechanistic hypothesis: 1) managers use accounting to deliberately mislead the share market;
market participants can be fooled
2) No-effect hypothesis: the market ignores accounting changes that have no cash flow
consequences

Chapter 13: Behaviour Research in Accounting

1. Definition and scope
(1) ‘Positive’ research encompasses
1) Capital markets research: ask how do securities markets react to accounting information; looks at
the macro level of aggregate securities markets
2) Agency theory research: ask what are the economic incentives that determine the choice of
accounting methods
3) Behavioural accounting research: ask how do people actually use and process accounting
information; agency and behavioural research both focus on the micro level of individual
managers and firms
(2) Capital markets and agency research are based on economics and assume everyone is a rational
wealth maximiser
(3) Behavioural research is based on psychology, sociology and organisational theory and generally
makes no assumptions about how people behave
(4) Definition (Hofstedt and Kinard): the study of the behaviour of accountants or the behaviour of non-
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accountants as they are influenced by accounting functions and reports

(5) The major type of BAR is: 1) human judgement theory (HJT); 2) human information processing
(HIP)
(6) Looks at the judgement and decision making of accountants and auditors and the influence their
output has on users’ judgements and decision making: aims to explain and predict behaviour and
improve decision making
2. Why is BAR important?
(1) It discovers how people use and process accounting information; it provides useful information to
accounting regulators; it leads to efficiencies in the work practices of accountants and other
professionals
(2) It provides valuable insights into the ways different types of decision makers produce, process and
react to particular items of accounting information and communication methods
3. An overview of approaches to understanding information processing: three major research approaches
(1) Brunswik lens model: the dominant approach
1) Used as an analytical framework and the basis for most judgement studies involving: 1)
prediction (e.g. bankruptcy); 2) evaluation (e.g. internal control)
2) Has provided valuable insights regarding
a. Patterns of cue use evident in various tasks; the stability (consistency) of human judgement
over time
b. Weights that decision makers implicitly place on a variety of information cues
c. Relative accuracy of decision makers of different expertise levelspredict and evaluate a
variety of tasks
d. The circumstances under which an expert system and/or ‘model of human behaviour’
outperforms humans
e. The degree of insight decision makers possess regarding their pattern of use of data
f. The degree of consensus displayed in a variety of group decision tasks
3) The model usually has good predictive power: it removes much of the random error due to
human things such as tiredness, illness or distraction
4) An important limitation is that it is not a good descriptor of how people actually make decisions:
so process tracing methods developed
(2) Process tracing: build representative decision trees
1) Provides an explanation about how a decision is made: a) ‘process tracing’ or ‘verbal protocol’;
b) produces a ‘decision tree’ to represent the decision process; c) ‘classification and regression
tree’ (CART)
(3) Probabilistic judgement: probability statements based on Bayes’s theorem
1) Useful where initial beliefs about a prediction or evaluation need to be revised as new data
arrives
2) Posterior odds = likelihood ratio x Prior odds; found use of rules of thumb to simplify complex
judgement task
4. Probabilistic judgement studies – the evidence
(1) Three rules of thumb (heuristic): representativeness, availability, anchoring and adjustment
(2) Representativeness: when judging the probability that a particular item comes from a particular
population of items, people’s judgement will be determined by the extent to which the item is
representative of the population
(3) Availability: the assessment of the probability of an event is based on the ease with which instances
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of that event come to mind; anchoring and adjustment: an initially given response serves as an
anchor, and other information is used to adjust that response
5. Limitations of BAR
(1) Frequent contradictions between the findings of similar studies; research settings fail to adequately
replicate real- world settings; should policy be influenced by research on individual decision makers
(2) Human information processing is far more complex than the development of current research
theories and methods
(3) The major limitation is the lack of a single underlying theory to unify diverse research questions and
findings: has borrowed from a multitude of disciplines and contexts and so no common framework
(4) A single theory is unlikely in the foreseeable future

Chapter 14: Emerging Issues in Accounting and Auditing

1. XBRL = Extensible Business Reporting Language
(1) Allows financial information to be presented in an interactive way that in turn allows individual
items of fata to be extracted by software to produce reports custom designed by individual users
(2) XBRL will loosen the control managers currently have on data aggregation decisions and place their
performance under greater scrutiny
2. Sarbanes-Oxley Act (2002): 1) peer reviews replaces by PCAOB inspections; 2) restrictions on provision
of non-audit services by audit firms to their audit clients
3. Issues surrounding the application of fair value accounting during the global financial crisis
(1) Some believe the practice of fair valuing assets was contributing factor: it requires the write-down in
the value of some assets when markets are turbulent – making financial assets to market
(2) Considerable dispute about this: SEC investigation (2008) – recommendations offered for improving
fair value
4. Auditors and the global financial crisis: the GFC could lead to regulatory action affecting auditors
(1) Relatively little attention paid to the auditor’s role in the crisis
(2) The accounting profession and regulators have proactively issued guidance
(3) Auditors of banks later suffering financial difficulties can expect to come under scrutiny
5. Sustainability can be regarded as meeting the needs of the present without compromising the ability of
future generations to meet their own needs: 1) environmental protection; 2) justice between peoples and
generations

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