Chapter 2

The nature and uses of accounting

Definitions of accounting ‘Accounting is the art of recording, classifying and summarizing, in a significant manner and in terms of money, transactions and events which are, in part at least, of a financial character, and interpreting the results thereof’

Committee on Terminology of the American Institute of Certified Public Accountants

(1953)

‘The process of identifying, measuring, and communicating economic information to permit informed judgments and decisions by users of the information’

American Accounting Association (1966)

Definitions of accounting (cont’d)

Definitions of accounting (cont’d)

The objective of financial reports The provision of relevant and reliable

information, which is primarily financial in nature, about economic entities and designed to assist various user groups to make and evaluate economic decisions relating to allocation of scarce resources

Based on the Australian Accounting Research Foundation’s Statement of Accounting Concepts

(SAC) No. 2

Accounting: an art or a science?

• Those who see accounting as an art or trade suggest that accounting skills should be taught as would any trade, and that a ‘legalistic’ approach to accounting is warranted

• Advocates of accounting as a science suggest the more conceptual approach of teaching foundations of accounting measurement models and related empirics

Accounting as a social science

• Accounting is widely viewed in academia as a social science, as argued by Mautz: ‘Accounting deals with enterprises, which

are certainly social groups; it is concerned with transactions … which have social consequences and influence social relationships; … it is primarily mental in nature’

• This view of accounting has created a schism between academia and the profession

Types of accounting measures

• Direct measures are actual measures of an object or its attributes

• Indirect measures are derived indirectly by an algebraic transformation of a set of numbers that themselves represent direct measure of some objects or attributes

• Accounting measures can be classified as a past measure, a present measure, or a future measure

Types of accounting measures (cont’d)

• Accounting measures can be classified as retrospective, contemporary or prospective

• Measurements can be either fundamental measurements or derived measurements

Types of scales

• A nominal scale assists in determining equality

• An ordinal scale assists in determining greater and lesser

• An interval scale assists in determining the equality of intervals or differences

• A ratio scale assists in determining the equality of ratios

Double-entry accounting

Type 1: Classificational double-entry accounting

• Aims to maintain the fundamental accounting equation:

assets = liabilities + owners’ equity

• In this type of accounting, a debit portrays a classification, while a credit portrays another classification

Double-entry accounting (cont’d)

Type 2: Causal double-entry accounting

• Describes the cause–effect relationship between an increment and a decrement

• In this type of accounting, the value of an increment (debit) is offset by an equal value of a decrement (credit)

Generally accepted accounting principles (GAAP)

• The implicit framework within which accounting is practised

• A guide to the accounting profession in the choice of accounting techniques and the preparation of financial statements

• The conventions, rules and procedures included in GAAP have substantial authoritative support

Major sources of GAAP in the USA

• Financial Accounting Standards Board (FASB) statements of financial accounting standards (SFAS)

• Accounting Principles Board (APB) opinions

• The American Institute of Certified Public Accountants (AICPA) accounting research bulletins (ARBs)

Sources of Australian GAAP • Australian Corporations Law• Approved Accounting Standards

(AASBs)• Australian Accounting Standards (AASs)• Statements of Accounting Concepts

(SACs)• Exposure Drafts (EDs)• Accounting Guidance Releases (AGRs)• ASIC practice notes and policy

statements

Where Australian GAAP differs from US GAAP

The LIFO method of valuing inventory is not allowed in Australia

The liability method of accounting is used for deferred taxes in Australia

The pooling-of-interests method of accounting for business combinations is not allowed in Australia

Changes in accounting policies or new accounting standards cannot be applied retroactively in Australia

Where Australian GAAP differs from US GAAP (cont’d)

Non-current assets can be revalued to market value in Australia

Other current-value regulations are more widespread in Australia than in the USA

The recognition criteria for assets, liabilities, revenue and expenses is less stringent in Australia than in the USA

Special GAAPsChanging perceptions of GAAPs

• Not seen as a rigid set of measurement rules• Their numerous applications differ, depending

on the circumstances• There are individual GAAPs for:

– business enterprises– government organisations– regulated business enterprises– non-profit organisations– investment companies– banks

Other comprehensive bases of accounting (OCBOA)

Four criteria for OCBOA classification1. A basis of accounting that is necessary to

meet regulatory requirements2. A basis of accounting that may be used

for income tax returns3. A basis of accounting based on cash

receipts and disbursements with or without some accrual support

4. A basis of accounting resulting from the application of a definite set of criteria

Problems with using OCBOA statements

• OCBOA statements may not appear as an acceptable or known alternative to the user

• OCBOA statements may present problems for the practitioner due because of the lack of comprehensive guidance available

GAAP, special GAAP or OCBOA?

• GAAP provides uniformity and comparability

• Special GAAP provides flexibility and better avenues for dealing with varying circumstances

• OCBOA is useful in unique circumstances and reduces standards overload

Little GAAP versus big GAAP

• According to SAC 1, company size is an important factor in compliance

• Company size can be determined using three criteria:1. separation of ownership from control2. the greater the economic or political

importance of an entity, the more likely there are to be dependent external users

3. financial characteristics (including sales turnover and indebtedness)

Little GAAP versus big GAAP (cont’d)

• A major issue of interpretation with the SAC 1 criteria is that they are expressed in qualitative rather than quantitative terms

• APS 1 provides a list of exemptions, but they are not necessarily denominated by size, but rather by ownership

Conformity with standardsThe Australian Accounting Research Foundation (AARF) Accounting Policy Statement APS 1 suggests the following entities are not likely to be reporting entities under SAC 1:

• close corporations

• family trusts

• partnerships

• exempt proprietary companies

• sole traders

• wholly owned subsidiaries of Australian reporting entities

Definition of a small companyIn contrast to the AASB, the FASB defines a small company in quantitative terms:• operations are relatively small, with total

revenues of less than $5 million• the company is owner-managed and has

few other owners, if any• all owners are actively involved in

conducting the enterprise’s affairs• the transfer of ownership interests is

infrequent• the company has a simple capital structure

Definition of a public company

FASB defines a public company as:• a company that is required to file

financial statements with the Securities and Exchange Commission

• a company whose securities trade in a public market

Users of financial statements

• The primary users of public companies’ financial statements are financial analysts and shareholders

• The primary users of private companies’ financial statements are owner-managers and creditors

Different users of financial statements

Statement number 4 of the APB identifies the following different user groups:

owners, creditors and suppliers, management, taxing authorities, employees, customers, financial analysts and advisers, stock exchanges, lawyers, regulatory or registration authorities, financial press and reporting agencies, trade associations and labour unions

Individual statements for different users?

• Statement 4 of the APB considers the difficulty, cost and confusion involved in providing individual statements for different users

• According to SAC 2, the objective of financial reporting is to serve the needs of financial-statements users in general and not the particular needs of specific users

• SAC 1 and SAC 2 do not differentiate between the information requirements of different user groups

Little GAAP committeeIn the USA in 1974, the Committee on Generally Accepted Accounting Principles for smaller and/or closely held businesses was formed.Four basic questions were considered:1. Are there any differences in the application

of generally accepted accounting principles, and, if so,

2. On what basis should the different applications be determined?

3. What differences would be appropriate?4. What impact would this have on the

independent CPA?

Conclusions of the little GAAP committee

• The same measurement principles should be applied in all entities’ financial statements because measurement should be independent of the nature of the users

• The nature of the information disclosed may vary depending on users’ needs

• There should be a distinction between those disclosures required by the GAAP and additional or analytical disclosures

Changes in the USA

• FASB suspended the earnings per share and segment disclosure requirements for reporting by private companies

• In contrast to the AASB, the FASB started including size tests that exempted small and private companies from certain requirements

Private companiesThe ICPA Technical Issues Committee recommend-ed changing or eliminating 11 accounting and disclosure requirements for private companies:• leases• capitalisation of interests• imputed interests• compensated balances• business combinations• troubled debt restructuring• research and development costs• discounted operations• tax benefit of operating loss carried forward• deferred income taxes• investment tax credits

Objections to having two sets of GAAP

• Improvements in reporting to one group of users should also result in improved reporting to other groups

• All companies operate in the same environment, face similar economic conditions, and could have the same types of transactions

• Different accounting requirements for different companies within an industry group could distort financial comparisons

• Most private companies would eventually become public

Changes to accounting policy

AASB 1001 notes that policies may be abandoned or changed for the following reasons:• introduction or variation in statutory

requirements, including an approved accounting standard

• introduction of or variation in statements of accounting standards

• a decision in the interests of improved financial reporting

Why do managers make accounting method changes?

According to Foster:• compliance with regulatory mandates• consistency with the accounting model• presentation of economic reality and

what is ‘true and fair’• comparability with other firms in the

same industry• economic consequences to the firm

Income smoothing• Income smoothing represents an attempt on

the part of the firm’s management to reduce abnormal variations in earnings to the extent allowed under accounting and management principles (Beidelman)

• AASB 1001 tries to prevent income smoothing by requiring, upon a change in accounting policy, disclosure of:– the nature of the change– the reason for the change– the financial effect of the change

Beidelman’s reasons for smoothing

A stable earnings stream:• suggests a stable level of future

earnings and dividends, and has a favourable effect on the firm’s shares

• counters the cyclical nature of reported earnings and reduces the correlation of a firm’s expected returns with market returns

Gordon’s theory on income smoothing

Four propositions1. Corporate management selects among

accounting principles to maximise its utility or welfare

2. The utility of management increases with:• job security• level and rate of growth in income• level and rate of growth in size of

corporation

Gordon’s theory on income smoothing (cont’d)

3. Achievement of management goals depends upon shareholders’ satisfaction

4. Shareholders’ satisfaction increases with the rate of income growth and stability of income

Given the above, management would smooth reported income and smooth the rate of growth in income

Constraints that lead to income smoothing

• Competitive market mechanisms that reduce options available to managers

• A management compensation scheme that is linked to the firm’s performance

• The threat of management displacement

Real smoothing versus artificial smoothing

• ‘Real’ smoothing refers to the transaction that is undertaken or not undertaken to smooth income

• ‘Artificial’ smoothing refers to accounting procedures that are implemented to shift costs and/or revenues from one period to another

(Dascher and Malcolm)

Further dimensions of smoothing

• Smoothing through events’ occurrence and/or recognition (real smoothing)

• Smoothing through allocation over time(artificial smoothing)

• Smoothing through classification (classificatory smoothing)

(Barnea and others)

Income smoothing and the conceptual framework

• Income smoothing practices have contributed to the development of conceptual frameworks

• Standard setters believe that a conceptual framework will reduce the accounting alternatives available to management

• Income smoothing is explicitly rejected in SAC 4 and by the AAR

The selective financial misrepresentation hypothesis

‘The problem is not accidental but instead results from contrived and flexible reporting rules promulgated by standard setters who have been “captured” by the intended regulatees and others involved in the financial reporting process’

(Revsine)

Why is selective financial misrepresentation favoured?• Managers prefer ‘loose’ reporting

standards because they allow:– income shifting between years

(bonuses)– impressing the shareholders– protecting their jobs by forestalling

takeovers• Shareholders benefit from lower

standards because this lowers the volatility of reported earnings, increasing firm value

Why is selective financial misrepresentation favoured? (cont’d)

• Auditors prefer these rules for client harmony

• Standard setters prefer financial misrepresentation for self-protection and altruism

• Academics may favour this hypothesis because it provides the opportunity for more theories and proposals

Insulating the standard-setting process

Revsine suggests the following:• educating the public• improving the process for selecting

and monitoring standard setters• establishing new funding

arrangements• creating independence for the

standard setters