Financial Accounting Theory [5 ed.] 0170460495, 9780170460491
129 89 17MB
English Pages [778]
Title Page
Imprint Page
Brief contents
Contents
Guide to the text
Guide to the online resources
Preface
About the author
Acknowledgements
Chapter 1: Introduction to financial accounting theory
What is a theory?
Why is it important for accounting students to study accounting theory?
A brief overview of theories of accounting
Inductive accounting theories
Explanatory and predictive (positive) accounting theories
Prescriptive (normative) accounting theories
Critical theories of accounting
Evaluating theories of accounting
Is the theory parsimonious?
Can we prove a theory?
Is the theory falsifiable?
Evaluating theories – considerations of logic and evidence
Evaluation through logical deduction
Evaluating the underlying assumptions
Universal applicability of theories
Generalising theories from the testing of samples
Can (or should ) more than one theory be used at a time?
Key factors that influence the research process
Study Tools
Chapter 2: Accountability and its link to responsibility and accounting
Introduction
The relationship between ‘accounting’ and ‘accountability’
What do we mean by accountability?
So, what are the responsibilities of organisations?
Who are the ‘stakeholders’ of an organisation?
Why might we all have different perceptions of organisational responsibilities, and therefore of organisational accountability?
Perceptions of organisational accountability will change over time
The influence of stakeholder power on corporate accountability
An accountability model
Why is an organisation collecting and disclosing particular information?
To whom is the account information being directed?
What information needs to be reported?
How should the information be disclosed?
The normative nature of the four-step accountability model
The materiality determination process
The influence of organisational objectives upon accounting
Identifying the problem for Walt Disney
Identifying the problem for Greenpeace
Identifying the problem for Harvard
Corporate governance
Study Tools
Chapter 3: The financial reporting environment
Introduction
The objective, use and regulation of general purpose financial reports
Alternative measures of financial performance disclosed within financial reports
Financial accounting versus management accounting
Application of our ‘accountability model’ to the practice of financial reporting
An overview of the development and regulation of accounting practice
Reliance on double-entry accounting
Early development of professional accounting bodies
Early codification of accounting rules
Development of disclosure regulations
Twenty-first-century political pressure on financial accounting regulation
The rationale for regulating financial accounting practice
The costs and benefits of accounting regulation
Regulation and enforcement
The role of professional judgement in financial accounting
How powerful is the accountant?
Study Tools
Chapter 4: The regulation of financial accounting
Introduction
What is regulation?
The ‘free-market’ perspective
Market-related incentives
The ‘pro-regulation’ perspective
The ‘invisible hand’
Enlightened self-interest
Public interest theory
Capture Theory
Economic and social impacts of accounting regulation
Lobbying and the economic interest group theory of regulation
Accounting regulation as an output of a political process
Study Tools
Chapter 5: International accounting
Introduction
Evidence of international differences in accounting prior to recent standardisation initiatives
Does it really matter if different countries use different financial accounting methods?
A brief overview of the IASB and its globalisation activities
Role of the European Union
Australia adopts IFRS
The United States’ role in the international standardisation of financial accounting
Does the international standardisation of accounting standards necessarily lead to the international standardisation of accounting practice?
Differences in taxation systems
Differences in economic and political influences on financial reporting
Modifications made to IFRS at a national level
Issues of translation
Differences in implementation, monitoring and enforcement
Explanations of differences in accounting
Culture
Religion
Legal systems
Business ownership and financing systems
Taxation systems
Strength of the accounting profession
Accidents of history
Impacts of culture on issues beyond financial reporting
Concluding comments about obstacles to the ongoing standardisation of financial accounting
Study Tools
Chapter 6: Measurement issues: accounting for the effects of changing prices and markets
Introduction
The process of measurement
Measurement bases utilised within financial reporting standards
Factors to consider when choosing between alternative measurement bases
Limitations of historical cost accounting in times of rising prices
Current purchasing power accounting (CPPA)
Calculating indices
Performing current purchasing power adjustments
Current cost accounting
Exit price accounting: the case of Chambers’ Continuously Contemporary Accounting
The demand for price-adjusted and value-adjusted accounting information
Fair value accounting
Fair value and its relationship to volatility and procyclicality in accounting measures
Fair value and the decision usefulness versus stewardship role of financial reporting
Study Tools
Chapter 7: Normative theories of accounting: the case of conceptual framework projects
Introduction
So, what is a conceptual framework of accounting?
A brief overview of the history of the development of conceptual frameworks
The Trueblood Report
The FASB conceptual framework project
The (UK) Corporate Report
Development of conceptual frameworks in Australia and elsewhere
Recent efforts of the IASB and the FASB
Building blocks of a conceptual framework
Definition of the reporting entity
Users of financial reports
Objectives of general purpose financial reporting
Qualitative characteristics of financial reports
Can financial statements provide neutral and unbiased accounts of an entity’s performance and position?
Definition and recognition of the elements of financial statements
Definition and recognition of assets
Definition and recognition of liabilities
Definition and recognition of expenses
Definition and recognition of income
Definition of equity
Measurement principles
Pros and cons associated with having a conceptual framework
A restricted view of accountability
Stifle future reporting innovation
A potentially distorted view of an organisation’s ‘performance’
Simply a reflection of existing accounting practice
A device to legitimise accounting standard setters and the accounting profession
Study Tools
Chapter 8: Positive Accounting Theory
Introduction
Positive Accounting Theory defined
The origins and development of Positive Accounting Theory
Role of the Efficient Markets Hypothesis
Share price reactions to unexpected earnings announcements
Use of Agency Theory to help explain and predict managerial choice of accounting policies
The perspective of the organisation as a ‘nexus of contracts’
The emergence of Positive Accounting Theory
Opportunistic and efficiency perspectives
Owner-manager contracting
Bonus schemes generally
Accounting-based bonus plans
Incentives to manipulate accounting numbers
Accounting-based bonus schemes that rely upon conservative accounting practices
Market-based bonus schemes
Debt contracting
The use of conservative accounting methods to reduce agency costs of debt
Evidence of the use of accounting-based debt covenants
Incentives to manipulate accounting numbers in the presence of debt contracts
Political costs
Relevance of PAT-based research to efforts by the IASB and FASB to promote fair value accounting
Earnings management
Accounting policy choice and ‘creative accounting’
Some criticisms of Positive Accounting Theory
Study Tools
Chapter 9: Unregulated corporate reporting decisions: considerations of systems-oriented theories
Introduction
Political Economy Theory
Legitimacy Theory
Legitimacy, public expectations and the social contract
Legitimacy and changing social expectations
Phases of legitimation
Use of accounting reports in legitimation strategies
Corporate views on the importance of the social contract
Empirical tests of Legitimacy Theory
Legitimacy Theory favoured by some researchers as it provides a parsimonious explanation of an underlying phenomenon
Some issues that are not currently addressed by Legitimacy Theory
Stakeholder Theory
The ethical branch of Stakeholder Theory
The managerial branch of Stakeholder Theory
Empirical tests of Stakeholder Theory
Institutional Theory
Isomorphism and decoupling as important components of Institutional Theory
Further empirical tests of Institutional Theory
Study Tools
Chapter 10: Extending corporate accountability: the practice of social and environmental reporting
Introduction
The meanings of social, environmental and sustainability reporting
Social reporting
Environmental reporting
Sustainability reporting
The incidence of CSR reporting
Developing notions of sustainability
Steps within the sustainability reporting process
Objectives of the social and environmental reporting process – the ‘why report?’ stage
An acceptance of accountability to provide information
To comply with legal requirements
To forestall efforts to introduce more onerous disclosure regulations
To influence the perceived legitimacy of the organisation
To align the organisation with its institutional environment
To manage particular stakeholder groups
To increase the wealth of the shareholders and the managers of the organisation
Identifying stakeholders – the who stage
Identifying stakeholder information needs and expectations – the ‘what do we report?’ stage
Theoretical perspectives on some social and environmental reporting procedures – the how stage
Limitations of traditional financial accounting in respect of its ability to reflect social and environmental performance
Triple bottom line reporting
The Global Reporting Initiative – a conceptual framework for social and environmental reporting?
Integrated reporting
Value creation versus accountability
Materiality
The capitals
Some shortfalls and some strengths of the International Framework
The International Sustainability Standards Board
The Sustainability Accounting Standards Board
The Task Force on Climate-related Financial Disclosures
The United Nations Sustainable Development Goals
The United Nations Global Compact
Other frameworks
Sustainability ratings
Accounting for externalities
Climate change
The Greenhouse Gas Protocol
The Carbon Disclosure Project
Accountability for modern slavery
Counter and dialogic accounts
Personal social responsibility
Study Tools
Chapter 11: Reactions of capital markets to financial reporting
Introduction
An overview of capital markets research
The information content of earnings
Results of capital markets research into financial reporting
Historical cost income is used by investors
Prior to an earnings release, investors obtain much of the information they need from other sources
The information content of earnings announcements depends on the extent of alternative sources of information
The capital market impact of unexpected changes in earnings depends on whether the change is expected to be permanent or temporary
Earnings persistence depends on the relative magnitudes of cash and accruals components of current earnings
The earnings announcements of other organisations in the same industry have information content 616
There are benefits associated with the voluntary disclosure of information
Recognition is perceived differently to mere footnote disclosure
Size of a company affects whether the capital market will react to a company’s release of information
Unexpected changes in accounting earnings created by unexpected increases in revenues
Do current share prices anticipate future accounting earnings announcements?
Relaxing assumptions about market efficiency
Study Tools
Chapter 12: Reactions of individuals to financial reporting: an examination of behavioural research in accounting
Introduction
An overview of behavioural research
The Brunswik Lens Model
The use of particular information items and the implications of different forms of presentation
Decision-making processes and the use of heuristics
Environmental factors that influence decisions
Issues of decision accuracy
Protocol analysis
The relevance of differences in culture
Limitations of behavioural research
Study Tools
Chapter 13: Critical perspectives of accounting
Introduction
The critical perspective defined
Insights into the partisan nature of accounting
A Marxist critique of accounting
Critical accounting research versus social and environmental accounting research
Possible impact of critical accounting research on social practice
The role of the state in supporting existing social structures
The role of accounting research in supporting existing social structures
Accounting research and support for deregulation of accounting
A critical accounting interpretation of increased accounting regulation post-Enron
A critical accounting view on the active role of academic and non-academic discourse in protecting capitalism
The role of accounting practice in supporting existing social structures
The role of accounting reports in creating a selective ‘reality’
The power of accountants through a false image of neutrality
A critical accounting perspective of accounting and legitimation
The role of accounting in legitimising the capitalist system
Counter accounts and dialogic accounts
A critical reflection on the role of critical accounting researchers in creating change
Study Tools
Glossary
Index
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Craig Deegan
Financial Accounting Theory
5e
Craig Deegan
Financial Accounting Theory
5e
Financial Accounting Theory
© 2023 Cengage Learning Australia Pty Limited
5th Edition Craig Deegan
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National Library of Australia Cataloguing-in-Publication Data ISBN: 9780170460491
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Brief contents CHAPTER 1 Introduction to financial accounting theory
1
CHAPTER 2 Accountability and its link to responsibility and accounting
43
CHAPTER 3 The financial reporting environment
74
CHAPTER 4 The regulation of financial accounting
111
CHAPTER 5 International accounting
159
CHAPTER 6 Measurement issues: accounting for the effects of changing prices and markets
219
CHAPTER 7 Normative theories of accounting: the case of conceptual framework projects
273
CHAPTER 8 Positive Accounting Theory
343
CHAPTER 9 Unregulated corporate reporting decisions: considerations of systems-oriented theories
422
CHAPTER 10 Extending corporate accountability: the practice of social and environmental reporting
498
CHAPTER 11 Reactions of capital markets to financial reporting
593
CHAPTER 12 Reactions of individuals to financial reporting: an examination of behavioural research in accounting
638
CHAPTER 13 Critical perspectives of accounting
669
iii
Contents Guide to the text
xiii
Guide to the online resources
xvi
Preface xvii About the author
xx
Acknowledgements xxi CHAPTER 1
Introduction to financial accounting theory What is a theory?
1 2
Why is it important for accounting students to study accounting theory? 4 A brief overview of theories of accounting Inductive accounting theories
10
Prescriptive (normative) accounting theories
12
Critical theories of accounting
14
Evaluating theories of accounting
18
Is the theory parsimonious? Is the theory falsifiable? Evaluating theories – considerations of logic and evidence Evaluation through logical deduction
21 22 23 24 24
Evaluating the underlying assumptions
26
Universal applicability of theories
28
Generalising theories from the testing of samples
29
Can (or should ) more than one theory be used at a time?
30
Key factors that influence the research process
31
Study Tools
35
Accountability and its link to responsibility and accounting 43 Introduction 44 The relationship between ‘accounting’ and ‘accountability’
46
What do we mean by accountability?
48
So, what are the responsibilities of organisations?
51
Who are the ‘stakeholders’ of an organisation?
52
Why might we all have different perceptions of organisational responsibilities, and therefore of organisational accountability?
54
Perceptions of organisational accountability will change over time
iv
8
Explanatory and predictive (positive) accounting theories
Can we prove a theory?
CHAPTER 2
7
56
The influence of stakeholder power on corporate accountability
57
An accountability model
58
Why is an organisation collecting and disclosing particular information?
59
To whom is the account information being directed?
61
Contents
What information needs to be reported?
62
How should the information be disclosed?
63
The normative nature of the four-step accountability model
63
The materiality determination process
65
The influence of organisational objectives upon accounting
CHAPTER 3
66
Identifying the problem for Walt Disney
68
Identifying the problem for Greenpeace
68
Identifying the problem for Harvard
68
Corporate governance
69
Study Tools
71
The financial reporting environment 74 Introduction 75 The objective, use and regulation of general purpose financial reports
76
Alternative measures of financial performance disclosed within financial reports
79
Financial accounting versus management accounting
80
Application of our ‘accountability model’ to the practice of financial reporting
80
An overview of the development and regulation of accounting practice
83
Reliance on double-entry accounting
83
Early development of professional accounting bodies
84
Early codification of accounting rules
85
Development of disclosure regulations
86
Twenty-first-century political pressure on financial accounting regulation 88 The rationale for regulating financial accounting practice The costs and benefits of accounting regulation
94
Regulation and enforcement
95
The role of professional judgement in financial accounting How powerful is the accountant? Study Tools
CHAPTER 4
91
96 99 106
The regulation of financial accounting 111 Introduction 112 What is regulation?
114
The ‘free-market’ perspective
114
Market-related incentives
117
The ‘pro-regulation’ perspective
119
The ‘invisible hand’
122
Enlightened self-interest
126
Public interest theory
130
Capture Theory
132
Economic and social impacts of accounting regulation
141
v
Contents
CHAPTER 5
Lobbying and the economic interest group theory of regulation
142
Accounting regulation as an output of a political process
146
Study Tools
150
International accounting 159 Introduction 160 Evidence of international differences in accounting prior to recent standardisation initiatives
161
Does it really matter if different countries use different financial accounting methods?
163
A brief overview of the IASB and its globalisation activities
165
Role of the European Union
170
Australia adopts IFRS
173
The United States’ role in the international standardisation of financial accounting 175 Does the international standardisation of accounting standards necessarily lead to the international standardisation of accounting practice? 179 Differences in taxation systems Differences in economic and political influences on financial reporting
181
Modifications made to IFRS at a national level
182
Issues of translation
182
Differences in implementation, monitoring and enforcement
182
Explanations of differences in accounting
CHAPTER 6
vi
181
187
Culture
189
Religion
200
Legal systems
201
Business ownership and financing systems
202
Taxation systems
204
Strength of the accounting profession
205
Accidents of history
206
Impacts of culture on issues beyond financial reporting
208
Concluding comments about obstacles to the ongoing standardisation of financial accounting
209
Study Tools
210
Measurement issues: accounting for the effects of changing prices and markets 219 Introduction 220 The process of measurement
221
Measurement bases utilised within financial reporting standards
227
Factors to consider when choosing between alternative measurement bases
229
Limitations of historical cost accounting in times of rising prices
230
Contents
Current purchasing power accounting (CPPA)
236
Calculating indices
237
Performing current purchasing power adjustments
238
Current cost accounting
241
Exit price accounting: the case of Chambers’ Continuously Contemporary Accounting
243
The demand for price-adjusted and value-adjusted accounting information 249 Fair value accounting
257
Fair value and the decision usefulness versus stewardship role of financial reporting
262
Study Tools
CHAPTER 7
252
Fair value and its relationship to volatility and procyclicality in accounting measures
266
Normative theories of accounting: the case of conceptual framework projects 273 Introduction 274 So, what is a conceptual framework of accounting?
275
A brief overview of the history of the development of conceptual frameworks 279 The Trueblood Report
280
The FASB conceptual framework project
281
The (UK) Corporate Report
282
Development of conceptual frameworks in Australia and elsewhere 282 Recent efforts of the IASB and the FASB Building blocks of a conceptual framework
283 285
Definition of the reporting entity
285
Users of financial reports
288
Objectives of general purpose financial reporting
290
Qualitative characteristics of financial reports
294
Can financial statements provide neutral and unbiased accounts of an entity’s performance and position?
302
Definition and recognition of the elements of financial statements
305
Definition and recognition of assets
308
Definition and recognition of liabilities
316
Definition and recognition of expenses
321
Definition and recognition of income
321
Definition of equity
323
Measurement principles
324
Pros and cons associated with having a conceptual framework
327
A restricted view of accountability
328
Stifle future reporting innovation
329
A potentially distorted view of an organisation’s ‘performance’
329 vii
Contents
Simply a reflection of existing accounting practice
334
A device to legitimise accounting standard setters and the accounting profession
335
Study Tools
CHAPTER 8
Positive Accounting Theory 343 Introduction 344 Positive Accounting Theory defined
345
The origins and development of Positive Accounting Theory
347
Role of the Efficient Markets Hypothesis
351
Share price reactions to unexpected earnings announcements
352
Use of Agency Theory to help explain and predict managerial choice of accounting policies
354
The perspective of the organisation as a ‘nexus of contracts’
358
The emergence of Positive Accounting Theory
362
Opportunistic and efficiency perspectives
366
Owner-manager contracting
369
Bonus schemes generally
370
Accounting-based bonus plans
370
Incentives to manipulate accounting numbers
372
Accounting-based bonus schemes that rely upon conservative accounting practices
374
Market-based bonus schemes
375
Debt contracting
CHAPTER 9
viii
337
381
The use of conservative accounting methods to reduce agency costs of debt
382
Evidence of the use of accounting-based debt covenants
383
Incentives to manipulate accounting numbers in the presence of debt contracts
386
Political costs
389
Relevance of PAT-based research to efforts by the IASB and FASB to promote fair value accounting
394
Earnings management
399
Accounting policy choice and ‘creative accounting’
404
Some criticisms of Positive Accounting Theory
406
Study Tools
412
Unregulated corporate reporting decisions: considerations of systems-oriented theories 422 Introduction 423 Political Economy Theory
425
Legitimacy Theory
427
Legitimacy, public expectations and the social contract
428
Legitimacy and changing social expectations
431
Phases of legitimation
434
Contents
Use of accounting reports in legitimation strategies
437
Corporate views on the importance of the social contract
439
Empirical tests of Legitimacy Theory
440
Legitimacy Theory favoured by some researchers as it provides a parsimonious explanation of an underlying phenomenon
449
Some issues that are not currently addressed by Legitimacy Theory
451
Stakeholder Theory
458
The ethical branch of Stakeholder Theory
461
The managerial branch of Stakeholder Theory
465
Empirical tests of Stakeholder Theory
467
Institutional Theory
471
Isomorphism and decoupling as important components of Institutional Theory
478
Further empirical tests of Institutional Theory
485
Study Tools
488
CHAPTER 10 Extending corporate accountability: the practice of social and environmental reporting 498 Introduction 499 The meanings of social, environmental and sustainability reporting
501
Social reporting
501
Environmental reporting
502
Sustainability reporting
502
The incidence of CSR reporting
503
Developing notions of sustainability
507
Steps within the sustainability reporting process
509
Objectives of the social and environmental reporting process – the ‘why report?’ stage
510
An acceptance of accountability to provide information
511
To comply with legal requirements
512
To forestall efforts to introduce more onerous disclosure regulations 514 To influence the perceived legitimacy of the organisation
515
To align the organisation with its institutional environment
516
To manage particular stakeholder groups
517
To increase the wealth of the shareholders and the managers of the organisation
518
Identifying stakeholders – the who stage
520
Identifying stakeholder information needs and expectations – the ‘what do we report?’ stage
522
Theoretical perspectives on some social and environmental reporting procedures – the how stage
525
Limitations of traditional financial accounting in respect of its ability to reflect social and environmental performance
526
Triple bottom line reporting
534
ix
Contents
The Global Reporting Initiative – a conceptual framework for social and environmental reporting? Integrated reporting Value creation versus accountability
535 545 547
Materiality
547
The capitals
549
Some shortfalls and some strengths of the International Framework
551
The International Sustainability Standards Board
552
The Sustainability Accounting Standards Board
554
The Task Force on Climate-related Financial Disclosures
556
The United Nations Sustainable Development Goals
557
The United Nations Global Compact
560
Other frameworks
561
Sustainability ratings
561
Accounting for externalities
563
Climate change
569
The Greenhouse Gas Protocol
574
The Carbon Disclosure Project
575
Accountability for modern slavery
576
Counter and dialogic accounts
578
Personal social responsibility
581
Study Tools
582
CHAPTER 11 Reactions of capital markets to financial reporting 593 Introduction 594
x
An overview of capital markets research
595
The information content of earnings
605
Results of capital markets research into financial reporting
610
Historical cost income is used by investors
611
Prior to an earnings release, investors obtain much of the information they need from other sources
612
The information content of earnings announcements depends on the extent of alternative sources of information
614
The capital market impact of unexpected changes in earnings depends on whether the change is expected to be permanent or temporary
615
Earnings persistence depends on the relative magnitudes of cash and accruals components of current earnings
615
The earnings announcements of other organisations in the same industry have information content
616
Earnings forecasts have information content
617
There are benefits associated with the voluntary disclosure of information
618
Contents
Recognition is perceived differently to mere footnote disclosure
618
Size of a company affects whether the capital market will react to a company’s release of information
618
Unexpected changes in accounting earnings created by unexpected increases in revenues
619
Do current share prices anticipate future accounting earnings announcements? 620 Relaxing assumptions about market efficiency
630
Study Tools
633
CHAPTER 12 Reactions of individuals to financial reporting: an examination of behavioural research in accounting 638 Introduction 639 An overview of behavioural research
641
The Brunswik Lens Model
646
The use of particular information items and the implications of different forms of presentation
650
Decision-making processes and the use of heuristics
654
Environmental factors that influence decisions
660
Issues of decision accuracy
660
Protocol analysis
661
The relevance of differences in culture
663
Limitations of behavioural research
663
Study Tools
665
CHAPTER 13 Critical perspectives of accounting 669 Introduction 670 The critical perspective defined
672
Insights into the partisan nature of accounting
676
A Marxist critique of accounting
679
Critical accounting research versus social and environmental accounting research
681
Possible impact of critical accounting research on social practice
686
The role of the state in supporting existing social structures
691
The role of accounting research in supporting existing social structures 693 Accounting research and support for deregulation of accounting
693
A critical accounting interpretation of increased accounting regulation post-Enron
695
A critical accounting view on the active role of academic and non-academic discourse in protecting capitalism
696
The role of accounting practice in supporting existing social structures 697 The role of accounting reports in creating a selective ‘reality’
698
xi
Contents
The power of accountants through a false image of neutrality
Glossary
699
A critical accounting perspective of accounting and legitimation
701
The role of accounting in legitimising the capitalist system
702
Counter accounts and dialogic accounts
703
A critical reflection on the role of critical accounting researchers in creating change
712
Study Tools
715
722
Index 730
xii
CHAPTER
1
Guide to the text As you read this text you will find a number of features in every chapter to enhance your study of financial accounting theory and help you understand how the theory is applied in the real world.
INTRODUCTION TO FINANCIAL ACCOUNTING THEORY CHAPTER-OPENING FEATURES
Identify the key concepts you will engage with through the Learning objectives at the start of each chapter.
LEARNING OBJECTIVES On completing this chapter, readers should: LO1.1
understand that there are many theories of accounting
LO1.2
understand how knowledge of different accounting theories increases our ability to understand and evaluate various alternative accounting practices
LO1.3
understand that the different theories of accounting are often developed to perform different functions, such as to describe accounting practice, or to prescribe particular accounting practices
LO1.4
understand that theories, including theories of accounting, are developed as a result of applying various value judgements and also appreciate that acceptance of one theory in preference to others will in part be tied to one’s own value judgements
LO1.5
be aware that we should critically evaluate theories (in terms of such things as the underlying logic, assumptions made and evidence produced) before accepting them
LO1.6
understand some alternative perspectives about how knowledge develops across time
LO1.7
understand why students of accounting should study accounting theories as part of their broader accounting education.
Check your understanding of accounting concepts with the Opening questions. Answers to these opening questions can be found at the end of the chapter so you can check how your understanding has changed.
1
BK-CLA-DEEGAN_FAT_5E-220197-Chp01.indd 1
21/09/22 7:33 AM
xiii
Guide to the text
FEATURES WITHIN CHAPTERS Reflection questions encourage you to pause and reflect on concepts that have you learned in the chapter.
Introduction to financial accounting theory CHAPTER 1
normative theories can be further subdivided. For example, some normative theories can be classified as ‘true income theories’, and other theories as ‘decision usefulness theories’. The true income theories make certain assumptions about the role of accounting and then seek to provide a single ‘best measure’ of profits (for example, see Lee, 1974).6
Why do I need to know …? boxes provide context to complex subject matter to show how the topic relates to the real world. REFLECTION QUESTION 1.1 Contrasting positive and normative research
Important first time.
Question There are two researchers: • Researcher 1 is undertaking research to determine whether organisations with greater levels of negative media attention directed at their activities are likely to provide greater levels of socially oriented disclosures. • Researcher 2 evaluates the disclosures being made by different organisations with the intention of developing reporting guidance that will assist organisations to Key terms marked bold inabout thetheir text and provide are relevant and reliablein information contributions to climate change.
Would the above research be considered positive or normative research? Solution • Positive research: Positive research seeks to explain or predict particular phenomena. Researcher 1 would be undertaking positive research. • Normative research: Normative research seeks to provide prescriptions about what should be done. Researcher 2 would be undertaking normative researchers.
defined in the margin when they are used for the
Decision usefulness theories ascribe a particular type of information for particular classes of users on the basis of assumed decision-making needs. According to Bebbington, Gray and Laughlin (2001, p. 418), the decision usefulness approach can be considered to have two branches – the decision-makers emphasis and the decision-models emphasis. The decision-makers emphasis relies on undertaking research that seeks to ask the users of the information what information they want.7 Once that is determined, this knowledge is used to prescribe what information should be supplied to the users of financial statements. Much of this research is questionnaire-based. This branch of research tends to be fairly disjointed, as different studies typically address different types of information, with limited linkages between them. Another variant of the decision-makers emphasis, which is explored in Chapter 11, is capital markets research. Briefly, capital markets research works on the assumption that if the capital market responds to information (as evidenced through share price changes that occur around the time of the release of particular information), then the information must be useful.8 This forms the basis for subsequent prescriptions about the types of information that should be provided to users of financial statements. It also has been used to determine whether particular mandatory reporting requirements (such as the introduction of new accounting standards) were necessary or effective, the rationale being that, if a new accounting standard does not evoke a market reaction, it is questionable whether the new requirement is useful or necessary in providing information to the capital market or investors. Research that evaluates information on the basis of whether it evokes a market reaction, or whether stakeholders indicate that it is useful to them, ignores the possibility that there could be information that is ‘better’ than that provided or sought. There is also the 6
7
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8
Decision usefulness theories Theories that ascribe a particular type of information for particular classes of users on the basis of assumed decisionmaking needs.
Much of the work undertaken in developing ‘true income theories’ relies on the work of Hicks (1946). Hicks defined ‘income’ as the maximum amount that can be consumed by a person or an organisation in a particular period without depleting the wealth that existed for that person or organisation at the start of the period. For example, in recent years a number of research studies have asked a number of different stakeholder groups what types of social and environmental performance information the stakeholders considered to be useful for their various decision-making processes. Based on the Efficient Markets Hypothesis, which predicts that the stock market instantaneously reacts, through price adjustments (changes), to all relevant publicly available information.
13
Guide to the text
END-OF-CHAPTER FEATURES Accountability and its link to responsibility and accounting CHAPTER 2
At the end of each chapter you will find several tools to help you to review, practise and extend your knowledge Accountability and its link to responsibility and accounting CHAPTER 2 of the key learning objectives.
STUDY TOOLS STUDY TOOLS
Review your understanding of the key chapter topics with the Chapter summary.
CHAPTER SUMMARY This chapter has addressed a number of issues that are fundamental to the understanding and practice
CHAPTER SUMMARY of accounting. We have provided definitions of ‘accounting’ and ‘accountability’, and we have explored
This chapter has between addressed a number ofresponsibilities, issues that are fundamental the understanding and practice the relationship organisations’ accountability,toand accounting practices. We of accounting. We have providedmanagers definitionswill of ‘accounting’ and ‘accountability’, we and havefor explored have emphasised that different interpret their responsibilities (to and whom, what) the relationship between organisations’ accountability, andthey accounting differently, and this will have implicationsresponsibilities, for the accounting practices that will havepractices. in place. We have that different managers will interpret their responsibilities (to whom, and for and what) have emphasised also emphasised that perceptions of organisational responsibility will change over time, this differently, and this implications for thepractice. accounting practices that they will have in place. We has implications forwill thehave evolution of accounting haveWe also emphasised that perceptions of organisational responsibility willvarious changejudgements over time, and thisas introduced a four-step accountability model that emphasises how made has for the evolution of accounting partimplications of an ‘accountability relationship’ between practice. organisations, and their stakeholders, have sequential We introduced a four-stepjudgements. accountability thatthe emphasises howmanagers various judgements made as implications for subsequent Formodel example, reasons why are reporting part of an ‘accountability relationship’ their stakeholders, have sequential information has implications for who isbetween intendedorganisations, to receive theand information, which in turn has implications implications for subsequent judgements. For example, the reasons why managers are reporting for what is reported, and how it is reported. information has concluded implicationswith for awho is discussion intended toofreceive the information, in turn has implications The chapter brief corporate governance which emphasised that for how it is reported. thewhat form isofreported, corporateand governance employed within an organisation ultimately is influenced by the Refer to the Answers the opening questions to assess how your understanding has that developed, Theto chapter concludedbywith a brief discussion of corporate governance which emphasised responsibilities accepted corporate managers. the form of corporate governance employed within an organisation ultimately is influenced by the reading the material provided within the chapter. responsibilities accepted by corporate managers.
as a result of
ANSWERS TO THE OPENING QUESTIONS
Financial Accounting Theory
At the beginning of the chapter, we asked the following five questions. As a result of reading this
ANSWERS TO THE OPENING QUESTIONS chapter, you should be able to provide informed answers to these questions – ours are shown below.
At beginning of the chapter,mean? we asked the following five questions. As a result of reading this 1 the What does ‘accountability’ chapter, you shouldwe behave able provided to provideainformed answers to these questions – ours are shown below. In this chapter number of definitions of accountability. useful definition 5 Is there a relationship between an organisation’s corporate governanceOne policies and the 1 What does ‘accountability’ mean?and Owen (2014, p. 50) which is ‘the duty to provide an account is that provided by Gray, Adams managers’ perceptions about organisational responsibility and accountability? In chapterofwe haveactions provided a number of accountability. One useful orthis reckoning those for which one of is definitions held responsible’. The ‘accountability’ of definition an Yes, there is a relationship. Managers’ assessments of their responsibilities and accountabilities is that provided by Gray, Adams Owen (2014,made p. 50)about whichan is organisation’s ‘the duty to provide an account organisation is very much linkedand to judgements responsibilities. will have direct implications for the corporate governance policies in place. For example, if reckoning of thoseof actions for which one is held responsible’. The ‘accountability’ of an 2 or How do perceptions organisational perceptions of organisational managers believe that they have a responsibility responsibility influence and an associated accountability to minimise organisation is very much linked to judgements made about an organisation’s responsibilities. accountability? their contribution to climate change, then they would put in place policies and procedures 2 How dochapter perceptions of organisational responsibility influence perceptions of Figure 2.1.they Asorganisational we discuss, In this we provided simple, but useful, – see (governance policies) thata aim to reduce their diagram emissions (for example, might have capital accountability? perceptions of policies organisational responsibilities perceptions to whomor anthey investment that stipulate that only directly energy influence efficient equipment is about to be acquired 2.1. As we discuss, In this chapter provided aand simple, but useful, diagram – seetoFigure organisation iswe responsible for what aspects of are performance it is responsible. Where there might have in place management bonuses that linked achieving emission reduction perceptions of organisational responsibilities directly influence perceptions about to in whom an to aretargets). responsibilities, managers need to provide anreporting account (that is, beinaccountable) relation They would also be expected to have practices place which measure organisation isthe responsible for undertaken what performance it is responsible. Wheretothere whether those responsibilities have beenaspects properly demonstrated. and report results ofand efforts to of reduce the organisation’s contribution are responsibilities, managers need to provide an account (that is,ofbeaccountability? accountable) in relation to climate change. 3 and How, if at all, is the practice ‘accounting’ related tothe perceptions Test your knowledge consolidate your of learning through end-of-chapter Questions. whether those about responsibilities haveofbeen properly demonstrated. The decisions what aspects an organisation’s performance are ‘accounted for’ areand accounting CHAPTER 2 Accountability and its link to responsibility 3 How, if at all, is the practice of ‘accounting’ related to perceptions of accountability? directly related to the types and extent of accountability accepted by managers. The broader the The decisions about whatbyaspects of an performance are ‘accounted for’ accountability accepted managers in organisation’s terms of to whom they are accountable, and forare what QUESTIONS directly to the types and of accountability by practice managers. The broader the aspectsrelated of performance they areextent accountable, then the accepted broader the of accounting that LO2.1 2.1 expectations Define ‘accountability’. regarding the of ‘accounts’ thatofparticular should prepare, and therefore, accountability accepted by types managers terms to whom they are accountable, and what will be adopted. If managers accept ainresponsibility and entities associated accountability to for a broad 2.2 in the Would different managers necessarily have similar views about organisational accountability? types or forms of ‘accounting’ that they should undertake. aspects ofstakeholders, performance theyfor are accountable, then the broaderthen the practice of accounting thatto range of and a broad range of performance, such managers will tend Why? LO2.2 will adopted. If managers accept responsibility andLO2.6 associated accountability to a broad Explain clearly the logic above quote. usebe accounting practices thatbehind provideathe information about various aspects of the organisation’s 2.3 Why might different managers have different perceptions of their organisation’s responsibilities? LO2.4 range of stakeholders, and for a broad rangeinofFigure performance, such managers will tend to financial, social and performance. 2.20 logic of environmental the relationship shown 2.1. LO2.2 then 2.4 Explain Doesthe it make sense to study accounting without considering, in some depth, the issue of accounting practices that provide information about various aspects of the 2.21 the managers of an organisation are primarily focused on satisfying the information 4 use If Ifwe were to develop a model of ‘organisational accountability’, and if it was toorganisation’s have fourneeds of LO2.2 ‘organisational accountability’? Why? financial, social and environmental performance. powerful then how would the managers determine what to disclose? Further, would steps, what might steps be? LO2.3 2.5sequential What isstakeholders, a ‘stakeholder’ of these an organisation? LO2.5 42.6IfThere we were tostakeholder develop a be model ‘organisational accountability’, and if it was to have has four opted such an aorganisation likely be to be high levels of accountability? could potentially a variety ofperson steps that could bepeople? identified, but this chapter LO2.3 Does have toofdeemed be a ordemonstrating group of LO2.7 sequential steps, these being ‘why steps, what might these steps be? 2.22 will accounting practices evolve over time? toWhy use a four-step accountability model which identifies four LO2.3 LO2.4 2.7sequential What is stakeholder engagement, and what isLO2.2 its purpose? could potentially be asked a between variety oftostakeholder steps thatand could beproduce identified, but chapter has step optedhas 2.23 If you were a consultant to help an organisation itsorganisational firstthis publicly report?’, ‘tois whom to report?’, ‘what report?’ ‘how to report?’ The answer toavailable each 2.8There What the connection engagement and to use a four-step accountability identifies sequential these are being ‘why to ‘sustainability thenLO2.3 it bewhich relevant to you four to know why thesteps, managers wanting implications for report’, the answer towould themodel following step. LO2.2 accountability? LO2.1 ‘tothe whom to report?’, ‘what LO2.6 to report?’ and ‘howshould to report?’ Theofanswer to eachgovernance step has produce report? Why? 2.9report?’, Would you consider that stakeholder engagement be part the corporate theorganisation? answer to the LO2.3 following 2.24 implications Would you for expect similar accounting practices LO2.8 step. to be used in different countries? policies of an LO2.2 the LO2.4 list LO2.6of References relevant to each chapter. Extend your understanding 2.10 Why? Arewith the views or expectations of all stakeholders likely to be considered/acted upon by an 71 organisation? LO2.5 2.11 What is ‘corporate governance’, and would you expect systems of corporate governance to be 71 REFERENCES influenced by managers’ perceptions of their organisational responsibilities? Why? LO2.8 AccountAbility (2018), AA1000 AccountAbility Principles 2018 , Gray, A. & Jenkins, B. (1993), ‘Codes of accountability in the 2.12 Are systems of corporate governance and accounting practices likely to be related? viewed 1 June 2022, http://www.accountability.org/ new public sector’, Accounting, Auditing & Accountability LO2.8 Why? LO2.7 BK-CLA-DEEGAN_FAT_5E-220197-Chp02.indd 71 15/09/22 8:10 PM standards Journal, 6(3). Some ‘accounting educators’ incorporate issues toR.,doAdams, with measuring and reporting information ASX2.13 Corporate Governance Council (2019), Corporate Gray, C. & Owen, D. (2014), Accountability, Social BK-CLA-DEEGAN_FAT_5E-220197-Chp02.indd 71 15/09/22 8:10 PM about organisational social and, environmental performance across their various accounting Governance Principles and Recommendations 4th edn, Responsibility and Sustainability: Accounting for Society Sydney: ASX. and the Harlow, UK: Pearson Education. subjects/units, whereas other accounting educators doEnvironment not. Why ,do you think that such differences Australian Corporations and Marketseducators Advisory Committee Colin, D., Dave, O., Richard, E. & Simon, Z. LO2.4 R.,LO2.6 between accounting exist? LO2.2 Gray, (2006), The Social Responsibility of Corporations, (1997), ‘Struggling with the praxis of social accounting: 2.14 What is a ‘surrogate stakeholder’, and what is their role? LO2.3 Canberra: Australian Government. stakeholders, accountability, audits and procedures’, 2.15A. D.What is ‘Public the ‘materiality determination process’?Accounting, Why would it be useful for readers of , 10(3), Barton, (2006), sector accountability and Auditing & Accountability Journal organisational accounts be provided with information commercial-in-confidence outsourcingtocontracts’, pp. 325–64.about the materiality determination Accounting, Auditing & Accountability , 19(2), of an organisation? Gray, R., Owen,LO2.6 D. & Adams, C. (1996), Accounting process instigated by theJournal managers pp. 256–71. and Accountability: Changes and Challenges in to make 2.16 Is it important for accounting researchers to explore the factors that motivate managers Benston, G. J. (1982), ‘Accounting and corporate Corporate Social and Environmental Reporting, particular accounting disclosures? Why? LO2.6 accountability’, Accounting, Organizations and Society, London: Prentice Hall. 2.17pp. 87–105. Explain why each step in the four-step accountability model discussed in https://www.greenpeace. this chapter influences 6(2), Greenpeace (2022), ‘Our values’, step that follows. For example, why does the answer to the ‘why report?’ step influence the BHP (2022), the ‘Sustainability’, https://www.bhp.com/ org/international/explore/about/values sustainability/approach Haque, C. & Inglis, R.step (2016),influence ‘Demand the for, and issue about ‘to whom?’ to report, and why does the S., ‘toDeegan, whom to report?’ ‘what Black, J. (2008), ‘Constructing contesting legitimacy impediments to, the disclosure of information about to report?’ step?andLO2.6 and accountability in polycentric regulatory regimes’, climate change-related corporate governance practices’, 2.18 Why might it be useful for stakeholders to have insights into ‘why’ managers are reporting Regulation & Governance, 2(2), pp. 137–64.
Accounting and Business Research, 46(6), pp. 1–45.
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Guide to the online resources FOR THE INSTRUCTOR Cengage is pleased to provide you with a selection of resources that will help you to prepare your lectures and assessments, when you choose this textbook for your course. Log in or request an account to access instructor resources at au.cengage.com/instructor/account for Australia or nz.cengage.com/instructor/account for New Zealand. SOLUTIONS MANUAL The Solutions Manual provides detailed solutions to every question in the text.
COGNERO® TEST BANK A bank of questions has been developed in conjunction with the text for creating quizzes, tests and exams for your students. Create multiple test versions in an instant and deliver tests from your LMS, your classroom, or wherever you want using Cognero. Cognero test generator is a flexible online system that allows you to import, edit, and manipulate content from the text’s test bank or elsewhere, including your own favourite test questions.
POWERPOINT™ PRESENTATIONS Use the chapter-by-chapter PowerPoint slides to enhance your lecture presentations and handouts by reinforcing the key principles of your subject.
AUTHOR VIDEOS Craig Deegan's signature author videos provide an overview of the contents and act as mini lectures for online units. These videos will be available for both students and instructors via the instructor website.
ARTWORK FROM THE TEXT Add the digital files of graphs and flow charts into your learning management system, use them in student handouts, or copy them into your lecture presentations.
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Preface About this book The underlying motivation for writing this book is a belief that all students of accounting, whether at the undergraduate or postgraduate level, and indeed all practitioners of accounting, should have a rich understanding of the implications that flow from the practice of accounting. Accounting practice can be linked to various economic, social, and environmental impacts that reverberate throughout society, and students and practitioners of accounting need to understand this. In understanding this, they need knowledge of different theories. This book has therefore been written to provide readers with a balanced discussion of different theories of accounting. Chapter 1 provides a discussion of the role and importance of theory and discusses the different types of accounting theories ‘out there’ and the different ways in which theories are developed. Chapter 1 also provides tools for evaluating theories. Chapter 2 then explores the link between organisational responsibilities, accountabilities, and accounting and in doing so, introduces a four-step accountability model. It also discusses corporate governance and the linkage between corporate governance and accounting practice. Chapter 2 emphasises that relevant and reliable accounting information provides power to users of that information that enables them to make informed choices. Chapters 3 and 4 explore the objectives, use and regulation of general purpose financial reports and critically discuss various theories for and against the regulation of financial reporting. Chapter 5 explores the topic of ‘international accounting’ and critically evaluates efforts towards, and the obstacles to, the standardisation of international financial reporting practices – something that has been aggressively pursued by the International Accounting Standards Board (IASB). The book also describes and evaluates the development of various normative theories of accounting, including various approaches developed to account for changing prices (Chapter 6), as well as various issues associated with the development of conceptual frameworks for financial reporting, in particular the Conceptual Framework for Financial Reporting developed by the IASB (Chapter 7). Apart from exploring various normative prescriptions for how the practice of financial reporting should be undertaken, we also explore various positive theories that have been used to explain and/or predict the practice of accounting. Chapter 8 explores Agency Theory and Positive Accounting Theory while Chapter 9 explores Political Economy Theory, Legitimacy Theory, Stakeholder Theory, and Institutional Theory. Reflecting the growing relevance globally of the sustainability agenda – including efforts to address climate change and modern slavery – social and environmental accountability/sustainability and reporting issues are discussed in depth in Chapter 10. Chapter 10 provides one of the most comprehensive coverages of sustainability/ social and environmental accounting and accountability available within any published accounting-related text. Chapters 11 and 12 then focus on how people use and react to accounting information, with Chapter 11 focusing on capital markets research and Chapter 12 focusing on behavioural research. The book then concludes with Chapter 13, which provides a fascinating exploration of the insights provided by critical accounting theorists – insights that tend to challenge many preconceived ideas about the role of accounting, accountants, professions and the state within society. From the outset, the aim has been to present a balanced perspective about alternative and sometimes conflicting theories of accounting. As such, this book also provides an excellent basis for readers contemplating further research in different areas of accounting. This book has proved to be an invaluable and highly cited resource for accounting researchers and accounting research students, including those pursuing a PhD in the area of accounting.
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Preface
In writing this book, a style has been adopted that enables readers at both the undergraduate and the postgraduate level to gain a sound understanding of accounting theory. As each chapter incorporates research from around the world, the book is of relevance to accounting students and researchers internationally. To assist in the learning process, each chapter provides learning objectives and opening questions which readers are encouraged to answer before reading the chapter. Solutions to each opening question are then provided at the end of the chapter and readers are encouraged to consider how their answers changed as a result of reading the chapter material. ‘Why do I need to know ….?’ boxes also appear throughout every chapter with the aim of enhancing the ‘real world relevance’ of the material by pointing out the respective materials’ likely relevance to readers’ lives within, and beyond, university. Reflection questions have also been incorporated throughout each chapter to encourage readers to apply the material to various realworld issues. There are also chapter summaries and end-of-chapter discussion questions. This fifth edition is also supported by videos for each chapter which are both entertaining and informative. Throughout the book readers are encouraged to critically evaluate and challenge the various views presented. To give the different theoretical perspectives a ‘real world’ feel, some chapters use extracts from newspapers, directly related to the issues under consideration. The chapters also draw upon various published research papers to support particular views. As a review of the references list at the end of each chapter will show, the writing of the chapters has drawn upon a great deal of high-quality internationally published research. A glossary of key terms is provided towards the back of the book which brings together in one place all the key terms that were used throughout the book. In the 23 years since the first edition of this book was published, it has proved very popular with students and academics across the world. This new edition retains and builds on the features of the previous four editions that readers have found so appealing and distinctive, such as the use of straightforward explanations, the assessable nature of the language, frequent practical examples, and illustrations using newspaper articles. We have taken the opportunity of updating the text to reflect significant developments in accounting theory over the 23 years.
How is this book different to other books? Unlike many other accounting theory texts, this text is written in language that should be accessible to most readers. It also draws on research that is international in orientation and is used in a way that reinforces the real-world relevance of the material that is addressed. That is, we show how the documented research has relevance to our daily lives. The text accepts that there are different, often competing, views about the role of theory and the roles of accounting and the accounting profession and we try to provide a balanced representation of these different beliefs. This is often not the case with other theory texts. What is clearly emphasised is that accounting is both a technical and social practice and that the impacts of accounting reverberate throughout society. The videos that support each chapter are also different to the material that generally accompanies books of this type. The videos are informal but informative and contribute greatly to the readers’ learning experience. The intention in writing this book has been to show that the practice of accounting is far from mundane. Rather, we show that accounting is actually a very interesting and arguably exciting practice that impacts all of our lives.
How to use this book? Divided into 13 chapters sequenced in a logical order, this book provides the basis for subjects/units that investigate financial accounting theory. Alternatively, the book can be used as a key text across multiple subjects/units that include coverage of different aspects of accounting practice. The entire book could realistically be used in an eleven- to thirteen-week university term, with chapters being studied in the sequence in which they are presented. Alternatively, some universities xviii
Preface
have elected to only use between eight and ten chapters from the book and this works, as there is not generally a need that certain chapters must be read in order to be able to understand other chapters. If only some of the chapters are to be used, then it is recommended that Chapter 1 be initially read as it sets the scene for all the chapters that follow. If a unit’s focus allows, then it would also be recommended that consideration be given to concluding the unit/subject with Chapter 13, as the ‘critical content’ of Chapter 13 provides a very useful and thought-provoking way to wrap up a discussion of accounting theory. We hope readers continue to find this book interesting, informative and enjoyable to read. As usual, we welcome constructive feedback.
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About the author Craig Deegan, BCom (University of NSW), MCom (Hons) (University of NSW), PhD (University of Queensland), FCA, is Professor of Accounting in the School of Accounting at the University of Tasmania. Craig has taught at both undergraduate and postgraduate level for many years and has supervised over 30 PhDs to completion as well as many Honours and Masters by Research students. Prior to working in the university sector, Craig worked as a chartered accountant. His research focuses on various social and environmental accountability and financial accounting issues, and he has been published in a number of leading international accounting journals, including: Accounting, Organizations and Society; Accounting and Business Research; Accounting, Accountability and Auditing Journal; Accounting and Finance; British Accounting Review; Critical Perspectives on Accounting; Journal of Business Ethics; Australian Accounting Review; Australian Journal of Management; Meditari Accountancy Research; Accounting Forum; The International Journal of Accounting; Managerial Auditing Journal; and Environmental and Planning Law Journal. According to Google Scholar, Craig’s work has attracted approximately 30 000 citations making him one of the most highly cited researchers internationally within the accounting and/or finance literature. On 28 September 2018, and reflective of the extent to which Craig’s research has been relied upon by many researchers and practitioners, the leading Australian national newspaper, The Australian (within its annual feature on research), identified Craig as being Australia’s Research Field Leader in the Field of Accounting and Taxation. Craig has regularly provided consulting services to corporations, government and industry bodies on issues pertaining to financial accounting, stakeholder engagement and corporate social and environmental accountability. He was former Chairperson of the Triple Bottom Line Issues Group of the Institute of Chartered Accountants in Australia (now Chartered Accountants Australia and New Zealand) and for many years was involved in developing the CPA Program of CPA Australia, as well as being a judge on the Australasian Sustainability Reporting Awards. He is on the editorial board of a number of academic accounting journals and has been the recipient of various teaching and research awards, including teaching prizes sponsored by KPMG and the Institute of Chartered Accountants in Australia. He was the inaugural recipient of the Peter Brownell Manuscript Award, an annual research award presented by the Accounting and Finance Association of Australia and New Zealand. He was also awarded the University of Southern Queensland Individual Award for Research Excellence. Craig is currently a member of the United Nations sponsored organisation, Education for Sustainability (EfS), is a member of the University of Tasmania Sustainability Committee, and is a member of the Australian Accounting Standards Board (AASB) Academic Advisory Panel. Craig is also the author of the leading corporate accounting textbook, Financial Accounting, now in its ninth edition (McGraw Hill), as well as being the author of the leading introductory accounting textbook, An Introduction to Accounting: Accountability in Organisations and Society, a second edition of which was published by Cengage in 2023. All Craig’s books are widely used throughout Australia as well as in many other countries. Above all, Craig has a passion for emphasising that accounting is both a technical and social practice that creates various affects that reverberate throughout society. This passion is very well reflected and encapsulated within the contents of this thought-provoking book.
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Acknowledgments The writing of this fifth edition, as well as the preceding editions, has been influenced by many people with whom I have been blessed to work with throughout my academic career. When the first edition was published back in 1999, various people generously provided invaluable help and insight, including Reg Mathews, Rob Gray, Dave Owen and Michaela Rankin. Reg and Rob have since passed away and are greatly missed, but their intellectual contribution to the accounting literature is still strongly evident today. I was also very fortunate to have some great mentors along my academic journey, including Malcolm Miller, the late Bill Birkett, Don Stokes, Richard Morris, and the late Ian Zimmer. I have supervised many Honours, Masters, and PhD students throughout my academic career, many of whom I have published with and several of whom have become lifelong friends. These people have exposed me to various important and rich insights and have helped maintain my motivation to gain new knowledge – knowledge that often challenged my pre-existing beliefs. Supervising research students is such a rewarding experience and a vital part of being within a university. Relatedly, I have co-authored over 40 papers in leading international accounting journals at the A or A* level [applying the Australian Business Deans Council (ABDC) Journal Quality List rankings] with my former research students. I deeply thank all the past research students that I was lucky enough to supervise. In writing this text I have drawn on much of the knowledge that has come from this supervisory-related work. I would also like to than Jeffrey Unerman who reviewed the third edition of this book and added some content to pre-existing chapters in order to ‘Europeanise’ it for the purpose of two ‘European editions’ of this book, which were published in 2006 (1st edition) and 2011 (2nd edition). Jeffrey is also sadly missed, but his work also continues to contribute widely to academic debate. The writing of the first four editions of this book was undertaken while I was employed at the University of Southern Queensland and RMIT University. I thank these two institutions for supporting my work. I am now at the University of Tasmania, and I would like to thank UTAS for supporting my efforts in writing this 5th edition – an exercise that does take considerable time. I would also like to thank the staff at Cengage for all the work they have done to publish this book. I would particularly like to extend my appreciation to Geoff Howard for his early support in making this 5th edition come to life, to Paul Petrulis VP Cengage Australia for supporting this book, as well as thanking Rachael Pictor, Nathan Katz and Anne Mulvaney for all their work. Lastly, I would like to thank my ‘most excellent’ daughter Cassandra Joy Deegan who was born around the time that the first edition of this book was published (no causality inferred). She provides my life with necessary love and purpose. Cengage Learning Australia would also like to thank the following reviewers for their helpful feedback: Robyn Cameron (Griffith University) Sarah Adams (Australian National University) Joanne Tingey-Holyoak (University of South Australia) Bobae Choi (University of Newcastle), Giulia (RMIT University) Patrick Mauder (Bond University), Tricia Ong (Edith Cowan University) Gerard Ilott (Central Queensland University) Sorin Daniliuc (Australian National University) Meiting Lu (Macquarie University) Dharmendra Naidu (Monash University), and Yeut Hong Tham (Curtin University). Every effort has been made to trace and acknowledge copyright. However, if any infringement has occurred, the publishers tender their apologies and invite the copyright holders to contact them. xxi
CHAPTER
1
INTRODUCTION TO FINANCIAL ACCOUNTING THEORY LEARNING OBJECTIVES On completing this chapter, readers should:
LO1.1
understand that there are many theories of accounting
LO1.2
understand how knowledge of different accounting theories increases our ability to understand and evaluate various alternative accounting practices
LO1.3
understand that the different theories of accounting are often developed to perform different functions, such as to describe accounting practice, or to prescribe particular accounting practices
LO1.4
understand that theories, including theories of accounting, are developed as a result of applying various value judgements and also appreciate that acceptance of one theory in preference to others will in part be tied to one’s own value judgements
LO1.5
be aware that we should critically evaluate theories (in terms of such things as the underlying logic, assumptions made and evidence produced) before accepting them
LO1.6
understand some alternative perspectives about how knowledge develops across time
LO1.7
understand why students of accounting should study accounting theories as part of their broader accounting education.
1
Financial Accounting Theory
OPENING QUESTIONS Before reading this chapter, please consider how you would answer the following three questions. We will return to these questions at the end of the chapter, where we suggest some answers. 1 Why do students of accounting need to bother with the study of ‘theories’? For example, why not just study some more of the numerous accounting standards (and there are certainly plenty of them!) or other pronouncements of the accounting profession? 2 Why would (or perhaps ‘should’) accounting practitioners and accounting regulators have knowledge of various theories of accounting? 3 Do all ‘theories of accounting’ seek to fulfil the same role, and, if there are alternative theories to explain or guide particular practice, how does somebody select one theory in preference to another?
LO1.1
Theory A scheme or system of ideas or statements held as an explanation or account of a group of facts or phenomena.
LO1.2
What is a theory?
In this book, we consider various theories of accounting. Perhaps, therefore, we should start by considering what we mean by a ‘theory’. There are various perspectives of what constitutes a theory. The Oxford English Dictionary provides various definitions, including: A scheme or system of ideas or statements held as an explanation or account of a group of facts or phenomena.
The Macquarie Dictionary provides the following definition of a theory: A coherent group of general propositions used as principles of explanation for a class of phenomena.
The accounting researcher Hendriksen (1970, p. 1) defines a theory as: A coherent set of hypothetical, conceptual and pragmatic principles forming the general framework of reference for a field of inquiry.
The definition provided by Hendriksen is very similar to the US Financial Accounting Standards Board’s definition of its Conceptual Framework for Financial Reporting (which, in itself, is deemed to be a normative theory of accounting), which is defined as: a coherent system of concepts that flow from an objective. (FASB, 2016)
The use of the word ‘coherent’ in three of the above four definitions of theory is interesting and reflects a view that the components of a theory (perhaps including assumptions about human behaviour) should logically combine together to provide an explanation or guidance in respect of certain phenomena. The definitions are consistent with a perspective that theories are not ad hoc in nature and should be based on logical (systematic and coherent) reasoning. Therefore, when we talk about a ‘theory’ we are talking about much more than simply an idea or a ‘hunch’, which we acknowledge is different from how the term ‘theory’ is used in some contexts (for instance, we often hear people say they have a ‘theory’ about why something might have occurred when they really mean they have a ‘hunch’). Theories can have various applications, including being used to answer particular research questions. A research question is a question that a particular research project seeks to answer. A well-constructed research question would be clear and specific. The determination of the research question is typically one of the first steps undertaken within a research project. The
2
Introduction to financial accounting theory CHAPTER 1
nature of the research question will be influenced by the theory to be used within the research, and the nature of the research question will influence the research methods to be applied to answer the research question. As will be seen in this book, some accounting theories are developed on the basis of past observations (they are empirically based), some of which are further developed to make predictions about likely occurrences (and sometimes also to provide explanations of why the events occur). That is, particular theories may be generated and subsequently supported by undertaking numerous observations of the actual phenomena in question. Such empirically based theories are said to be based on inductive reasoning and are often labelled ‘scientific’, as, like many theories in the ‘sciences’, they are based on observation. However, empirical research is restricted by the data that is currently available, which in turn means that empirically based studies cannot be undertaken of phenomena that cannot be observed by the researcher – and this has broader philosophical implications. Alternatively, other accounting theories that we also consider do not seek to provide explanations or predictions of particular phenomena but, rather, prescribe what should be done (as opposed to describing or predicting what is done) in particular circumstances. Llewelyn (2003) points out that the term ‘theory’ in accounting not only applies to ‘grand theories’ that seek to tell us about broad generalisable issues (like the theory of gravity in physics) but also applies to any framework that helps us make sense of aspects of the (social) world in which we live, and that helps provide a structure to understand our (social) experiences. We stress that different theories of accounting often have different objectives. Llewelyn provides some interesting views about what constitutes theory. She states (2003, p. 665) that:
Empirically based theories A theory developed on the basis of past observations, and developed to make predictions about likely occurrences of particular events.
Inductive reasoning A way to explain a set of particular facts, weighing up observational evidence for a general proposition about a set of facts.
Empirical research Research that relies upon observing actual phenomena or data.
Theories impose cohesion and stability (Czarniawska, 1997, p. 71). So that whenever ‘life’ is ambiguous (which is most of the time!) people will work at confronting this ambiguity through ‘theorizing’. Also, because ‘life’ and situations commonly have multiple meanings and give rise to different assessments of significance, everyone has a need for ‘theory’ to go about their everyday affairs. ‘Theories’ do not just reside in libraries, waiting for academics to ‘dust them down’; they are used whenever people address ambiguity, contradiction or paradox so that they can decide what to do (and think) next. Theories generate expectations about the world. …Theorizing expresses the meaning and significance of social phenomena, it negotiates peoples’ everyday experiences, and it generates expectations about the social world.
Llewelyn (2003) suggests that five levels of theorising can be, and have been, utilised within the accounting literature, ranging from ‘level 1 theories’ which rely on ‘metaphors’ and which form foundations for simple insights that can be further developed, through to ‘level five theories’ that are considered as ‘grand theories’ and which are proposed as having universal application across all settings. ‘Grand theories’ are deemed to be those that tend to generate concepts that are highly abstract and which cannot easily be operationalised into, for example, variables which might be used within hypotheses developed to explain particular organisational activities. According to Llewelyn, at the extreme, level five theorisation may aim for universal explanations that are beyond history and society and where ‘meaning’ attributed to local conditions and issues by organisational actors are not seen as particularly significant. Llewelyn argues that ‘level four theorising’, which explains, for example, specific social, organisational or individual phenomena in their respective settings (rather than across all settings as would be the case for grand theories), is the form of theorising most often applied within accounting research. Level four theories explain relationships between various social phenomena in the particular social or environmental context in which they are being researched (but perhaps, not beyond such settings). Some of the theories we explore within this book (Legitimacy Theory, Institutional Theory, Stakeholder Theory) are identified by Llewelyn as being level four theories. 3
Financial Accounting Theory
While we do not need to fully understand all the different levels of theorising proposed by Llewelyn, it is nevertheless useful to know that theories can be classified in terms of their sophistication or their perceived level of generalisability to different settings. Other researchers have also applied similar schema to categorise theories. For example, Merton (1968) used the term ‘middle range theories’, which referred to theories that fall somewhere in between theories that are based upon ‘minor hypotheses’ and those that are ‘grand theories’. Middle range theorists tend to focus on measurable aspects of social reality; for example, they focus on issues that are studied within particular settings, rather than seeking to explain the entire social world. This is similar to what Llewelyn refers to as ‘level four theorists’. Llewelyn (2003) also suggests that accepted theories form part of, and are influenced by, the cultural environments in which they are applied. Further, Llewelyn notes that the application of particular theories brings particular objects or phenomena into view that otherwise might go unnoticed, as well as noting that the same objects or phenomena might be seen differently as the result of the application of a different ‘theoretical lens’. Because accounting is a human activity (we cannot have ‘accounting’ without accountants), theories of accounting (and there are many) will consider such things as people’s behaviour and/or people’s needs as regards to accounting information, or the reasons why people within organisations might elect to supply particular information to particular stakeholder groups. For example, this book considers, among others, theories that: • prescribe how, based on a particular perspective of the role of accounting, assets should be measured for external reporting purposes (such prescriptive or normative theories are considered in Chapters 6 and 7) • predict that managers paid bonuses on the basis of measures such as profits will seek to adopt those accounting methods that lead to an increase in reported profits (such descriptive or positive theories are considered in Chapter 8) • seek to explain how an individual’s cultural background will impact on the types of accounting information that the individual seeks to provide to people outside the organisation (such theories are considered in Chapters 5 and 9) • prescribe the accounting information that should be provided to particular classes of stakeholders on the basis of their perceived information needs (such theories are often referred to as decision usefulness theories, and are discussed in Chapter 6) • predict that the relative power of a particular stakeholder group (with ‘power’ often being defined in terms of the group’s control over scarce and necessary resources) will determine whether that group receives the accounting information it desires (which derives from a branch of Stakeholder Theory, which is discussed in Chapter 9) • predict that organisations seek to be perceived by the community as ‘legitimate’ and that accounting information can be used by the organisation as a means of gaining, maintaining or regaining organisational legitimacy (which derives from Legitimacy Theory and Institutional Theory, both considered in Chapter 9) • explain how certain commonly used accounting practices are not neutral in orientation (as conceptual frameworks for financial reporting suggest), but rather act to maintain a social order that privileges those people with financial capital at the expense of workers (some theories with this orientation come from a class of accounting theories known as ‘critical theories’, which are examined in Chapter 13).
Why is it important for accounting students to study accounting theory? LO1.2
LO1.7
As a student of, for example, financial accounting, you will be required to learn how to construct and read financial statements prepared in conformity with various accounting standards and 4
Introduction to financial accounting theory CHAPTER 1
other professional and statutory requirements. In your working life (whether or not you choose to specialise in financial accounting), you could be involved in such activities as analysing financial statements for the purposes of making particular decisions, compiling financial statements for others to read, or generating accounting guidance or rules for others to follow. The better you understand the accounting practices underlying these various activities, the more effective you are likely to be in performing these activities – and therefore the better equipped you are likely to be to succeed in your chosen career. Given that accounting theories aim to provide a coherent and systematic framework for investigating, understanding and/or developing various accounting practices, the evaluation of individual accounting practices is likely to be much more effective if the person evaluating these practices has knowledge of accounting theories. Although all students of accounting (like students in any subject) should be interested in critically evaluating the phenomena they are studying, we recognise that, in the past, many students have been content with simply learning how to apply various accounting practices without questioning the basis of these practices. However, in the wake of a growing number of high-profile corporate failures (such as Lehman Brothers, Enron and WorldCom in the United States, HMV Group in the United Kingdom, Parmalat, Lernout and Hauspie Speech in Europe, Wirecard in Germany, and HIH Insurance, One.Tel, Harris Scarfe and Allans Music in Australia), which have subsequently been linked to questionable accounting practices, it has arguably never been more important for accountants to understand thoroughly and be able to critique the accounting practices that they use. Without such a theoretically informed understanding, and with the increasingly relevant role of ‘accounting’ to addressing social and environmental problems such as climate change, it is difficult to evaluate the suitability of current accounting practices, to develop improved accounting practices where current practices are unsuitable for changed business situations, and to defend the reputation of accounting where accounting practices are blamed for causing companies to fail. This is a key reason why it is important for you to study and understand accounting theories. As a result of studying various theories of accounting in this book, you will be exposed to various issues, including: • how the various elements of financial accounting should be measured • what motivates managers to provide certain types of accounting information (whether it be financial, social, environmental or sustainability-related information) • what motivates managers to select particular accounting methods in preference to others • what motivates individuals to support and perhaps lobby regulators for some accounting methods in preference to others • what the implications for particular types of organisations and their stakeholders are if one method of accounting is chosen or mandated in preference to other methods • how different cultural attributes influence accounting practices • how and why the capital markets react to particular accounting information • whether there is a ‘true measure’ of profit • how accounting can contribute to, or be used to solve, social and environmental problems such as climate change, or the incidence of ‘modern slavery’ within supply chains. Accounting plays a very important and pervasive role within society. Simply to learn, for example, the various rules of financial accounting (as embodied within accounting standards, conceptual frameworks for financial reporting and the like), or particular sustainability-related reporting frameworks (such as that of the Global Reporting Initiative or the International Sustainability Standards Board), without considering the implications that accounting information can have, would seem illogical, and potentially dangerous. Many significant decisions, which in turn might lead to various financial, social and environmental impacts, are made on the basis of information that accountants provide (or in some circumstances, elect not to provide), so accountants are often regarded as being very 5
Financial Accounting Theory
powerful and influential people. The practice of ‘accounting’, which often relies upon various technical rules, principles or standards, leads to decisions that can create various social consequences. This is why accounting can be considered as both a technical and social practice. The information generated by accountants enables others to make important decisions. Indeed, relevant and reliable information provides the users of accounting information with ‘power’ to make informed decisions. For example: should they support the organisation? What social and environmental impacts is the organisation creating? Is the organisation earning sufficient ‘profits’? Is it earning excessive ‘profits’? Is the organisation fulfilling its social responsibilities by investing in community support programs and environmentally responsible production technologies and, if so, how much? In considering profits, is profitability a valid measure of organisational success? Further, if the accountant/accounting profession emphasises particular attributes of organisational performance (for example, profitability), does this in turn impact on what society perceives as being the legitimate goals of business?1 As a result of considering various theories of accounting, this book provides some answers to these important issues. At a broader level, an understanding of accounting theories can be crucial to the reputation and future of the accounting profession. Unerman and O’Dwyer (2004) have argued that the rise in high-profile accounting failures has raised the level of awareness among non-accountants about some of the significant social impacts that accounting has on their lives. These events have also led to a substantial reduction in the level of trust that many non-accountants place in financial accounts and in accountants. Massive corporate failures, such as those at Enron and WorldCom, fuelled various criticisms of accounting, including that financial accounting practices failed to reveal a deterioration of the financial position and financial performance of such entities to shareholders and other interested groups on a timely basis. Moreover, prior to such corporate collapses, there was evidence that financial accounting was being used to create benefits for managers (for example, by using methods that inflated profits, thereby leading to larger and potentially unjustifiable bonuses) at a time when the company was actually in financial distress. Research could look at devising ways to guard against such practices. If this trust is to be rebuilt, along with the reputation of accountants, it is now more crucial than ever that we develop the capacity to critically evaluate existing (and potential) accounting practices and to refine these practices as the business environment rapidly changes. The insights from a varied range of accounting theories are essential to this process of continual improvement in accounting practices.
Why do I need to know about accounting theory? In your career, you might hold various roles. For example, you might be a manager/accountant considering making particular accounting disclosures; you will likely be a reader of various accounting disclosures; or perhaps you might be in a role that involves introducing regulations or standards relating to accounting practice. Some knowledge of accounting theory will allow you to consider the context, implications of
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or motivations for particular accounting practices that might otherwise not be considered. Arguably, your accounting education would be incomplete, and your ability to be a critical thinker with respect to accounting practice would be undermined, if you did not have sufficient exposure to different accounting theories.
Chapters 3 and 4 consider some research (for example, Hines, 1988) that suggests that accountants and accounting do not necessarily provide an unbiased account of reality, but rather create reality. If the accounting profession emphasises a measure (such as profitability) as being a measure of success and legitimacy, then, in turn, profitable companies will be considered successful and legitimate. If something other than profitability had been supported as a valid measure, then this may not have been the case.
Introduction to financial accounting theory CHAPTER 1
LO1.1
LO1.2
LO1.3
A brief overview of theories of accounting
There are many theories of accounting. That is, there is no universally accepted theory of accounting or, indeed, any universally agreed perspective of how accounting theories should be developed. In part, this is because different researchers have different perspectives of the role of accounting theory and/or what the central objective, role and scope of accounting should be. For example, some researchers believe that the principal role of accounting theory should be to explain and predict particular accounting-related phenomena (for example, to explain why some accountants adopt one particular financial accounting method while others elect to adopt an alternative approach), whereas other researchers believe that the role of accounting theory is to prescribe (as opposed to describe) particular approaches to accounting (for example, based on a perspective of the role of accounting, there is a theory that prescribes that assets should be measured on the basis of market values rather than historical costs). Also, the practice of accounting is continuously evolving. For example, financial accounting is not represented by a static set of rules, and many of the accounting rules we learn at university – perhaps as embodied within accounting standards – will be superseded in due course. It is generally accepted that business transactions have, in recent decades, become more varied and complicated, with direct implications for how we account for such transactions. There is also a growing recognition of the role of accounting in addressing issues associated with sustainable development. Societal expectations and priorities change across time, with implications for accounting. Technical capabilities of information (accounting) systems increase across time, as do the size and influence of many corporations. These ongoing changes create new research questions, which then might require the refinement of existing theories, or the development of new theories, to perhaps explain or guide practice. For example: • In recent times, it has been accepted that climate change is a significant issue for societies globally. Accounting has a role in addressing this issue. Relevant research questions would include: how can accounting be used to reduce organisations’ contribution to climate change; what disclosures stakeholders demand in relation to climate change; and what motivates managers to provide particular climate change-related disclosure, or to use particular accounting methods to account for the assets and liabilities associated with emission trading schemes. • The global financial crisis (GFC) (2007–09) and the more recent COVID-19 pandemic (2019–22) created pressures for governments, organisations and societies that had not been encountered in recent history. Interesting research questions would include: the role of poor financial accounting practices in contributing to the GFC; the efficiency of regulatory reactions; the merit of the accounting profession’s response to the GFC in terms of the development of new accounting practices and related governance practices; and whether financial accounting practices appropriately responded to COVID-19 in respect of adjustments to asset valuations and going concern assumptions. • Since 2005, many countries throughout the world elected to adopt the accounting standards issued by the International Accounting Standards Board (IASB), these being known as International Financial Reporting Standards (IFRS). This raises a number of questions, including: how well the IASB standards ‘fit’ local requirements; whether the related financial statements are now more useful to various financial statement users relative to former locally developed reporting standards; or how the switch to IFRS has impacted the way financial accounting numbers are used within debt contracts or management bonus systems. Again, to address the above issues, we can potentially use theory that currently exists, or there may be a need to develop new theory. In the discussion that follows, we consider some general classifications of theories.
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Financial Accounting Theory
Inductive accounting theories Induction The development of ideas or theories through observation.
Deductive reasoning A way to explain a set of particular facts which is based more on the use of logic rather than observation.
Early development of financial accounting theory relied on the process of induction, that is, the development of ideas or theories through observation. According to Chalmers (1982, p. 4), there are three general conditions that would ideally exist before theory could be developed through observation: 1 The number of observations forming the basis of a generalisation must be large. 2 The observations must be repeated under a wide variety of conditions. 3 No accepted observation should conflict with the derived universal law. From approximately the 1920s to the 1960s, theories of financial accounting were predominantly developed on the basis of observation of what accountants actually did in practice. That is, they were developed by the process referred to as ‘induction’. This can be contrasted with a process wherein theories are developed by deductive reasoning, which is based more on the use of logic rather than observation.2 Returning to the use of observation to develop generalisable theories (inductive reasoning), after observing what accountants did in practice, common practices were then codified in the form of doctrines or conventions of accounting (for example, the doctrine of conservatism). Notable theorists at this time included Paton (1922), Hatfield (1927), Paton and Littleton (1940) and Canning (1929). Henderson, Peirson and Harris (2004, p. 54) describe the approaches adopted by these theorists as follows: Careful observation of accounting practice revealed patterns of consistent behaviour. For example, it could be observed that accountants tended to be very prudent in measuring both revenues and expenses. Where judgement was necessary it was observed that accountants usually underestimated revenues and overstated expenses. The result was a conservative measure of profit. Similarly, it could be observed that accountants behaved as if the value of money, which was the unit of account, remained constant. These observations of accounting practice led to the formulation of a number of hypotheses such as ‘that where judgement is needed, a conservative procedure is adopted’ and ‘that it is assumed that the value of money remains constant’. These hypotheses were confirmed by many observations of the behaviour of accountants.
Prescriptive research Research that is generally based on deductive reasoning and provides prescriptions, or suggestions, about what people should do.
While there was a general shift towards prescriptive research in the 1960s, some research of an inductive nature still occurs. Research based on the inductive approach (that is, research based on observing particular phenomena) has been subject to many criticisms. For example, Gray, Owen and Maunders (1987, p. 66) state: Studying extant practice is a study of ‘what is’ and, by definition, does not study ‘what is not’ or ‘what should be’. It therefore concentrates on the status quo, is reactionary in attitude, and cannot provide a basis upon which current practice may be evaluated or from which future improvements may be deduced.
Inductive approach An inductive approach to research is based upon developing theory through observation of particular phenomena.
In generating theories of accounting based on what accountants actually do, it is assumed (often implicitly) that what is done by the majority of accountants is the most appropriate 2
8
Chapter 6 considers various theories of accounting that were developed to deal with problems that arise in times of rising prices – for example, when there is inflation. Such theories include one developed by a famous accounting researcher named Raymond Chambers. His theory of accounting, known as Continuously Contemporary Accounting, was developed on the basis of a number of logical assumptions about what types of information the readers of financial accounting reports needed. His theory was not based on observing what accountants do (which would be inductive reasoning); rather, his theory was based on what he thought they should do. Using various key assumptions about people’s information needs, he derived his theory through deductive (logical) reasoning. His proposals for accounting represented radical departures from what accountants were actually doing in practice.
Introduction to financial accounting theory CHAPTER 1
practice. In adopting such a perspective there is, in a sense, a perspective of accounting Darwinism – a view that accounting practice has evolved, and the fittest, or perhaps ‘best’, practices have survived. Prescriptions or advice are provided to others on the basis of what most accountants do, the ‘logic’ being that the majority of accountants must be doing the most appropriate thing. What do you think of the logic of such an argument? As a specific example of this inductive approach to theory development, we can consider the work of Grady (1965). His research was commissioned by the American Institute of Certified Public Accountants (AICPA) and was undertaken at a time when there was a great deal of prescriptive (as opposed to descriptive) research being conducted. Interestingly, in 1961 and 1962, the Accounting Research Division of the AICPA had already commissioned prescriptive studies by Moonitz (1961) and Sprouse and Moonitz (1962), which proposed that accounting measurement systems be changed from historical cost to one based on current values. However, before the release of these research works, the AICPA issued a statement saying that ‘while these studies are a valuable contribution to accounting principles, they are too radically different from generally accepted principles for acceptance at this time’ (Accounting Principles Board, 1962). History shows that rarely have regulatory bodies accepted suggestions (or, as some people call them, prescriptions) for significant changes to accounting practice. This is an interesting issue which is considered more fully in Chapter 7 when the IASB Conceptual Framework for Financial Reporting is discussed. However, it is useful to consider at this point a statement made in the United States by Miller and Reading (1986, p. 64): The mere discovery of a problem is not sufficient to assure that the Financial Accounting Standards Board will undertake its solution … There must be a suitably high likelihood that the Board can resolve the issues in a manner that will be acceptable to the constituency – without some prior sense of the likelihood that the Board members will be able to reach a consensus, it is generally not advisable to undertake a formal project.
Grady’s (1965) work formed the basis of APB Statement No. 4, ‘Basic concepts and accounting principles underlying the financial statements of business enterprises’. In effect, APB Statement No. 4 simply reflected the generally accepted accounting principles of the time. That is, the research was inductive in nature (as it was based on observation) and did not seek to evaluate the logic or merit of the accounting practices being used. It was therefore not controversial and had a high probability of being acceptable to the AICPA’s constituency (Miller and Reading, 1986). While some accounting researchers continued to adopt an inductive approach, a different approach became popular in the 1960s and 1970s. This approach sought to prescribe particular accounting procedures, and as such was not driven by existing practices. The period of the 1960s and 1970s is commonly referred to as the ‘normative period’ of accounting research. That is, in this period the financial accounting theories were not developed by observing what accountants were doing; many of the theories being developed at this time were based on arguments about what the researchers considered accountants should do. Rather than being developed on the basis of inductive reasoning, these theories were being developed on the basis of deductive reasoning. At this time, there tended to be widespread inflation throughout various countries of the world and much of the research and the related theories sought to explain the limitations of historical cost accounting and to provide improved approaches (based on particular value judgements held by the researchers) for asset measurement in times of rapidly rising prices. However, while a number of highly respected researchers were arguing that measuring assets on the basis of historical cost was inappropriate and tended to provide misleading information, particularly in times of rising prices, there was a lack of agreement among the various researchers about what particular asset measurement basis should be used. For example, some argued that assets should be measured at replacement costs, some argued that assets should be measured at net realisable 9
Financial Accounting Theory
value, and others argued for measurements based on present values. Throughout this debate, there was no clear choice in terms of which approach was best, and, perhaps because it was difficult to resolve the differences in opinions provided by the various normative researchers, the historical cost approach to accounting continued to be used.
Explanatory and predictive (positive) accounting theories
Positive research Research that seeks to explain and/or predict particular phenomena.
Normative research Research that is generally based on deductive reasoning and seeks to develop a basis for informing people as to what they should do.
In the mid to late 1970s, there were further changes in the focus of accounting research and theory development. At this time, a great deal of accounting research had the major aim of explaining and predicting financial accounting practice, rather than prescribing particular financial accounting approaches. This was another movement by many accounting researchers away from descriptive research – this time, towards predictive research. Nevertheless, there are many researchers who still undertake descriptive research. What is being emphasised is that a variety of accounting theories have been developed across time; for example, some are descriptive in nature, some attempt to explain and predict particular aspects of financial accounting practice, and others generate guidance about what accountants should do. Different theories serve different purposes. In reading accounting research, you will see that much research is labelled either positive research or normative research. Research that seeks to predict and explain particular phenomena (as opposed to prescribing particular activity) is classified as positive research, and the associated theories are referred to as positive theories. Such theories tend to try to ‘make sense’ of what is currently happening. Henderson, Peirson and Harris (2004, p. 414) provide a useful description of positive theories. They state: A positive theory begins with some assumption(s) and, through logical deduction, enables some prediction(s) to be made about the way things will be. If the prediction is sufficiently accurate when tested against observations of reality, then the story is regarded as having provided an explanation of why things are as they are. For example, in climatology, a positive theory of rainfall may yield a prediction that, if certain conditions are met, then heavy rainfall will be observed. In economics, a positive theory of prices may yield a prediction that, if certain conditions are met, then rapidly rising prices will be observed. Similarly, a positive theory of accounting may yield a prediction that, if certain conditions are met, then particular accounting practices will be observed.
Positive theories Theories that provide the basis for explaining or predicting particular phenomena.
As noted above, positive theories can initially be developed through some form of deductive (logical) reasoning. Their success in explaining or predicting particular phenomena will then typically be assessed based on observation – that is, observing how the theory’s predictions corresponded with the observed facts.3 The predictions emanating from a positive theory are often framed in terms of hypotheses. Empirically (observation) based theories can continue to be tested and refined through further observation, perhaps in different institutional or geographical settings, and a great deal of published research is undertaken to see if particular results can be replicated in different settings, thereby increasing the generalisability of the theory in question. Apart from providing the basis for predicting future actions or effects, positive accounting research often goes to the next step of attempting to provide explanations for the phenomena in question. Positivistic research, which uses or generates positive theories, 3
10
Again, it is stressed that not all theories will be assessed in terms of how the theory’s predictions match actual behaviour. Normative theories, for example, might provide prescriptions about how accounting should be undertaken, and such prescriptions might represent significant departures from current practice. These theories, which may be developed through logical deduction, should not be evaluated by observing the theories’ correspondence with current behaviours of accountants.
Introduction to financial accounting theory CHAPTER 1
typically uses large numbers of observations (often referred to as quantitative research) and seeks to provide theoretical insights that have relevance across different geographical and institutional settings. Chapter 8 considers a positive theory of accounting principally developed by Watts and Zimmerman (relying on the works of other researchers, such as Jensen and Meckling (1976) and Gordon (1964)). Their positive theory of accounting, which they called Positive Accounting Theory, seeks to predict and explain why managers (and/or accountants) elect to adopt particular accounting methods in preference to others.4 Chapter 8 demonstrates that the development of Positive Accounting Theory relied in great part on work undertaken in the field of economics, and central to the development of the theory was the acceptance of the economics-based ‘rational economic person assumption’. That is, an assumption was made that accountants (and, in fact, all individuals) are primarily motivated by self-interest (tied to wealth maximisation), and that the particular accounting method selected (where alternatives are available) will be dependent on certain considerations, such as: • whether the person supporting the use of a particular accounting method, for example a manager or an accountant, is rewarded in terms of accounting-based bonus systems (for example, whether they receive a bonus tied to reported profits) • whether the organisation they work for is close to breaching negotiated accounting-based debt covenants (such as a debt-to-asset constraint) • whether the organisation that employs them is subject to political scrutiny from various external groups, such as government, employee groups or environmental groups (with that scrutiny being focused on the organisation’s reported profits). The assumption of self-interest, as embraced by researchers who use Positive Accounting Theory, challenges the view that accountants will predominantly be objective, and will embrace the qualitative characteristic of ‘representational faithfulness’ when determining which accounting methods to use to record particular transactions and events (‘representational faithfulness’, which is linked to completeness, neutrality and freedom from error, is a qualitative characteristic promoted within the IASB Conceptual Framework, as is seen in Chapter 7).5 Positive theories of accounting do not seek to tell us that what is being done in practice is the most efficient or equitable process. For example, while we have a (positive) theory of accounting, developed to predict which accounting methods most accountants will use in particular circumstances (Positive Accounting Theory), this theory will not tell us what we should do (it is not a ‘prescriptive’ theory), nor will it tell us anything about the efficiency of what is being done. As Watts and Zimmerman (1986, p. 7) state:
Positive Accounting Theory A theory that seeks to predict and explain why managers and/or accountants elect to adopt particular accounting methods in preference to others. Developed by Watts and Zimmerman and others, it is concerned with explaining accounting practice. It is designed to explain and predict which organisations will and which organisations will not use a particular accounting method, but says nothing about which method an organisation should use. It is based on the central economicsbased assumption that all individuals’ actions are driven by self-interest.
It [Positive Accounting Theory] is concerned with explaining [accounting] practice. It is designed to explain and predict which firms will and which firms will not use a particular [accounting method] … but it says nothing as to which method a firm should use.
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5
It should be noted at this point that Positive Accounting Theory is one of several positive theories of accounting (other positive theories that relate to accounting include Legitimacy Theory, Institutional Theory and certain branches of Stakeholder Theory). This book uses lower case when referring to the general class of theories that attempt to explain and predict accounting practice (that is, ‘positive theories of accounting’) and refers to Watts and Zimmerman’s positive theory of accounting as ‘Positive Accounting Theory’ (that is, it uses upper case). As emphasised throughout this book, researchers make a choice between the theories they will apply in particular circumstances. In part, the choice of theory will be influenced by the researcher’s own beliefs and values. For example, many accounting researchers will not use Positive Accounting Theory to explain particular phenomena because they reject the central assumption made within the theory that all individual action is best explained on the basis that individuals are driven by self-interest. For example, Gray, Owen and Adams (1996, p. 75) reject Positive Accounting Theory because it portrays ‘a morally bankrupt view of the world’. We will return to Gray, Owen and Adams’ dismissal of this theory later in the chapter.
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As will be seen shortly, the practice of electing not to advise others as to what should be done in particular circumstances has been the subject of criticism of positive accounting research.
Prescriptive (normative) accounting theories
Normative theory or prescriptive theory Based on the norms or values or beliefs held by the researchers proposing the theories, it is usually based on a process of deduction rather than induction.
While positive theories tend to be based on empirical observation, there are other theories that are based not on observation but instead on what the researcher believes should occur in particular circumstances. For example, Chapter 6 discusses a theory of financial accounting developed by Raymond Chambers. His theory of financial accounting, called Continuously Contemporary Accounting, describes how financial accounting should be undertaken – that is, his theory is prescriptive. Central to his theory is a view that the most useful information about an organisation’s assets, for the purposes of economic decision making, is information about its ‘current cash equivalents’ – a measure tied to their current net market values. As such, it prescribes that assets should be measured on the basis of their net market values. Theories that prescribe (as opposed to describe) particular actions are called normative theories, as they are based on the norms (or values or beliefs) held by the researchers proposing the theories (they are also often referred to as prescriptive theories). The dichotomy of positive and normative theories is one often used to categorise accounting theories and this dichotomy is adopted throughout this book. A simple diagrammatic representation of some of the differences between normative and positive theories is provided in Figure 1.1. FIGURE 1.1 Some differences between positive and normative theories Normative theories • Provide prescription about particular phenomena • The ‘worth’ of the theory is not evaluated on the basis of empirical data
Positive theories • Seek to explain and predict particular phenomena • The worth of the theory is evaluated on the basis of empirical data – that is, on the basis of the correspondence between ‘real world’ observations and the theoretical predictions generated by the theory
As noted above, normative theories of accounting are not necessarily based on observation and therefore cannot (or should not) be evaluated on the basis of whether the theories reflect actual accounting practice. That is, many normative accounting theories are based on a process of deduction (logical argument) rather than induction (observing practice). In fact, they may suggest radical changes to current practice. For example, for a number of decades Chambers had been advocating the measurement of assets on a basis related to their net market values – a prescription that challenged the widespread use of historical cost accounting (it is interesting to note, however, that in recent years the use of market values, or more specifically, fair values, for asset measurement has gained popularity with the IASB). Other researchers concerned about the social and environmental implications of business (see, for example, Gray and Bebbington, 2001; Gray, Adams and Owen, 2014; Mathews, 1993) have developed theories that prescribe significant changes to traditional financial accounting practice (Chapters 9 and 10 of this book consider such theories). The IASB Conceptual Framework, which is discussed in Chapter 7, is an example of a normative theory of accounting. Relying on various assumptions about the types or attributes of information useful for decision making, the Conceptual Framework provides guidance on how assets, liabilities, expenses, income and equity should be defined, when they should be recognised, and ultimately how they should be measured. As is seen in later chapters, 12
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normative theories can be further subdivided. For example, some normative theories can be classified as ‘true income theories’, and other theories as ‘decision usefulness theories’. The true income theories make certain assumptions about the role of accounting and then seek to provide a single ‘best measure’ of profits (for example, see Lee, 1974).6
REFLECTION QUESTION 1.1 Contrasting positive and normative research Question There are two researchers: • Researcher 1 is undertaking research to determine whether organisations with greater levels of negative media attention directed at their activities are likely to provide greater levels of socially oriented disclosures. • Researcher 2 evaluates the disclosures being made by different organisations with the intention of developing reporting guidance that will assist organisations to provide relevant and reliable information about their contributions to climate change.
Would the above research be considered positive or normative research? Solution • Positive research: Positive research seeks to explain or predict particular phenomena. Researcher 1 would be undertaking positive research. • Normative research: Normative research seeks to provide prescriptions about what should be done. Researcher 2 would be undertaking normative researchers.
Decision usefulness theories ascribe a particular type of information for particular classes of users on the basis of assumed decision-making needs. According to Bebbington, Gray and Laughlin (2001, p. 418), the decision usefulness approach can be considered to have two branches – the decision-makers emphasis and the decision-models emphasis. The decision-makers emphasis relies on undertaking research that seeks to ask the users of the information what information they want.7 Once that is determined, this knowledge is used to prescribe what information should be supplied to the users of financial statements. Much of this research is questionnaire-based. This branch of research tends to be fairly disjointed, as different studies typically address different types of information, with limited linkages between them. Another variant of the decision-makers emphasis, which is explored in Chapter 11, is capital markets research. Briefly, capital markets research works on the assumption that if the capital market responds to information (as evidenced through share price changes that occur around the time of the release of particular information), then the information must be useful.8 This forms the basis for subsequent prescriptions about the types of information that should be provided to users of financial statements. It also has been used to determine whether particular mandatory reporting requirements (such as the introduction of new accounting standards) were necessary or effective, the rationale being that, if a new accounting standard does not evoke a market reaction, it is questionable whether the new requirement is useful or necessary in providing information to the capital market or investors. Research that evaluates information on the basis of whether it evokes a market reaction, or whether stakeholders indicate that it is useful to them, ignores the possibility that there could be information that is ‘better’ than that provided or sought. There is also the 6
7
8
Decision usefulness theories Theories that ascribe a particular type of information for particular classes of users on the basis of assumed decisionmaking needs.
Much of the work undertaken in developing ‘true income theories’ relies on the work of Hicks (1946). Hicks defined ‘income’ as the maximum amount that can be consumed by a person or an organisation in a particular period without depleting the wealth that existed for that person or organisation at the start of the period. For example, in recent years a number of research studies have asked a number of different stakeholder groups what types of social and environmental performance information the stakeholders considered to be useful for their various decision-making processes. Based on the Efficient Markets Hypothesis, which predicts that the stock market instantaneously reacts, through price adjustments (changes), to all relevant publicly available information.
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broader philosophical issue of whether the information stakeholders ‘want’ is actually what they ‘need’. These broader issues are explored throughout this book. On the other hand, proponents of the decision-models emphasis develop models based on the researchers’ perceptions of what is necessary for efficient decision making. Information prescriptions follow (for example, that information should be provided about the market value of the reporting entity’s assets). This branch of research typically assumes that classes of stakeholders have identical information needs. Unlike the decision-makers emphasis, the decision-models emphasis does not ask the decision makers what information they want; instead, it concentrates on the types of information considered useful for decision making. As Wolk and Tearney (1997, p. 39) indicate, a premise underlying this research is that decision makers may need to be taught how to use this information if they are unfamiliar with it.9
Critical theories of accounting Another class of accounting theories are those deemed to be part of what are known as ‘critical accounting theories’. These theories are explored in Chapter 13. As Chapter 13 explains, the view promoted by researchers operating from a critical perspective is that accounting, far from being a practice that provides a neutral, unbiased or representationally faithful depiction of underlying economic facts, actually provides the means of maintaining the powerful/privileged positions of some sectors of the community (those currently in power and with wealth) while suppressing the position and interests of those without wealth. These theorists challenge any perspectives that suggest that various rights and privileges are spread throughout society – instead, they argue that most rights, opportunities and associated power reside with a small group. Such researchers seek to highlight the perceived inequalities and structural problems inherent in existing social systems (and how accounting acts to sustain inequitable systems) – systems that are typically taken for granted by other ‘non-critical’ researchers. Critical theorists explore how accounting potentially contributes to elements of society that are not equitable for some stakeholders, such as employees or particular communities. This can be contrasted with most accounting researchers who, while often testing for particular relationships between chosen variables, frequently do not question any inequities associated with the processes or systems that they are investigating.
Why do I need to know that there are many ‘theories of accounting’? Different theories have different roles and purposes and provide different insights into – or ‘lenses’ through which to view – the practice of accounting. Learning about different theories will allow us to have a more comprehensive perspective of the potential roles, or influence, of accounting within society and upon particular stakeholders. No accounting theories can provide a complete understanding of the practice of accounting. Different theories make different assumptions about such things as the roles or objectives of different forms of accounting; the motivations of managers/accountants in
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producing particular ‘accounts’; or about how different stakeholders use, or respond to, accounting information. Some theories prioritise the needs or rights of some stakeholders over and above the needs or rights of other stakeholders. Knowledge of different theories will enable us to use theories that correspond with our own assumptions ‘about the world’, and which appear to address the question or objective we are seeking to solve. At times, we will find it useful to combine the insights provided by different accounting theories.
As an example, not relating to accounting, about why asking subjects/individuals what they need might not lead to optimal outcomes, we can consider the following scenario. If we were to ask people what they needed/demanded to dig a hole in the garden then, if they had never been exposed to a shovel/spade, they might say ‘a spoon’. Actually showing them that a shovel exists will likely change their future demand for gardening implements towards an instrument that is more efficient/fit for purpose. Similarly, subjects might need to be shown/taught the benefits of using particular information before they can make an informed choice about what information to demand.
Introduction to financial accounting theory CHAPTER 1
Do researchers always use pre-existing theories or can they develop their own theory? The aim of research is to advance, refine and expand a given body of knowledge. Commonly, research is performed in a way that utilises a particular theory (or perhaps a combination of theories) that have gained widespread acceptance within a given research community. That is, the theory to be used is usually predetermined by the researcher before entering a particular field or domain to collect data. As we now know, the researcher might use the chosen theory to either explain particular activity or phenomena (for example, a theory might be used to explain which organisations are more likely to make particular financial accounting disclosures, or which organisations are more likely to make particular social disclosures), or the researcher might apply a theory to evaluate particular activities or behaviours (for example, to evaluate the decision usefulness of particular financial accounting information, or the quality of particular social disclosures). Our own personal or philosophical beliefs will influence what theories we choose to apply. If the research evaluates or prescribes particular activities – that is, is ‘normative’ in nature – then the evaluation, or prescription, will be influenced by the philosophical beliefs of those who developed the theory. For example, if research explores the accountability of organisations in respect of animal welfare-related initiatives, then the evaluation will be influenced by the theorist’s views about the ‘rights’ of animals relative to humans. This in turn might be influenced by which philosophical theories/beliefs the researcher embraces (for example, if the researcher is influenced by the ‘deep ecology movement’ then humans would not be considered to have greater rights than animals, and this would influence perceptions about what level of accountability an organisation should demonstrate in relation to animals). In this book, we generally explore theories that have widespread acceptance within the various accounting research communities, and which researchers would then often apply to investigate particular phenomena. Such theories might be used by many hundreds, or thousands, of researchers and might be traced back to the works of particular ‘leading’ (or ‘seminal’) theorists who were credited with developing the theory. Much subsequent research might use such theories without questioning, or justifying, the theories themselves, unless, of course, the theories seem to have lost their relative ability to predict or explain particular phenomena or to enable certain practices to be evaluated in an appropriate sense. It should, however, be noted that not all research starts with an accepted theory. Rather, some research is done in such a way that the theory emerges from the data. That is, the theory itself is grounded in the data being collected by the researcher. This is referred to as ‘grounded theory’. The aim of such research would be to generate theory, rather than to apply theory.
Grounded theory Grounded theory has been used by various accounting researchers. Strauss and Corbin (1990,
p. 24) define grounded theory as ‘a qualitative research method that uses a systematic set of procedures to develop and inductively derive grounded theory about a phenomenon’. As we know, something is ‘inductively derived’ if its derivation is based upon observing and analysing particular data. Grounded theory generates theory that is ‘grounded’ in the data. Grounded theory is not generated in the absence of immersing oneself in the data. Grounded theories can take on a variety of forms, cover a variety of research questions, be developed from different sets of observations and be based upon different philosophical beliefs. Therefore, ‘grounded theory’ is more correctly considered to be an umbrella term for theories that are developed ‘ground up’ from the data rather than being reflective of theory that shares particular ‘world views’. What grounded theories have in common, however, is that they are generated from observing data relating to various forms of communication between subjects in the research field.
Grounded theory A theory that is developed though the collection and analysis of data and which involves the application of inductive reasoning. Ideas, concepts and, ultimately, a theory ‘emerge’ from the data.
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Efforts to generate a grounded theory might be undertaken when researchers believe that important data relating to a particular phenomenon have not been considered and/or the relationships between particular ‘concepts’ are not properly understood. Grounded theory is particularly appropriate when little is known about particular phenomena. Grounded theory research questions would tend to be quite broad at the outset of a research project, but would then tend to narrow to more specific research questions as the research proceeds and the theory becomes more refined. When developing grounded theory, the author does not commence with a theory. That is, researchers using grounded theory typically try not to have any form of prior commitment to a particular pre-existing theory (which is not necessarily easy, as we do tend to see the world in accordance with particular theories, and this can shape what data we collect and how we interpret it). Rather, the grounded researcher will commence with an area of study and, as part of the research process, allow research constructs and theory to emerge from the data. In generating grounded theory, relevant data will be collected through interviews, meetings, observations, reviews of documents and so forth (Strauss, 1987). The term ‘grounded theory’ actually implies that the researcher has immersed themselves into a setting where various forms of communication are studied. Emerging concepts are coded with the aim of developing explanations, or core categories, which explain variations in the collected data. According to Glaser (1978), grounded theory seeks to arrange ‘many ideas which have emerged from analysis of the data’. Grounded theory seeks to make sense or give meaning to the data that are collected and to attribute some structure to that data. In doing so, the researcher needs to understand the context in which the subjects are located. This is because people undertaking grounded theory research typically believe that the meaning that different people within a study (the ‘subjects’) attribute to particular items of data potentially only occurs within particular research contexts (‘meanings’ are context specific). Hence, consideration of situational context is important to grounded research (this can be contrasted to ‘grand theories’ that were discussed earlier in this chapter, which are theories that are deemed – rightly or wrongly – to have application across potentially all settings and time). The view that the context (or situation) of the research impacts how the data is analysed and interpreted is in contrast to much research, in accounting and elsewhere, wherein researchers often assume that there is an ‘objective world’ in which we would all see, and interpret, data in much the same way. A grounded researcher will consider the data carefully and continuously throughout data collection. This is in contrast to many other researchers using predetermined theories, wherein a hypothesised outcome is predicted and the data are often all collected before testing of the hypotheses is ultimately undertaken. As with most theories, if the same accounting theory is applied across time, it has the potential to become distant, or decoupled, from everyday phenomena. Society’s behaviour and expectations can change across time, thereby potentially invalidating some central assumptions that were utilised in earlier research. If we have researchers undertaking grounded theory research, then this can provide some level of safeguard against the research community applying ‘obsolete’ theories. Once all the research has been completed by the grounded researcher, it is possible that the grounded theory might ultimately be very similar (or even the same) as pre-existing theories. It might also represent significant and valuable departures from pre-existing theories.
Hermeneutics and phenomenology In the discussion above, we have not mentioned ‘hermeneutics’, a term that is often used within certain accounting research communities. Advocates of grounded theory typically explore hermeneutics. This is what differentiates somebody who is referred to as a ‘grounded theorist’ from other researchers. Hermeneutics is a term that refers to written, verbal and non-verbal communication, and ‘hermeneutical research’ seeks to interpret and give meaning to these forms of communication in the context of both the author and the audience of the communication. 16
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Grounded theorists, who typically engage in hermeneutical research, would argue – as we have already emphasised – that without considering context, the meanings attributed to particular communication might be easily misconstrued. Hermeneutical research (and grounded research) is often, in turn, linked to what is referred to as ‘phenomenology’, a philosophical movement which has the objective of investigating phenomena as experienced by particular people, and without imposing theories about what might explain how particular events or influences impact those involved. The research would aim to not be bound by previous preconceptions and presuppositions. Phenomenology is the study of lived experiences and seeks to study the world as it is interpreted by, and through, human consciousness. The object being studied should not be considered distinct from its context under this philosophical approach to research. Again, understanding data is considered by these researchers to be context dependent. Researchers working within a ‘phenomenological paradigm’ typically assume that the social world is subject to constant change. While we have dedicated a number of paragraphs to explaining grounded theory, it should again be noted that the vast number of accounting researchers do not seek to generate a grounded theory. That is, most accounting researchers apply predetermined theories. It is generally accepted that research applying grounded research approaches is more difficult to undertake (particularly for early researchers), and consumes greater research time. Nevertheless, very significant knowledge breakthroughs can be generated through the time-consuming work associated with quality grounded research. In the balance of this book, we will not be considering grounded theories, and nor will we be exploring hermeneutics or phenomenology in any depth. They are beyond the scope of this book. Nevertheless, there would be various ‘research methods’ texts that explore these areas in depth for those readers who now have an interest in these areas.
REFLECTION QUESTION 1.2 Grounded theorists’ approaches to research Researchers using grounded theory tend to explore various forms of communication (hermeneutics) and consider them in the context of the social environment in which the communication was undertaken. Prior to collecting the data, such researchers try not to have any form of a priori commitment to a particular theory. Rather, they want the data to be analysed in a way that generates theory. Question How might the research approach of a grounded theorist differ from that of a researcher who applies Positive Accounting Theory to explain why managers support the use of particular financial accounting methods? Solution Positive Accounting Theorists will typically apply a predetermined theory developed by other leading researchers (this being Positive Accounting Theory), and will also typically have developed their hypotheses before collecting any data. The data will be reviewed to determine whether it supports
the theory, and if not, some consideration will be given to modify the theory. This contrasts with the grounded theorists, who allow the theory to be derived from the data. Positive Accounting Theorists also typically assume that the data they are collecting would be viewed equally by all people and that the context of where the data originates is not important. This means that the data can be extracted from various ‘environments’, or organisations, without adjustment prior to it being used to test the hypotheses that have been developed. That is, the assumption by positive theorists is that we all see ‘the world’ similarly and that different forms of communication are interpreted in the same way by all people, thereby meaning that results are deemed to be generalisable. By contrast, a grounded theorist assumes that how particular communications are interpreted will be influenced by the contexts in which the communications were generated. As such, the results derived from grounded theory will tend to have limited generalisability.
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Evaluating theories of accounting
As we have now indicated, in the process of studying accounting, students will typically be exposed to numerous theories of accounting, and the accompanying research and argument that attempts to either support or reject the particular theories in question. In undertaking this study, students should consider the merit of the argument and the research methods employed by respective researchers. What students often find interesting is that many researchers seem to embrace one theory of accounting and thereafter adopt various strategies (including overt condemnation of alternative theories) in an endeavour to support their own research and theoretical perspective. In some respects, the attitudes of some researchers are akin to those of the disciples of particular religions. (In fact, Chambers [1993] refers to advocates of Positive Accounting Theory as belonging to the ‘PA Cult’.) Deegan (1997) provides a series of quotes from the works of various high-profile researchers who were opposed to Watts and Zimmerman’s Positive Accounting Theory. In providing arguments against the contribution or validity of Positive Accounting Theory, the opponents – who were advocates of other theories, typically normative in nature – used such terms and descriptions as shown in Figure 1.2. FIGURE 1.2 Arguments against the contribution or validity of Positive Accounting Theory It is a dead philosophical movement (Christenson, 1983, p. 7).
It has provided no accomplishments (Sterling, 1990, p. 97).
It is marred by oversights, inconsistencies and paradoxes (Chambers, 1993, p. 1).
It is imperiously dictatorial (Sterling, 1990, p. 121).
It is akin to a cottage industry (Sterling, 1990, p. 132).
It is empty and commonplace (Sterling, 1990, p. 130).
It is responsible for turning back the clock of research 1000 years (Chambers, 1993, p. 22).
It suffers from logical incoherence (Williams, 1989, p. 459).
It is a wasted effort (Sterling, 1990, p. 132).
These criticisms indicate the degree of emotion that a particular theory stimulated among its critics, particularly those accounting researchers who saw the role of accounting theory as providing prescription rather than description, explanation or prediction. Students of accounting theory will find it interesting to ponder why some people are so angered by such a theory – after all, it is just a theory (isn’t it?). Many proponents of Positive Accounting Theory have also tended to be very critical of normative theorists.
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Introduction to financial accounting theory CHAPTER 1
The Positive Accounting Theorists and the normative theorists would be considered to be working from different paradigms that provide greatly different perspectives about the role of accounting research. According to Hussey and Hussey (1997, p. 47): The term paradigm refers to the progress of scientific practice based on people’s philosophies and assumptions about the world and the nature of knowledge; in this context, about how research should be conducted. Paradigms are universally recognised scientific achievements that for a time provide model problems and solutions to a community of practitioners. They offer a framework comprising an accepted set of theories, methods and ways of defining data … Your basic beliefs about the world will be reflected in the way you design your research, how you collect and analyse your data, and even the way in which you write your thesis.
Paradigm Refers to the progress of scientific practice based on people’s philosophies and assumptions about the world and the nature of knowledge.
Hussey and Hussey’s discussion about ‘paradigms’ is consistent with Kuhn (1962), who states that a paradigm can be defined as an approach to knowledge advancement that adopts particular theoretical assumptions, research goals and research methods. For example, earlier in this chapter we briefly discussed the research approach adopted by grounded theorists. They consider that particular forms of communication can have different meanings in different social contexts and therefore it is often inappropriate to generalise about what motivates particular people to initiate certain communications, or to generalise about how receivers of certain communications will react to particular information. By contrast, Positive Accounting researchers typically assume an objective world in which all actors tend to attribute the same meaning to communications. Therefore, Positive Accounting researchers often argue that data collected in one research setting can be pooled with data from another setting when testing various predetermined hypotheses; and because of the pooling of data from different settings, positivists typically have large amounts of data that they then subject to various statistical examination (because of this, ‘positive research’ and ‘quantitative research’ are terms that are often used interchangeably). In explaining or describing why a certain ‘camp’ of researchers might try to denigrate the credibility of alternative research paradigms, it is relevant to consider one of the various views about how knowledge advances (and there are various theories to explain how knowledge, science and theories develop across time – indeed, there are theories about nearly everything!). Kuhn (1962) explained how knowledge, or science, develops: scientific progress is not evolutionary but revolutionary. His view is that knowledge advances when one theory is replaced by another as particular researchers attack the credibility of an existing paradigm and advance an alternative, promoted as being superior, thereby potentially bringing the existing paradigm into ‘crisis’. As knowledge develops, the new paradigm may be replaced by a further research perspective, or a prior paradigm may be resurrected. In discussing the process of how researchers switch from one research perspective (or paradigm) to another, Kuhn likens it to one of ‘religious conversion’.10 While the perspective provided by Kuhn does appear to have some relevance to explaining developments in the advancement of accounting theory, so far no accounting theory has ever been successful in overthrowing all other alternatives. There have been, and no doubt will continue to be, advocates of various alternative theories of accounting, many of which are discussed in this book. Returning to our brief review of accounting theories, we have stated previously that positive theories of accounting do not seek to prescribe particular accounting practices (that is, they do not tell us which accounting practices we should adopt). Some critics of this positive theoretical
10
Kuhn’s ‘revolutionary’ perspective about the development of knowledge is in itself a theory and, as with accounting theories, there are alternative views of how knowledge develops and advances. Although a review of the various perspectives of the development of science is beyond the scope of this book, interested readers are referred to Popper (1959), Lakatos and Musgrove (1974), Feyerabend (1975) and Chalmers (1982).
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perspective have argued that the decision not to prescribe could alienate academic accountants from their counterparts within the profession. As Howieson (1996, p. 31) states: … an unwillingness to tackle policy issues is arguably an abrogation of academics’ duty to serve the community which supports them. Among other activities, practitioners are concerned on a day-to-day basis with the question of which accounting policies they should choose. Traditionally, academics have acted as commentators and reformers on such normative issues. By concentrating on positive questions, they risk neglecting one of their important roles in the community.
Counter to this view, many proponents of Positive Accounting Theory have, at different times, tried to undermine normative research because it was not based on observation but on personal opinion about what should happen. (Observation-based research was deemed by them to be ‘scientific’, and ‘scientific research’ was considered to be akin to ‘good research’.) Positive Accounting Theorists often argue that in undertaking research they do not want to impose their own views on others as this is ‘unscientific’; rather, they prefer to provide information about the expected implications of particular actions (for example, the selection of a particular accounting method) and thereafter let people decide for themselves what they should do (for example, they may provide evidence to support a prediction that organisations that are close to breaching accounting-based debt covenants will adopt accounting methods that increase the organisation’s reported profits and assets, thereby ‘loosening’ the effects of the accounting-based debt covenants). However, as a number of accounting academics have quite rightly pointed out, and as should be remembered when reading this book, selecting a theory to adopt for research (such as Public Interest Theory, Capture Theory, Legitimacy Theory, Stakeholder Theory, Institutional Theory, Positive Accounting Theory or various critical accounting theories) is based on a value judgement; what to research is based on a value judgement; believing that all individual action is driven by self-interest (as the Positive Accounting Theorists do) is a value judgement; believing that traditional accounting practices sustain the privileged position of particular members of society (as various ‘critical theorists’ do) is based on a value judgement, and so on. Hence, no research, whether using Positive Accounting Theory or otherwise, is value free and it would arguably be quite wrong to assert that it is value free. As Gray, Owen and Maunders (1987, p. 66) state: In common with all forms of empirical investigation we must recognise that all perception is theory-laden. That is, our preconceptions about the world significantly colour what we observe and which aspects of particular events we focus upon. Thus accountants are more likely to view the world through accounting frameworks and conventions.
Watts and Zimmerman (1990, p. 146) did modify their original stance in relation to the objectivity of their research and conceded that value judgements do play a part in positive research just as they do in normative research. They stated: Positive theories are value laden. Tinker et al. (1982, p. 167) argue that all research is value laden and not socially neutral. Specifically, ‘Realism operating in the clothes of positive theory claims theoretical supremacy because it is born of fact, not values’ (p. 172). We concede the importance of values in determining research: both the researcher’s and user’s preferences affect the process. Competition among theories to meet users’ demand constrains the extent to which researcher values influence research design. Positive theories are ‘If … then’ propositions that are both predictive and explanatory. Researchers choose the topics to investigate, the methods to use, and the assumptions to make. Researchers’ preferences and expected pay-offs (publications and citations) affect the choice of topics, methods and assumptions. In this sense, all research, including positive research, is ‘value laden’. 20
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The position taken in this book is that theories of accounting, of necessity, are abstractions of reality, and the choice of one theory in preference to another is based on particular value judgements. Some of us may prefer particular theories in preference to others because they more closely reflect how we believe people do, or should, act. Apart from issues associated with whether a particular theory is compatible with our own values and beliefs, other factors that might influence whether we accept a theory might include: • the perceived authority or reputation of those responsible for important developments in the theory • the extent of acceptance of the theory by other researchers within our ‘research community’. However, we must remember that just because a reputable researcher or researchers have developed or embraced a theory does not necessarily mean it is ‘right’. We must still consider whether it has been logically developed and provides logical explanations, predictions or prescriptions – something that we consider in the following sections of this chapter. The second point above also deserves further attention. It is common for many researchers to adopt particular theories because the majority of people researching the particular topic use that theory. As Deegan (2019, p. 2317) states when explaining the apparent dominance of Legitimacy Theory (which we explore later in this book), within the social and environmental accounting literature: It is possible that Legitimacy Theory continues to be used because it has effectively become ‘institutionalised’ within the social and environmental accounting literature, albeit that it is clear that alternative theories (particularly various forms of institutional theory) are gaining traction and challenging the previously dominant position of Legitimacy Theory. As indicated earlier, Dumay et al (2018) note that Legitimacy Theory has remained one of the most commonly used theories in the social and environmental accounting literature. Consistent with this, and because many perceived ‘leaders’ in the area were apparent supporters of the theory, then it might have also been seen as potentially the least resistant path to ultimate publication. This, in itself, might have constrained the possibility of other important insights being explored and revealed.
This is an interesting way to consider how theories are selected and how theories can tend to have a level of acceptance that gains momentum. But again, we would hope that theories are selected based on their merit!
Is the theory parsimonious? Another issue that we might consider when evaluating theories is whether the theories seem to be overly simplistic, or perhaps, too complicated, either of which might not be acceptable. One term that is of relevance here is parsimony. It is generally accepted that a simple explanation for a phenomenon is better and easier to understand than a complicated explanation. The same applies to theories. Generally speaking, a parsimonious theory is preferred, which means that the researcher has applied the most economically logical explanation to explain a particular phenomenon. For example, if one researcher has generated a theory that predicts certain choices of accountants (such as the choice to use a particular financial accounting method) and the theory uses 20 measured variables, but another researcher has developed a theory that appears to have the same explanatory ability, but only uses four explanatory variables, then that latter theory would be preferred. In relation to ‘parsimony’, Deegan (2019, p. 2316) states:
Parsimonious theory A theory that performs as well as other theories but, relative to alternative theories, has fewer assumptions and variables. It is a theory that embraces simplicity and is consistent with the view that simpler explanations are preferred to more complex ones.
This practice of embracing parsimonious explanations is consistent with what has for a long time been known as ‘Occam’s razor’ (a principle purportedly developed in science and philosophy by English philosopher, William of Occam, circa 1282–1340) in which a preferred explanation of a particular phenomenon is the simplest explanation that provides acceptable answers to a particular, and otherwise complex, problem. Applying 21
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this principle, if multiple theories are available which each satisfactorily explain something that is occurring then the theory making the fewer assumptions/having the fewest variables should be the one that is ultimately chosen.
In concluding this section, we note that we cannot really expect to provide perfect explanations or predictions of human behaviour, nor can we expect to assess perfectly what types of information the users of ‘accounts’ actually need – my perceptions of information needs will probably be different from your views about information needs. There is a role for prescription if it is based on logical argument, and there is a role for research that provides predictions if the research methods employed to provide the predictions are assessed as valid.
Why do I need to know that it is important to critically evaluate theories? Arguably, we should critically evaluate most of the things we learn. This is particularly important for theories. Theories can provide a very useful lens through which to understand the world in which we exist. However, before we seek to apply particular theories, we need to consider whether the theory was developed to answer the types of problems or questions we want answered; whether the theory adopts certain
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assumptions that we are likely to accept or reject; whether the theory appears to be logically derived; and whether the previous testing of the theory, which has perhaps created acceptance of the theory, has been undertaken properly, or whether there are flaws in the research design or processes used to previously support the theory.
Can we prove a theory?
This book does not intend to provide an in-depth insight into the development of scientific thought, but one interesting issue that often arises with students is whether a theory can actually be ‘proved’. In this book various theories are considered, a number of which provide alternative explanations for the same events. Further, there are often alternative theories that relate to a specific phenomenon, and which provide different and even opposite explanations or prescriptions. For example, in relation to climate change, some theories suggest global warming is very much due to the way people are using the planet’s resources and that we need to change or modify our production and consumption activities. Other theories suggest that climate change is a natural event that occurs without human intervention, is cyclical in nature, and therefore there is no need for direct action. We always need to guard against simply accepting a theory – not all theories provide sound explanations, predictions or prescriptions for particular practice, and where theories provide opposite explanations then, generally speaking, both cannot be right. The next section considers how to evaluate a theory in terms of logic and evidence, but first we look at the issue of whether we can prove a theory. One’s view about whether we can prove a theory as ‘correct’ depends on how one views the development of scientific thought. When it comes to accounting theories – which might, for example, consider how people react to particular accounting numbers or why accountants would choose particular accounting methods in preference to others – we need again to appreciate that accounting is a human activity (we cannot have accounting without accountants) and that common sense would dictate that not all people will react in a similar way to specific ‘accounts’. Hence, logic might indicate that a theory of accounting (and therefore a theory that describes human behaviour in relation to preparing and using ‘accounts’) would not provide perfect predictions of behaviour in all cases (and in this explanation we are talking about positive theories – theories that seek to explain and predict particular phenomena). If the theories of accounting were developed to explain and predict people’s actions and reactions to accounting information (that is, they are positive theories), we might consider that if a theory provides sound predictions the majority of the time, then the theory is still of use, albeit 22
Introduction to financial accounting theory CHAPTER 1
that its predictions are not ‘perfect’. That is, we would evaluate it on the basis of the correspondence between the prediction of behaviours provided by the theory and the subsequent behaviour, and we might accept that a theory is useful even though it does not provide accurate predictions in all cases. That is, an ‘acceptable’ theory might admit exceptions.11 It should also be appreciated that, while we might use observations to ‘support’ a theory, it would generally be inadvisable to state that we have proved a theory on the basis of observations. There is always the possibility that one further observation might be made that is inconsistent with our theory’s predictions.
Is the theory falsifiable? In relation to the issue of whether we can ‘prove’ a theory (or not), it is useful to refer to insights provided by a group of theorists known as ‘falsificationists’, the major leader of which is considered to be Karl Popper.12 Popper and the falsificationists consider that knowledge develops through trial and error. For example, a researcher might develop hypotheses from a theory.13 To develop scientific knowledge, the falsificationists believe that these hypotheses must be of a form that allows them to be rejected if the evidence is not supportive of the hypotheses. For example, a hypothesis of the following form would be deemed to be falsifiable: Hypothesis 1: Managers who receive bonuses based on accounting profits will select income-increasing accounting methods.
According to Popper and other falsificationists, knowledge develops as a result of continual refinement of a theory. When particular hypotheses are deemed to be false through lack of empirical support, the pre-existing theories will be refined (or abandoned). The refined theories will be accepted until a related hypothesis is deemed to be false (falsified), at which time the theory will be further refined. Chalmers (1982, p. 38) provides a useful overview of falsificationism. He states:
Falsificationist Describing a philosophy that uses experiment and observation to attempt to show that a theory is false, rather than attempting to verify it.
Falsifiable A theory is considered to be falsifiable if it provides predictions that can be tested and ultimately rejected.
The falsificationist freely admits that observation is guided by and presupposes theory. He [or she] is also happy to abandon any claims implying that theories can be established as true or probably true in the light of observational evidence. Theories are construed as speculative and tentative conjectures or guesses freely created by the human intellect in an attempt to overcome problems encountered by previous theories and to give an adequate account of the behaviour of some aspects of the world or universe. Once proposed, speculative theories are to be rigorously and ruthlessly tested by observation and experiment. Theories that fail to stand up to observational and experimental tests must be eliminated and replaced by further speculative conjectures. Science progresses by trial and error, by conjectures and refutations. Only the fittest theories survive. While it can never be legitimately said of a theory that it is true, it can hopefully be said that it is the best available, that it is better than anything that has come before.
From the falsificationist’s perspective, researchers should not test a theory by finding observations or facts that confirm the theory. Rather, researchers should look for cases that do not fit the theory, thereby effectively disproving the theory. The degree to which we might consider a theory to be acceptable will perhaps depend on the costs or implications associated with the theory ‘getting it wrong’ in a particular circumstance. For example, if the theory related to medicine and the theory was wrong only 10 per cent of the time – thereby causing deaths in 10 per cent of the patients – such a theory might not be acceptable. In accounting, we might tolerate higher levels of inconsistency between theory predictions and related outcomes. 12 One of the first detailed descriptions of falsificationism appeared in Karl Popper, The Logic of Scientific Discovery, Hutchinson, London, 1968. 13 Simply stated, a hypothesis can be defined as a proposition typically derived from theory which can be tested for causality or association using empirical data. For example, a hypothesis might be: the greater the negative media attention given to a particular social issue the greater the amount of organisational disclosures addressing the issue. 11
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Popper’s view regarding how theories are developed can be contrasted with the views adopted by the inductivists considered earlier in the chapter. The inductivists construct theories based on typically long periods of careful observation. This discussion will not be pursued any further in terms of how theories develop but, consistent with some of the above discussion, we would caution readers about making any claims to ‘proving’ a theory. It is always safer to say that our evidence ‘supports’ a theory, but that it is also possible that we might embrace an alternative theoretical perspective at a future time should better explanations for a particular phenomenon become available.
REFLECTION QUESTION 1.3 Claiming that a theory is ‘proved’ Question If you were attending a research seminar and somebody said they had generated results that proved a theory, would it be appropriate for you to challenge such a claim? Solution You would be correct to challenge such a claim. The view taken by many philosophers is that it is more appropriate to say that the results generated by particular research support a theory, or are consistent with a theory, rather than prove a theory. Theories, particularly theories relating to human behaviour, are necessarily abstractions of reality and therefore provide a simplifying lens through which to view the world. Samples
or evidence collected to test theories do not typically include the entire population of a particular item/variable. Rather, samples are typically used and therefore it is always possible that a different sample might include units or items that do not conform with the theory. That is, there is always a chance that other evidence, yet to be collected, could exist which is inconsistent with the theory. So, play it safe, and never say you have proved a theory! Something that researchers often say, which typically is not challenged, is that evidence was collected that proves a theory is wrong and this occurs as a result of having evidence which is inconsistent with the theory.
Evaluating theories – considerations of logic and evidence LO1.4
Logical deduction A conclusion or judgement that is made based upon logical argument or reasoning. Often developed through a series of steps, where each step is true if the preceding step is deemed to be true. Represents a process of reasoning using a series of statements (premises) to generate a logical conclusion.
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LO1.5
Throughout this book, various theories of accounting are discussed. Where appropriate, an evaluation of the theories is also undertaken. The book considers such issues as whether the argument supporting the theories is (or at least appears to be) logical and/or plausible in terms of the central assumptions (if any) that are being made. If possible, the argument or theory should be broken down into its main premises to see if the argument, in simplified form, appears logical. What is emphasised is that we must question the theories that we are exposed to – not simply accept them. Acceptance of a theory and its associated hypotheses must be tied to whether we accept the logic of the argument, the underlying assumptions and any supporting evidence provided. (As indicated previously, hypotheses can be described as predictions typically expressed in the form of a relationship between one or more variables.)
Evaluation through logical deduction As an example of logical deduction, consider the simplistic non-accounting-related argument (reflecting the bias of the author, who is an ‘old surfer’, it refers to surfing) shown in Figure 1.3. It demonstrates that, although the argument may be logical (if we accept the premises), if it can be shown that one of the premises is untrue or in doubt, then the conclusions or predictions may be rejected. Where there are a number of premises and a conclusion, it is often referred to as a ‘syllogism’. If we accept the premises in Figure 1.3, we might accept the conclusion. It is logical. To determine the logic of the argument, we do not need to understand what a ‘surfer’ is or what a ‘longboard’ is. That is, we do not need to refer to ‘real world’ observations. We could have deconstructed the argument to the form in Figure 1.4.
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FIGURE 1.3 An example of a syllogism Premises All surfers over the age of 35 ride longboards. Jack is a surfer over the age of 35.
Conclusion
Jack therefore rides a longboard.
FIGURE 1.4 Deconstructing the argument Premises All As ride a B. C is an A.
Conclusion
Therefore, C rides a B.
An argument is logical to the extent that if the premises on which it is based are true then the conclusion will be true. That is, the argument (even if logical) will only provide a proper account of the real world if the premises on which it is based are true. Referring to the above syllogism, evidence gathered through observation will show that the first premise does not always hold. There are surfers over 35 who do not ride longboards. Hence, we reject the conclusion on the basis of observation, not on the basis of logic. Therefore, we had two considerations. If the argument seeks to provide an account of real-world phenomena, we must consider the logic of the premises and the correspondence between the premises and actual observation. This simplistic example can be extended to a review of theories. We might try to break the theory down into a series of premises. When the central premises are considered, do they lead to a logical conclusion? Further, if the premises are based on ‘real world’ observation, do they seem to be true? However, it should be remembered that not all theories or arguments seek to correspond with real-world phenomena – for example, some normative theories of accounting promote radical changes to existing practices. For many normative theories, we might consider only the logic of the argument and whether we are prepared to accept the premises on which the argument is based. That is, empirical data is not analysed in research that is purely deductive. Returning to the subject of the syllogism provided above, we could have argued alternatively, as shown in Figure 1.5. FIGURE 1.5 An alternative argument Premises A lot of surfers over 35 ride longboards. Jack is a surfer over 35.
Conclusion Therefore, Jack rides a longboard.
The argument in Figure 1.5 is not a logical argument. The first premise has admitted alternatives and hence the conclusion, which does not admit alternatives, does not follow. We can dismiss the argument on the basis of a logical flaw without actually seeking any evidence to support the premises. 25
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Evaluating the underlying assumptions Assumption An assumption is something taken for granted or accepted as true without further proof.
Chapter 8 reviews in greater depth Positive Accounting Theory as developed by such researchers as Jensen and Meckling (1976) and Watts and Zimmerman (1978). As noted earlier, their positive theory of accounting has a number of central assumptions, including an assumption that all people are opportunistic and will adopt particular strategies to the extent that such strategies lead to an increase in the personal wealth of those parties making the decisions. That is, selfinterest is a core belief about what motivates individual action. Wealth accumulation is assumed to be at the centre of all decisions. The theory does not incorporate considerations of morality, loyalty, social responsibility and the like. If we were to accept the economics-based assumption or premise of researchers such as Watts and Zimmerman that: • self-interest tied to wealth maximisation motivates all decisions by individuals, and if we accept the following premises (which we might confirm through direct observation or through research undertaken by others) that: – manager X is paid on the basis of reported profits (for example, he/she is given a bonus of 5 per cent of accounting profits), and – accounting method Y is an available method of accounting that will increase reported profits relative to other methods, then we might accept a prediction that, all other things being equal, • then, manager X will adopt accounting method Y. This argument appears logical. Whether manager X is paid on the basis of reported profits, and whether accounting method Y will increase reported profits, are matters that can be confirmed though observation. But if the premises are both logical and true, then the conclusion will be true. The argument may be logical, but we might accept it only if we accept the critical assumption that the actions of individuals are motivated by the desire to maximise personal wealth. If we do not accept the central assumption, then we may reject the prediction. What is being emphasised here is that you need to consider whether you are prepared to accept the logic and the assumptions on which the arguments are based. If not, then we may reject the theory and the associated predictions. For example, in Gray, Owen and Adams (1996), the authors explicitly state that they reject the central assumptions of Positive Accounting Theory (although by their own admission it has generated ‘some useful insights’) and that they will not use it as a means of explaining or describing the practice of corporate social responsibility reporting. (The topic of corporate social reporting is covered in Chapter 10 of this book.) As Gray, Owen and Adams state (p. 75): There is little doubt that these theories have provided some useful insights into the way in which they model the world. There is equally little doubt that some company management and many gambling investors may act in line with these theories. It is also the case that some authors have found the form of analysis employed in these theories useful for explaining corporate social reporting; but apart from the limitations which must arise from a pristine liberal economic perspective on the world and the profound philosophical limitations of the approach, the approach cannot offer any justification why we might accept the description of the world as a desirable one. It is a morally bankrupt view of the world in general and accounting in particular. Its (usual) exclusion of corporate social reporting is therefore actually attractive as an argument for corporate social reporting.
Chapter 7 discusses the IASB Conceptual Framework for Financial Reporting, which is considered to be a normative theory of accounting (applying a decision usefulness perspective). This framework provides a view about the objective of general purpose financial reporting (to provide information that is useful for economics-based decisions) and the qualitative characteristics that 26
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financial information should possess. It also provides definitions of the elements of accounting (assets, liabilities, income, expenses, equity) and prescribes recognition criteria for each of the elements. As discussed in Chapter 7, in recent years the IASB made various revisions to its Conceptual Framework. The Conceptual Framework (IASB, 2022, paragraph 1.1) states that: The objective of general purpose financial reporting forms the foundation of the Conceptual Framework. Other aspects of the Conceptual Framework – the qualitative characteristics of, and the cost constraint on, useful financial information, a reporting entity concept, elements of financial statements, recognition and derecognition, measurement, presentation and disclosure – flow logically from the objective.
Hence, if we were to decide whether we agreed with the guidance provided within the revised Conceptual Framework as developed by the IASB, which is an example of a normative theory (as already indicated, a normative theory prescribes how we should undertake a particular activity – in this case, how we should do financial accounting), then we clearly would need to evaluate the assumed objective identified in the framework. As everything else is constructed around this objective (as the quote shows, it is deemed to be the ‘foundation of the Conceptual Framework’), then, logically, if we disagree with the stated objective, we would have to disagree with the balance of the prescriptions provided in the revised Conceptual Framework. Within the IASB Conceptual Framework (2022, paragraph 1.2), the objective is identified as: 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 relating to providing resources to the entity. Those decisions involve decisions about: (a) buying, selling or holding equity and debt instruments; (b) providing or settling loans and other forms of credit; or (c) exercising rights to vote on, or otherwise influence, management’s actions that affect the use of the entity’s economic resources.
Therefore, if we believed that the central objective of financial accounting was to provide information to a broad cross-section of stakeholders, inclusive of employees, local communities and other groups that are not directly involved as capital providers, then we would reject the conceptual framework developed by the IASB, despite the fact that it might be considered to be logically structured. While the in-depth study of logic and a critique of argument are beyond the scope of this book, interested readers should consider studying books or articles that concentrate on the development of logical argument.14 For example, Thouless (1974) describes various approaches to identifying logical flaws in arguments and he also identifies 38 ‘dishonest tricks in argument’ that some writers use to support their arguments. Some of the ‘tricks’ he refers to, and which are often used to distract readers from limitations in the logic of an argument or theory, are: • the use of emotionally toned words • making a statement in which ‘all’ is implied but ‘some’ is true • evasion of a sound refutation of an argument by use of a sophisticated formula • diversion to another question, to a side issue, or by irrelevant objection • the use of an argument of logically unsound form • change in the meaning of a term during the course of an argument • suggestion by repeated affirmation • prestige by false credentials • the appeal to mere authority • argument by mere analogy. 14
A good book in this regard is Straight and Crooked Thinking by Robert H. Thouless (1974). Sterling (1970) is also useful.
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When reading documents written to support particular ideas or theories, we must also be vigilant to ensure that our acceptance of a theory has not, in a sense, been coerced through the use of colourful or emotive language, or an incorrect appeal to authority. Earlier, reference was made to terms and descriptions used by critics of Positive Accounting Theory, some of which were very emotive. Quite often (but not always) emotive or colourful language is introduced to support an otherwise weak argument. Where emotive or colourful language has been used, we should perhaps consider whether we would take the same position in terms of accepting the author’s arguments if the author had used relatively neutral language. Thouless (1974, p. 24) provides some advice in this regard: The practical exercise which I recommend is one that I have already performed on some passages in which truth seemed to be obscured by emotional thinking. I suggest that readers should copy out controversial passages from newspapers, books, or speeches which contain emotionally coloured words. They should then underline all the emotional words, afterwards rewriting the passages with the emotional words replaced by neutral ones. Examine the passage then in its new form in which it merely states facts without indicating the writer’s emotional attitude towards them, and see whether it is still good evidence for the proposition it is trying to prove. If it is, the passage is a piece of straight thinking in which emotionally coloured words have been introduced merely as an ornament. If not, it is crooked thinking, because the conclusion depends not on the factual meaning of the passage but on the emotions roused by the words.
Universal applicability of theories While we must always consider the logic of an argument and the various assumptions that have been made, what we also must remember is that theories, particularly those in the social sciences, are by nature abstractions of reality. We cannot really expect particular theories about human behaviour to apply all the time. People (thankfully) are different and to expect theories or models of human behaviour (and remember, accounting theories relate to the action of accountants and the users of accounting information) to have perfect predictive ability would be naive. If a number of theories are available to describe a particular phenomenon, then considering more than one theory may provide a more rounded perspective. Difficulties will arise if the theories provide diametrically opposite predictions or explanations, and in such cases a choice of theory must generally be made. For those theories that attempt to predict and explain accounting practice (positive theories of accounting), it is common practice to test the theories empirically in various settings and potentially across various types of decisions. But what if the particular theories do not seem to hold in all settings? Should the theories be abandoned? Returning to an issue considered previously in this chapter, can we accept a theory that admits exceptions? Certainly, readings of various accounting research journals will show that some studies that adopt Positive Accounting Theory, or other forms of positivistic accounting theories (for example, capital markets theories, Legitimacy Theory and particular stakeholder theories) as the theoretical basis of the argument, fail to generate findings consistent with the theory (however, many studies do generate results consistent with the respective theory). According to Christenson (1983, p. 18), an outspoken critic of Positive Accounting Theory: We are told, for example, that ‘we can only expect a positive theory to hold on average’ [Watts and Zimmerman, 1978, p. 127, n. 37]. We are also advised ‘to remember that as in all empirical theories we are concerned with general trends’ [Watts and Zimmerman, 1978, pp. 288–289], where ‘general’ is used in the weak sense of ‘true or applicable in most instances but not all’ rather than in the strong sense of ‘relating to, concerned
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Introduction to financial accounting theory CHAPTER 1
with, or applicable to every member of a class’ [American Heritage Dictionary, 1969, p. 548] … A law that admits exceptions has no significance, and knowledge of it is not of the slightest use. By arguing that their theories admit exceptions, Watts and Zimmerman condemn them as insignificant and useless.
Christenson uses the fact that Positive Accounting Theory is not always supported in practice to reject it.15 However, as stressed previously, as a study of people (accountants, not ‘accounting’), it is very hard to see how any model or theory could ever fully explain human action. In fact, ability to do so would constitute a very dehumanising view of people. Hence, the failure of a particular study to support a theory might not in itself provide a basis for rejecting a theory as ‘useless and insignificant’. From another perspective, the failure to support the theory may have been due to the data being inappropriately collected or the data not providing a sound correspondence with the theoretical variables involved. However, if the theory in question continuously fails to be supported, then its acceptance will obviously be threatened. At this point we could speculate whether in fact there are any theories pertaining to human activities that always hold.
Generalising theories from the testing of samples In developing and testing accounting theories, many accounting researchers – particularly those embracing positivistic research – use methods borrowed from the pure sciences (such as physics and chemistry) that assume the phenomena being studied will behave in the same way in all similar situations. As we will see when reading accounting (and other) research, these researchers believe that it is possible to develop generalisable accounting theories and therefore that the results they derive from particular samples of observations can be generalised to the broader population of the phenomenon in question. Such researchers would therefore include the generalisability of a theory as one of the key considerations when evaluating the acceptability of the theory (and remember, in this chapter we noted other issues that are also criteria that might be considered when evaluating a theory, such as: the logic inherent in the theory; the key assumptions made within the theory; the reputation of those people who developed the theory; whether the theory is parsimonious; and, whether the theory provides predictions that are falsifiable). Other researchers hold the opposite view – that it is not possible to make any valid generalisations in the social sciences as we are dealing with human activity, and human behaviour varies from person to person. These researchers will develop theories of a fundamentally different nature from those developed by researchers who believe that it is possible to generalise in accounting theory, and these theories will tend to deal with specific localised situations. Hence, generalisability would not be a key criterion these researchers would use when evaluating a theory. Between these two extremes, there are other researchers (such as Laughlin, 1995, 2004) who believe that it is possible to make some very broad generalisations in developing social science theories, but the way these broad generalisations apply to specific situations will vary according to the specific individual factors applicable to each situation. Researchers holding this view regarding the way the world works may use some very broad theories to help understand some aspects of the phenomena they are studying, but are ready to amend and adapt these broad generalisations in light of specific evidence from each individual study. While a comprehensive review of research methods is beyond the scope of this book, if researchers are attempting to generalise the findings of their studies (based on particular samples) to a larger population, we need to consider the data on which the generalisation is
15
Generalisability Generalisability is concerned with whether research findings can be generalised beyond the specific context in which the research was conducted. A study may be valid in one setting but not in another and in this instance the research results would not be generalisable.
Where a proposition is not supported in a particular instance, many of us have probably heard the phrase ‘the exception proves the rule’ being applied. Such a statement implies that we cannot accept a rule or proposition unless we find some evidence that appears to refute it. This clearly is an illogical argument. As emphasised above, we must always guard against accepting arguments that are not logically sound.
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based.16 For example, if we are going to generalise our findings from a sample (we typically cannot test the whole population), then we must consider how the original sample was chosen. For instance, if we have a prediction that all companies will adopt a particular accounting method in times of inflation, and we test this prediction against the 10 largest companies listed on a securities exchange in a period of inflation, then common sense should dictate that the findings really should not be considered generalisable. Can we really be confident about what small companies will do given that our sample included only large listed companies? Hence, throughout your readings of various research studies, you should consider not only how the argument is developed, but also how it is tested. If there are flaws in how the testing has been done, we may question or reject the significance of the findings. We must evaluate whether the data collected really represent valid measures of the theoretical variables in question. As noted previously, it is usually not appropriate to test normative theories (those theories that provide prescription) empirically. If researchers are arguing that accountants should provide particular types of accounting information, or if other researchers are stating a view that organisations have a social responsibility to consider the needs of all stakeholders, then this does not mean that what they are prescribing actually exists in practice. For example, if Chambers’ model of accounting prescribes that all assets should be measured at their net market value, and we go out and find that accountants predominantly measure their assets on the basis of historical cost, we should not reject Chambers’ theory, as he was prescribing, not predicting or describing. We should always keep in mind what the researchers are attempting to achieve. Our acceptance of Chambers’ theory is dependent on whether we accept the logic of the argument as well as the assumptions made by Chambers, including the assumption that the central role of accounting should be to provide information about an entity’s ability to adapt to changing circumstances (which he argues is best reflected by measures of assets that are tied to their net market values), and the assumption that organisations should exist primarily to increase the wealth of the owners.
Can (or should ) more than one theory be used at a time? Most researchers apply a predetermined theory when undertaking research (although there are exceptions, such as the ‘grounded researchers’ discussed earlier in this chapter). They choose a theory from among competing theories. Taking this further, do researchers ever apply a combination of theories when undertaking their research? The answer to this question is ‘yes’. Some researchers do use multiple theories to explore particular research questions. This is often referred to as ‘theoretical triangulation’, or ‘theoretical pluralism’. Logically, and as we have already stressed, no theory can be expected to provide fully comprehensive explanations in relation to a particular social practice, such as accounting practice. For a practice involving human interaction, such as accounting, it is hard to imagine that one theory will ever address and make sense of the many complex issues that arise. Theoretical triangulation allows different theoretical perspectives, which generate different factors or variables to consider, to be used to examine particular research questions. The term ‘theoretical triangulation’ sometimes causes confusion. It does not mean that we are using three different theories (we know there are three angles in a triangle). Rather, the term indicates that we are looking at solving or addressing a particular question from different theoretical angles or perspectives (or looking at an issue through different ‘lenses’). It represents a potential convergence of knowledge as a result of a convergence of insights from quite separate points of origin. 16
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Entire books are dedicated to research methods. Interested readers may refer to: C. Humphrey and B. Lee (eds) (2004), The Real Life Guide to Accounting Research: A Behind-the-Scenes View of Using Qualitative Research Methods, Kidlington, Oxford: Elsevier; J. Collis and R. Hussey (2021), Business Research: A Practical Guide for Undergraduate and Postgraduate Students, 5th edn, London: Red Globe Press; T. Clark, L. Foster, L. Sloan and A. Bryman (2021), Bryman’s Social Research Methods, 6th edn, Oxford: Oxford University Press; and P. Ghauri, K. Gronhaug and R. Strange (2020), Research Methods in Business Studies, 5th edn, Cambridge University Press, Cambridge.
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In justifying theoretical triangulation, it is often argued that failure to consider multiple theories may cause the researcher to miss important issues that are not explored because they are not addressed by a particular theory. Different theories provide different insights, and provide ‘multiple lenses’ through which to understand particular phenomena. As Covaleski et al. (2003) argue, research that embraces multiple theories can potentially enable a more complete understanding of a particular phenomenon than is possible through applying a single theory. If we try to use multiple theories to address particular research questions, we need to make sure that it is actually logical to jointly utilise particular theories. Generally, researchers would only use theories in combination when the chosen theories share similar ontological assumptions (which relate to how we ‘see the world’ and whether we believe we all attribute the same meanings to particular phenomena) and similar epistemological assumptions (which relate to how we determine whether certain things are ‘true’ or not, and whether data collected can have a generalised meaning or must be considered relative to its context). Epistemological assumptions are typically linked to ontological assumptions. As an example, we would probably be unwise to consider in combination a theory that assumes that all people are driven by ‘self-interest’ and that there is an objective reality in which all people see and interpret things the same way (which is the cornerstone of various economic and accounting theories, such as Positive Accounting Theory) with a theory that assumes that individual human behaviour is influenced by factors such as culture, education, religion, professional memberships and so forth (as some accounting-related theories do). Arguably, such a combination of theories could lead to ‘theoretical incoherence’, wherein the different theories just do not logically work, or ‘fit’, together – something that we would need to guard against. Where theoretical triangulation has been applied, a single interpretation of the answer to a particular research question might not arise. Indeed, there could be multiple valid interpretations which imply multiple ‘truths’ (Freeman, 2003). This is not a bad thing. However, not all researchers might be comfortable with the view that there can be ‘multiple truths’. We will not pursue the issue of theory triangulation further in this text. But when we discuss particular theories, you might consider which theories could potentially work well together to provide richer insights and which theories would be problematic to utilise in combination. The major point we want to stress here is that theories provide a lens through which to see the world, and sometimes it can be useful to consider multiple ‘lenses’. A given ‘lens’ often will only expose part of the ‘whole story’ or ‘truth’.
Key factors that influence the research process LO1.3
LO1.4
LO1.6
We now use some of what we have learned within this chapter to summarise some factors that might influence the research process. As the previous material in this chapter indicates, there is a logical linkage between the theory chosen for particular research, the related research questions raised and research methods used, and the generalisability, or universal applicability, of any results being generated from the research project. That is, for a given research project, issues such as theory selection, development of research questions and selection of research methods should not be considered independently – they are all very interdependent. This is reflected relatively simplistically in Figure 1.6. In explaining the linkages in Figure 1.6, we continue to refer to a theory that we have already used to explain various research and theoretical issues – this being Positive Accounting Theory (discussed in more depth in Chapter 8). As this chapter and Chapter 8 explain, Positive Accounting Theory was developed by researchers who believed that the role of financial accounting theory is to explain and predict the choice of financial accounting practices (rather than providing prescriptions for improved practice). These researchers utilised simplifying assumptions adopted from the economics literature when developing their theory – which matched the researchers’ own values and 31
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FIGURE 1.6 The interdependence of various factors within the research process Ontological assumptions of the researcher (how we see the world)
Interests, values, beliefs of researcher
Research questions to be addressed
Choice of theory to be used
Research methods to be used
Degree of generalisability or universal applicability of research results
beliefs – including the assumption that all individuals are motivated by self-interest, with this self-interest being directly tied to wealth maximisation. It is also assumed within Positive Accounting Theory that individuals will always be opportunistic and will select strategies that are expected to maximise their own wealth, despite any potential implications for other individuals. That is, such a theory assumes that individual actions are predictable and that all individuals see the world in the same way (they have a shared view of the world). It is assumed that there is an ‘objective reality’ in which all individuals (such as managers) will behave identically (due to the same preferences for particular outcomes). These researchers’ perspective of what constitutes a ‘good’ theory is one that provides explanations or predictions that apply to all managers across all types of organisations, and across time. As indicated earlier in this chapter, assumptions about human behaviour, such as those briefly identified above, are often referred to as ontological assumptions, which, simply stated, are assumptions we make about how we see the world. Positivist researchers would have an ontological assumption that the world is objective and external to the researcher and that all observers would see that ‘world’ similarly. By contrast, phenomenologists would believe the world is socially constructed and will be seen and interpreted differently by different social actors. They would also, in contrast to positivists, believe that researchers themselves are affected by the process of research. They would not tend to generalise results from one research location to another. Positive Accounting Theory was developed to explain or predict the accounting practices that managers would elect to adopt in situations where the accounting method choice is not restricted by regulation. This theory was therefore applicable for answering the research questions the researchers were interested in answering – specifically, what accounting methods managers will choose to use when the respective area of financial accounting is unregulated. So, to this point, we can see how the ontological assumptions of the researcher, their values and beliefs, the theory being used and the research questions to be addressed are all highly interdependent and interwoven. With Figure 1.6 still in mind, we can now consider how the particular theory being used impacts the choice of research methods being used. As indicated above, Positive Accounting Theory adopts the assumption that all individuals are motivated by the same thing – wealth maximisation. It also assumes that where managers have a choice with regard to selecting an accounting method, then the method chosen will be the one that ultimately 32
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provides the greatest financial benefits to themselves. This theory leads to generalisable hypotheses, such as: managers of organisations with bonus plans [tied to reported income] are more likely to use accounting methods that increase current period reported income.
Hence, all managers are perceived as the same and somewhat interchangeable, meaning that large-scale testing across samples of many managers can be undertaken. This has direct implications for the research methods used.17 In this case, large samples of accounting policy choices can be investigated and statistical techniques would be utilised (with the result that this form of research is often classified as belonging within a body of research known as ‘quantitative research’). Again, with Figure 1.6 in mind, the results of the research would be deemed to be generalisable across all managers. That is, there is a direct linkage between the research method used (which might be based on large, randomly selected samples) and the generalisability of the results. By contrast with Positive Accounting Theorists, there will be other accounting researchers who consider that it is unrealistic and perhaps naïve to expect that all individuals are driven by identical motivations. For example, rather than believing that all managers are motivated purely by maximising their own wealth, some researchers might believe that while some managers are primarily motivated by wealth maximisation, other managers might prefer to maximise the wellbeing of the local community or to minimise the environmental impacts caused by their organisation. This does not mean that all managers are not expected to act rationally, but that they have different preferred outcomes. Because managers are considered to have different motivations, a theory other than Positive Accounting Theory would be chosen by such researchers. Further, managers would not be treated as being interchangeable, and this has implications for the type of research methods used (which might tend to be smaller in scale, possibly trying to understand the motivations of a limited number of managers within particular types of organisations and perhaps lending itself to case study style research. This form of research is often classified as belonging within a body of research known as ‘qualitative research’). The results of such research would also not be considered by the researchers to be generalisable across the population of all ‘managers’. Another, somewhat ‘external’ factor, that has been proposed in recent years as influencing the type of research being undertaken, and the theories being applied, is the research assessment exercises (RAEs) being undertaken across various countries. Such exercises can have various unintended consequences. RAEs have been undertaken regularly in a number of countries (for example, the United Kingdom, Australia, New Zealand, Netherlands, France and Italy) and their purpose is to assess the ‘quality’ of research by analysing research outputs of universities at a national level. The scores or ranks generated from such assessment exercises are often linked to university ‘brand’, ‘image’ and marketability, and they are often perceived as being useful in attracting students (and therefore income) to a highly rated university. In some countries, the outcomes of the RAEs also directly influence the research funding provided by government to particular disciplines within universities. Universities are known to strategically appoint staff and to focus on particular areas of research in order to achieve a higher ranking in such assessment exercises. O’Connell et al. (2020) specifically investigated the apparent impact the RAE undertaken within Australia, known as the Excellence in Research for Australia (ERA) review and administered by the Australian Research Council (ARC), had on accounting research undertaken within Australia. The research assessment conducted as part of the ERA assessment is done by a
17
When we refer to research methods, we are referring to the methods or tools used by the researcher to test or explore the research questions, propositions or hypotheses that they have formulated. For example, research methods might include the use of large scale surveys with associated statistical analysis of the survey results. Alternatively, for research where there is no expectation of generating generalisable findings, case study research might be relevant, inclusive of the use of a limited number of in-depth interviews of research subjects.
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panel of assessors chosen by the ARC, and is undertaken at the level of disciplines, with the unit of evaluation being a designated field of research, such as ‘accounting’. The results of the investigation by O’Connell et al. (2020) indicated that there appeared to be a form of positive bias applied by the ERA-nominated assessors towards research that was positivistic, and therefore highly quantitative, in nature, and which tended to provide generalisable prescriptions and did not consider individual organisational, or human, differences. That is, those institutions that undertook positivistic, quantitative accounting research appeared to be rated higher by the assessment panel members than those institutions that did not, despite the actual number of publications being generated within different institutions. Such a result created a perception that a focus on positivist research provided a pathway to higher ERA rankings, whereas research of a non-positivist and qualitative nature, such as interpretive or critical research, seemed to go unrewarded within the ratings exercise. Because of quests to ‘play the game’ and achieve higher ratings in subsequent ERA rounds, this arguably leads to an increase in positivistic research and a reduction in non-positivistic research. The positivistic research tends to focus on financial accounting, earnings management, capital markets and audit judgement, but not on areas associated with critiques of accounting practices, social and environmental accountability/responsibility, and broader sustainability issues as they relate to accounting. If the results of the O’Connell et al. (2020) research are reasonably accurate (and, as we have noted in this chapter, before we accept any research results, we need to carefully review how the respective authors performed their research), then this would be a concern for those people who believe that the Earth is in ‘trouble’ environmentally, and that accounting has a role in assisting sustainable development. Such environmentally focused research should arguably be encouraged rather than potentially undermined through such government-sponsored ratings exercises. In trying to understand the reasons why positivistic research seemed to be rated higher within the ERA process, the authors specifically considered the people who were appointed to the assessment panels of the ERA exercise. What was apparently clear was that the assessors themselves undertook positivistic research, and they tended to be employed by institutions that prioritised positivistic (highly quantitative) research. Because assessors tend to be selected from institutions that were highly ranked in previous ERA rounds, and because positivistic research is ranked higher, the ranking exercise becomes a self-sustaining exercise for prioritising and privileging positivistic research. This was deemed to be consistent with the view projected by O’Connell et al. (2020) that the whole research evaluation process had been captured by a particular field of researchers (positivists) who prioritised their own theoretical and philosophical perspectives to the detriment of ‘non-conforming’ (non-positivist) researchers. All this happens while the whole process is outwardly promoted by the government as one that fosters research excellence and which is objective, free from bias and rigorous. That is, the process appears to have a level of ‘legitimacy’ within the broader community. According to O’Connell et al. (2020, p. 1297): Our findings have implications for the literature on governance together with the literature on academic elitism. In the case of university governance, our findings show that a new public management focus on achieving key performance targets in research rankings has impacted on academics by narrowing the type of research undertaken and types of methods chosen. This outcome is unlikely to be in the public interest given that a primary aim of universities should be to study a wide range of problems using diverse methods and to educate future generations well and with breadth.
While the discussion in this section is brief, it does indicate that how people undertake their research (including the research methods used) will be influenced by a number of factors, even including the external assessment of research quality (which is undertaken by individuals who have their own views about what constitutes ‘good research’). All these various factors should be kept in mind throughout this book when we consider alternative accounting theories and the related research that has been conducted. 34
Introduction to financial accounting theory CHAPTER 1
STUDY TOOLS OUTLINE OF THE FOLLOWING CHAPTERS OF THIS BOOK A book of this size cannot be expected to cover all the theories of accounting. In this book, we tend to focus on theories that relate to the external reporting of accounting-related information, rather than theories that address how managers use information to manage an organisation (which might be broadly referred to as management accounting theories). In doing so, this book covers those theories that have gained widespread acceptance by various sectors of the accounting community. Chapter 2 introduces a ‘four-step accountability model’ and links it to issues associated with organisational responsibility, accountability and accounting. It is stressed that an individual’s perceptions of organisational responsibility ultimately impact the ‘accounting’ that we do and that we teach, and the theories that researchers apply in their research. The evolving nature of ‘accounting’ and ‘accounting theory’ are also addressed. Corporate governance is introduced and its linkage to corporate mission statements and organisational responsibilities stressed, as is the linkage between ‘accounting’ and different forms of corporate governance. Consideration is also given to what is commonly referred to as the ‘materiality determination process’, wherein the accounting information provided to stakeholders is determined through a process that engages particular stakeholders. Chapter 3 provides an overview of various financial reporting decisions that entities typically face, emphasising that some reporting pertaining to particular transactions and events is regulated and some is unregulated. The chapter emphasises that financial accountants typically make many professional judgements throughout the accounting process, and discusses the qualitative attribute of objectivity; but it emphasises that considerations (other than the pursuit of objectivity) may sometimes influence accounting method selection and disclosure practices. Chapter 4 provides an overview of various arguments for and against the regulation of financial reporting, with an overview of various perspectives on the costs and benefits of regulating financial reporting. The chapter explores why some accounting approaches and/or methods are adopted by regulators and/or the profession, while others are not. The political process involved in the setting of accounting standards is highlighted. Chapter 5 explores the international harmonisation of accounting requirements. In recent decades, moves have been made to standardise accounting practices internationally. Australia and the European Union were at the forefront of such moves. This chapter considers some potential costs and benefits of this process. Particular consideration is given to issues of culture and how cultural differences have typically been proposed as a reason to explain international differences in accounting requirements. International standardisation ignores this research and assumes that all countries (with different cultures) can and should simply adopt the same financial accounting practices. Chapter 6 provides an overview of various normative (or prescriptive) theories of accounting that have been advanced to deal with various accounting issues associated with periods of rising prices (inflation). The chapter considers such issues as whether there is a ‘true’ measure of income. Conceptual frameworks of financial reporting, as normative theories of accounting, are considered in Chapter 7. Applying material covered in Chapter 4, Chapters 6 and 7, we also consider why various normative theories of accounting did not gain favour with the accounting profession or the respective accounting standard-setters. Chapters 8 and 9 show that, while much financial reporting is regulated, managers still have some scope for voluntarily selecting between alternative accounting methods for particular types of transactions. The treatment of many transactions, and the disclosure of many/most issues associated with various social and environmental events relating to an organisation, are unregulated. Chapters 8 and 9 consider some theoretical perspectives (including Positive Accounting Theory, Legitimacy Theory, Stakeholder Theory, Political Economy Theory and Institutional Theory) that explain what drives the various unregulated/voluntary reporting decisions. Chapter 10 considers the development and use of systems of accounting that incorporate the economic, social and environmental performance of an organisation. The relationship between accounting and sustainable development is explored and the role of ‘accounting’ in advancing sustainable development is stressed. This chapter includes a consideration of the limitations of traditional 35
Financial Accounting Theory
financial accounting, with particular focus on the failure of financial accounting to incorporate social and environmental issues/impacts in measures of ‘profits’. Chapters 11 and 12 consider how individuals and capital markets react to various corporate disclosures. The chapters consider the various theories that have been used to test whether the market is actually using particular types of disclosures, as well as theories that indicate how individuals use accounting information. The chapters also consider who should be deemed to be the users of various types of disclosures. Issues associated with stakeholder rights to know are also explored. The concluding chapter, Chapter 13, provides an overview of various critical perspectives of accounting – perspectives that tend to criticise entire systems of accounting (accounting practices can be perceived as anthropocentric, masculine, marginalising and so on). Reference is made to theoretical perspectives that claim that accounting tends to support current and ‘accepted’ social systems, which tend to favour those parties with economic power, but marginalise the interests of parties that lack control of necessary resources. In summary, the balance of this book can be presented diagrammatically, as in Figure 1.7. FIGURE 1.7 Diagrammatic overview of accounting theory CHAPTER 1 An introduction and overview of accounting theory
CHAPTER 2 The relationship between organisational responsibility, accountability and ‘accounting’. The linkage between perceptions of organisational responsibility and corporate governance is also explored.
CHAPTER 3 Building on the material in Chapters 1 and 2, this chapter explores the rationale for ‘why’ particular accounting approaches or methods are adopted. Some accounting policies will be adopted because of regulatory requirements, whereas other accounting policies will be adopted voluntarily and reliant on professional judgement.
Regulated reporting decisions
Unregulated reporting decisions
Chapter 4 Costs and benefits of accounting regulation and political processes associated with regulation accounting
Chapter 6 and 7 Normative prescriptions for accounting practice, including different suggestions for measuring assets, inclusive of fair value
Chapter 5 A critique of decisions to internationally harmonise accounting practice approaches
Chapter 8 and 9 Theories to explain the voluntary choice to adopt particular financial, social and environmental accounting policies and approaches
CHAPTER 10 Application of material from previous chapters to explain the practice of, and provide prescriptions for, social and environmental (sustainability) reporting
CHAPTER 11 AND 12 Individual and market reactions to particular accounting disclosures
CHAPTER 13 Critical perspectives of accounting – an exploration of views that suggest different forms of ‘accounting’ information privilege some members of the society to the detriment of other members of society. ‘Accounting’ is seen as an ‘instrument’ to support the position and status of particular segments of the community
36
Introduction to financial accounting theory CHAPTER 1
ANSWERS TO THE OPENING QUESTIONS At the beginning of the chapter, we asked the following three questions. As a result of reading this chapter, you should be able to provide informed answers to these questions – ours are shown below. 1 Why do students of accounting need to bother with the study of ‘theories’? For example, why not just study some more of the numerous accounting standards (and there are certainly plenty of them!) or other pronouncements of the accounting profession? Accounting can be a very technical practice, with many rules or guidelines about how we perform various forms of ‘accounting’. While it is important to understand how to technically perform various accounting practices, for example, to know when and how to recognise and measure various assets, liabilities, income and expenses, or when and how to measure and report various social and environmental impacts, as thinking individuals, we need more knowledge. Accounting practices can in turn create various social impacts. That is, accounting is both a technical and social practice – it is a rich process that requires ongoing research. We need theory to understand issues such as: • why managers elect to apply particular accounting practices • why regulators mandate particular accounting disclosures • to whom managers will elect to make particular disclosures, and why • how different stakeholders will react to particular disclosures • what disclosures should be made to assist users’ decisions • how particular stakeholders will impact accounting practice and accounting research • what role accounting practice has in supporting particular social structures. As this chapter shows, accounting theories provide us with ‘lenses’ through which to answer questions such as those above. Theory allows us to ‘make sense’ of the world which we inhabit. Therefore, the perspective we adopt in this book is that theory provides valuable insights about what accountants do and about the implications of accounting practice. It would arguably be inappropriate to just consider accounting standards and practice without deeper thinking about the reasons for, and the implications of, accounting practice. 2 Why would (or perhaps ‘should’) accounting practitioners and accounting regulators have knowledge of various theories of accounting? ‘Accounting numbers’ are used throughout society. Accounting numbers are used by various stakeholders to make many decisions that in turn create various economic, social and environmental impacts that affect us all. Accounting practitioners and regulators need to appreciate the factors that influence their various judgements, and they need to understand which stakeholders use the related accounting information, how they use it and the impacts the various accounting-related decisions have on different stakeholder groups. Accounting theories provide us all with knowledge to understand such issues. Accounting theories encourage practitioners and regulators to be ‘critical thinkers’. That is, accounting theory provides insights through which people can critically evaluate and understand the basis and merit (or otherwise) of their various accounting-related decisions. 3 Do all ‘theories of accounting’ seek to fulfil the same role, and, if there are alternative theories to explain or guide particular practice, how does somebody select one theory in preference to another? As this chapter shows, different theories can have very different roles. For example, some theories prescribe particular accounting practice, whereas other theories explain and/or predict why particular accounting practices will be selected. Different theories make different assumptions about what motivates the selection of particular disclosures, and different theories make different assumptions about the generalisability of the theoretical insights to
37
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different organisational settings. Some theories are developed and tested through large-scale (quantitative) data collection, whereas other theories are developed and tested through smallscale, in-depth (qualitative) data collection. This chapter has suggested that the theories that we individually select will be influenced by our view of the world and how closely the available theories match that world view. The research questions we are attempting to answer will also influence our theory selection. Processes such as ‘research assessment exercises’, and the research undertaken by our colleagues, will also potentially influence the theories we embrace. What needs to be appreciated is that different theories provide different ‘lenses’ through which to see the world and answer particular questions. A combination of theories (theory triangulation) may, at times, also be appropriate.
QUESTIONS 1.1 1.2
1.3 1.4
1.5 1.6 1.7
1.8
1.9 1.10 1.11 1.12
1.13
1.14
38
What is the difference between a positive theory of accounting and a normative theory of accounting? LO1.3 If you developed a theory to explain how a person’s cultural background influences how they prepare financial statements, would you have developed a positive theory or a normative theory? LO1.3 What is a conceptual framework, and would it be considered to be a positive or a normative theory of accounting? LO1.3 In an article that appeared in The Age (‘Way cleared for Turnbull to challenge’; Grattan, 2008), Peter Costello, former federal treasurer, was quoted as saying, ‘I have a theory that every government wins one more term than it should’. Do you believe he really has a ‘theory’ in terms of the way a ‘theory’ is defined in this chapter? LO1.5 Why would it not be appropriate to reject a normative theory of accounting because its prescriptions could not be confirmed through empirical observation? LO1.3 LO1.4 If some hypotheses developed by a Positive Accounting researcher were not supported by the data that was collected, should we reject the theory? The IASB and the FASB have developed conceptual frameworks for financial reporting. If you have been asked to review these frameworks – which are examples of a normative theory of accounting – why would it be important for you to pay particular attention to how the objective of financial reporting is defined within them? LO1.5 If a normative theory of financial accounting has been developed to prescribe how we should do financial accounting, is it possible that we can decide to reject the theory because we do not agree with a central assumption of the theory (such as an assumption about the objective of financial reporting), but at the same time decide that the theory is nevertheless logical? Explain your answer. LO1.4 LO1.5 What is the difference between developing a theory by induction and developing a theory by deduction? LO1.4 What is theory triangulation, and what are some of the advantages and disadvantages of pursuing theory triangulation? LO1.4 LO1.5 Is the study of accounting theory a waste of time for accounting students? Explain your answer. LO1.7 What is a research question? Why would we expect there to be some form of relationship between the research questions to be addressed and the theories being applied by the researcher? LO1.1 LO1.2 In the 1960s, a number of accounting researchers concentrated on developing theories of accounting based on observing and documenting the behaviour of practising accountants. Do you think that such research is useful in improving the practice of financial accounting? Explain your answer. LO1.1 LO1.5 Gray, Owen and Maunders (1987, p. 66) make the following statement in relation to research based on the inductive approach (that is, research based on observing particular phenomena):
Introduction to financial accounting theory CHAPTER 1
Studying extant practice is a study of ‘what is’ and by definition does not study ‘what is not’ or ‘what should be’. It therefore concentrates on the status quo, is reactionary in attitude, and cannot provide a basis upon which current practice may be evaluated or from which future improvements may be deduced.
With this comment in mind, do you consider that research based on induction is useful for improving the practice of financial accounting? Explain your answer. LO1.5 1.15
Explain the meaning of the following paragraph and evaluate the logic of the perspective described: In generating theories of accounting that are based upon what accountants actually do, it is assumed (often implicitly) that what is done by the majority of accountants is the most appropriate practice. In adopting such a perspective there is, in a sense, a perspective of accounting Darwinism – a view that accounting practice has evolved, and the fittest, or perhaps ‘best’, practices have survived. Prescriptions or advice are provided to others on the basis of what most accountants do, the logic being that the majority of accountants must be doing the most appropriate thing. LO1.1 LO1.5
1.16
1.17
In 1961 and 1962, the Accounting Research Division of the American Institute of Certified Public Accountants (AICPA) commissioned studies by Moonitz and by Sprouse and Moonitz. These studies proposed that accounting measurement systems be changed from historical cost to a system based on current values. However, before the release of these studies, the AICPA released a statement saying that ‘while these studies are a valuable contribution to accounting principles, they are too radically different from generally accepted principles for acceptance at this time’ (Accounting Principles Board, 1962). Explain why if something is ‘radically different’ (though it might be logically sound) this difference in itself might be enough to stop regulators embracing a particular approach to accounting. LO1.3 LO1.5 Read the following quotation from Miller and Reading (1986, p. 64). In doing so, you should consider that if constituency support is necessary before particular accounting approaches become embodied in accounting standards, then does this have implications for the ‘neutrality’ and ‘representational faithfulness’ (qualitative characteristics that exist in various conceptual framework projects around the world) of reports generated in accordance with accounting standards? The mere discovery of a problem is not sufficient to assure that the Financial Accounting Standards Board will undertake its solution … There must be a suitably high likelihood that the Board can resolve the issues in a manner that will be acceptable to the constituency – without some prior sense of the likelihood that the Board members will be able to reach a consensus, it is generally not advisable to undertake a formal project. LO1.5
1.18
1.19 1.20 1.21 1.22 1.23 1.24 1.25 1.26
1.27
As Watts and Zimmerman (1986, p. 7) state, Positive Accounting Theory ‘is concerned with explaining [accounting] practice. It is designed to explain and predict which firms will and which firms will not use a particular accounting method … but it says nothing as to which method a firm should use’. Do you think that this represents an ‘abrogation’ of the academics’ duty to serve the community that supports them? LO1.1 LO1.3 LO1.5 Briefly identify the two branches of ‘decision usefulness’ theories described in this chapter and explain what they are. LO1.1 Briefly explain the revolutionary perspective of knowledge advancement proposed by Kuhn (1962). LO1.6 What is a ‘paradigm’? Would you expect accounting researchers to embrace more than one paradigm when undertaking research? Explain your answer. LO1.1 LO1.4 LO1.6 Is there a difference between financial accounting theory and financial accounting research? LO1.2 In your opinion, can accounting research be ‘value free’? Explain your answer. LO1.4 Why might particular theories have widespread acceptance within particular research communities? LO1.4 LO1.5 What role do value judgements have in determining what particular accounting theory a researcher might elect to adopt to explain or predict particular accounting phenomena? LO1.4 If an accounting researcher adopts a particular accounting theory to predict which organisations will make particular accounting disclosures, how much supporting evidence must the researcher gather before they can claim that the theory is ‘proved’? Explain your answer. LO1.5 Can we ever claim to have finally ‘proved’ a theory? LO1.5 LO1.6 39
Financial Accounting Theory
1.28 1.29 1.30 1.31 1.32
1.33 1.34
1.35
1.36 1.37 1.38 1.39 1.40
1.41
1.42
Should all researchers have a theory in mind before they conduct their research? LO1.6 Identify and explain five different criteria that we might use to evaluate a theory. LO1.5 According to the ‘falsificationists’, what should a ‘good’ theory do? LO1.6 What differentiates a grounded theory from other theories? LO1.3 LO1.6 What is the role of data collection in the research work of a ‘grounded researcher’? Would a ‘grounded researcher’ believe that the results generated within one research setting can be generalised to other settings? LO1.3 LO1.6 Assume that you have been asked to evaluate a particular theory of accounting. What factors would you consider before making a judgement that the theory appears ‘sound’? LO1.5 If you were trying to convince another party to support your theory about a particular facet of financial accounting, would you be inclined to use emotive or colourful language? Why, or why not? LO1.5 The IASB has a number of roles, including formulating accounting standards and developing a conceptual framework. Is the work it does in developing an accounting standard or the conceptual framework normative or positive in nature? LO1.1 LO1.3 What do we mean when we say that ‘theories are abstractions of reality’? Do you agree that theories of accounting are necessarily abstractions of reality? LO1.2 Does a ‘positivist’ believe that there is an ‘objective world’? If they did, how might that influence their perceptions about the generalisability of their research results? LO1.4 LO1.6 If we were to say that a theory provided the most parsimonious explanation of a particular phenomena, would that be good, and if so, why is it good? LO1.2 What is a ‘hypothesis’? Do you consider that accounting research should necessarily involve the development of empirically testable hypotheses? LO1.3 LO1.6 Would you reject as ‘insignificant and useless’ a positive theory of accounting on the basis that in a particular research study the results derived failed to support the hypotheses and the related theory? Explain your answer. LO1.2 LO1.3 LO1.5 If a researcher tested a theory on a particular sample of companies, what factors would you consider before you would agree with the researcher that the results can be generalised to the larger population of companies? In an article by Gray, Owen and Adams (2010), the authors discuss an apparent ‘herding phenomenon’ that seems to be occurring in respect of the selection and use of particular theories. They state: ‘there has been a strange herding tendency, especially around legitimacy theory’, as well as stating they ‘also have a sneaking feeling that institutional theory may be coming up fast as the next theory around which to herd’. What do they mean by this apparent practice of ‘herding’, and what are some possible advantages and disadvantages that are related to this practice? LO1.6
1.43 Refer to Figure 1.6 in this chapter and provide an explanation, in no more than 200 words, of what the diagram is trying to emphasise. LO1.6 1.44 Do we really need financial accounting theory if all we are interested in doing is developing accounting standards? LO1.2 LO1.7
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Chambers, R. J. (1993), ‘Positive accounting theory and the PA cult’, ABACUS, 29(1), pp. 1–26. Christenson, C. (1983), ‘The methodology of positive accounting’, The Accounting Review, 58 (January), pp. 1–22. Clark, T., Foster, L., Sloan, L. & Bryman, A. (2021), Bryman’s Social Research Methods, 6th edn, Oxford: Oxford University Press. Collis, J. & Hussey. R. (2003), Business Research, London: Palgrave Macmillan. Collis, J. & Hussey, R. (2021), Business Research: A Practical Guide for Undergraduate and Postgraduate Students, 5th edn, London: Red Globe Press.
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Covaleski, M. A., Evans, J. H., Luft, J. L. & Shields, M. D. (2003), ‘Budgeting research: three theoretical perspectives and criteria for selective integrations’, Journal of Management Accounting Research, 15, pp. 3–19. Deegan, C. (1997), ‘Varied perceptions of positive accounting theory: a useful tool for explanation and prediction, or a body of vacuous, insidious and discredited thoughts?’, Accounting Forum, 20(5), pp. 63–73. Deegan, C. (2019), ‘Legitimacy theory: despite its enduring popularity and contribution, time is right for a necessary makeover’, Accounting, Auditing & Accountability Journal, 32(8), pp. 2307–29. Feyerabend, P. (1975), Against Method: Outline of an Anarchic Theory of Knowledge, London: New Left Books. Financial Accounting Standards Board (2016), FASB Exposure Draft: Proposed Statement of Financial Accounting Concepts – Concept Statement 8, FASB. Financial Accounting Standards Board (1976), Scope and Implications of the Conceptual Framework Project, FASB. Freeman, M. (2003), ‘Identity and difference in narrative inquiry’, Narrative Inquiry, 13(2), pp. 331–346. Ghauri, P. & Gronhaug, K. (2002), Research Methods in Business Studies: A Practical Guide, Harlow: Prentice Hall. Ghauri, P., Gronhaug, K. & Strange, R. (2020), Research Methods in Business Studies, 5th edn, Cambridge: Cambridge University Press. Glaser, B. (1978), Theoretical Sensitivity, Mill Valley, CA: Sociology Press. Gordon, M. J. (1964), ‘Postulates, principles, and research in accounting’, The Accounting Review, 39 (April), pp. 251–63. Grady, P. (1965), An Inventory of Generally Accepted Accounting Principles for Business Enterprises, Accounting Research Study No. 7, New York: AICPA. Grattan, M. (2008), ‘Way cleared for Turnbull to challenge’, The Age, 12 September. Gray, R., Adams, C. & Owen D, (2014), Accountability, Social Responsibility and Sustainability, London: Pearson. Gray, R. & Bebbington, J. (2001), Accounting for the Environment, London: Sage Publications. Gray, R., Owen, D. & Adams, C. (1996), Accounting and Accountability: Changes and Challenges in Corporate Social and Environmental Reporting, London, Prentice Hall. Gray, R., Owen, D. & Adams, C. (2010), ‘Some theories for social accounting? A review essay and a tentative pedagogic categorisation of theorisations around social accounting’, Sustainability, Environmental Performance and Disclosures, 4, pp. 1–54. Gray, R., Owen, D. & Maunders, K. T. (1987), Corporate Social Reporting: Accounting and Accountability, Hemel Hempstead: Prentice Hall. Hatfield, H. R. (1927), Accounting, Its Principles and Problems, New York: D. Appleton & Co. Henderson, S., Peirson, G. & Harris, K. (2004), Financial Accounting Theory, Sydney: Pearson Education Australia. Hendriksen, E. (1970), Accounting Theory, Homewood, IL: Richard D. Irwin. Hicks, J. R. (1946), Value and Capital, Oxford: Oxford University Press. Hines, R. (1988), ‘Financial accounting: in communicating reality, we construct reality’, Accounting, Organizations and Society, 13(3), pp. 251–62. Howieson, B. (1996), ‘Whither financial accounting research: a modern-day Bo-peep?’, Australian Accounting Review, 6(1), pp. 29–36.
Humphrey, C. & Lee, B. (eds) (2004), The Real Life Guide to Accounting Research: A Behind-the-Scenes View of Using Qualitative Research Methods, Kidlington, Oxford: Elsevier. Hussey, J. & Hussey, R. (1997), Business Research: A Practical Guide for Undergraduate and Postgraduate Students, London: Macmillan Business. International Accounting Standards Board (2022). Conceptual Framework for Financial Reporting. https:// www.ifrs.org/ issued-standards/list-of-standards/ conceptual-framework.html/content/dam/ifrs/ publications/html Jensen, M. C. & Meckling, W. H. (1976), ‘Theory of the firm: managerial behavior, agency costs and ownership structure’, Journal of Financial Economics, 3(October), pp. 305–60. Kuhn, T. S. (1962), The Structure of Scientific Revolutions, Chicago, IL: University of Chicago Press. Lakatos, I. & Musgrove, A. (1974), Criticism and the Growth of Knowledge, Cambridge: Cambridge University Press. Laughlin, R. (1995), ‘Empirical research in accounting: alternative approaches and a case for “middle-range” thinking’, Accounting, Auditing and Accountability Journal, 8(1), pp. 63–87. Laughlin, R. (2004), ‘Putting the record straight: a critique of “Methodology choices and the construction of facts: some implications from the sociology of knowledge”’, Critical Perspectives on Accounting, 15(2), pp. 261–77. Lee, T. A. (1974), ‘Enterprise income – survival or decline and fall’, Accounting and Business Research, 15, pp. 178–92. Llewelyn, S. (2003), ‘What counts as “theory” in qualitative management and accounting research?’, Accounting, Auditing and Accountability Journal, 16(4), pp. 662–708. Mathews, M. R. (1993), Socially Responsible Accounting, London: Chapman & Hall. Merton, R. K. (1968), Social Theory and Social Structure, New York: Free Press. Miller, P. B. W. & Reading, R. (1986), The FASB: The People, the Process, and the Politics, Burr Ridge, IL: Irwin. Moonitz, M. (1961), The Basic Postulates of Accounting, Accounting Research Study No. 1, New York: AICPA. O’Connell, B., De Lange, P., Stoner, G. & Sangster, A. (2020), ‘Impact of research assessment exercises on research approaches and foci of accounting disciplines in Australia’, Accounting, Auditing and Accountability Journal, 33(6), pp. 1277–1302. Paton, W. A. (1922), Accounting Theory, Kansas: Scholars Book Co., reprinted 1973. Paton, W. A. & Littleton, A. C. (1940), An Introduction to Corporate Accounting Standards, USA: American Accounting Association. Popper, K. R. (1959), The Logic of Scientific Discovery, London: Hutchinson. Popper, K. (1968), The Logic of Scientific Discovery, 2nd edn, London: Hutchinson. Sprouse, R. & Moonitz, M. (1962), A Tentative Set of Broad Accounting Principles for Business Enterprises, Accounting Research Study No. 3, New York: AICPA. Sterling, R. R. (1970), Theory of the Measurement of Enterprise Income, Lawrence, KS: University of Kansas Press. Sterling, R. R. (1990), ‘Positive accounting: an assessment’, ABACUS, 26(2), pp. 97–135. Strauss, A. (1987), Qualitative Analysis for Social Scientists, Cambridge: Cambridge University Press.
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Strauss, A. & Corbin, J. (1990), Basics of Qualitative Research: Grounded Theory Procedures and Techniques, Newbury Park, CA: Sage. Thouless, R. H. (1974), Straight and Crooked Thinking, London: Pan Books. Tinker, A. M., Merino, B. D. & Neimark, M. D. (1982), ‘The normative origins of positive theories: ideology and accounting thought’, Accounting Organizations and Society, 7(2), pp. 167–200. Unerman, J. & O’Dwyer, B. (2004), ‘Enron, WorldCom, Andersen et al.: a challenge to modernity’, Critical Perspectives on Accounting, 15(6–7), pp. 971–93. Watts, R. & Zimmerman, J. (1978), ‘Towards a positive theory of the determination of accounting standards’, The Accounting Review, 53(1), pp. 112–34.
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Watts, R. L. & Zimmerman, J. L. (1986), Positive Accounting Theory, Englewood Cliffs, NJ: Prentice Hall. Watts, R. L. & Zimmerman, J. L. (1990), ‘Positive accounting theory: a ten year perspective’, The Accounting Review, 65(1), pp. 131–56. Williams, P. F. (1989), ‘The logic of positive accounting research’, Accounting, Organizations and Society, 14(5/6), pp. 455–68. Wolk, H. I. & Tearney, M. G. (1997), Accounting Theory: A Conceptual and Institutional Approach, International Thomson Publishing.
CHAPTER
2
ACCOUNTABILITY AND ITS LINK TO RESPONSIBILITY AND ACCOUNTING LEARNING OBJECTIVES On completing this chapter, readers should:
LO2.5
be able to explain the possible influence of ‘stakeholder power’ on corporate accountability and corporate accounting practices
LO2.1
be able to explain, for the purposes of this book, how ‘accounting’ and ‘accountability’ are defined
LO2.2
understand the relationship between organisational responsibilities, organisational accountabilities, and the accounting practices used within an organisation
LO2.6
be able to explain the role of, and logic behind, the four-step accountability model introduced within this chapter
LO2.7
understand the influence of organisational objectives on accounting practices
LO2.3
be able to explain the meaning of ‘stakeholders’
LO2.8
LO2.4
understand that there can be various perceptions of the responsibilities of an organisation, and be aware of some of the factors that could influence these perceptions
understand the meaning of ‘corporate governance’, and understand some of the factors that influence the implementation of specific corporate governance practices.
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OPENING QUESTIONS Before reading this chapter, please consider how you would answer the following five questions. We will return to these questions at the end of the chapter, where we suggest some answers. 1 What does ‘accountability’ mean? 2 How do perceptions of organisational responsibility influence perceptions of organisational accountability? 3 How, if at all, is the practice of ‘accounting’ related to perceptions of accountability? 4 If we were to develop a model of ‘organisational accountability’, and if it was to have four sequential steps, what might these steps be? 5 Is there a relationship between an organisation’s corporate governance policies and the managers’ perceptions about organisational responsibility and accountability?
Introduction In Chapter 1, we provided an overview of various theories of accounting and noted that the theories which accounting researchers choose to use, or to develop, will be influenced by their own views about various issues, such as their perceptions about: • what constitutes ‘good’ theory, including views about the ‘role’ of theory (for example, is the role of theory to predict or explain practices, or is it to prescribe particular practice?) • how ‘knowledge’ within particular research domains develops across time • what motivates people to undertake certain actions, including selecting particular accounting methods • how, and why, people will react to particular accounting information or disclosures • whether ‘power’ is shared equally throughout society, or whether some particular sections of society hold the power (in which case, accounting theory might be used as a means to demonstrate the partisan role that accounting practices might play in advancing the interests of some members of society, at the expense of others) • whether there is an objective or shared reality ‘out there’ that we can all see and interpret equally, or whether we see and interpret organisations and their activities differently (this has implications for whether we believe theory is generalisable to different settings) • the roles and responsibilities of organisations within society (for example, there will be alternative views about organisational responsibilities in terms of to whom they owe a responsibility and for what aspects of performance they are responsible). Just as views about the various issues or factors described above will influence theory development and selection (from among competing theories), this chapter discusses how such factors also influence the practice of ‘accounting’ utilised within different organisations and societies. For example, perceptions of organisational responsibilities and associated accountabilities will influence the ‘accounting we do’ and, for people teaching ‘accounting’, the forms of accounting we elect to teach our students. As an illustration of this, if managers hold the belief that an organisation has a responsibility and an associated accountability to various stakeholder groups, including future generations, the ‘environment’ or workers across supply chains, then the ‘accounting’ that is undertaken will likely include such issues as accounting for contributions to climate change (carbon emissions), waste generation, impacts upon important areas of biodiversity, support of disadvantaged groups, support of workers throughout supply chains and so forth. By contrast, if managers do not hold such a belief, then they might not think it is important to generate accounts that 44
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address, and therefore help to manage and control, issues such as an organisation’s actions to reduce its contributions to climate change or impacts upon important areas of biodiversity. Similarly, as accounting educators, if we believe that organisations have a responsibility, and an associated accountability, to future generations then we might be more inclined to embed aspects of sustainability throughout an accounting curriculum relative to an accounting educator who held the view that managers’ responsibilities are restricted to ensuring that profitability, and organisational value, is maximised primarily for the benefits of owners and shareholders. This chapter also introduces a ‘four-step accountability model’ and links it to issues associated with organisational responsibility, accountability and accounting. The four sequential steps we explore by way of this accountability model are: 1 Why does an organisation report particular information? 2 To whom shall it report the information? 3 What information shall it report? 4 How shall it report? We apply this four-step accountability model in different chapters of this book. For example, in Chapter 10 we apply it when exploring and explaining the practice of social and environmental (and sustainability) reporting. In this chapter, we also discuss corporate governance. We explain how the systems of corporate governance in place within an organisation, including various accounting systems, will also be influenced by perceptions about the responsibilities and accountabilities of an organisation. We explore the linkage between guiding principles, such as corporate mission statements, and corporate governance mechanisms and emphasise that a ‘one-size-fits-all’ approach to corporate governance (and ‘accounting’) is not appropriate across all organisations. Applying the material learned within this chapter, consideration is also given to what is commonly referred to as the ‘materiality determination process’, wherein the accounting information provided by an organisation to its stakeholders is determined through a process which engages particular stakeholders in order to determine what aspects of ‘organisational performance’ those stakeholders believe is important and about which they wish to be informed.
REFLECTION QUESTION 2.1 Why are there differences in the types, or focus, of accounting practices being taught by different ‘accounting educators’? Question If we review the accounting courses being taught across different universities, we will find that some schools of accounting incorporate various issues to do with sustainability and sustainable development across various accountingrelated subjects, whereas other schools provide very little, or no, coverage of such issues. Why might this difference between educators exist? Solution As we shall learn in this chapter, and throughout this book, there will be different views about the responsibilities and accountabilities of managers and their organisations. These views influence judgements made about what types of ‘accounting’ organisations should practise. Those educators who believe that organisations have accountability for their financial, social and environmental
performance would tend to be more likely to embed sustainability-related considerations throughout an accounting curriculum. By contrast, for those cases where there is little or no coverage of issues associated with accounting for sustainability, such educators must presumably believe that managers have limited responsibility and accountability for issues of performance beyond simply financial performance. This would represent a very narrow view of organisational responsibility and accountability. Another point is that many accounting programs teach particular topics because this is what has traditionally been done in years gone by (effectively the course contents become institutionalised). Such a fixation does not respond to changing community needs and expectations.
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The relationship between ‘accounting’ and ‘accountability’ LO2.1
Accounting A process of collecting, summarising, analysing and communicating information to enable users of that information to make informed decisions. It can involve the provision of information to stakeholders about aspects of the organisation’s social, environmental and economic performance.
Accounts Written records detailing an organisation’s performance in relation to a specific aspect of performance.
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LO2.2
Given that this is a book relating to accounting theory, we cannot ignore the broader issue of accountability. As we shall explain, there is a direct relationship between ‘accounting’ and ‘accountability’, but for our purposes, the significant questions are: • what is ‘accounting’ • what is ‘accountability’? Broadly speaking, ‘accounting’ can be defined as: a process of collecting, summarising, analysing and communicating information to enable users of that information to make informed decisions. It involves the provision of information about aspects of the performance of an entity to a particular group of people with an interest, or stake, in the organisation – we can call these parties stakeholders. (Deegan, 2023, p. 3)
This definition of ‘accounting’ is purposely broad. The intention is to emphasise that accounting-related reports (‘accounts’) do not need to be presented in quantitative or financial terms. An account can be descriptive in nature (for example, an ‘account’ of the forms or types of mechanisms that have been put in place to ensure that employees have a safe and healthy work environment). But what ‘aspects of performance’ should ‘accounting’ address and what ‘accounts’ are stakeholders entitled to? These are important questions which necessitate some form of professional judgement, perhaps based on some underlying theoretical framework or philosophical perspective. The nature of the ‘accounts’ being produced by an organisation, and the individuals or groups who will be given access to those accounts (or reports), will be influenced by managers’ judgements about an organisation’s responsibilities and its associated accountabilities. For example, if we were to embrace a view that an organisation was only responsible primarily for its financial performance and that the responsibilities for such performance were restricted simply to owners (shareholders) and loan providers, then such an organisation might decide to only produce financial accounts, and those accounts would only be distributed to owners and lenders. This would be considered as a very restricted, or narrow, view of ‘accountability’. By contrast, if an organisation’s managers believed that they also had a responsibility for the organisation’s social and environmental performance and impacts, and that this responsibility is extended to all affected stakeholders, then such an organisation would also produce various social and environmental accounts (as well as financial accounts) and would generally allow broad access to such accounts (for example, it might make the financial, social and environmental performance information publicly available on its website). This would represent a broader view of ‘accountability’. For example, some clothing companies collect and disclose detailed information about the sources of their clothes and what actions are being taken to ensure that the factories supplying garments are providing a safe and healthy environment for the employees, and this could be in the absence of any regulation requiring them to provide such accounts (see Figure 2.1). By contrast, other clothing companies disclose very little information. The managers of the organisations disclosing the detailed information (that is, those managers providing an ‘account’) would likely be embracing the view that it is their responsibility to be accountable for the health and safety of employees in their supply chain, whereas the managers of other organisations might not accept such a responsibility and hence might disclose little information. As another example, two or three decades ago it would have been very unusual for an organisation to collect and publicly disclose information about its emissions of greenhouse gases (which are known to contribute to climate change; see Figure 2.2). However, as global concerns have increased about climate change, it is now quite common for organisations – particularly
Accountability and its link to responsibility and accounting CHAPTER 2
FIGURE 2.1 If a large multinational company is buying some of its products from this factory, then should that multinational company provide publicly available accounts about how the employees are treated within the factory?
Source: Shutterstock.com/thomas koch
FIGURE 2.2 Who is accountable for these emissions and what sorts of ‘accounts’ should they provide to the public?
Source: Shutterstock.com/dugdax
large organisations in carbon-intensive industries – to publicly disclose information about their emissions, as well as information about the initiatives being undertaken to reduce these emissions. We consider issues associated with accounting for climate change in Chapter 10 when we look at various reporting frameworks relating to accounting for non-financial aspects of performance. Therefore, when it comes to what ‘accounts’ will be, or should be, prepared, it really is a matter of opinion and often there is no single correct answer. It is what we refer to as a normative judgement (a ‘normative judgement’ being a value judgement about whether a choice, activity or situation is desirable or otherwise, and it is a judgement that reflects what a person believes should, or ought to, be – it represents a person’s preferred ‘norm’). Nevertheless, there is a direct relationship between the responsibilities (or duties) the managers of an organisation believe the organisation has and the accepted accountabilities. The argument is that if managers of an organisation accept a responsibility to particular stakeholders for certain 47
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aspects of performance, then the managers accept that those stakeholders have a right to information about those aspects of the organisation’s performance. That is, they have a right to be provided with ‘accounts’ about various aspects of an organisation’s performance. This is diagrammatically represented in Figure 2.3. FIGURE 2.3 The relationship between responsibility, accountability and accounts Views about organisational responsibilities
Views about organisational accountabilities
Decisions about what accounts to prepare
Why do I need to know about the relationship between accounting and accountability? The argument we adopt in this book is that accounting does not exist in the absence of considerations of ‘accountability’. In simple terms, organisations (and even us individually) will provide an ‘account’ (through the process of ‘accounting’) of those things for which managers believe they are, or for which others (society, legislators, non-government organisations, powerful stakeholders) believe them to be, accountable. Understanding actual or prescribed practices of accounting (and related theories) will necessarily require us to consider what perceived or required accountabilities (and responsibilities) are linked to the particular requirements or prescriptions. In a book that addresses accounting theory, we need to consider accountability, as many of the different theories being addressed either explicitly or implicitly will have some underlying assumptions about the responsibilities and accountabilities of managers and their organisations. Indeed, the type of research
LO2.1
Accountability The duty to provide an account of those actions for which an organisation is deemed to be responsible. The accounts can take a variety of forms and would be provided to those stakeholders most affected by the activities of the organisation.
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LO2.2
that accounting academics individually do will, in some way, be linked to assumptions or judgements they personally make about the role of accounting, and organisations, in society. The relationship is important as it helps us understand why managers of some organisations might report particular information, whereas others might not. The absence of particular accounts being reported potentially indicates to us that the managers in question do not believe they have an ‘accountability’ for particular aspects of performance. This could be due to a belief by managers that they have no ‘responsibility’ with respect to particular aspects of social and environmental performance. Knowing this relationship between responsibilities, accountabilities and accounting allows us to understand the context of particular corporate disclosures and accounting practices.
What do we mean by accountability?
As is becoming clear, we will not all share the same views about the ‘responsibilities’ and ‘accountabilities’ of organisations, and therefore we will not all share the same views about the role of ‘accounting’. For example, we might not share the same opinion about to whom an organisation is responsible and accountable (that is, who are the stakeholders?), or for what aspects of performance the organisation is accountable. This discussion leads us to a definition of accountability, a useful definition of which is provided by Gray, Adams and Owen (2014, p. 50). They define accountability as: The duty to provide an account or reckoning of those actions for which one is held responsible.
We can see in this definition – which has been widely embraced within the accounting literature – that there is a direct linkage between perceptions of responsibilities, or duties, and the provision of ‘accounts’, as reflected in Figure 2.3. Gray, Adams and Owen (2014) emphasise that ‘accountability’ involves two key responsibilities or duties, these duties being: 1 to undertake certain actions (or to refrain from taking actions) in accordance with the expectations of a group of stakeholders 2 to provide a reckoning, or account, of those actions to the stakeholders. Gray, Adams and Owen (2014) also emphasise that the accounts being prepared do not have to be presented in financial terms (although they often are). So, for example, if a clothing company is acquiring
Accountability and its link to responsibility and accounting CHAPTER 2
its clothes from a supplier in a developing country, such as Bangladesh, and if its managers accept a responsibility for ensuring that the supplier provides a safe and healthy environment for its employees, then the clothing company would (or should) provide ‘accounts’ that would disclose information about how it is ensuring that the factories are safe and healthy environments for employees. These ‘accounts’ might provide information about working hours, employee training in terms of health and safety, as well as information about checks, or audits, of the safety of the buildings being used by the suppliers. There might be no financial numbers within such an ‘account’, but it would still be considered to constitute part of the organisation’s ‘accounting’.
REFLECTION QUESTION 2.2 The subjective nature of views about ‘responsibilities’ Question Do you think that an organisation in a developed country has a responsibility to ensure that workers across its supply chain (and the supply chain comprises the network between an organisation and its suppliers and customers, as necessary to produce and distribute a particular good or service) are treated in a way that is fair and equitable? Solution The point to be made here is that there is no standard answer to such a question. We will have different opinions about this. It is a normative question. We would hope that most managers will believe the organisation does have
this responsibility, but this will not be the case for all managers. In part, this is why regulatory requirements like Modern Slavery Acts were introduced in various countries. These Acts legally require certain organisations (typically larger organisations) to explicitly consider the treatment of workers within their supply chains, rather than leaving it to managers’ discretion. Modern Slavery Acts are considered in Chapter 10. If managers do accept a responsibility for a particular aspect of their performance, then ultimately this will influence the ‘accounts’ they elect to provide to stakeholders about the organisation’s operations.
We can also consider some other definitions of ‘accountability’. For example: The concept of accountability is a pervasive one … The notions underlying it are those of accounting for, reporting on, explaining and justifying activities, and accepting responsibility for the outcomes. Accountability involves an obligation to answer for one’s decisions and actions when authority to act on behalf of one party (the principal) is transferred to another (the agent)… Accountability requires openness, transparency and the provision of information, and the acceptance of responsibility for one’s actions. (Barton, 2006, p. 257) Accountability is the state of acknowledging, assuming responsibility for, and being transparent about the impacts of an organisation’s policies, decisions, actions, products, services and associated performance. When an organisation holds itself fully accountable, it seeks to involve stakeholders in identifying, understanding and responding to material sustainability topics and concerns, and to communicate with and be responsive to stakeholders regarding one’s decisions, actions and performance. (AccountAbility, 2018, p. 12) The obligation of an individual or organization to account for its activities, accept responsibility for them, and to disclose the results in a transparent manner. (Dictionary. com, 2022) Accountability, as we use the term, implies that some actors have the right to hold other actors to a set of standards, to judge whether they have fulfilled their responsibilities in light of these standards, and to impose sanctions if they determine that these responsibilities have not been met. (Grant and Keohane, 2005, p. 29) 49
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In essence, accountability is an obligation to present an account of, and answer for, the execution of responsibilities to those who entrusted those responsibilities. (Gray and Jenkins, 1993, p. 55)
As with the definition of accountability provided by Gray et al. (2014), the above definitions all link an organisation’s responsibilities with the obligation to provide information about the organisation’s performance and its adherence to the expectations of certain others. Reviewing all of the above definitions, we can again see that definitions of accountability, even though quite similar in nature, depend on subjective perceptions of the extent of an organisation’s responsibility. Again, we stress that individually we will have different beliefs about organisational responsibilities and therefore individually we will have some differences of opinion about the accountability of organisations and about the ‘accounts’ the managers of an organisation should prepare.
REFLECTION QUESTION 2.3 Can we have ‘accounting’ without ‘accountability’? Question Does ‘accounting’ exist in the absence of any form or consideration of ‘accountability’? Solution The function, or process, of accounting ultimately leads to the generation of ‘accounts’ for use by particular stakeholders. The accounts that are produced will ultimately be linked to perceptions held by the managers about the responsibilities of the organisation in terms of to whom the organisation is responsible and for what aspects of performance it
is responsible. That is, the forms of ‘accounting’ that are practised within an organisation are very much linked to perceptions about the responsibilities and associated accountabilities of the organisation. Therefore, ‘accounting’ is directly linked to accountability, and accounting within organisations really cannot logically exist in the absence of some considerations, explicitly or implicitly, of the accountability of managers and their organisations.
REFLECTION QUESTION 2.4 The relevance of ‘accountability’ to accounting education Question Despite the linkage between ‘accounting’ and ‘accountability’, as described above, many accounting programs currently being taught within universities and colleges fail to explore the concept of ‘accountability’. Why do you think that many accounting education programs ignore an in-depth exploration of ‘accountability’? Solution The reality is that many accounting programs taught within universities and other places of education spend very little time actually exploring issues of ‘accountability’. In particular, many accounting programs do not explore in depth how considerations of organisational responsibility (including issues associated with to whom an organisation is responsible and for what aspects of performance the organisation is responsible) ultimately impact accounting practice. In large part, this is probably because some
50
accounting educators tend to focus on accounting as a ‘technical process’ rather than accounting as a ‘social practice’. As this entire book demonstrates, accounting is both a technical and social practice. The broader our perceptions of organisational responsibilities and accountabilities, then the broader the forms of accounting that will be undertaken. Logically, we cannot have ‘accounting’ without ‘accountability’, and therefore it is logical for an accounting educational program to commence with an in-depth consideration of the responsibilities and accountabilities of organisations, as this will then provide the necessary foundation for explaining why different forms of accounting (perhaps broadly classified into different forms of financial, social and environmental accounting) will be explored within the respective accounting program. Conversely, it makes little sense to ignore such issues.
Accountability and its link to responsibility and accounting CHAPTER 2
So, what are the responsibilities of organisations? LO2.4
Consideration of the responsibilities of organisations is a normative issue. As we now know, definitions of accountability typically link accountability to responsibilities. In this regard, there are many contrasting views about the responsibilities of organisations, and hence there will be different views about the accounting practices that organisations should implement. At one extreme are the views of the famous economist Milton Friedman. In his widely cited book entitled Capitalism and Freedom, Friedman rejects the view that corporate managers have any moral obligations or responsibilities. He notes (1962, p. 133) that such a view: shows a fundamental misconception of the character and nature of a free economy. In such an economy, there is one and only one social responsibility of business [and that is] to use its resources and engage in activities designed to increase its profits as long as it stays within the rules of the game, which is to say, engages in open and free competition, without deception or fraud.
Divergent views on the responsibilities of business are nothing new and it is not likely there will ever be agreement on how far, and to whom, the social responsibilities of an organisation should extend. Reflective of this, in an Australian report by the Corporations and Markets Advisory Committee (2006), it was stated (p. 19): In a famous debate in the 1930s, Professor Adolf Berle, in supporting the ‘shareholder primacy’ view, argued that the powers and duties given to directors of a corporation should be exercisable only for the benefit of, and to maximise the profits for, the shareholders, given that they are the investors who have put their capital at risk, and that the directors should be answerable only to them. Any attempt to broaden these responsibilities to persons other than shareholders may result in directors having no legally enforceable responsibilities to anyone. In reply, Professor Merrick Dodd argued that larger corporations owe duties to the broader community, not just shareholders, and that directors should have greater leeway to take non-shareholder interests into account. An argument in support was that, as the act of incorporation confers significant privileges (including perpetual succession and limited liability), society is entitled to expect that a corporation will act in the general public interest, not just out of self-interest.
Consistent with the views of Dodd, Mathews (1993, p. 26) also states: Society (as a collection of individuals) provides corporations with their legal standing and attributes and the authority to own and use natural resources and to hire employees. Organisations draw on community resources and output both goods and services and waste products in the general environment. The organisation has no inherent rights to these benefits and, in order to allow their existence, society would expect the benefits to exceed the costs to society.
Anita Roddick, founder of The Body Shop, made the following statement in the introduction to her book Business as Unusual: The Journey of Anita Roddick and The Body Shop (2007): In terms of power and influence, you can forget the church, forget politics. There is no more powerful institution in society than business, which is why I believe it is now more important than ever before for business to assume a moral leadership. The business of business should not be about money, it should be about responsibility. It should be about public good, not private greed. 51
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Applying the thoughts of Dodd, Mathews and Roddick, the corporation receives its permission to operate from society, and is ultimately accountable to society for how it operates and what it does (see also Benston, 1982). As societies’ expectations change, we would expect accounting practices to evolve and change. This contrasts with the views of Friedman and Berle, and perhaps also contrasts with the views of many current corporate managers, who often seem to prioritise financial performance above other aspects of organisational performance. Again, we must appreciate the link between perceived corporate responsibilities and associated accountabilities, as reflected in Figure 2.3 earlier in the chapter. If an entity is not considered to have a responsibility in relation to a particular aspect of its performance, it would not be expected to provide an ‘account’ of that performance. Because different teams of managers will have different views about corporate social responsibilities and associated accountabilities, they will inevitably provide different sets of ‘accounts’.
REFLECTION QUESTION 2.5 Friedman’s perspective of corporate responsibilities Questions 1 Do you agree with the views of Friedman as provided in the material above? 2 If somebody did agree with Friedman’s perspectives of corporate responsibilities, then do you think they would be likely to be supportive of their organisation collecting and disclosing information about its social and environmental performance? Solution 1 Answers will vary. Many corporate managers seem to agree with Milton Friedman given that they seem to highly prioritise financial performance and the rights of investors over and above other aspects of performance and other stakeholders. But there are also many managers who have broader views of corporate responsibilities. While this text advocates a broader view of corporate responsibilities than Friedman, this is ultimately the individual’s choice.
LO2.3
2 If you were to agree with Friedman then, in general, you would not be in favour of collecting and disclosing information about social and environmental performance, unless you were of the opinion that such disclosure would ultimately lead to financial benefits that favour the investors. Managers that embrace the views of Friedman would not be responsive to the concerns of those stakeholders who do not have the power to influence the successful operations of the organisation. As noted above, to be accountable in a broader sense, requires managers to provide information to people that are significantly impacted by an organisation’s operations, regardless of their power. It also requires the managers to be responsive to the legitimate concerns of all stakeholders. That is, to accept that if the evidence (the ‘accounts’) shows that the organisation has not performed in accordance with stakeholder expectations, then to accept a responsibility to amend behaviour accordingly.
Who are the ‘stakeholders’ of an organisation?
We have mentioned the word ‘stakeholder’ a number of times already – but what is a stakeholder? Individually, we will have different views about who are the ‘stakeholders’ of an organisation. That is, we will have different views about ‘to whom’ an organisation is responsible and accountable. Taking a broader perspective on the responsibilities of business, an entity’s stakeholders have been defined by Freeman and Reed (1983, p. 91) as: any identifiable group or individual who can affect the achievement of an organisation’s objectives, or is affected by the achievement of an organisation’s objectives. (emphasis added)
Later in this book (Chapter 9), we consider a group of theories known as stakeholder theories. As we will see, there are two broad branches to these stakeholder theories. One branch, which we might refer to as the managerial branch of Stakeholder Theory, predicts which stakeholders an organisation will respond to on the basis of which stakeholders
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have command over resources that are necessary to the functioning of the organisation. Broadly speaking, those stakeholders with control of resources necessary to the organisation’s survival and success (which gives these stakeholders relative ‘power’) will be more likely to have their requirements or expectations met by the managers relative to stakeholders without access or control over necessary resources (relatively low power stakeholders). In such an environment, these would be the stakeholders that are prioritised by management (which coincides with the first part of the definition of ‘stakeholders’ provided by Freeman and Reed above – that is, a stakeholder is ‘any identifiable group or individual who can affect the achievement of an organisation’s objectives’). The other branch of Stakeholder Theory that we explore in Chapter 9, which we might refer to as the ethical or moral branch (also sometimes referred to as the normative branch) of Stakeholder Theory, provides arguments, based upon particular ethical beliefs, that all stakeholders who are impacted by the operations of an organisation have a right to be heard, and to have a voice in the functioning of an organisation (which coincides with the second part of the definition of ‘stakeholders’ provided by Freeman and Reed above – that is, a stakeholder is any identifiable group or individual who ‘is affected by the achievement of an organisation’s objectives’). They would also have rights to information (and therefore to ‘accounts’). If we accept that an organisation has a responsibility to provide information to its ‘stakeholders’, then the more broadly an organisation defines its ‘stakeholders’, the greater the responsibilities and associated accountabilities it will tend to accept. As perceptions of accountabilities become broader, the practice of ‘accounting’ will also expand to focus on a broader group of stakeholders, with a corresponding increase in the types of impacts that will be accounted for. That is, the practice of accounting will correspondingly become broader as perceptions of accountability become broader. Many organisations explicitly identify their stakeholders and provide information on how they engage with them. For example, on the website of BHP Ltd – the world’s largest mining company – BHP (2022) notes that it identifies its stakeholders as: • Industry peers and associations; • Shareholders; • Investment community; • Employees; • Labour unions • Local communities; • Indigenous peoples; • Media; • Non-government organisations and civil society • Host governments • Society partners; • Suppliers; and • Customers. BHP also provides details about how it engages with each of the above stakeholder groups, and about what aspects of BHP’s performance each stakeholder group seemed to prioritise. The determination about who are the stakeholders of an organisation also has implications for any attempt to assess the apparent ‘decision usefulness’ of the information/accounts being generated by an organisation. As we explain in Chapter 7, decisions as to what is useful information (that is, information that is useful for helping people make informed decisions) are generally considered to have two fundamental qualitative characteristics, these being: 1 relevance 2 reliability (or ‘representational faithfulness’).
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Information that is ‘relevant’ to some stakeholders will not be relevant to others, and vice versa. That is, different stakeholders will have different information needs or demands. As we further discuss within Chapter 7, information is deemed to be relevant if it has the potential to change the decisions being made by the readers of the information. Information about an organisation’s financial performance will be more relevant to some stakeholders (for example, investors, potential investors, lenders, creditors and employees) in making various decisions (such as whether to invest in an organisation or to loan the organisation some funds), whereas information about an organisation’s social and environmental performance might be relatively more relevant to other stakeholders (for example, consumers, local communities, labour unions and environmental groups might all use such information when determining whether, and how, they might support, or oppose, an organisation). Therefore, the point to be made here is that we should not assess the relevance, and relatedly the decision usefulness, of information without a consideration of who is the audience of the accounts (the stakeholders), what are their information requirements, and what is their expertise and knowledge in relation to the particular form of reporting. Hence, when any reporting framework – for example, the IASB Conceptual Framework for Financial Reporting, the Global Reporting Initiative Sustainability Reporting Standards or the framework of the International Sustainability Standards Board – provides guidance about the qualitative characteristics that useful information shall possess, it necessarily needs to make judgements about the intended audience of the reports, what are their broad information needs, and what is their assumed knowledge and expertise in relation to understanding the related information. At the core of these judgements is the belief that a ‘one-size-fits-all’ approach to formulating accounting practice is inappropriate. Different organisations will have different stakeholders with potentially different characteristics, and these stakeholders will likely have different information needs and expectations.
Why do I need to know the relationship between stakeholder identification and accounting practice? As is clear by now, to understand why the managers and accountants of an organisation produce particular information, we need to understand who they perceive to be the organisation’s stakeholders. The determination of who are the ‘stakeholders’ will be directly linked to the perceived responsibilities the managers believe they have, and this will in turn influence managers’ perceptions of accountabilities and explain why certain accounts are being produced. Knowing who the stakeholders are provides context to why certain accounting choices have been made.
From a practical perspective, once the stakeholders of an organisation are identified this then helps us to determine, or understand, with whom to engage and what types of information to provide to satisfy the stakeholders’ needs. Assumptions about stakeholder knowledge and expertise with respect to using particular information can also then be more reliably framed.
Why might we all have different perceptions of organisational responsibilities, and therefore of organisational accountability? LO2.2
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As Gray et al. (1997, p. 334) assert, the nature of the responsibility-driven accountability relationship between managers and stakeholders, and the stakeholders’ expectation and rights to information, will be contextually determined by the society in which the relationship occurs. That is, different societies will tend to have different perceptions about the responsibilities and accountabilities of organisations. Within societies, there will also be differences of opinion between managers about the accountabilities of organisations and about the need for particular accounting practices.
Accountability and its link to responsibility and accounting CHAPTER 2
In various chapters of this book, we explore theories that explain differences in accounting practices. For example: • In Chapter 4, we discuss the regulation of accounting and explore how different societies and different individuals have different perceptions about the role of regulation, and the role of government, in relation to the regulation of accounting practice. We show that this has implications for accounting practice, and for the accountability required of managers and their organisations. • In Chapter 5, we explore international differences in accounting practice and consider research that explains international differences in accounting practice by linking it back to differences globally in ‘culture’. As discussed within Chapter 5, relative to other cultures, some cultures are more: – individualistic – inclined to seek to avoid uncertainty – ‘masculine’ (or more ‘feminine’) – disposed towards allowing professions to self-regulate accounting practice rather than having statutory control of accounting practice, and this has implications for the accountability of organisations – conservative (or optimistic) – accepting of secrecy than transparency. All these cultural differences can, through theory, be linked to differences in perceptions of organisational accountability, and to differences in beliefs about the accounting practices that are appropriate within a particular cultural setting. Such research further emphasises the point that globally a ‘one-size-fits-all’ approach to accounting is not appropriate. This has implications for the appropriateness of having globally standardised accounting standards, such as the International Financial Reporting Standards (IFRS) of the International Accounting Standards Board (IASB). These accounting standards have been adopted in most countries (with the exception of the United States). • Chapter 7 discusses various normative theories of accounting that prescribe how accounting (in particular, financial accounting) should be undertaken. The prescriptions are based on the respective researchers’ beliefs about the responsibilities of organisations and what information is best in allowing an organisation to demonstrate accountability. • Chapter 8 introduces Agency Theory and further explores Positive Accounting Theory. Such theories were developed by researchers who believed that the role of accounting is to provide information to motivate/control managers in a way that encourages them to work in the interests of owners/shareholders. Such theorists typically fail to consider social and environmental responsibilities. Rather, they focus on responsibilities and accounting practices linked to maximising financial performance, and organisational value, and they tend to prioritise financial accounting above social and environmental accounting. • In Chapter 9, we consider a number of theories. We consider Legitimacy Theory, which directly links the reporting behaviour of organisations to quests to maintain the ‘legitimacy’ of the organisation. This theory suggests that managers’ reporting decisions are really not about ‘accountability’ or ‘responsibility’, but, rather, are about supporting the survival of the organisation (and its managers). Accounting disclosures are linked to efforts to create, maintain or restore corporate legitimacy. We also consider different versions of Stakeholder Theory. As we have already indicated, one branch suggests that the generation of particular ‘accounts’ is more about controlling or managing powerful stakeholders rather than about demonstrating accountability. Another branch of Stakeholder Theory is linked to notions of accountability and prescribes that managers owe a duty of accountability to those parties (stakeholders) that are impacted by the operations of the organisation. Chapter 9 also explores Institutional Theory, which explains how various factors within an ‘institutional environment’ influence the accounts being prepared by the managers of an organisation. 55
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• Chapter 11 explores capital market research. Capital market researchers tend to prioritise
the interests of investors and evaluate the usefulness of particular disclosures on the basis of whether the accounting disclosures create a change in share price. Where a disclosure fails to impact share price, the view typically embraced by such researchers is that the information does not have value. Such research ignores the needs and expectations of a broader group of stakeholders beyond capital market participants. • Chapter 13 explores various critical theories of accounting. These theories typically project the view that accounting practices act to subvert the interests of many people in society, in particular, those members of society who do not have control over financial capital. Other research in the accounting literature, some of which we discuss in different chapters of this book, also addresses how managers’ perceptions of organisational responsibility and accountability will be influenced by a variety of factors, as shown in Figure 2.4. FIGURE 2.4 Managers’ perceptions of accountability can be influenced by a variety of factors Cultural background Family, friends and so forth
Professional groups with which they are associated
Social and sporting clubs with which they are associated
Religion
Gender Manager’s perceptions of organisational responsibility and accountability
The type of education they have received
Where they received their education
Previous workplaces Prior professional experience
Perceptions of organisational accountability will change over time Societal expectations change across time in relation to many issues. If society’s, or stakeholders’, views about organisational responsibilities change across time, then, consistent with the discussion already provided within this chapter, we would expect the related views about organisational accountability to change. This would then have implications for changing accounting practice across time – something that is very evident in any historical review of accounting practices. In our discussion of Legitimacy Theory in Chapter 9, we explain how society’s expectations influence accounting practice. As Deegan (2019, p. 2315) states: Legitimacy Theory – as typically applied within the social and environmental accounting literature – adopts a central assumption that the maintenance of successful organisational operations requires managers to ensure that their organisation appears to be operating in conformance with community expectations, and therefore is attributed the status of being ‘legitimate’. Within Legitimacy Theory, organisations are viewed as being part of
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a broader social system and are not considered to have any inherent right to resources. Rather, a right to resources must be ‘earned’ (Mathews, 1997) and it is ‘legitimate organisations’ that are able to sustain their access (or ‘rights’) to needed resources.
Deegan (2019, p. 2315) further notes that for organisations to be judged as ‘legitimate’, they need to comply with the social contract in place between the organisation and society. Specifically: Legitimacy as explained within Legitimacy Theory is often linked to the idea of a ‘social contract’ (Patten, 1992; Deegan and Rankin, 1996; Adler et al., 2018) wherein the social contract represents the multitude of implicit and explicit expectations that society has about how an organisation should conduct its operations. The legitimacy of an organisation is considered likely to be challenged when an organisation does not comply with the terms of the ‘social contract’, and therefore with the expectations of the society in which it operates (creating what is referred to as a ‘legitimacy gap’).
Deegan further notes: Where departures from the social contract (society’s expectations) occur then it is predicted within Legitimacy Theory (and consistent with the strategic focus embraced by Legitimacy Theorists), that managers will then be motivated to strategically take corrective actions, with disclosure being central to such actions. Corporate disclosures and the production of ‘accounts’ are seen as an integral part of the suite of available managerial strategies to manage, or manipulate, relationships with ‘society’. (p. 2315)
Because what is deemed to be ‘legitimate’ behaviour changes across time, the argument embraced by Legitimacy Theorists is that accounting practices will change. For example, some years ago, it was not generally considered that an organisation had a responsibility for employees in unrelated supply factories located within developing countries. As a result, it was very unusual to find that managers provided any accounts of health and safety of these factory workers. These days it is now generally considered within most societies that managers have a responsibility to ensure that those organisations supplying their products treat their workers properly. Accordingly, particularly for larger organisations, it is now common to find publicly available disclosures (accounts) of what the organisation is doing to ensure that they are acquiring their products from organisations that treat their employees equitably. As another example, as community concern about climate change has increased in recent decades, it has become more common for organisations to provide information about their carbon-related emissions and initiatives undertaken to alleviate the organisations’ ongoing contribution to climate change.
The influence of stakeholder power on corporate accountability LO2.5
Perhaps somewhat ideally, accountability should be demonstrated by the managers of an entity regardless of the power of particular stakeholders to enforce the organisation to accept such an accountability. That said, in the accounting literature, discussions of the ‘accountability relationship’ is often accompanied by a discussion of power as a determinant of accounting (Barton, 2006; Black, 2008; Gray et al., 1997; Mulgan, 2000). In such a context, power refers to the authority/ability of the particular stakeholders to demand or call for their rights to information to be actioned by managers. This raises the issue of whether the recipient actually has the power to enforce accountability, that is, the power to enforce any perceived rights to, or needs for, information. While some managers will provide information because they believe that stakeholders have a ‘right’ to information regardless of the power of the stakeholder, some managers will only provide information to stakeholders that have the power to enforce their rights/needs for information. 57
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Following on from the above argument, unless a stakeholder can effectively enforce an accountability-related disclosure, then from a practical or realistic perspective, no real accountability relationship might exist, and no real accountability can be expected to be demonstrated. Rather, disclosures may take the appearance of being generated from a perspective of responsibility, whereas in actuality they might be disclosed for the economic benefit of the respective power wielders (argument from Tricker, 1983, as quoted in Gray et al., 1997). A similar argument is articulated by Rubenstein (2007), who suggests that accountability is a ‘crucial tool for limiting constrained power’, and therefore ‘vital for democratic politics’ (Rubenstein, 2007, p. 631). However, she asserts that in many cases, some stakeholders are often too weak to enforce the accountability due to them. This may be due to their social or political exclusion, illiteracy, lack of awareness, remoteness and/or poverty. Rubenstein (2007) suggests the need for a ‘second-best’ form of accountability under conditions of power inequality, which offer as many of the benefits of standard accountability as possible – the idea of ‘surrogate accountability’. The concept of surrogate accountability, as suggested by Rubenstein (2007, p. 617), involves an actor – a surrogate – who substitutes for accountability holders [accountees] during one or more phases of the accountability process: setting standards, finding and interpreting information, and, most importantly, sanctioning the power wielder [accountor] if it fails to live up to the relevant standards.
As an example of a surrogate stakeholder, we can refer to a labour rights organisation which perhaps has the power to enforce the rights of workers within factories located within developing countries that might otherwise have no power to force employers to provide safe work environments or to demonstrate proper accountability. We return to the issue of surrogate accountability in Chapter 9. Now that we have some insights into the meaning of ‘accountability’, we can move to our four-step accountability model.
Why do I need to know that accountability, and therefore accounting practices, both change over time and are influenced by issues relating to stakeholder power? It is important that we understand that accounting practices evolve over time as various stakeholder and community expectations change. We need to appreciate that accounting practices that are appropriate, or relevant, at one point in time, might not be relevant at another point in time. This insight is important to accounting researchers as it might signal the need to continually engage stakeholders to determine whether existing accounting practices still satisfy the needs of stakeholders. Knowing that accounting practices are often influenced by powerful stakeholders is also important because it provides
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context to why some accounting methods might be used instead of others. If the accounts produced by an organisation are influenced by the demands of powerful stakeholders, then this might indicate a need to protect the rights and information needs of less powerful stakeholders. This has implications for whether calls should be made by researchers for some form of regulation to protect the information rights of less powerful stakeholders.
An accountability model
To this point, we have mentioned the idea of ‘accountability’ many times and we have explained how perceptions of accountability are influenced by managers’ perceptions of an organisation’s responsibilities. We now turn our attention to various assessments, or decisions, that need to be made as part of the process of accounting for, and reporting aspects of, an organisation’s performance. We consider four issues here, and also do so many times throughout this book as we study various aspects of accounting. These four issues, or questions, are: 58
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1 Why do the managers of an organisation decide to collect, and disclose, information (or
‘accounts’) about particular aspects of the organisation’s performance? 2 Who are the stakeholders to whom the disclosures (‘accounts’) will be directed? 3 What types of information will be collected, and what disclosures will be made to stakeholders
outside the organisation (that is, what are the information needs of various stakeholders)? 4 How should the information be disclosed (for example, what should be the format and media
of the disclosures/accounts)? Figure 2.5 reflects the sequential nature of our four-step accountability model and emphasises how each step then leads to the next – that is, the answers to the previous step (or question) inform the answer to the next step. FIGURE 2.5 A diagrammatic representation of the four-step accountability model
Why is the organisation collecting and reporting particular information?
To whom is the organisation reporting the information?
What information is it collecting and reporting?
How is it reporting the information? – where is the information appearing and what reporting frameworks are being used?
As we show in the following text, these four issues are usefully addressed at various times throughout the process of ‘accounting’. We now consider each of these steps in turn.
Why is an organisation collecting and disclosing
particular information? Issues associated with what motivates, or necessitates, managers to make particular disclosures are issues that many accounting researchers spend much of their career investigating. This first issue of data collection and subsequent reporting will be influenced by various factors. In deciding what information to collect, various factors might be considered by managers. Some of these factors are outlined in the following sections.
Legal requirements In many cases, managers will effectively have no choice about whether to collect and disclose particular information. Therefore, in terms of why they are reporting, they might simply be complying with legal requirements. For example, the disclosure of various items of information about an organisation’s financial performance is required by law (although not all aspects of financial performance are required to be disclosed by law). We consider theories of regulation in Chapter 4. 59
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They potentially forestall the imposition of reporting requirements Often, various interest groups within society, such as environmental groups or employee trade unions, will lobby government to put in place laws that require organisations to make particular disclosures. Evidence has shown that managers often understand that this lobbying might be happening and might decide to collect particular information, and to make certain public disclosures, in an effort to placate potentially powerful lobby groups and possibly forestall the likelihood that even more onerous disclosure or accounting regulations might be put in place by government. The argument is that if an organisation is making at least some disclosures in respect of certain aspects of performance then the likelihood that related disclosures might be mandated by government will be reduced, and this might explain why the organisation decides to prepare the particular accounts and disclose them publicly. We would consider such disclosure practices to be ‘opportunistic’. We consider the influence of managerial opportunism on accounting practices in Chapter 8.
Managers’ perceived responsibilities As discussed earlier in this chapter, managers might want to ensure that their operations do not adversely impact others. Such managers might voluntarily collect a variety of information about the organisation’s social, economic and environmental performance. As an example, if managers are particularly concerned about saving water because the organisation is operating in a populated environment with low water levels then the managers might put in place processes to measure water used in the various activities of the organisation with the intention of monitoring, controlling and reducing water usage. They might then disclose such information publicly because they have a belief that people outside the organisation have a right to know about how much water the organisation is using. By contrast, if managers in other organisations do not believe they have a responsibility to control their water use then they might elect not to collect, or publicly disclose, information about their water use. In this chapter, we have already considered how managers’ perceptions of responsibility impact accounting practice. We further consider this issue in Chapters 9 and 10.
Demands of powerful stakeholders As we explain in other chapters of this book, and in particular within our discussion of Stakeholder Theory in Chapter 9, organisations often collect and disclose information because certain powerful stakeholders want to know about particular aspects of their operations, and therefore collecting and disclosing some information is a means of ‘managing’ some powerful stakeholders. While it is common that organisations will only report information because powerful stakeholders want it (and if the powerful stakeholders are not provided with the information, they might withdraw valuable support from the organisation), ideally all stakeholders – regardless of their power – that are significantly impacted by the operations of an organisation will be provided with information to enable them to understand the impacts the organisation is creating and what initiatives the organisation is implementing to reduce the impacts.
To increase profits Related to the above point, at times it would appear that some managers elect to make disclosures primarily for purposes related to enhancing the financial position and financial performance of an organisation, rather than because they have a true belief that people have a right to know about particular aspects of organisational performance. What this means is that some managers are simply reactionary and will effectively ‘do the right thing’ because it will generate higher profits and not because they particularly believe they should be responsible, or accountable, for particular actions.
As a response to a crisis There is much available evidence that indicates that if the reputation, or legitimacy, of an organisation appears to be badly damaged, the organisation in question (and perhaps even other 60
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organisations within the same industry) will produce public ‘accounts’ of how seriously they are taking the matter and what initiatives they have put in place to help ensure such events will not reoccur in the future. Such disclosure would be considered to be responsive, or reactive, rather than being driven by real concerns about the need to be accountable and responsible (otherwise, why would they wait until the public raises their concerns before making disclosures?). Our discussion of Legitimacy Theory in Chapter 9 provides evidence of how particular crises have motivated managers to make particular disclosures. For example, some of the research embracing Legitimacy Theory has shown that when there has been a significant environmental incident that potentially damages the reputation, or legitimacy, of the organisation, then managers will often generate publicly available information which appears consistent with the aim of winning back support, and legitimacy, for the organisation. The disclosures that managers make might identify other positive aspects of their organisations’ performance, or the disclosures might be of the nature to assure stakeholders that modifications have been made to their organisations’ operations which ensure that similar crises will not recur. What the above discussion seeks to demonstrate is that it is not always an easy exercise to try to understand why some managers elect to make some disclosures, but not others. Some disclosures will be made because managers believe they have an underlying responsibility to inform various people about particular aspects of performance, whereas other managers might make disclosures simply because they think there are business benefits in doing so. That is, the broad objectives driving any particular organisation to generate particular ‘accounts’ for use by stakeholders external to the organisation can range from an ethically motivated desire to be accountable for the positive and negative impacts the organisation has on society and the natural environment, through to an economically focused motive to use reporting to protect, or enhance, profits and therefore owner and shareholder value. Another point to be made here is that before we read particular corporate disclosures, it is useful to try to understand why the disclosures were made in the first place. If a particular management team typically only makes disclosures when there are direct business benefits in doing so, then perhaps we would be right to question the extent to which we should rely upon such disclosures. By contrast, if an organisation seems to always have respected the rights of people to be informed about the various impacts of the organisation, then we might be more inclined to rely upon the organisation’s disclosures, particularly those disclosures that are being made voluntarily. The reason why an organisation has elected to provide particular accounts will have a direct consequence for the next question about ‘to whom’ those accounts are directed, as we now discuss.
To whom is the account information being directed? Once it is determined why an entity decides to report, this decision will in turn inform the decision as to whom the information will be directed. If an organisation’s reporting is motivated exclusively by managerial reasoning and ‘strategising’ (for example, it is primarily focused on increasing the wealth of the owners and/or managers), the stakeholders to whom that organisation’s reporting is directed might be narrowly defined as those who hold and exercise the greatest economic power, or influence, over the organisation and who have the greatest ability to influence the economic success of the organisation. Conversely, reporting motivated by ethical and moral reasoning will seek to address the information needs of a broader range of stakeholders. Specifically, a broader ‘ethical’ approach to reporting (providing ‘accounts’) would direct the reports and accounts towards those stakeholders most affected by the operations of the organisation, regardless of the economic or other power held by those stakeholders, and would focus on issues such as various stakeholders’ ‘rights-to-know’.
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What is being emphasised is that the question about to whom the reports or ‘accounts’ will be targeted will ultimately be dependent on managers’ views about organisational responsibilities and accountabilities, and hence dependent upon views held about the initial issue of why the organisation has decided to produce a report. That is, what motivated the organisation to make the disclosures in the first place? Again, views will vary from manager to manager. Ultimately, proper or ‘full’ accountability requires that all stakeholders, which includes those with and without power to influence the operations of an organisation, have the ability to hold more powerful people (such as the managers of large companies) to account for the impacts caused by their operations. Proper accountability requires managers to be responsive to legitimate concerns held by those parties who are impacted by the operations of the organisation and who seek information about organisational performance.
What information needs to be reported? Once the organisation has determined which stakeholders are the target recipients of the reports (the ‘accounts’) – that is, once it has addressed the first two steps of ‘why report’ and ‘to whom to report’ – it can then move to the next (third) step of considering the information demands of the identified stakeholders. That is, it can address the ‘what to report?’ question in terms of what types of information will be disclosed and what issues the ‘accounts’ should address. Identifying what aspects of performance that various stakeholders believe an entity should be held responsible for and accountable to involves dialogue (discussion) between the organisation and its identified target stakeholders (often referred to as a process of ‘stakeholder engagement’). However, the issue about who to engage will depend upon managers’ motivations for reporting. If managers are simply disclosing information to keep powerful stakeholders happy (and therefore to help bolster the value of the organisation) then they might only concentrate on providing the information that is demanded by powerful stakeholders – that is, those stakeholders that might impact the flow of resources into an organisation (such as investors, lenders and key customers). However, if managers are more concerned about being accountable to those stakeholders impacted the most by their operations, they would consider the nature of their various economic, social and environmental impacts and provide information to the most affected people about the nature of these impacts, and perhaps about what is being done to address, or mitigate, any negative impacts in the future. Various types of accounting research address issues associated with what information to report. For example: • In Chapter 7, we consider qualitative characteristics that information needs to satisfy for it to be ‘useful’ for decision making. These qualitative characteristics include relevance, reliability, comparability, verifiability, timeliness and understandability. Consideration of such qualitative characteristics arguably should be considered prior to the release of particular information. Such consideration requires attention to be directed to the stakeholders involved, their information needs and their knowledge with respect to understanding particular forms of information. • In Chapter 11, we explore capital markets research. Such research, which focuses on the information needs of investors, often evaluates the relevance of particular information on the basis of whether the disclosure of information creates a change in share price. If there is no change in share price following the release of particular information, then capital markets researchers would often argue that there is no ‘information content’ in the disclosure, and therefore the information is relatively irrelevant (at least from the perspective of capital market participants). • In Chapter 12, we consider behavioural research in accounting which explores how individuals react to particular accounting disclosures. If such research shows that particular information did not change individual decisions, then this might also be used as a basis for arguing that the information is not relevant. 62
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How should the information be disclosed? Once the managers of an organisation have determined the first three steps of the four-step accountability model, they will be in a position to answer the fourth question in the model: How should the information be disclosed (for example, what should be the format and media of the disclosures/accounts)? To understand how information should be disclosed, we need to determine if an appropriate reporting framework exists and where the related information should be disclosed. Different chapters of this book address various financial, social and environmental (and sustainability) reporting frameworks. If managers are providing information about the financial performance of a large company then they might elect to use IFRS issued by the IASB, or if they are providing information about social and environmental performance then they might use the framework provided by the Global Reporting Initiative or that developed by the International Integrated Reporting Council. If managers are particularly concerned about providing information about carbon emissions, then they might use the framework developed by Greenhouse Gas Protocol. Alternatively, if managers are concerned about providing information about their organisation’s water use, then they might use standards such as those developed within Australia by the Water Accounting Standards Board. We consider some of these reporting frameworks in other chapters of this book.
Where to disclose Apart from considering which reporting frameworks might be appropriate, we also need to consider where the information should be disclosed. For example, should it be provided on corporate websites? Should it be provided within reports mailed to stakeholders? Should it be provided by way of posters provided within particular buildings? There are indeed many choices with regards to the best media to make information, or ‘accounts’, available to interested stakeholders. Research can explore which media are more effective in reaching different stakeholder groups. As an example, if we are dealing with stakeholders with knowledge and access to the internet then it would be quite reasonable to supply the required accounting information on the organisation’s website. However, if the stakeholders were, for example, the employees working within factories in developing countries then it might be more appropriate to provide the information by way of posters on the factory wall or by way of printed documents made available within the factory. So, we can see that in this fourth step of our accountability model, there are many judgements to be made.
The normative nature of the four-step accountability model Each of the four steps in our four-step accountability model can represent a ‘departure point’ in opinion between various stakeholders, and this can ultimately lead to significant differences in expectations regarding the types of ‘accounts’ that particular entities should prepare, and therefore in the types or forms of ‘accounting’ that they should undertake. For example, and applying the above four steps, if a judgement (grounded in certain ‘values’) is made from a neo-classical economic perspective (for example, a ‘Friedmanite-type’ perspective) that ‘accounts’ of particular aspects of performance should be prepared only to the extent that the activity of preparing the accounts increases corporate profitability (the ‘why? ’ question), then the target audience of those reports might be those stakeholders who have the power to influence the economic value of the organisation (the ‘to whom?’ question) – for example, shareholders and providers of debt capital. In terms of what aspects of performance should be reflected in the ‘accounts’, in this scenario it would be likely that measures of economic/financial performance 63
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would be prioritised (the ‘what to report?’ question), and the information would be provided in financial reports by use of a financial reporting framework, such as those provided by the IASB or FASB (the final ‘how to report?’ question). By contrast, if a judgement is made that an organisation has a responsibility and associated accountability to a broader group of stakeholders in relation to economic, social and environmental performance (the ‘why?’ report issue), then the audience of the reports would tend to be those stakeholders that are most affected (economically and/or socially and/or environmentally) by the operations of the entity or that work/act in the interests of the affected stakeholders (for example, NGOs) (the ‘to whom?’ question). Issues of stakeholder power would not be particularly pertinent in this ‘view of the world’. Continuing this example, in terms of the aspects of performance that would be reported within the accounts (the ‘what to report?’ question), the information would tend to be prioritised in terms of the perceived (subjectively determined) importance of the various social, environmental and economic impacts. The information would be provided by virtue of frameworks beyond financial reporting, and which would enable (the ‘how to report?’ question) impacts to be reported in a way which promotes further dialogue and improvement in an organisation’s social and environmental performance. What is being demonstrated here is that although we are applying the same four-step accountability model in both scenarios, and therefore the same four broad ‘steps’ in our decision making, we can nevertheless arrive at very different normative prescriptions about how an organisation should ‘account’ for its operations as a result of the different ‘world views’ that we might possess. When we consider the different academics within different schools of accounting nationally and internationally – some schools being very ‘capital market’ focused, while others are more focused on broader stakeholder rights and organisational responsibilities – then this, in part, might explain why different schools of accounting teach and research different aspects of ‘accounting’ and, relatedly, why they might attempt to instil different values about organisational responsibilities within the minds of their students. To explain some of this discussion, and drawing on the earlier example, we again consider how two individuals might answer the four general accountability-related questions and how their answers would influence the ‘accounting’ they believe should be undertaken. In this regard, see Table 2.1. TABLE 2.1 An illustration of the application of an accountability model to different ‘world views’ Question
Individual 1 characteristics
Individual 2 characteristics
Somebody who believes in the efficiencies of the capital market and that maximising shareholder wealth is the central mission and responsibility of management (e.g. Milton Friedman)
Somebody who believes that an organisation has a responsibility to a diverse group of affected stakeholders and that this responsibility relates to economic, social and environmental performance
Why should an entity report/provide an account?
Would likely argue that an ‘account’ should be prepared to the extent that it increases the value of the organisation and therefore shareholder wealth
Would likely argue that an organisation has a responsibility or duty to provide an account of the various impacts it has on a diverse group of stakeholders
To whom is that account being primarily directed?
Those with power to influence the economic value of an organisation, and therefore the wealth of shareholders (and managers). A major focus would be to provide financial performance information to current and potential investors, lenders and creditors
Those stakeholders who are most impacted by the operations of an entity and therefore have a right-toknow about such impacts and efforts undertaken by management to reduce such impacts
What elements of performance should be accounted for?
Predominantly financial information that reflects organisational value and likely dividends to investors
A mixture of information about social, environmental and economic performance and impacts
How should the account be presented?
Typically, in a financial report using generally accepted financial reporting frameworks
By virtue of various forms of ‘accounts’ prepared using a variety of financial, social and environmental reporting frameworks
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Why do I need to know about the four-step accountability model? Knowing about the four-step accountability model allows us to appreciate the interrelated nature of the decisions involved in ultimately providing information to different stakeholders. Of course, some people might use alternative models, or steps, to explain managers’ decisions to report information,
but our model emphasises how particular decisions in the reporting process have implications for subsequent decisions. The model is logical and provides us with a framework to understand some quite interesting factors that influence organisational accountability.
The materiality determination process Organisations, particularly larger organisations, will disclose large amounts of information about their financial, social and environmental performance. Some of this information is disclosed because there is a legal requirement to do so, but much information will be disclosed voluntarily. For example, for larger organisations there tends to a great deal of regulation requiring the public disclosure of information about the organisation’s financial position and performance. By contrast, much of the information publicly released about organisational social and environmental (and sustainability-related) performance tends to be disclosed voluntarily by organisations. In making the decisions about what information to report, most larger organisations undertake some form of stakeholder engagement to determine what information would be ‘material’ to the respective stakeholders. Information is considered to be ‘material’ if it is important (material to) the respective individual or group that is making a decision. That is, information is material if its presence or absence is likely to influence the decisions being made by readers of that information. Once the managers of an organisation determine why they are reporting, and then to whom they are reporting, it is appropriate to engage those identified stakeholders to ask them what items of information they would like, or expect, to receive. Because the disclosure of information about social and environmental performance is largely voluntary, it is useful for readers of organisations’ reports to understand why particular information was disclosed and other information was not disclosed. This process is referred to as the ‘materiality determination process’ – the process of determining what to disclose to stakeholders and what not to disclose. Disclosing information about the materiality determination process, which can be directly related to our four-step accounting model, helps stakeholders to understand the context of why particular disclosures are being made by an organisation. To this end, larger organisations that produce social and environmental reports (or sustainability reports) will often provide information about their materiality determination process towards the commencement of the respective report in which they: • identify their key stakeholders (often explaining why they are deemed to be ‘key’) • explain how they engaged with the stakeholders (through general meetings, focus groups, survey, interviews, feedback mechanisms, etc.) • identify the aspects of performance the key stakeholders were most interested in • identify where in the organisational reports this information is reported.
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REFLECTION QUESTION 2.6 The importance of disclosing information about the ‘materiality determination process’ Question Information about the ‘materiality determination process’ outlines the processes the managers of an organisation establish to determine which items of information are considered important enough to disclose and, conversely, explain why other information is excluded from reports. In this respect, what are the benefits to report readers of knowing about the materiality determination process? Solution Where the disclosure of information is predominantly voluntary, as is the case with much social and environmental
information, then it would be reasonable for readers to question the logic, or merit, of why particular information was, or was not, disclosed. If managers are able to provide a clear, overall rationale for why particular information was deemed important enough to disclose then, even though readers might not agree with the materiality determination processes the managers have employed, the disclosure about the process should enable readers to better understand the context for why some information is reported and other potential information is not reported, and this should increase the understandability of the report.
The influence of organisational objectives upon accounting LO2.7
As should be becoming clear by now, an organisation’s assumed responsibilities and objectives will also influence how it does its ‘accounting’. If an organisation’s primary objective is to maximise profits, then the accounting and reporting will tend to fixate on financial measures. If an organisation has an objective of reducing greenhouse gas emissions, then the accounting and reporting will focus on emissions, improvements in emissions, targets and so forth. If an organisation, such as a university, has a goal that research publications must be increased, then this will impact what information is collected and what accounts are generated. Information about who is, and is not, generating publications will be collected, as will publication rates by other universities as a means of comparison and benchmarking. Amounts being spent on initiatives to support publishing would also be collected. Relatedly, if an organisation such as a university has a goal of making sure its students like the lecturers’ way of teaching, then the organisation will collect information from students about their assessment of the lecturers. This is all considered to be ‘accounting’. Many more examples could be provided here, but the point being made is that just as assessments of organisational responsibilities and accountabilities influence the practice of accounting, so will the objectives of the organisation influence the types of accounting being practised. We could imagine that there will also be some form of relationship between organisational objectives and the responsibilities and accountabilities the organisation accepts. For example, if a not-for-profit organisation is established to provide emergency housing for homeless people, then its objectives would tend to focus on helping disadvantaged people in the community and ensuring that the funds provided to the organisation are used as efficiently as possible to create the greatest benefit to the homeless, rather than simply being used to maximise profits. The main accounts would probably provide information about how quickly people are being housed, how many were housed, how many could not be housed, where they were housed, what negative impacts flowed to nearby residents and so forth. The key responsibilities and accountabilities would seem to be to funding bodies, to the homeless and to those interest groups that work for the benefit of the homeless. This example emphasises again that how we do accounting will be impacted by the organisations’ objectives as well as by the responsibilities and accountabilities that the managers within the organisations accept.
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Organisations usually have a ‘mission’. Larger organisations will typically document their mission in writing and make this publicly available, such as on corporate websites. An organisation’s ‘mission’ reflects its core purpose and focus and generally does not change that often – for example, it might stay unaltered for several years. It represents a guiding principle. The mission, if well written, acts to identify what aspects of performance are considered important, and it provides overall direction for the managers. We will consider, as an example, the mission statements of three quite different organisations to see how each of them differ. These organisations are: • The Walt Disney Company • Greenpeace • Harvard College. Their respective mission statements are as follows: Walt Disney Mission Statement Our Mission The mission of The Walt Disney Company is to entertain, inform and inspire people around the globe through the power of unparalleled storytelling, reflecting the iconic brands, creative minds and innovative technologies that make ours the world’s premier entertainment company. (The Walt Disney Company, n.d.) Greenpeace Mission Statement Mission Statement Greenpeace is an independent campaigning organisation, which uses peaceful, creative confrontation to expose global environmental problems, and develop solutions for a green and peaceful future. Our goal is to ensure the ability of the earth to nurture life in all its diversity. That means we want to: • protect biodiversity in all its forms • prevent pollution and abuse of the earth’s ocean, land, air and fresh water • end all nuclear threats • promote peace, global disarmament and non-violence. (Greenpeace, 2022) Harvard College Mission Statement Mission The mission of Harvard College is to educate the citizens and citizen-leaders for our society. We do this through our commitment to the transformative power of a liberal arts and sciences education. Beginning in the classroom with exposure to new ideas, new ways of understanding, and new ways of knowing, students embark on a journey of intellectual transformation. Through a diverse living environment, where students live with people who are studying different topics, who come from different walks of life and have evolving identities, intellectual transformation is deepened and conditions for social transformation are created. From this we hope that students will begin to fashion their lives by gaining a sense of what they want to do with their gifts and talents, assessing their values and interests, and learning how they can best serve the world. (Harvard College, 2022)
A review of these three mission statements will highlight core issues that subsequent planning should address. For example, when considering the sorts of problems Walt Disney would want to address, a key factor is profitability and this will factor into the planning phase more than it would at Greenpeace or Harvard, albeit that these two other organisations will still need to ensure that their resources are used efficiently so as to enable them to achieve their objectives. 67
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Identifying the problem for Walt Disney We can also see that the focus of Walt Disney is entertainment and the provision of information. Therefore, there would have to be a very good reason to start planning in other areas, such as, for example, commercial construction. A great deal of the information being collected by Walt Disney will relate to addressing the major problem of how to create content, services and products that are accepted by stakeholders as being creative and innovative (two key terms within the mission statement), while at the same time being profitable. This, in turn, might require various forms of research and planning, such as: • current and projected demands of consumers • stakeholder perceptions about what aspects of the industry are reflective of creativity and innovation • research to identify current and projected innovations and innovation opportunities in the intended areas of operation • apparent innovations being introduced by competitors. As potential projects are identified, budgeting will be undertaken to ensure that the intended actions appear likely to generate the desired level of profits.
Identifying the problem for Greenpeace Turning our attention to Greenpeace, it is reasonably clear that the planning should not be about generating profits, but rather, the central problems seem to relate to how to create the most positive environmental and social outcomes with the available funds. Problems to be addressed within planning might include: • identifying important areas of biodiversity that are currently, or potentially, at risk and priortising them in terms of importance • identifying and prioritising important initiatives to reduce dangerous levels of pollution in vulnerable areas • identifying and prioritising initiatives to reduce nuclear risk • identifying and prioritising strategies to address global peace • identifying and maintaining sources of funding to enable key initiatives to be undertaken. If a manager within Greenpeace wanted to operate in an area not involved with advancing the interests of particular habitats, species or people then much justification would be required, as it would represent an apparent departure from the organisation’s mission. The mission statement of Greenpeace also emphasises that the organisation is ‘independent’; therefore, planning must ensure that the organisation does not appear to be dependent upon particular stakeholders, for example particular providers of financial resources.
Identifying the problem for Harvard When it comes to Harvard, the mission would again seem to have little to do with making profits or other financial gains. Rather, the problems seem to be about creating a place of education excellence that creates future leaders, sets the standards for other universities to follow and transforms the lives of students intellectually, socially and personally. As with all organisations, to achieve the organisation’s goals, Harvard would also need to manage its resources efficiently and be clear about the plans it has for generating funding. While our discussion about the mission statements of the three organisations is rather brief, the point we are making is that the problems managers set, which will then be addressed or solved through establishing plans to be followed (and there can be many levels to these plans), will be influenced by the underlying mission of the organisation. The mission can be considered to be a very ‘high level’ direction, which then will be broken down to manageable plans that are each consistent with achieving the mission of the organisation. Accounting researchers who are attempting to understand why organisations have particular accounting practices in place need to understand the mission and objectives of the organisations being researched. 68
Accountability and its link to responsibility and accounting CHAPTER 2
LO2.8
Corporate governance
Appropriate systems of accounting, monitoring and reporting are components of a wellfunctioning corporate governance system – but, what is ‘corporate governance’? According to the ASX Corporate Governance Council (2019, p. 1), governance refers to the framework of rules, relationships, systems and processes within and by which authority is exercised and controlled within corporations. It encompasses the mechanisms by which companies, and those in control, are held to account.
As you can see, accountability and accounting are central elements of good governance, and therefore of the proper functioning of an organisation. Achieving the organisation’s mission and objectives typically relies on well-functioning governance systems. The elements shown in Figure 2.6 (which are not all-inclusive) identify several policies that a well-functioning governance system might include. Where governance policies are in place, it is also important that appropriate monitoring systems exist to ensure that formal policies are actually being followed. Having a policy in place without effective monitoring and enforcement mechanisms can render policies relatively useless. Managers’, and stakeholders’, perceptions of organisational responsibilities and accountabilities (to whom and for what) influence the suite of corporate governance policies and procedures that an organisation will have in place. For example, managers who accept that they FIGURE 2.6 Corporate governance systems include many elements
Clear ‘whistle-blower’ policies
Social and environmental audits/assurances Environmental audits
Anti-bribery and corruption policies
Managerial budgeting
Management remuneration plans
Audit committees Boards of management
Codes of conduct for directors, senior executives and other employees
Accounting and reporting policies
Supply chain audits
Environmental committees
Mission statements
Elements of corporate governance systems
Waste audits
Customer audits
Stakeholder engagement policies
Environmental management systems
Social audits
Stakeholder engagement policies
Financial statement audits
Occupational, health and safety policies
Environmental policies
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have a responsibility for mitigating their organisations’ contributions to climate change will aim to put in place policies and procedures that seek to measure and control the release of carbonrelated emissions (for example, see Haque, Deegan and Inglis [2016] for details of some climaterelated corporate governance practices that can be implemented). Conversely, an organisation that does not accept responsibility for mitigating its contribution to climate change will be relatively unlikely to have such governance policies. As another example, if managers believe they have a responsibility for ensuring the health and safety of workers across their supply chains, then they will be relatively more likely to have formal policies (governance policies) requiring workplace audits (social audits) of the overseas factories supplying their goods and services. Knowledge of the governance policies in place within an organisation will reduce the risks (financial, social and environmental) that stakeholders face. For example, organisations with poor climate change-related governance policies will suffer increasing likelihood of suffering financial loss as community concerns, and legislation, increase to penalise those organisations with poor climate-related performance. Appropriate climate change-related governance policies will help an organisation respond to the risks (in Chapter 10 we discuss the physical and transitional risks that climate changes poses) and opportunities that climate change poses for it. Providing information about an organisation’s corporate governance systems is therefore an important element in demonstrating organisational accountability. In this regard, internationally, large organisations will typically have website links that provide information about their various governance policies and practices. Different organisations in different industries, and different countries, will require different corporate governance systems. This is because their impacts on stakeholders will be different and there will be differences in the expectations of managers and their stakeholders. Therefore, a ‘one-size-fits-all’ approach to corporate governance is not appropriate. Governance policies will change and evolve over time as community and stakeholder expectations change, as knowledge about effective governance policies increases and as knowledge about the various impacts of organisational activities develops. There has been much published research within the corporate governance literature that has investigated the relationship between various components of an organisation’s total suite of governance policies and procedures, and other variables, such as various types of performance. For example, published research has found that there appear to be links between, for example: • the adoption of particular reporting frameworks and various aspects of organisational performance • the genders of people on the board of directors and aspects of organisational performance • the number and expertise of outside/independent directors and aspects of organisational performance • the diversity of the board of directors and aspects of organisational performance • CEO pay structure and organisational social and environmental performance • board of directors diversity and corporate innovation • audit committee composition and financial performance • management remuneration plans and organisational financial performance • managerial budgeting and financial performance • adoption of particular climate-related reporting practices and actual carbon-related emissions. Research exploring some of the above links typically treats the various aspects of performance as the dependent variable and the respective governance policy as the independent variable. In evaluating much of this research, it is important to determine whether there is simply a statistical association, rather than a causal relationship. To argue that there is a causal relationship (for example, that the greater the number of female members on the board of directors, the better the organisation’s corporate social performance, as has been asserted in some research) requires clear theory and logical argument, which often can be missing in some of this research. Nevertheless, it is clear that different corporate governance policies and practices will impact attributes of organisational performance. 70
Accountability and its link to responsibility and accounting CHAPTER 2
STUDY TOOLS CHAPTER SUMMARY This chapter has addressed a number of issues that are fundamental to the understanding and practice of accounting. We have provided definitions of ‘accounting’ and ‘accountability’, and we have explored the relationship between organisations’ responsibilities, accountability, and accounting practices. We have emphasised that different managers will interpret their responsibilities (to whom, and for what) differently, and this will have implications for the accounting practices that they will have in place. We have also emphasised that perceptions of organisational responsibility will change over time, and this has implications for the evolution of accounting practice. We introduced a four-step accountability model that emphasises how various judgements made as part of an ‘accountability relationship’ between organisations, and their stakeholders, have sequential implications for subsequent judgements. For example, the reasons why managers are reporting information has implications for who is intended to receive the information, which in turn has implications for what is reported, and how it is reported. The chapter concluded with a brief discussion of corporate governance which emphasised that the form of corporate governance employed within an organisation ultimately is influenced by the responsibilities accepted by corporate managers.
ANSWERS TO THE OPENING QUESTIONS At the beginning of the chapter, we asked the following five questions. As a result of reading this chapter, you should be able to provide informed answers to these questions – ours are shown below. 1 What does ‘accountability’ mean? In this chapter we have provided a number of definitions of accountability. One useful definition is that provided by Gray, Adams and Owen (2014, p. 50) which is ‘the duty to provide an account or reckoning of those actions for which one is held responsible’. The ‘accountability’ of an organisation is very much linked to judgements made about an organisation’s responsibilities. 2 How do perceptions of organisational responsibility influence perceptions of organisational accountability? In this chapter we provided a simple, but useful, diagram – see Figure 2.1. As we discuss, perceptions of organisational responsibilities directly influence perceptions about to whom an organisation is responsible and for what aspects of performance it is responsible. Where there are responsibilities, managers need to provide an account (that is, be accountable) in relation to whether those responsibilities have been properly demonstrated. 3 How, if at all, is the practice of ‘accounting’ related to perceptions of accountability? The decisions about what aspects of an organisation’s performance are ‘accounted for’ are directly related to the types and extent of accountability accepted by managers. The broader the accountability accepted by managers in terms of to whom they are accountable, and for what aspects of performance they are accountable, then the broader the practice of accounting that will be adopted. If managers accept a responsibility and associated accountability to a broad range of stakeholders, and for a broad range of performance, then such managers will tend to use accounting practices that provide information about various aspects of the organisation’s financial, social and environmental performance. 4 If we were to develop a model of ‘organisational accountability’, and if it was to have four sequential steps, what might these steps be? There could potentially be a variety of steps that could be identified, but this chapter has opted to use a four-step accountability model which identifies four sequential steps, these being ‘why report?’, ‘to whom to report?’, ‘what to report?’ and ‘how to report?’ The answer to each step has implications for the answer to the following step.
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5 Is there a relationship between an organisation’s corporate governance policies and the managers’ perceptions about organisational responsibility and accountability? Yes, there is a relationship. Managers’ assessments of their responsibilities and accountabilities will have direct implications for the corporate governance policies in place. For example, if managers believe that they have a responsibility and an associated accountability to minimise their contribution to climate change, then they would put in place policies and procedures (governance policies) that aim to reduce their emissions (for example, they might have capital investment policies that stipulate that only energy efficient equipment is to be acquired or they might have in place management bonuses that are linked to achieving emission reduction targets). They would also be expected to have reporting practices in place which measure and report the results of efforts undertaken to reduce the organisation’s contribution to climate change.
QUESTIONS 2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8 2.9 2.10 2.11 2.12 2.13
2.14 2.15
2.16 2.17
2.18 2.19
Define ‘accountability’. LO2.1 Would different managers necessarily have similar views about organisational accountability? Why? LO2.2 Why might different managers have different perceptions of their organisation’s responsibilities? LO2.4 Does it make sense to study accounting without considering, in some depth, the issue of ‘organisational accountability’? Why? LO2.2 What is a ‘stakeholder’ of an organisation? LO2.3 Does a stakeholder have to be a person or group of people? LO2.3 What is stakeholder engagement, and what is its purpose? LO2.3 LO2.4 What is the connection between stakeholder engagement and organisational accountability? LO2.2 LO2.3 Would you consider that stakeholder engagement should be part of the corporate governance policies of an organisation? LO2.3 LO2.8 Are the views or expectations of all stakeholders likely to be considered/acted upon by an organisation? LO2.5 What is ‘corporate governance’, and would you expect systems of corporate governance to be influenced by managers’ perceptions of their organisational responsibilities? Why? LO2.8 Are systems of corporate governance and accounting practices likely to be related? Why? LO2.7 LO2.8 Some ‘accounting educators’ incorporate issues to do with measuring and reporting information about organisational social and environmental performance across their various accounting subjects/units, whereas other accounting educators do not. Why do you think that such differences between accounting educators exist? LO2.2 LO2.4 LO2.6 What is a ‘surrogate stakeholder’, and what is their role? LO2.3 What is the ‘materiality determination process’? Why would it be useful for readers of organisational accounts to be provided with information about the materiality determination process instigated by the managers of an organisation? LO2.6 Is it important for accounting researchers to explore the factors that motivate managers to make particular accounting disclosures? Why? LO2.6 Explain why each step in the four-step accountability model discussed in this chapter influences the step that follows. For example, why does the answer to the ‘why report?’ step influence the issue about ‘to whom?’ to report, and why does the ‘to whom to report?’ step influence the ‘what to report?’ step? LO2.6 Why might it be useful for stakeholders to have insights into ‘why’ managers are reporting particular information? LO2.6 In this chapter it was stated: Each of the four steps in our four-step accountability model can represent a ‘departure point’ in opinion between various stakeholders, and this can ultimately lead to significant differences in
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expectations regarding the types of ‘accounts’ that particular entities should prepare, and therefore, in the types or forms of ‘accounting’ that they should undertake.
Explain clearly the logic behind the above quote.
LO2.6
2.20 Explain the logic of the relationship shown in Figure 2.1. LO2.2 2.21 If the managers of an organisation are primarily focused on satisfying the information needs of powerful stakeholders, then how would the managers determine what to disclose? Further, would such an organisation likely be deemed to be demonstrating high levels of accountability? LO2.5 2.22 Why will accounting practices evolve over time? LO2.2 LO2.7 2.23 If you were a consultant asked to help an organisation produce its first publicly available ‘sustainability report’, then would it be relevant to you to know why the managers are wanting to produce the report? Why? LO2.1 LO2.6 2.24 Would you expect similar accounting practices to be used in different countries? Why? LO2.2 LO2.4 LO2.6
REFERENCES AccountAbility (2018), AA1000 AccountAbility Principles 2018, viewed 1 June 2022, http://www.accountability.org/ standards ASX Corporate Governance Council (2019), Corporate Governance Principles and Recommendations, 4th edn, Sydney: ASX. Australian Corporations and Markets Advisory Committee (2006), The Social Responsibility of Corporations, Canberra: Australian Government. Barton, A. D. (2006), ‘Public sector accountability and commercial-in-confidence outsourcing contracts’, Accounting, Auditing & Accountability Journal, 19(2), pp. 256–71. Benston, G. J. (1982), ‘Accounting and corporate accountability’, Accounting, Organizations and Society, 6(2), pp. 87–105. BHP (2022), ‘Sustainability’, https://www.bhp.com/ sustainability/approach Black, J. (2008), ‘Constructing and contesting legitimacy and accountability in polycentric regulatory regimes’, Regulation & Governance, 2(2), pp. 137–64. Deegan, C. (2019), ‘Legitimacy theory: despite its enduring popularity and contribution, time is right for a necessary makeover’, Accounting, Auditing & Accountability Journal, 32(8), pp. 2307–29. Deegan, C. (2023), An Introduction to Accounting: Accountability in Organisations and Society, 2nd edn, Melbourne: Cengage Learning. Dictionary.com (2022), ‘Accountability’, https://www. dictionary.com/browse/business Freeman, R. E. & Reed, D. L. (1983), ‘Stockholders and stakeholders: a new perspective on corporate governance’, California Management Review, 25(3), pp. 88–106. Friedman, M. (1962), Capitalism and Freedom, Chicago: University of Chicago Press. Grant, R. W. & Keohane, R. O. (2005), ‘Accountability and abuses of power in world politics’, American Political Science Review, 99(1), pp. 29–43.
Gray, A. & Jenkins, B. (1993), ‘Codes of accountability in the new public sector’, Accounting, Auditing & Accountability Journal, 6(3). Gray, R., Adams, C. & Owen, D. (2014), Accountability, Social Responsibility and Sustainability: Accounting for Society and the Environment, Harlow, UK: Pearson Education. Gray, R., Colin, D., Dave, O., Richard, E. & Simon, Z. (1997), ‘Struggling with the praxis of social accounting: stakeholders, accountability, audits and procedures’, Accounting, Auditing & Accountability Journal, 10(3), pp. 325–64. Gray, R., Owen, D. & Adams, C. (1996), Accounting and Accountability: Changes and Challenges in Corporate Social and Environmental Reporting, London: Prentice Hall. Greenpeace (2022), ‘Our values’, https://www.greenpeace. org/international/explore/about/values Haque, S., Deegan, C. & Inglis, R. (2016), ‘Demand for, and impediments to, the disclosure of information about climate change-related corporate governance practices’, Accounting and Business Research, 46(6), pp. 1–45. Harvard College (2022), ‘Mission’, https://college.harvard. edu/about/mission-vision-history Mathews, M. R. (1993), Socially Responsible Accounting, London: Chapman and Hall. Mulgan, R. (2000), ‘“Accountability”: an ever-expanding concept?’, Public Administration, 78(3), pp. 555–73. Roddick, A. (2007), Business as Unusual: The Journey of Anita Roddick and The Body Shop, London: Anita Roddick Books. Rubenstein, J. (2007), ‘Accountability in an unequal world’, Journal of Politics, 69(3), pp. 616–32. Walt Disney Company, The (n.d.), ‘Our mission’, https://thewaltdisneycompany.com/about
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3
THE FINANCIAL REPORTING ENVIRONMENT LEARNING OBJECTIVES On completing this chapter, readers should:
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LO3.1
be aware of some of the arguments for and against the existence of financial accounting regulation
LO3.2
have a broad understanding of the history of the accounting profession and of financial accounting regulation
LO3.3
be aware of some of the theoretical perspectives used to explain the existence of regulation
LO3.4
be aware of how and why various groups within society try to influence the accounting standard-setting process
LO3.5
understand that many accounting decisions are based on professional opinions and have an awareness of some of the theories used to explain what influences the accountant to choose one accounting method in preference to another
LO3.6
be aware of some of the arguments advanced to support a view that the accountant can be considered to be a very powerful member of society
LO3.7
be aware of some assumptions made by accounting standard setters (in regards to such issues as report readers’ knowledge and information needs), and how such assumptions influence the development of accounting regulation.
The financial reporting environment CHAPTER 3
OPENING QUESTIONS Before reading this chapter, please consider how you would answer the following two questions. We will return to these questions at the end of the chapter, where we suggest some answers. 1 Through such mechanisms as conceptual frameworks for financial reporting, accounting professions throughout the world promote a view that accounting reports, when prepared properly, will be objective and will faithfully represent the underlying transactions and events of the reporting entity. Is it in the interests of the accounting profession to promote this view of objectivity and neutrality, and if so, why? 2 Many different types of stakeholders make various decisions (for example, investment or consumption decisions) based – at least in part – on information generated by accountants, and these decisions can in turn create social and/or environmental impacts. Different accounting information is expected to create different decisions, and therefore, different impacts. Because of the potential economic and social impacts created by the accountants’ choice of accounting methods (for example, decisions that involve choosing one method of accounting in preference to another), and because accounting standard-setters take such economic and social impacts into account when developing new accounting standards (accounting standard setters consider the various costs and benefits that might arise from the introduction of an accounting standard), then it can be argued that standard-setters themselves are not developing accounting standards that lead to representationally faithful (and therefore, neutral or balanced) accounts of organisational performance. Do you agree or disagree with this view, and why?
Introduction A great deal of this book focuses on accounting theory as it relates to the practice of financial accounting. Therefore, it is quite important that we understand the meaning of ‘financial accounting’. Financial accounting is a process involving the collection and processing of financial information to assist in the making of various decisions by many stakeholders that are internal and external to the organisation. For larger organisations – such as large organisations with their equity listed on a securities exchange – these stakeholders are diverse and potentially include present and potential investors, lenders, suppliers, employees, customers, governments, non-government organisations, the local community, parties that are performing a review or oversight function, and the news media. Financial accounting generates information for use by managers, and also for other stakeholders who are not necessarily involved in the day-to-day running of the organisation. Financial reports that meet the specific information needs of a specifically identified, and potentially narrow group of stakeholders, are often referred to as ‘special purpose financial reports’, and these reports do not need to comply with accounting standards. Special purpose financial reports are prepared for stakeholders who have the power to command reports that satisfy their own information demands, and these ‘powerful’ stakeholders therefore do not typically require that regulation exists to protect their rights to information. For larger organisations, with potentially thousands (or hundreds of thousands, or even millions) of interested stakeholders with various information demands and needs, it is effectively not possible to generate financial reports that will satisfy each and every need of each and every stakeholder. To do so would potentially require the generation of many thousands of specifically tailored reports, and this is obviously not practical.
Financial accounting A process involving the collection and processing of financial information to assist in the making of various decisions by many parties internal and external to the organisation.
Special purpose financial reports Financial reports that meet specific information needs of particular parties.
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General purpose financial statements (GPFSs) Financial statements that comply with conceptual framework requirements and accounting standards and meet the information needs common to users who are unable to command the preparation of reports tailored specifically to satisfy all their information needs.
As such, the process of financial accounting as applied by larger organisations (and these financial reports will comply with the financial reporting standards issued by organisations such as the International Accounting Standards Board [IASB] or the Financial Accounting Standards Board [FASB]) leads to the generation of reports deemed to be general purpose financial reports, and more specifically, their externally released financial statements would be referred to as general purpose financial statements (GPFSs).
The objective, use and regulation of general purpose financial reports LO3.1
LO3.7
General purpose financial statements are prepared for stakeholders who do not have the power to demand reports that satisfy their own specific information needs; rather, such stakeholders need to rely upon general purpose financial reports that will ‘generally’ meet many, but not all, of their information requirements. Much of the research that is undertaken in the broad area of financial accounting and financial reporting focuses on general purpose financial statements, and not special purpose financial statements. It should be noted that large organisations will also, in addition to releasing general purpose financial statements, also generally privately release a number of special purpose financial reports for a limited number of stakeholders. The IASB Conceptual Framework for Financial Reporting (IASB, 2022) defines general purpose financial reports and general purpose financial statements, as follows: • general purpose financial report: a report that provides financial information about the reporting entity’s economic resources, claims against the entity, and changes in those economic resources and claims that is useful to primary users (existing and potential investors, lenders and other creditors) in making decisions relating to providing resources to the entity • general purpose financial statement: a particular form of general purpose financial report that provides information about the reporting entity’s assets, liabilities, equity, income and expenses. In the IASB Conceptual Framework (IASB, 2022), the objective of general purpose financial reporting is described in the following way (paragraph 1.2): 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 relating to providing resources to the entity. Those decisions involve decisions about: (a) buying, selling or holding equity and debt instruments; (b) providing or settling loans and other forms of credit; or (c) exercising rights to vote on, or otherwise influence, management’s actions that affect the use of the entity’s economic resources.
In terms of the objective of general purpose financial statements – and from what we have already discussed, we know that general purpose financial statements are a form of general purpose financial reports that specifically provide information about the five elements of financial statements (assets, liabilities, equity, income and expenses) – paragraph 3.2 of the IASB Conceptual Framework states: The objective of financial statements is to provide financial information about the reporting entity’s assets, liabilities, equity, income and expenses that is useful to users of financial statements in assessing the prospects for future net cash inflows to the reporting entity, and in assessing management’s stewardship of the entity’s economic resources
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As we discussed in Chapter 1, the IASB Conceptual Framework is based upon this guiding objective. Therefore, if we disagreed with this central objective (as some accounting researchers do), then we might be inclined to disagree with the prescriptions provided within the balance of the Conceptual Framework. In further explaining the role of general purpose financial reports, paragraphs 1.5 to 1.7 of the IASB Conceptual Framework state: 1.5 Many existing and potential investors, lenders and other creditors cannot require reporting entities to provide information directly to them and must rely on general purpose financial reports for much of the financial information they need. Consequently, they are the primary users to whom general purpose financial reports are directed 1.6 However, general purpose financial reports do not and cannot provide all of the information that existing and potential investors, lenders and other creditors need. Those users need to consider pertinent information from other sources, for example, general economic conditions and expectations, political events and political climate, and industry and company outlooks 1.7 General purpose financial reports are not designed to show the value of a reporting entity; but they provide information to help existing and potential investors, lenders and other creditors to estimate the value of the reporting entity
There is a great deal of accounting research that explores the role of other sources of information beyond general purpose financial statements in providing information to investors and other stakeholders. For example, research also explores the role and use of reports such as sustainability reports, climate change-related reports, modern slavery statements, social audit reports, and so forth. We consider some of this research in other chapters of this book. At this point it needs to be emphasised that when we talk about the regulation of financial reporting in this chapter, and the chapters that follow, we are typically restricting our discussion to the regulation of general purpose financial reports. General purpose financial reports are subject to high levels of regulation because they are used by a large number of stakeholders who are not involved in the management of the organisation and who do not have the power to demand reports to satisfy their specific information needs, such as investors, lenders and creditors, to make various decisions about providing resources to the organisation. It is considered that because so many stakeholders make resource allocation decisions that are based, at least in part, on general purpose financial reports, then this creates a need for such reports to be regulated to help ensure these reports are of high quality and to provide a faithful depiction of what they purport to represent. Also, consistent with the objective of general purpose financial reporting provided above, while people other than investors, lenders and creditors might use general purpose financial reports, they are not the primary intended audience. This is confirmed by paragraph 1.10 of the IASB Conceptual Framework, which states:
Regulation A rule of order, as for conduct, prescribed by authority; a governing direction or law. It is designed to control or govern conduct.
Other parties, such as regulators and members of the public other than investors, lenders and other creditors, may also find general purpose financial reports useful. However, those reports are not primarily directed to these other groups.
This restricted audience of general purpose financial reports is consistent with the objective provided earlier. Having now provided some insight into what we mean by general purpose financial reporting, and general purpose financial statements, we again need to note that such reporting tends to be heavily regulated in most countries, with many accounting standards and other regulations 77
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governing how particular transactions and events are to be recognised, measured and presented in general purpose financial reports. The reports generated, such as the balance sheet (or, as it is also called, the ‘statement of financial position’), the profit and loss account (or, as it also called, the ‘statement of profit or loss and other comprehensive income’), the statement of cash flows, the statement of changes in equity and the supporting notes, are directly affected by the various accounting regulations in place.1 When existing accounting regulations change, or new accounting regulations are implemented, this will typically have an impact on the various accounting numbers (such as particular items of income, expenses, assets and liabilities) included in the statements provided to the public. To the extent that people make decisions on the basis of accounting numbers, and such decisions have various social consequences (as we explained in Chapter 2), then changing accounting regulations will potentially create various social impacts. The economic and social impacts of changing accounting requirements is an area addressed by many accounting researchers. Ideally, readers of financial statements should have a sound working knowledge of the various accounting standards and other regulations, because without such knowledge it can be difficult (or perhaps near impossible) to interpret what the financial statements are actually reflecting. For example, ‘profit’ is the outcome of applying particular accounting rules and conventions, many of which are contained within accounting standards (or, as they are also called, financial reporting standards). As these rules change (and they frequently do), the same series of transactions will lead to different measures of income and expenses and therefore of ‘profits’ and ‘net assets’ at different points in time.2 Such a situation leads to an obvious question: should readers of general purpose financial statements be expected to understand financial accounting? The answer is ‘Yes’, even though many users of financial statements (including many company directors and financial analysts) have a very poor working knowledge of financial accounting. In this regard, the IASB Conceptual Framework (paragraph 2.36) notes that: Financial reports are prepared for users who have a reasonable knowledge of business and economic activities and who review and analyse the information diligently. At times, even well-informed and diligent users may need to seek the aid of an adviser to understand information about complex economic phenomena.
A review of an annual report of a company listed on a securities exchange will soon reveal just how confusing such a document would be to readers with a limited knowledge of accounting (and, as became clear in the aftermath of the collapse of Enron, WorldCom, HIH Insurance and other large entities, many people with formal qualifications in accounting also have trouble interpreting the accounting reports of companies that have complex financial structures and engage in complex financial transactions). Unfortunately, many readers of financial statements have tended to consider figures such as ‘profits’ or ‘assets’ as being ‘hard’ objective numbers that are not subject to various professional judgements. Hence, although such users may not 1
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The names of the financial statements changed as a result of accounting standards being issued by the AASB. There is no clear theory to explain how changing the names of these financial statements provides benefits for financial statement users or preparers. Which brings into question a great deal of published research that looks at trends in company profitability across time. For example, there is a deal of research that looks at trends in corporate profits across time and seeks to link changes in reported profits back to changes in various attributes of an organisation. Such research often fails to adjust for the fact that across time, many accounting standards are changed or introduced which directly affect how we calculate reported profits. Therefore, because accounting rules do change across time, an identical set of events and transactions will generate different profits in different years because they are being calculated using a different set of rules. As such, it really only makes sense to do research that looks at trends in reported profit if some adjustments are made to each year’s profits to ensure that they are actually being calculated using the same set of rules – but such adjustments are often not made, in large part because researchers do not have enough information available about the underlying corporate transactions.
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understand some of the descriptions of accounting methods used, they may believe that they understand what ‘profits’ and ‘net assets’ mean. As we know, however, the financial accounting results (or numbers) will be heavily dependent on the particular financial accounting methods chosen, as well as on various professional judgements made. Different teams of accountants working independently would likely generate quite different results for the same organisation because of different professional judgements being made. That is, depending on who compiles the accounting reports, the measures of profits and net assets can vary greatly.3
Alternative measures of financial performance disclosed within financial reports Many companies provide summary ‘highlight’ statements at the beginning of their annual reports. Often, multi-year summaries are given of such figures as profits, return on assets, earnings per share, dividend yield and net asset backing per share. By highlighting particular information, management could be deemed to be helping the less accounting-literate readers to focus on the important results. However, a downside of this is that management itself is selecting the information to be highlighted (that is, such disclosures are voluntary) and, as a result, a large amount of otherwise important information may be overlooked. While larger organisations are required to produce general purpose financial reports that measure and report profit in accordance with financial reporting standards, it is also becoming quite common to find that many organisations additionally disclose alternative (additional) measures of ‘profits’ that are derived in a way that is inconsistent with financial reporting standards, but which are argued by the managers of the organisation to provide a measure of performance which they believe is more representative of the organisation’s performance. The news media also often refer to these alternative measures of financial performance. The motivations for providing these alternative measures of financial performance might come from a belief by managers that the measures of performance derived by not complying with financial reporting standards provides a relatively superior indicator of the organisation’s underlying performance, and this measure is more useful to both the managers of the organisation in terms of effectively managing the organisation, as well as to the readers of the financial reports. Alternatively, such disclosures might be made opportunistically by managers to generate a result that managers think will provide some form of benefits to the organisation or to themselves. Perhaps it could also be a mixture of both incentives. Evidence indicates that, when calculating these alternative measures of profits, the most commonly excluded expenses are depreciation and amortisation, the costs assigned to share-based remuneration provided to managers, research and development costs, and major impairments of assets. When referring to these alternative measures of financial performance, organisations often refer to the alternative measure as ‘underlying profit’, ‘underlying earnings’, ‘cash earnings’ or ‘underlying profit after tax’ (Chartered Accountants Australia and New Zealand, 2016). Even though many people think it is inappropriate to provide these alternative measures of profits in the same financial reports in which accounting standards must be followed, it is generally permitted in most countries unless the disclosures are considered to be misleading. If the alternative financial performance measures are reported in a way that is misleading, then corporate regulators can potentially take action against the directors of the company. So, the point to be emphasised here is that although larger organisations are required to produce general purpose financial statements that comply with accounting standards, there will nevertheless also 3
Yet the various financial statements prepared by the different teams of accountants for the same organisation may all be deemed to be ‘true and fair’ despite the differences in net assets or reported profits, which implies that different teams of accountants are able to provide different versions of the ‘truth’.
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be some financial disclosures within such reports that do not strictly comply with accounting standards, and the reasons for these ‘non-complying’ disclosures is a topic investigated by many accounting researchers through the use of varying accounting theories, some of which we discuss within this book.
Financial accounting versus management accounting Financial accounting can be contrasted with management accounting. Management accounting focuses on providing information for decision making by parties who work within an organisation (that is, for internal as opposed to external users) and it is largely unregulated. Generally speaking, there is a whole different body of literature and theory that explores management accounting practices, and this literature is beyond the scope of this book. Whereas most countries have a multitude of financial accounting standards that are often given the force of law (and these standards are typically those of the IASB), the same cannot be said for management accounting. Because management accounting relates to the provision of information for parties within the organisation who have the power to demand the information they need, the view taken is that there is no need to protect their information needs or rights. It is the information rights of outsiders who have funds invested in an organisation, but who are not involved in the day-to-day management of an entity, that must be protected. Because financial statements are often used as a source of information for parties contemplating transferring resources to an organisation, it is arguably important that certain rules be put in place to govern how the information should be compiled. That is (adopting a pro-regulation perspective), to protect the interests of parties external to an organisation, some regulation relating to financial accounting information is required.
Why do I need to know about the difference between general purpose financial reports and special purpose financial reports? If we are studying financial accounting theory and some related research that addresses financial reporting and associated regulation, then we need to be aware that the vast majority of this research relates to general purpose financial reports and not special purpose financial reports.Therefore, it is important that we know the difference between these two forms of reporting. Also, in our daily lives we will often hear about the ‘profits’ or ‘assets’ of large, high-profile organisations. It is important to understand that these financial numbers are extracted from general purpose financial statements, and that these financial
statements are generated by applying accounting standards. If we also know the contents of the various applicable accounting standards, then that allows us to understand the context of the financial accounting numbers being reported. This further allows us to understand that as accounting standards change, then the same series of transactions and events will be recognised and measured using new rules, meaning that a different measure of ‘profit’ would be calculated.
As already noted, much of the research undertaken in financial accounting and reporting relates to general purpose financial statements so it is important that you understand what they are. This overview should make that clear. Figure 3.1 provides a diagrammatic representation of when general purpose financial statements are to be prepared.
Application of our ‘accountability model’ to the practice of financial reporting In Chapter 2, we introduced the four-step accountability model, which can be used to explain various forms of ‘accounting’. We recall that the model has four basic questions, these being
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FIGURE 3.1 The requirement to produce general purpose financial statements Is the organisation: (1) relatively large such that there are many stakeholders who have a significant financial interest in the organisation, but (2) who have nothing to do with the ongoing management of the organisation, and (3) who do not individually have the power to demand information that specifically satisfiestheir needs? Yes
The organisation’s financial accounting practices will tend to be regulated. The organisation will prepare general purpose financial statements that comply with accounting standards and other financial reporting requirements
No
The organisation’s financial accounting practices will tend not to be regulated. The organisation will prepare special purpose financial statements that do not need to comply with accounting standards but will be tailored to meet the specific needs of the limited number of users
‘why report?’, ‘to whom to report?’, ‘what to report?’ and ‘how to report?’. We now consider each of these questions in turn as they relate to financial reporting, specifically, general purpose financial reporting.
Why disclose financial accounting information? The most obvious answer here is that an extensive amount of regulation requires the disclosure of financial information about an organisation, in particular, for larger organisations. Governments throughout the world typically require larger organisations to prepare general purpose financial statements. As we have discussed, governments impose this regulation so that those stakeholders with a financial interest in an organisation (such as shareholders, creditors and lenders) are more likely to receive relevant and reliable information about financial performance, and therefore more able to adopt strategies which safeguard their financial interests (for example, if an organisation is not performing well financially, then one strategy that investors might adopt would be to sell their investments in the organisation and move their funds to alternative investments). Further, governments typically want people to have confidence in capital markets as this will support economic growth (but, as we explain in Chapter 13, there are diverse views about who in society actually prospers from this ‘economic growth’). Regulating the financial disclosures that larger organisations are required to make helps to promote investors’ confidence in capital markets. Nevertheless, even without regulation, investors and other stakeholders with a financial interest in the organisation would still demand financial statements. Investors (owners) would demand financial statements that allow them to assess how well their funds are being used in terms of their investment aims (which might be high capital growth and receipt of dividends), thereby effectively reducing the risks of the investment. Receiving financial reports reduces the risks of those stakeholders with a financial interest in, or claim on, the organisation because the information provides a means to monitor, on a periodic basis, the financial performance and position of the organisation, thereby assisting the stakeholders to assess, on an ongoing basis, the security of their financial interests in the organisation. Financial accounting is also important for managers as it provides information that is useful for managing an organisation. Hence, it is again stressed that even in the absence of regulation we would still expect financial statements to be prepared, albeit that they might be prepared in a multitude of ways. Indeed, history shows that financial statements were voluntarily prepared long before regulation required them, although in the absence of regulation there was much
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variation in reporting practices being adopted by different organisations, thereby making comparisons between organisations difficult. Importantly, in the absence of producing externally available financial statements, organisations would find it very difficult to attract funds. Most of us would be reluctant to invest in an organisation, or loan funds to an organisation, if that organisation was not prepared to provide us with periodic reports about its financial position and financial performance. For example, a lender would want to know that the organisation to which it has loaned funds is in a financial position that enables it to be able to ultimately repay the funds that have been borrowed.
To whom are the financial disclosures directed? The primary audience of financial accounting information and, in particular, general purpose financial statements, are, according to the IASB Conceptual Framework, current and potential investors, lenders and other creditors. Managers will also use the information generated by the financial accounting system. Many other stakeholders would also have an interest in the financial position, financial performance and cash flows of an organisation. Employees, and their representatives such as labour unions, might also have an interest in knowing about an organisation’s financial performance, to determine not only whether the organisation can continue to pay current salaries, but also whether the organisation could, or should, pay higher salaries. Customers might also have an interest in the financial performance of an organisation as, for example, if the organisation is earning large profits, then this might justify calls for price decreases on its goods or services. There are many other ways in which financial accounting assists the decisions being made by different stakeholders.
What types of disclosures are made? The types of disclosures to be made will be influenced by the expectations of the stakeholders to whom the information is being directed. Accounting standard-setters, such as the IASB, do much research, often in conjunction with university-based accounting researchers, to determine what types of information the main users of general purpose financial reports (who are assumed to be investors, potential investors, lenders and other creditors) want, or need. We consider some of this research throughout this book. Once an accounting standard-setter determines that particular information is justifiably needed by financial statement users, then the standard-setter will tend to initiate actions leading to the introduction of regulations in respect of that information. Managers will also make various disclosures beyond that required by regulation (voluntarily) and we explore motivations driving voluntary disclosure in other chapters of this book, in particular, in Chapters 8 and 9. Requirements for particular financial accounting disclosures will be incorporated within the accounting standards released by accounting standard-setters, and different financial accounting disclosure requirements might also be included within a country’s securities exchange and corporations law requirements. How differences in international cultures influence national accounting and securities regulations is something that we explore in Chapters 5 and 9.
How
are disclosures made?
The format of the disclosures, and the medium for disclosure, will also tend to be regulated (with respect to the general purpose financial statements being issued by larger organisations). For example, there are accounting standards that stipulate how to define, recognise, measure and disclose various transactions and events. Accounting standards also provide guidance about what types of financial statements shall be prepared and what information shall be disclosed within the respective financial statements.
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Having provided a broad overview of current requirements pertaining to the preparation of general purpose financial statements, we now consider the history of accounting practice and its associated regulation.4
An overview of the development and regulation of accounting practice LO3.1
LO3.2
This section examines the development of accounting regulations in jurisdictions where the primary role of general purpose financial reports – which, as we know, are those financial reports that are released by larger organisations such as large public companies – has been to aid investment decisions made by external investors in developed capital markets. Such external investors typically have no role in the management of the entity, and hence rely upon general purpose financial reports as a source of important information. As we will learn in Chapter 5, the primary role of financial reporting in many European countries has historically been different to the capital market-based roles in other countries. This is because in Europe there was traditionally not such a high reliance on publicly raised finance. Rather, finance was often provided by a limited number of investors (including banks) which, because of their ‘closeness’ to the organisation, were able to stipulate the specific information they wanted to receive from the organisation (with such information being incorporated within ‘special purpose financial reports’). However, with increasing globalisation of business and capital markets, the role of financial reporting undertaken by large companies in all European countries is now focused on the provision of financial information to capital markets, with the consequence that regulations developed over a long period of time in economies dominated by capital markets (with a large number of external shareholders) now apply to most large European Union (EU) companies. While the practice of financial accounting can be traced back many hundreds of years, the regulation of financial accounting and, in particular, general purpose financial reporting, in most capital-market-dominated economies (such as the United States, the United Kingdom, Ireland, Australia and Canada) generally commenced in the twentieth century. In part, this lack of regulation in the early days is likely due to the fact that there was limited separation between the ownership and management of business entities, and, as such, most systems of accounting were designed to provide information to the owner/manager. In the twentieth century there was an increase in the degree of separation between ownership and management in many countries, and with this increased separation came an increased tendency to regulate financial accounting disclosures so as to protect the financial interests of the capital providers that otherwise had no direct information about how the organisation was financially performing.
Reliance on double-entry accounting Early systems of double-entry bookkeeping and accounting, similar to the system we use today, have been traced back to thirteenth- and fourteenth-century northern Italy. One of the earliest surviving descriptions of a system of double-entry accounting is by the Franciscan monk Luca Pacioli as part of his most famous work, Summa de Arithmetica, Geometrica, Proportioni et Proportionalita, published in Venice in 1494. A review of this work (there are translated versions) 4
Although this text devotes several chapters to financial accounting, a similar argument can be made in favour of the regulation of social and environmental reporting. Corporations generate many social and environmental impacts that can affect a variety of stakeholders. Such stakeholders arguably have a right to know about the social and environmental implications of an organisation’s operations. Such information could then provide the basis for decisions about whether to support the organisation’s operations. Chapter 10 considers various issues associated with social and environmental reporting.
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indicates that our current system of double-entry accounting is very similar to that developed many hundreds of years ago. Even in the days of Pacioli there were debits and credits, with debits going on the left and credits on the right.5 There were also journals and ledgers. Reflecting on the origins of double-entry accounting, Hendriksen and Van Breda (1992, p. 36) state: Debits, credits, journal entries, ledgers, accounts, trial balances, balance sheets and income statements all date back to the Renaissance. Accounting, therefore, can claim as noble a lineage as many of the liberal arts.6 Accounting students can take pride in their heritage. Part of this heritage is a rich vocabulary, almost all of which dates back to this period and much of which is fascinating in its origin.
Debits and credits have, over the ages, proved to be the bane of many an accounting student. So, did we really need them? Why couldn’t we have simply used positive and negative numbers? For example, if we were to pay wages, why couldn’t we have simply put a positive number under the wages column and a negative number under the cash column? The simple answer to this question appears to be that negative numbers were not really used in mathematics until the seventeenth century. Hence, the t-account was devised to solve this problem, with increases being on one side and decreases on the other. But why keep the t-account, and debits and credits, now that we accept the existence of negative numbers? Pondering this issue, Hendriksen and Van Breda (1992, p. 51) comment: Textbook writers still explain how debits are found on the left and credits on the right and teach students the subtraction-by-opposition technique that was made obsolete in arithmetic three centuries ago. Programmers then faithfully seek to reflect these medieval ideas on the modern computer screen.
As is demonstrated in subsequent chapters, there are many criticisms of our financial accounting systems. For example, there is an increasing trend towards the view that financial accounting should reflect the various social and environmental impacts created by an organisation. Unfortunately, however, our ‘dated’ double-entry system has a general inability to take such consequences into account and this means that measures of ‘profits’ using doubleentry accounting typically fail to take account of the vast majority of social and environmental impacts generated by business organisations – but more of this is covered in later chapters, particularly Chapter 10.7
Early development of professional accounting bodies While ‘accounting’ and ‘accountants’ have existed for hundreds of years, it was not until the nineteenth century that accountants within the United Kingdom and the United States banded together to form professional associations. According to Goldberg (1949), a Society of Accountants was formed in Edinburgh in 1854, later to be followed by a number of other bodies, including the Institute of Chartered Accountants in England and Wales (ICAEW), which was established in 1880. According to Mathews and Perera (1996, p. 16), from the early years the 5
6
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According to Hendriksen and Van Breda (1992, p. 36), our use of the word ‘debit’ can be traced back to the word debere (shortened to ‘dr’), which is the Latin word for an obligation and can be interpreted as meaning ‘to owe’. The word ‘credit’ (abbreviated to ‘cr’) can be linked to the Latin word credere, which means to believe or trust in someone. Hatfield (1924) points out that Luca Pacioli (who was a prominent academic of his day) was a close friend of Leonardo da Vinci, and that da Vinci was one of the first people to buy a copy of Summa de Arithmetica and drew the illustrations for one of Pacioli’s later books. At this point, let’s ponder the following question: if a company’s operations led to the release of toxic gases that killed many birds, but no fines were imposed because there were no strict environmental laws, would there be any debits or credits to reflect this cost that was imposed upon nature (and if so, what would be the debits and credits)? Chapter 10 addresses this issue.
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ICAEW was very concerned about the reputation of its members and as a result set conditions for admission, including general education examinations, five years of articles served with a member of the institute, and intermediate and final examinations in a range of subjects. In the United States, the American Association of Public Accountants was formed in 1887 (Goldberg, 1949). This association went on to form the basis of the American Institute of Certified Public Accountants (AICPA). While members of these bodies were often called upon to perform audits in particular circumstances, and while companies were generally required to prepare accounting reports subject to various company laws and securities exchange requirements,8 there was a general absence of regulation about what the reports should disclose or how the accounting numbers should be compiled (that is, there was effectively a ‘free-market’ approach to accounting regulation).9
Early codification of accounting rules In the early part of the twentieth century, limited work was undertaken to codify particular accounting principles or rules. Basically, accountants used those rules of which they were aware and which they (hopefully) believed were most appropriate to the particular circumstances. There was very limited uniformity between the accounting methods adopted by different organisations, thereby creating obvious comparability problems (and one of the enhancing qualitative characteristics as espoused within the IASB Conceptual Framework that useful financial information should possess is ‘comparability’). Around the 1920s, a number of people undertook research that sought to observe practice and to identify commonly accepted accounting conventions that would then be prescribed to other accountants as the most appropriate way to perform financial accounting. That is, they sought to describe ‘what was’, rather than assuming a normative position with regard to ‘what should be’. By simply describing current practice, the researchers gave themselves limited possibilities of actually improving accounting procedures. As Mathews and Perera (1996, p. 20) state: This led to a practice–theory–practice cycle and tended to retard the progress of accounting, because there was no value judgement exercised in respect of the practices which were observed. In other words, there was no opportunity to examine critically what was being practised before the next generation of accountants were prepared in the same manner.
Early researchers who provided detailed descriptions of existing conventions of accounting included Paton (1922), Sanders, Hatfield and Moore (1938), Gilman (1939) and Paton and Littleton (1940). These studies described such things as the doctrines of conservatism, concepts of materiality, consistency, the entity assumption and the matching principle – principles which are still often discussed, and taught, today. A great deal of the early work undertaken to establish particular accounting rules and doctrines was undertaken in the United States. In 1930 the accounting profession within the United States cooperated with the New York Stock Exchange (NYSE) to develop a list of broadly used accounting principles which would then be prescribed to all accountants. According to Zeff (1972), this publication is one of the most important documents in the history of accounting 8
9
For example, within the United Kingdom the Joint Stock Companies Act 1844 required that companies produce a balance sheet and an auditor’s report thereon for distribution to shareholders before the annual meeting. This requirement was removed in an 1862 Act, but reinstated in a 1900 Act. In 1929 a requirement to produce a profit and loss account was introduced. In 1900, the New York Stock Exchange required companies applying for listing to prepare financial statements showing the results of their operations as well as details about their financial position. In 1926 the exchange further required that all listed companies provide their shareholders with an annual financial report in advance of the companies’ annual general meetings. The report did not have to be audited.
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regulation and set the foundation for the codification and acceptance of generally accepted accounting principles. The NYSE asked the accounting profession to compile the document as it was concerned that many companies were using a variety of (typically undisclosed) accounting methods.10
REFLECTION QUESTION 3.1 Accounting regulation based upon generally accepted accounting practice As the material above describes, much early accounting research focused on investigating what financial accounting practices (including the various assumptions and conventions practised by accountants) were being applied by most financial accountants and these practices were then documented and formed the basis for what accounting practices all accountants were then expected to apply. The rationale was that if most accounting practitioners were applying particular methods, then all practitioners should apply them. Question Why might prescribing accounting practice on the basis of what most accountants do – as was the case several decades ago – not necessarily generate the ‘best’ accounting practices?
Solution Somewhat logically, just because most people in a particular profession do something does not mean it’s the best possible, or most efficient, thing to do. For example, the population of home gardeners might all be happy to use a spoon to dig holes for planting small trees if none of them have been exposed to a shovel. If people do not know there are better practices available, then they may be inclined to follow commonly used, but suboptimal, practices. People typically need to be shown that there are better practices available before they change what they do. Accounting researchers, and their appropriate use of theory, have a role in identifying potential improvements in existing accounting practice. Adhering to what most people do will not necessarily reflect best possible practice.
Development of disclosure regulations In the United States, it was not until 1934 that specific disclosures of financial information were required by organisations seeking to trade their securities. The Securities Exchange Act of 1934, as administered by the Securities and Exchange Commission (SEC), stipulated the disclosure of specific financial information. The SEC was given authority to stipulate accounting principles and reporting practices. However, it allowed the accounting profession to take charge of this activity as long as it could clearly indicate that it would perform such duties diligently. In an effort to convince the SEC that it could identify acceptable accounting practices, the American Institute of Accountants (one of the predecessors of the AICPA) released, in 1938, a study by Sanders, Hatfield and Moore entitled A Statement of Accounting Principles. In 1938 the SEC stated (within Accounting Series Release No. 4) that it would accept only those financial statements that had been prepared in accordance with the generally accepted accounting principles of the accounting profession, thereby giving a great deal of power to the profession. In part, ASR No. 4 stated: In cases where financial statements filed with the Commission … are prepared in accordance with accounting principles for which there is no substantial authoritative support, such financial statements will be presumed to be misleading or inaccurate despite disclosures contained in the certificate of the accountant or in footnotes to the statements provided the matters are material. In cases where there is a difference of opinion between the Commission and the registrant as to proper principles of
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Five of the identified principles subsequently formed the basis of Chapter 1 of Accounting Research Bulletin No. 43, as issued by the Committee on Accounting Procedure.
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accounting to be followed, disclosure will be accepted in lieu of correction of the financial statements themselves, only if the points involved are such that there is substantial authoritative support for the practices followed by the registrant and the position of the Commission has not previously been expressed in rules, regulations, or other releases of the Commission, including the published opinion of its chief accountant.
While the above statement does indicate that the SEC was to allow the accounting profession to determine acceptable practice, many considered that the SEC was also warning the accounting profession that it must take an authoritative lead in developing accounting standards, otherwise the SEC would take over the role (Zeff, 1972). From 1939 the Committee on Accounting Procedure, a committee of the accounting profession, began issuing statements on accounting principles, and between 1938 and 1939 it released 12 Accounting Research Bulletins (Zeff, 1972). Development by the accounting profession of mandatory accounting standards is a relatively recent phenomenon. In the United Kingdom, it was not until 1970, when the Accounting Standards Steering Committee was established (later to become the Accounting Standards Committee and then the Accounting Standards Board), that UK accountants had to conform with professionally developed mandatory accounting standards. Prior to this time, the ICAEW had released a series of ‘recommendations’ to members. In the United States, although there had been Accounting Research Bulletins (released by the Committee on Accounting Procedure, formed in 1938) and Opinions (released by the Accounting Principles Board [APB], formed in 1959), these Bulletins and Opinions were not mandatory. Rather, they indicated perceived best practice. There tended to be many corporate departures from these Bulletins and Opinions and, as a result, in 1965 a rule (Rule 203 of the AICPA) was introduced that required departures from principles published in APB Opinions to be disclosed in footnotes to financial statements. From 1 July 1973 the APB was replaced by the Financial Accounting Standards Board (FASB), which has subsequently released many accounting standards that are mandatory. As might be expected given overseas experience, the history of accounting regulation within a country such as Australia is quite recent. In 1946, the Institute of Chartered Accountants in Australia (ICAA) (which has subsequently become Chartered Accountants Australia and New Zealand, or CAANZ) released five ‘Recommendations on accounting principles’, which were largely based on documents released by the Institute of Chartered Accountants in England and Wales (ICAEW). In 1956, a number of recommendations were released by the Australian Society of Accountants (now known as CPA Australia). In later years the two bodies agreed to issue statements and recommendations jointly through the Australian Accounting Research Foundation (AARF), a body jointly funded by the ICAA and CPA Australia. In 2005, the AARF was disbanded. Its elimination placed the development of accounting standards in the hands of the federal government (through the Australian Accounting Standards Board), rather than in the hands of the accounting profession, thereby effectively reducing the ability of the accounting profession to ‘self-regulate’. Further, with the adoption of International Financial Reporting Standards (IFRS) within Australia from 2005, a great deal of the work involved in developing accounting standards has been centralised with the International Accounting Standards Board (IASB, located in London), such that the scope for the AASB to develop accounting standards independently within Australia has been greatly reduced (although domestic accounting standards will be developed from time to time to fill voids not addressed by the IASB). This situation is common to many other countries that have also adopted IFRS in recent years such that, internationally, most countries now use the IFRS developed by the IASB. However, whether different countries, with potentially different cultures and different information expectations, should all use the same rules for preparing general purpose financial reports is something that we address in Chapter 5.
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The development of accounting regulation in Europe is also worthy of consideration. As is explored in greater depth in Chapter 5, financial accounting practices (and therefore the regulation of financial reports) in many European countries were not primarily focused on the provision of information to aid investment decisions by external shareholders in capital markets (in large part because European companies did not typically attract funds from a diverse and large number of shareholders who were not involved in the management of the organisation). The regulation of financial reporting through professionally developed standards is therefore an even more recent phenomenon in large parts of continental Europe than it is, for example, in the United Kingdom, the United States or Australia. However, regulation (through a requirement to follow the accounting standards released by the IASB) of the consolidated financial statements of all companies whose shares are traded on any securities exchange in the EU became compulsory from 1 January 2005.
Twenty-first-century political pressure on financial accounting regulation A further significant change in the accounting regulatory frameworks of many countries occurred following several high-profile accounting and audit failures in the United States in 2001 and 2002 (including Enron and WorldCom). Although, as Unerman and O’Dwyer (2004) point out, these were not the first large-scale accounting failures to occur since the inception of regulation through professional accounting standards, they were much larger than previous failures and occurred at a time of sharply falling securities markets. Private investors who were already losing confidence in securities markets due to their financial losses on falling share prices now perceived accounting failures as contributing to even larger losses. In this climate, politicians came under pressure to make accounting regulation more rigorous, and they passed legislation (such as the US Sarbanes–Oxley Act of 2002) to give greater legal force to many existing and new regulations. Significant political pressure for changes in accounting regulations and regulatory regimes was again exerted for a period following the sub-prime banking crisis and ensuing global financial crisis (GFC) from 2007–09 and onwards.11 The sub-prime banking crisis saw several banks fail, including the major financial institution of Lehman Brothers, and other banks needing very large amounts of government support. These failures exacerbated a loss of confidence within the global banking system, with such confidence being an essential element in the smooth running of the banking system, which in turn is essential for economic stability and growth. Among the many practices that have been implicated in causing the sub-prime banking crisis and ensuring the credit crunch and GFC, the effectiveness of financial accounting and its regulation was called into question (for a variety of theoretical perspectives on the role of accounting and accountants in the sub-prime crisis and credit crunch see, for example, Arnold, 11
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Some readers might not be familiar with the term ‘sub-prime’. As applied to lending, ‘sub-prime lending’ refers to a situation where loans are made to people – known as ‘sub-prime borrowers’ – who have a higher probability of defaulting on loan repayment requirements compared to ‘prime borrowers’. It is generally considered that a key trigger for the GFC was sub-prime lending and the inflated US property market, which peaked in 2005–06. Further, and at the same time, various loan incentives were being offered to borrowers, such as initial discounts on repayments. In the period when property prices had been rising, many ‘sub-prime borrowers’ took loans believing that they would be insulated by continuously rising property prices. However, when property prices started to fall and interest rates rose, defaults and forclosures sharply rose and refinancing became difficult. Many loans could not be repaid and the amount of the loan often greatly exceeded the value of the secured property. Also, many mortgage-backed securities (which arise, for example, where mortgage loans – of which many at the time included sub-prime loans – are purchased from lenders, such as banks, and are placed into ‘pools’ into which investors can acquire an interest) became worth very little. Interestingly, in March 2013 the US Federal Government took legal actions against the credit ratings agency, Standard and Poors, which had provided credit ratings on various mortgage-backed securities funds. The government argued that the ratings attributed to the funds were too high (allegedly to please the banks in charge of the funds and thereby hopefully enable S & P to attract further ratings work from the client), indicating that the investments were of low risk and, as a result, many investors, including financial institutions invested in the securities, on the basis of the ratings and this further helped trigger the GFC.
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2009; Hopwood, 2009; Laux and Leuz, 2009; Roberts and Jones, 2009; Sikka, 2009). Politicians questioned why the financial statements of failed banks had not given adequate warning of the significant risks and problems faced by banks. This political questioning of the role of accounting, and pressure to take action to ensure that financial statements helped to provide greater transparency in the future, reached the highest level when it was placed on the agenda of G-20 leaders’ summit meetings from their inception in 2008.12 At the first of these summit meetings, in November 2008, the first of the five policy areas in the area of reforming financial markets was transparency and accountability. Strengthening Transparency: We will strengthen financial market transparency, including by enhancing required disclosure on complex financial products and ensuring complete and accurate disclosure by firms of their financial conditions. Incentives should be aligned to avoid excessive risk-taking. (G-20, 2008a, paragraph 9)
In detailing how they were to achieve the desired reforms in this area, the G-20 leaders agreed to a series of short-term and medium-term actions, most of which require changes in specific accounting regulations or in the manner in which accounting is regulated (G-20, 2008b, p. 1): Immediate Actions by March 31, 2009 • The key global accounting standards bodies should work to enhance guidance for valuation of securities, also taking into account the valuation of complex, illiquid products, especially during times of stress. • Accounting standard setters should significantly advance their work to address weaknesses in accounting and disclosure standards for off-balance sheet vehicles. • Regulators and accounting standard setters should enhance the required disclosure of complex financial instruments by firms to market participants. • With a view toward promoting financial stability, the governance of the international accounting standard setting body should be further enhanced, including by undertaking a review of its membership, in particular in order to ensure transparency, accountability, and an appropriate relationship between this independent body and the relevant authorities. • Private sector bodies that have already developed best practices for private pools of capital and/or hedge funds should bring forward proposals for a set of unified best practices. Finance Ministers should assess the adequacy of these proposals, drawing upon the analysis of regulators, the expanded FSF [Financial Stability Forum], and other relevant bodies. Medium-term actions • The key global accounting standards bodies should work intensively toward the objective of creating a single high-quality global standard. • Regulators, supervisors, and accounting standard setters, as appropriate, should work with each other and the private sector on an ongoing basis to ensure consistent application and enforcement of high-quality accounting standards. • Financial institutions should provide enhanced risk disclosures in their reporting and disclose all losses on an ongoing basis, consistent with international best practice, as appropriate. Regulators should work to 12
The G-20 is a forum for the financial ministers and central bank governors from 19 of the world’s largest economies plus the EU. In responding to the GFC, the G-20 convened a series of semi-annual summits of the leaders of the G-20.
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ensure that a financial institution’s financial statements include a complete, accurate, and timely picture of the firm’s activities (including off-balance sheet activities) and are reported on a consistent and regular basis.
At the G-20 summit in September 2009, the G-20 called for further strengthening of accounting standards in the form of early completion (by June 2011) of the FASB/IASB convergence project, aiming to produce a single set of accounting standards for use internationally. By the time of the June 2010 summit, this timetable had slipped, with a revised target to achieve convergence by the end of 2011: We re-emphasized the importance we place on achieving a single set of high quality improved global accounting standards. We urged the International Accounting Standards Board and the Financial Accounting Standards Board to increase their efforts to complete their convergence project by the end of 2011. (G-20, 2010, p. 20, paragraph 30)
The convergence project was not completed by the end of 2011, which prompted the G-20 to ask that the IASB and FASB set a new deadline of mid 2013 for convergence (as reported by Reuters in an article on 5 November 2012 entitled ‘G20 hopes for fourth time lucky on global accounting’). This deadline was not met and there is an acceptance now that such convergence, if it is to occur, is some time away (in Chapter 5 we examine some arguments that question the logic of international convergence of accounting standards). According to a ‘Final Staff Report’ issued by the US SEC (2012), some of the reasons against the convergence of the accounting standards issued by the IASB and the FASB included: • too much diversity in how IFRS were being interpreted, applied and enforced in various jurisdictions throughout the world • the potentially high costs to US organisations of adopting IFRS • the cost involved in educating US investors • the implications for changes in corporate governance. Interestingly, in 2019 the International Federation of Accountants issued a report entitled The Global Accountancy Profession’s Call to Action for G20 Leaders: Counting on Society 5.0, in which it made various calls for revised regulation across countries that are ‘fundamental to achieving the G20’s aim of fair and sustainable development through an agenda that is people centred, inclusive and forward looking. These are actionable steps toward realizing the United Nations Sustainable Development Goals and Japan’s global vision for ‘Society5.0’” (IAF, 2019). The ‘Call for Action’ is shown in Figure 3.2. We return to issues of international convergence in accounting standards in Chapter 5, but at this stage we can see how various factors can influence the development of accounting regulation, including pressure from powerful groups such as the G-20. Specifically, we can see how significant events such as the GFC create pressures on regulators to change, or create pressures for changes, in accounting practices. In more recent times, the implications of the COVID-19 pandemic have also led to calls for changes in accounting practice, particularly in relation to accounting for the impairment of non-current assets. In Chapter 4, we discuss what motivates regulators or politicians to make changes to regulations in response to such pressures, and see that there are a variety of theories to explain regulators’ actions and motivations.13 13
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For example, some researchers might assume that regulations were introduced because regulators believed it was in the public interest to introduce such regulation. Alternatively, some researchers who embrace the view that everybody in society is primarily motivated by their own self-interest (perhaps not an overly optimistic view of human nature) would assume that regulators support particular regulation because it is in their own self-interest to do so. For example, Taylor (2009, p. 319) argues that ‘legislative intervention to create new regulations and regulatory apparatus is frequently a reflection of how players in the political arena attempt to ensure they are not held to blame for investor losses’.
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FIGURE 3.2 The Global Accountancy Profession’s ‘Call to Action’ for G20 leaders
Smarter regulation
Heightened transparency
Inclusive growth
1 Make Regulation Smarter, and More Effective 2 Create a Consistent, Transparent, Global Regulatory Environment 3 Implement Internationally Accepted Standards
4 Strengthen Governance 5 Embrace Integrated Reporting 6 Enhance Public Sector Financial Management 7 Collaborate to Tackle Corruption
8 Create an Environment for Small and Medium-sized Entity Growth and Inclusiveness 9 Create a Secure and Digital Ready Investment Environment 10 Collaborate for a Coherent International Tax System
Source: Adapted from International Federation of Accountants (2019), The Global Accountancy Profession’s Call to Action for G20 Leaders: Counting on Society 5.0, https://www.ifac.org/system/files/publications/ files/GAP-Counting-on-Society-5.0-paper-v4.pdf, p. 1.
Why do I need to know about how the regulation of financial accounting has developed? In some capacity or another, we will all be influenced by numbers generated through general purpose financial reporting. Financial accounting numbers, such as the profits of large organisations listed on securities exchanges, are often given much media coverage. Such numbers, in turn, influence dividend payments, share prices, wage growth expectations and so forth. Knowing about the evolution of financial accounting regulation helps us to be able to place in context such widely used financial numbers. Further, for those of us who will have a career in accounting, whether it perhaps be as a practitioner or as a researcher, it should be of interest to know how events, such as particular global financial, social or environmental crises have influenced the accounting practices we know. For example, in very recent years, regulators throughout the world have required reporting entities to consider
how climate change is influencing the financial performance and financial position of organisations and have issued related guidance. In this regard, regulators such as the IASB, International Sustainability Standards Board (ISSB) and the AASB have recently released requirements pertaining to how changing laws and expectations around climate change must be kept in mind when considering the impairment of assets, and the useful lives of assets for depreciation purposes. The COVID-19 pandemic has also led to changing financial reporting guidance. Therefore, to understand current practice, it is useful to understand that the body of accounting regulation in place at a point of time has been influenced by a multitude of past events – some financial, some environmental and some social.
The rationale for regulating financial accounting practice LO3.1
LO3.3
LO3.4
As indicated, even though financial reports have been in existence for hundreds of years, the regulation of accounting in economies dominated by capital markets (with large numbers of external investors) is a fairly recent phenomenon. Early moves for regulation of accounting were introduced in the United States around the 1930s and followed events such as the Wall Street stock-market crash of 1929. Rightly or wrongly, it was argued that problems inherent to accounting led to many poor and uninformed investment decisions (Boer, 1994; Ray, 1960), and this fuelled the public desire for information generated by companies to be subject to greater regulation. 91
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In most countries with developed capital markets and large numbers of external investors, there is a multitude of financial accounting regulations covering a broad cross-section of issues. But do we need all this regulation? As the next chapter discusses, there are two broad schools of thought on this issue. There are parties who argue that regulation is necessary, and their reasons include the following: • Markets for information are not efficient and without regulation a sub-optimal amount of information will be produced. • While proponents of the ‘free-market’ (or ‘anti-regulation’) approach to providing accounting information may argue that the capital market on average is efficient, such ‘on average’ arguments ignore the rights of individual investors, some of whom can lose their savings as a result of relying on unregulated disclosures. • Some parties who demand information about an organisation can obtain their desired information due to the power they possess as a result of their control over scarce resources required by the organisation. Conversely, parties with limited power (limited resources) will generally be unable to secure information about an organisation, even though that organisation may impact on their existence. • Investors need protection from fraudulent organisations that may produce misleading information, which, due to information asymmetries, cannot be known to be fraudulent when used. • Regulation leads to uniform methods being adopted by different entities, thus enhancing comparability. Other parties argue that regulation is not necessary, particularly to the extent that it currently exists. Some of the reasons cited against accounting regulation include the following: • Accounting information is like any other good, and people (financial statement users) will be prepared to pay for it to the extent that it has use. This will lead to an optimal supply of information by entities.14,15 • Capital markets require information, and any organisation that fails to provide information will be punished by the market; an absence of information will be deemed to imply bad news.16 • Because users of financial information typically do not bear its cost of production, regulation will lead to an over-supply of information (at a cost to the producing firms) as users will tend to overstate the need for the information. • Regulation typically restricts the accounting methods that may be used. This means that some organisations will be prohibited from using accounting methods that they believe most efficiently reflect their particular performance and position. This is considered to impact on the efficiency with which the organisation can inform the markets about its operations.17 When regulation is introduced, there are various theories available to describe who benefits from such regulation. There is the public interest theory of regulation, which proposes that Advocates of a regulated approach would argue, however, that accounting information is a public good and, as a result, many individuals will obtain the information for free (this is often referred to as the ‘free-rider’ problem). Once this occurs, reliance on market-mechanism arguments tends to be flawed and the usual pricing mechanisms of a market cannot be expected to operate (Cooper and Keim, 1983). 15 This ‘free-market’ perspective is adopted by researchers who work within the ‘agency theory paradigm’. This paradigm is discussed in Chapter 8. 16 Accepting this perspective, and consistent with Akerlof (1970), companies that fail to produce the necessary information, particularly if the information is being produced by other entities, will be viewed as ‘lemons’ (a ‘lemon’ is something of inferior quality), and these ‘lemons’ will find it more costly to attract funds than other (‘non-lemon’) entities. 17 For example, pursuant to IAS 38 Intangibles (which, for example, is equivalent to AASB 138 Intangibles in the Australian context), all expenditure on research has to be expensed as incurred. This means that all companies have to adopt the same ‘one-size-fits-all’ approach, even though some entities may have undertaken very valuable research that will lead to significant future economic benefits. On the basis of efficiency, this regulation is deemed to be inappropriate, as it does not allow annual report readers to differentiate between companies with or without valuable research. 14
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regulation is introduced to protect the public. This protection may be required as a result of inefficient markets. Public interest theory assumes that the regulatory body (usually government) is a neutral arbiter of the ‘public interest’ and does not let its own self-interest impact on its rule-making processes. According to Scott (2003, p. 448), following public interest theory, the regulator ‘does its best to regulate so as to maximise social welfare. Consequently, regulation is thought of as a trade-off between the costs of regulation and its social benefits in the form of improved operation of markets’. A contrary perspective of regulation is provided by Capture Theory, which argues that, although regulation is often introduced to protect the public, the regulatory mechanisms are often subsequently controlled (captured) so as to protect the interests of particular self-interested groups within society, typically those whose activities are most affected by the regulation. That is, the ‘regulated’ tend to capture the ‘regulator’. Posner (1974, p. 342) argues that ‘the original purposes of the regulatory program are later thwarted through the efforts of the interest group’. Empirical evidence of a regulator making individual decisions that favour the groups that it regulates is not sufficient to demonstrate regulatory capture (as each of these decisions might be regarded as the most appropriate in the circumstances). Rather, most of the regulator’s whole program of regulation needs to work in the interests of the regulated and usually against the interests of those who the regulator is intended to protect. This implies that accounting regulations can have a different impact on different people or groups, and there is evidence (discussed in the next chapter) showing that specific accounting regulations do have social and/ or economic consequences that vary between different groups. As an example of Capture Theory, Walker (1987) argues that in less than two years following the establishment of the Accounting Standards Review Board (ASRB) in Australia (subsequently replaced by the AASB), the Australian accounting profession (the ‘industry’ subject to the regulation) was able to control, or capture, the ASRB’s regulatory process. Walker provides evidence to support this claim, including the subsequent merger of the Australian Accounting Research Foundation (the professionally funded body) with the AASB (the government body), and that the great majority of issues to be addressed in accounting standards were raised by the accounting profession itself.18 Both public interest theories and capture theories of regulation assert that initially regulation is put in place to protect the public (Capture Theory simply asserts that the regulated will then subsequently attempt to control the regulatory process). Another view, which is often referred to as private interest theory (or economic interest group theory), is proposed by researchers such as Stigler (1971) and Peltzman (1976). This theory relaxes the assumption that regulations are initially put in place to protect the public interest, as well as the assumption that government regulators are neutral arbiters not driven by self-interest. Stigler (1971) proposes that governments are made up of individuals who are self-interested and will introduce regulations more likely to lead to their re-election. In deciding on a particular regulation, they will consider the impacts on key voters, as well as on election campaign finances. Individuals with an interest in particular legislation are deemed more likely to get their preferred legislation if they can form themselves into large organised groups with strong cohesive voting power. These theories of regulation (public interest theory, Capture Theory and private interest theory), as well as others, are further considered in Chapter 4. 18
The establishment of the ASRB in the first place, however, can be explained by a public interest theory perspective. Prior to the establishment of the ASRB, accounting standards in Australia were released by a private sector body, the Australian Accounting Research Foundation (AARF). The AARF, which was not a government body, had limited ability to impose sanctions against entities that did not follow the AARF standards. This was believed to be a major cause of the numerous corporate non-compliances, and the associated social and economic costs that such non-compliances might cause. The ASRB, a government body, was established to give legal backing to accounting standards through the operation of the Corporations Law. With renewed confidence in the information being produced, there was also a view that the capital markets would function more efficiently, which would be considered to be in the public interest.
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If we are to accept the need for accounting regulation, a further issue to consider is who should be responsible for the regulation: should it be in the hands of the private sector (such as the accounting profession) or in the hands of the public (government) sector?19 Can private sector regulators be expected to put in place regulations that are always in the public interest or will they seek to put in place rules that favour their own constituency? Obviously, the answer to such questions will be dependent on our particular view of the world (and our own view of the world will in turn influence which particular theory of regulation we are more likely to embrace). Advocates of private sector accounting standard-setting would argue that the accounting profession is best able to develop accounting standards because of its superior knowledge of accounting and because of the greater likelihood that its rules and regulations would be accepted by the business community. Proponents of public sector accounting standard-setting argue that government has greater enforcement powers, hence the rules of government are more likely to be followed. It might also be less responsive to pressures exerted by business and more likely to consider the overall public interest. What is demonstrated in subsequent chapters is that the regulation of accounting (or indeed an absence of regulation) can have many economic and social consequences. As such, the accounting standard-setting process is typically considered to be a very political process, with various interested parties lobbying the standard-setters.
The costs and benefits of accounting regulation At the core of the accounting process is an expectation that accountants should be objective and free from bias when performing their duties. The information being generated should faithfully represent the underlying transactions and events and it should be neutral and free from error (see paragraphs 2.12 to 2.18 of the IASB Conceptual Framework).20 However, can we really accept that accounting can be ‘neutral’ or objective? Throughout the world, accounting standard-setters, such as the IASB and the FASB, have explicitly considered the economic and social implications of possible accounting standards prior to their introduction. (The consideration of economic and social consequences prior to the release of an accounting standard is specifically referred to in the IASB Conceptual Framework.) If the economic or social implications of a particular accounting standard have been deemed to be significantly negative, then it is likely that the introduction of the standard would have been abandoned, even though the particular standard may have been deemed to reflect more accurately particular transactions or events. While it is difficult to criticise a process that considers potential impacts on others, it is nevertheless difficult to accept that accounting standards are neutral or unbiased if the fear of the potential economic or social consequences relating to a potential accounting standard – and the information it will make available – are used as a rationale not to release an accounting standard. In a sense, the acceptance of the need to consider economic and social consequences as part of the standard-setting process has created a dilemma for standard-setters. According to Zeff (1978, p. 62): The board (FASB) is thus faced with a dilemma which requires a delicate balancing of accounting and non-accounting variables. Although its decisions should rest – and be In some countries, accounting regulation is in the hands of both private sector and public sector entities. As an example, within the EU, accounting regulations are developed by the IASB (private sector) but have to be endorsed by the ARC (public sector) before they are enforced for EU companies. In the United States, both the FASB (private sector) and the SEC (public sector) have released accounting standards. In Australia, and following restructuring that occurred a number of years ago, accounting standard-setting is now in the hands of the AASB, a government body. 20 According to Hines (1991, p. 330), it is in the accounting profession’s interest to promote publicly, perhaps through conceptual frameworks, a perspective of objectivity. As she states, ‘the very talk, predicated on an assumption of an objective world to which accountants have privileged access via their “measurement expertise”, serves to construct a perceived legitimacy for the profession’s power and autonomy’. 19
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seen to rest – chiefly on accounting considerations, it must also study – and be seen to study – the possible adverse economic and social consequences of its proposed actions … What is abundantly clear is that we have entered an era in which economic and social consequences may no longer be ignored as a substantive issue in the setting of accounting standards. The profession must respond to the changing tenor of the times while continuing to perform its essential role in the areas in which it possesses undoubted expertise.
Referring to the IASB Conceptual Framework (IASB, 2022), we find: Paragraph 2.42: In applying the cost constraint, the Board assesses whether the benefits of reporting particular information are likely to justify the costs incurred to provide and use that information. When applying the cost constraint in developing a proposed Standard, the Board seeks information from providers of financial information, users, auditors, academics and others about the expected nature and quantity of the benefits and costs of that Standard. In most situations, assessments are based on a combination of quantitative and qualitative information. Paragraph 2.43: Because of the inherent subjectivity, different individuals’ assessments of the costs and benefits of reporting particular items of financial information will vary. Therefore, the Board seeks to consider costs and benefits in relation to financial reporting generally, and not just in relation to individual reporting entities. That does not mean that assessments of costs and benefits always justify the same reporting requirements for all entities. Differences may be appropriate because of different sizes of entities, different ways of raising capital (publicly or privately), different users’ needs or other factors.
In Chapter 13, we consider the works of researchers whose work is informed by what is referred to as ‘critical accounting theory’. These theorists also question the objectivity of financial reporting standards, and they argue that all the accounting standards in place simply act to support the interests of financial capital providers while effectively marginalising the interests of other stakeholders, such as workers. That is, these theorists believe that the ‘benefits’ generated from general purpose financial reporting disproportionately favour capital market participants to the detriment (cost) of other stakeholders.
Regulation and enforcement For regulation to be effective, it also jointly requires appropriate monitoring and enforcement mechanisms to be in place. Logically, the existence of regulation without strong mechanisms to ensure regulatory compliance renders any regulation ineffectual. In this chapter we have discussed the requirement for large organisations to prepare general purpose financial statements. For most countries throughout the world, the requirement in these countries is that these statements shall comply with the accounting standards issued by the IASB, with these standards referred to as International Financial Reporting Standards (IFRS). According to the website of the IASB (https://www.ifrs.org), 144 jurisdictions use IFRS for all, or most, of their publicly listed companies, while a further 12 jurisdictions permit their use. The moves towards international standardisation of financial reporting have been in place now for over two decades and these moves have been there because of the perception that international standardisation of financial reporting practice brings many benefits. In this regard, the IFRS website (2022) states: IFRS Standards provide a high quality, internationally recognised set of accounting standards that bring transparency, accountability and efficiency to financial markets around the world. 95
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IFRS Standards bring transparency by enhancing the international comparability and quality of financial information, enabling investors and other market participants to make informed economic decisions. IFRS Standards strengthen accountability by reducing the information gap between the providers of capital and the people to whom they have entrusted their money. Our Standards provide information that is needed to hold management to account. As a source of globally comparable information, IFRS Standards are also of vital importance to regulators around the world. And IFRS Standards contribute to economic efficiency by helping investors to identify opportunities and risks across the world, thus improving capital allocation. For businesses, the use of a single, trusted accounting language lowers the cost of capital and reduces international reporting costs.
The benefits of international standardisation of financial reporting practices, some referred to in the above quote, are premised on the basis that when countries move to adopt IFRS, and later claim that their national organisations are applying IFRS, that they also have in place mechanisms to enforce widespread national compliance with IFRS. However, the reality is that there are many countries (particularly some developing countries) that claim that their large companies are applying IFRS, when, due to ineffective or non-existent national enforcement strategies, they are not. The IASB, which is located in London and is under the auspices of the IFRS Foundation, has no power to enforce its accounting standards. Its role is to develop accounting standards (it is a standard-setting body and not an enforcement body), which it then hopes will be adopted throughout the world, but again, it has no power to enforce compliance. Rather, it is left to national regulators to ensure compliance within their respective countries. Many countries have very poor enforcement programs such that even though companies might be publicly stating that they are applying IFRS, they really are not complying with the requirements of the many accounting standards. Therefore, even though we might be told that IFRS have been adopted in many countries throughout the world, this really needs to be tempered by the fact that many of these countries have very poor enforcement strategies in place such that high levels of non-compliance render any claims that IFRS have been applied as incorrect. We return to this issue of enforcement as it relates to the international standardisation of accounting practice in Chapter 5.
The role of professional judgement in financial accounting LO3.5
As we know from studying accounting, the process involved in generating financial statements depends on many professional judgements. While the accounting treatment of many transactions and events is regulated, a great deal of accounting treatment pertaining to other transactions and events is unregulated. Even when particular regulations are in place, for example that property, plant and equipment such as buildings must be depreciated, there is still scope to apply judgement in selecting the useful life of the building and the residual value. Many such judgements must be made. For example, should an item of expenditure be capitalised or expensed, or should an income item be recognised now or deferred to a future reporting period? This in turn will depend on crucial assessments as to whether the expenditure is likely to generate future economic benefits or whether the expected future inflow of economic benefits (the income) is deemed reasonably likely to occur this period, next period or potentially not at all. Chapters 8 and 9 consider various theoretical perspectives proposed as explanations for why particular accounting methods may be implemented by a reporting entity (remember, the 96
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accounting treatment of many transactions and events is not subject to accounting standards). Consistent with the perspective that managers and their accountants should prepare reports that are representationally faithful is a view that organisations and their stakeholders are best served when managers select those accounting methods that best reflect their underlying performance. This is referred to as an ‘efficiency perspective’ (derived from Positive Accounting Theory, which is explained in Chapter 8). The efficiency perspective asserts that different organisational characteristics explain why different organisations adopt different accounting methods (Jensen and Meckling, 1976). For example, a view often promoted by some accounting researchers is that organisations that have different patterns of use in relation to a particular type of asset will be predicted to adopt different amortisation policies. Advocates of the efficiency perspective argue that organisations should be able to choose those accounting methods that best reflect their performance and circumstances, and that accounting regulations that restrict the set of available accounting techniques will be costly in the sense that they will restrict the ability of managers to provide measures that efficiently represent, or signal, the performance of the organisation. For example, if a new accounting standard is released that bans a particular accounting method being used by a reporting entity, this will lead to inefficiencies as the resulting financial statements may no longer provide the best reflection of the performance of the organisation. Some accounting researchers argue that management is best able to select which accounting methods are appropriate in given circumstances, and government or other bodies should not intervene through the standard-setting process. This perspective, however, does not consider that some financial statement preparers may be less than objective (that is, as with Enron or WorldCom, they may be creative) when preparing the financial reports. The efficiency perspective also dismisses the comparability benefits that may arise if standard-setters reduce the available set of accounting methods. An alternative perspective to explain why particular accounting methods are selected (that is also derived from Positive Accounting Theory, which we explore in Chapter 8) is the ‘opportunistic perspective’. This perspective does not assume that those responsible for selecting accounting methods will be objective. Rather, it assumes that managers and accountants, like most people, will be driven by self-interest (Watts and Zimmerman, 1978). This perspective provides an explanation of the practice of ‘creative accounting’, which is defined as an approach to accounting wherein objectivity, or representational faithfulness, is not prioritised, but rather refers to a situation where those responsible for the preparation of accounts select accounting methods that provide the accounting result desired by the preparers. As an example, an organisation might, like Enron, opportunistically elect to structure certain transactions in a manner designed to remove specific assets and related liabilities from its balance sheet (a technique known as off balance sheet funding). This is not because these assets and liabilities do not ‘belong’ to the organisation, but perhaps because this off balance sheet funding has the effect of reducing the reported debt to equity (capital gearing) ratio at a time when the organisation is close to breaching particular accounting-based agreements negotiated with external parties, such as loan agreements that have a stipulated minimum allowable debt to equity ratio, below which particular assets of the reporting entity may be seized. Apart from the efficiency and opportunistic perspectives, there are a number of other theoretical perspectives proposed to explain why managers might select particular accounting and disclosure policies (other perspectives include those coming from Legitimacy Theory, Political Economy Theory, Institutional Theory, Stakeholder Theory and Critical Accounting Theory). Chapters 9 and 13 further explore some of the alternative theoretical perspectives. However, what is being emphasised at this point is that, although there is much accounting regulation in place (and there are various theories to explain the existence of regulation), there are also many accounting decisions that are unregulated (giving rise to various theories to explain the accountants’ and managers’ choices of particular accounting methods from the set of available alternatives). 97
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REFLECTION QUESTION 3.2 Application of professional judgement in accounting The existence of a high degree of professional judgement in financial accounting practice raises a number of issues, or questions, that we can potentially address or answer through the application of appropriate theory. Question What are some of these issues that we might address through the application of different theories? Solution Some of the questions that researchers might like to address in relation to the application of professional judgement in accounting include: 1 What are some of the costs and benefits associated with government bodies and other regulators allowing professional judgement to be applied in respect of accounting for certain transactions and events? 2 Why do regulators allow professional judgements to be applied by accountants (which is effectively a principlesbased approach to regulation) rather than mandating strict rules that must be followed (which would be considered to represent a rules-based approach to regulation)? We consider theories of regulation in Chapter 4. 3 What are some of the motivations driving managers and their accountants to make certain accounting choices (for example, as Chapter 8 discusses, we can apply efficiency arguments, or opportunism-based arguments, to explain managers’ accounting choices)? 4 How do the users of accounts react to different accounting numbers at both the individual level
(perhaps explored through some form of behavioural research, which we look at in Chapter 12) and at an aggregated level (perhaps explored through measuring the movements of share prices within capital markets as particular information is released – an area we explore in Chapter 11)? 5 Does allowing professional judgement to be applied provide relatively greater benefits to particular categories of stakeholders (relative to strictly enforced rules), and what are those respective benefits (we could use some form of stakeholder theory to address this issue – stakeholder theory is addressed in Chapter 9 – or we could use insights from critical accounting theories, which are addressed in Chapter 13)? 6 What are some of the attributes of preparers and/or their organisations that influence accounting policy choice (for example, the organisations’ total debt, closeness to breaching debt covenants, size, industry, profitability, whether managers are on an accounting-based bonus scheme – such issues are addressed in Chapter 8. Behavioural research, which is discussed in Chapter 12, also explains how particular behavioural attributes can influence accounting policy choice)? 7 Whether there are systematic international differences in the accounting choices made by managers and their accountants (we consider international differences in accounting in Chapter 5).
Why do I need to know that financial accounting numbers rely very much on the exercise of professional judgement? If you are to read accounting reports, then it is important that you understand that many judgements have been made by the managers, and their accountants, in the formulation of the accounting reports. In respect of financial accounting, and given the amount of professional judgement involved, it is quite true to say that if we had a medium to large organisation with many transactions and events, and if we asked a number of teams of accountants to prepare the financial statements independently, then it would be almost impossible that the different teams of accountants would come up with the same income, expenses, assets and liabilities. Indeed, there could be quite significant differences in the accounting numbers generated. With this in mind, we should think about whether there are particular
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attributes of an organisation, or the managers, that makes it likely that managers might have used their judgement opportunistically and against the best interests of the various stakeholders, or whether they select those accounting methods that most efficiently represent the actual performance of the organisation. Theory can provide such insights. We should also consider why regulators have potentially opted for ‘principles-based accounting rules’ wherein guidelines or principles for reporting are provided (for example, that property, plant and equipment should be depreciated over their useful lives), rather than prescribing detailed rules that must be adhered to (for example, that buildings must be depreciated over 40 years). The accounting standards of the IASB are considered to be fundamentally principles-based in nature.
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LO3.4
LO3.6
How powerful is the accountant?
The idea of accountants being very powerful individuals within society is probably not an idea that is shared by many people. Indeed, accountants might be unfairly seen as being rather boring, unimaginative and methodical individuals. Certainly, this is the stereotype that is attributed to accountants.21 According to Bougen (1994), such a view is, in large part, driven by the interdependency between accounting and bookkeeping. Reflecting on the work of Bougen, Dimnik and Felton (2006, p. 133) state: Although much accounting work requires judgment, imagination and creativity, bookkeeping is boring and routine. Bougen suggests that historically accountants may have been willing to accept a personally disparaging, often laughable image because it was in their professional interest to do so. Since bookkeeping is also identified with positive characteristics such as objectivity, accuracy and conservatism, the stereotype of the unimaginative, harmless, methodical number cruncher may have actually heightened the accountant’s reputation for dependability, giving the profession more credibility with the public.
Following from this quote, it could be argued that accountants might actually have decided to embrace an unimaginative and harmless persona because of the financial benefits associated with being seen as ‘dependable’ and ‘credible’. How clever! Nevertheless, accountants are frequently the subject of many a cruel joke. They are often portrayed as small, weak individuals with poor social skills. For example, consider the depictions of accountants in various movies and television programs. In the (in)famous Monty Python lion tamer sketch, in which John Cleese is cast as a recruitment consultant who interviews Michael Palin (who plays Mr Anchovy, the accountant and aspiring lion tamer), Cleese describes the accountant as: An extremely dull fellow, unimaginative, timid, lacking in initiative, spineless, easily dominated … Whereas in most professions these would be considerable drawbacks, in accountancy they are a positive boon.22
Some of us ‘older folk’ might also remember such characters as Louis Tully, the ‘nerd’ accountant in Ghostbusters (1984), who invites business associates to a party rather than friends so as to make the party tax-deductible, and Leo Getz, the bumbling accountant who constantly annoys two police officers in Lethal Weapon 2 (1989) and Lethal Weapon 3 (1992). In past decades, and within the Australian context, CPA Australia tried to distance itself from the accounting stereotype by promoting members of CPA Australia as ‘not being your average accountant’. This form of promotion in itself appears critical of most (the ‘average’) accountants. Many accounting firms within Australia also embraced this approach. A recent search of the internet (2022) using the words ‘not your average accountant’ shows that many accounting firms still attempt to differentiate themselves from other accountants by specifically noting on their website that they are ‘not your average accountants’. Of course, this begs the question – if none of these firms are ‘your average accountant’, then where does one find an ‘average accountant’? While accountants may be the subject of such (poorly informed and unpleasant) depictions and taunts as discussed above, and there might be concerns about the character of abilities of ‘the average accountant’, which might in turn create pressures to create some form of differentiation, According to Dimnik and Felton (2006, p. 131), a stereotype may be defined as a collection of attributes believed to describe the members of a social group. 22 Smith and Briggs (1999) provide a comprehensive overview of how accountants have been portrayed in movies and on television. Other research that looks at how accountants are depicted in movies includes Cory (1992), Beard (1994), Holt (1994) and Christensen and Rocher (2020). 21
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we can rest in the knowledge that we accountants are indeed very powerful individuals.23 The assertion that accountants are powerful (which is obviously more flattering than being seen as dull and unimaginative) is based on a number of perspectives, as follows: 1 The output of the accounting process (for example, profits, total assets, total liabilities or net asset backing per share) impacts on many decisions, such as whether to invest in or lend funds to an entity, whether to lobby for increased wages based on profitability, whether to place an entity into technical default for failure to comply with previously agreed accounting-based restrictions, whether to lobby government for intervention because of excessive profits, and so on. That is, many transfers of funds (and therefore wealth) arise as a result of reports generated by accountants through the accounting process. Many extremely large companies throughout the world have had to cease operations because they breached various borrowing agreements, ones that are directly tied to numbers generated by the accountant (for example, organisations might have entered an agreement that restricts the amount of debt they can borrow relative to their total assets). Because accounting is heavily reliant on professional judgement, the judgement of the accountant can directly impact upon various parties’ wealth. 2 There is also a perspective that accountants, in providing relevant and representationally faithful information to interested parties, can, in a sense, provide or transfer to them a source of ‘power’ to drive changes to corporations’ behaviour. That is, accounting information informs people about certain aspects of an organisation’s performance and this information, compiled by accountants, might motivate the people to take various actions that might be advantageous or disadvantageous to the organisation and, indeed, to society more generally (remember we have argued previously that accounting is both a technical and social practice). Such actions might not be initiated in the absence of the accounting information. As Gray (1992, p. 404) states: … power can be exercised in some degree by all … external parties. For that power to be exercised there is a basic need for information (as an essential element of the participatory democratic process …) and this information will be an extension of that currently available. That is, the widest possible range of participants must be emancipated and enabled through the manifestation of existing but unfulfilled rights to information.
Accountants generate information that is used to guide the actions of many people throughout society. Indeed, a deal of the ‘language’ used in business is directly tied to the work undertaken by the accountant. 3 By emphasising particular performance attributes (such as profits), accountants can give legitimacy to organisations that otherwise may not be deemed to be legitimate. The financial press often praises companies because of their reported profits. That is, profitability might tend to be a ‘proxy’ for legitimacy and overall ‘success’. However, profitability is also often used as a basis for criticising a company. For example, consumer groups or employee groups might use the reported profits of a company as a justification for demanding that the company reduce the costs of its goods or services, or pay higher salaries to its workforce. What is being emphasised here is that the output of the accounting system is used in many different ways throughout society, which is further evidence of the influence of accounting and therefore of accountants.
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In further research, Dimnik and Felton (2006) undertook a review of 121 movies and, while many accountants are depicted as ‘plodders’ (having low-level jobs with little status) or ‘dreamers’ (deemed to be out of touch with reality), a number of movies actually portray the accountant as a hero. More recently, the release of the movie, The Accountant (2016), depicted the story of a forensic accountant who was an anti-hero who eliminated several people of questionable morality. Perhaps we are finally reaching a point where accountants are deemed more generally to be powerful people.
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4 When accounting standard-setters, such as the IASB or FASB, create new rules this can lead
to economic and social consequences. For example, originally, when a company issued share options to its managers, this was not typically recognised as an expense of the company. However, for a number of years this has no longer been allowed and an expense must now be attributed to the granting of share options. There is evidence to show that this accounting change had a real influence on the use of share options to motivate employees, and the use of share options decreased. As a second example, when Australia adopted IAS 38 Intangibles (which is released as AASB 138 in the Australian context) in 2005, this required all research expenditure to be expensed as incurred whereas previously there was the option within Australia of capitalising applied research. There was widespread concern that this accounting change would negatively impact the amount of research being undertaken given its impact on reported profits or losses. Third, we can consider an accounting standard on leasing that took the IASB years to finalise, in large part because of the potentially significant impacts it was going to have on reporting entities’ balance sheets. This standard, IFRS 17 Leases (AASB 17 in the Australian context), which was operational after 2016, created some reduction in the use of leases of property, plant and equipment because many such leases are now required to be shown on the balance sheet when previously many (those previously designated as operating leases) were not required to be disclosed. We could give many more such examples, but what is being emphasised here is that when a new accounting standard is released the effects can reverberate throughout society, and not just in the offices of accountants. Further reflecting on the above points, consider the work of Hines (1988, 1991). Hines (1991, p. 313) stresses a perspective that ‘financial accounting practices are implicated in the construction and reproduction of the social world’. What she is arguing is that by emphasising a measure such as profits (which ignores many negative social and environmental impacts), accounting can lead people to support particular organisations that may not otherwise be supported. By holding ‘profitability’ out as some ‘ideal’ in terms of performance, profitable companies are often considered to be ‘good companies’, despite the fact that they might generate various negative social and environmental impacts. In terms of everyday experiences, we often find that news media reports emphasise the profits, or perhaps, record profits of organisations – typically larger organisations. If profits increase from one period to the next (or if the profits are larger than those of other organisations in the industry), this is typically portrayed by journalists as a sign of sound management. The earning of profits tends to be seen as consistent with a notion of legitimacy – profits are reported and emphasised as some form of objective measure of performance. But as we know, and what the news media typically neglects to note, the measure of ‘profits’ really depends on the assumptions and judgements made by the particular team of accountants involved. In media reports, no mention is typically made of the accounting methods employed by the organisations being discussed or how the accounting methods or policies being used might have changed from previous periods (perhaps because of a choice made by the managers or because a new accounting standard was released which prohibited previously used methods). Indeed, media articles often compare profits of the different organisations as some form of performance benchmarking. However, some of the differences in reported profits might be due to the fact that the organisations being compared might be using different accounting methods for some types of transactions. Also, news articles often make comparisons with previous years’ profits despite the fact that this is fraught with problems given that accounting methods do change across time, thereby making prior period profit comparisons somewhat problematic (when you get the opportunity, you can look at the financial news media yourself and see how financial measures, such as profits, are discussed and whether the above commentary is applicable). In a sense, there is no ‘shared reality’ between accountants and non-accountants because many nonaccountants, including financial journalists who often have no education in accounting, think that ‘profit’ is a ‘hard’ number that is objectively determined without the need for professional 101
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judgement; whereas we, as accountants, know that much judgement is required in calculating profits. This is typical of media coverage given to corporate performance, with accounting results (such as profits) being apparently promoted as hard, objective calculations. Financial accounting can engender such views because it is promoted (through such media as the IASB Conceptual Framework) as being representationally faithful, and therefore complete, neutral and free from error, and having the capacity to reflect accurately underlying facts.24 As Hines (1991, p. 315) states in relation to conceptual framework projects: It appears that the ontological assumption underpinning the Conceptual Framework is that the relationship between financial accounting and economic reality is a unidirectional, reflecting or faithfully reproducing relationship: economic reality exists objectively, inter-subjectively, concretely and independently of financial accounting practices; financial accounting reflects, mirrors, represents or measures this preexistent reality.
What also should be appreciated is that the measures of profit calculated for the many organisations discussed in the multitude of news media articles ignore many social and environmental externalities caused by the reporting entity. For example, in recent years there have been many articles about the record profits of banks at the same time that banks continued to retrench workers and, while this ‘slashing of worker numbers’ might have positive impacts on reported profit, such retrenchments cause various social costs for the unemployed (and they also cause costs for governments, and hence taxpayers, in terms of unemployment benefits). Accounting, however, ignores these externalities – something we explore more fully in Chapter 10. A counterview to the perspective provided in frameworks such as the IASB Conceptual Framework (that accounting is complete, neutral and free from error and thereby provides an accurate reflection of a pre-existent reality) is the view adopted by Hines that accountants can, in a sense, create different realities, depending on the particular judgements taken, the accounting standards available, and so on. That is, accounting does not objectively reflect a particular reality – it creates it. This view is also supported by Handel (1982, p. 36), who states: Things may exist independently of our accounts, but they have no human existence until they become accountable. Things may not exist, but they may take on human significance by becoming accountable … Accounts define reality and at the same time they are that reality … The processes by which accounts are offered and accepted are the fundamental social process … Accounts do not more or less accurately describe things. Instead, they establish what is accountable in the setting in which they occur. Whether they are accurate or inaccurate by some other standards, accounts define reality for a situation in the sense that people act on the basis of what is accountable in the situation of their action. The account provides a basis for action, a definition of what is real, and it is acted on so long as it remains accountable.
Related to the above points, unless an expense is recognised in relation to particular actions (and the expense will impact profit or loss) then such actions might continue unabated – again reflective of the potential power of accounting. We can consider the issue of carbon taxes (which is a shorthand way of referring to taxes on CO2 emissions) and emissions trading schemes. For many years, companies have treated the atmosphere as a ‘free good’ and have released emissions into the atmosphere with no direct cost implications because, given the way we define both assets and expenses, emissions into the atmosphere were not considered to be expenses of 24
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Authors such as Molotch and Boden (1985) provide a view that a form of social power is attributed to those people and professions that are able to ‘trade on the objectivity assumption’ (p. 281).
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the reporting entity. Because ‘profits’ were not impacted, many shareholders were indifferent to the emissions. Had organisations been charged an expense for their emissions this might have encouraged them to develop ways to reduce their emissions, and their costs. The recent introduction of carbon taxes and emissions trading schemes in some parts of the world has meant that many organisations will now have to internalise aspects of the environmental impacts of their business that were previously ignored. The philosophy behind the introduction of carbon taxes and related regimes is that, if organisations are required to pay for the amount of pollution they create (which would otherwise be treated as an externality) and to disclose this payment as an ‘expense’ (thereby reducing reported profits), then this will have behavioural implications. Specifically, motivated by efforts to improve corporate profitability, companies will, in the presence of such things as ‘carbon taxes’, focus on reducing emission levels and, therefore, the amount of (carbon) taxes they are required to pay. Again, accounting is a central element in creating behavioural change! Accounting is powerful!
REFLECTION QUESTION 3.3 The accountant’s role in defining ‘reality’ In this section, it was noted that accountants, and the accounts and reports they produce, act to define ‘reality’, with different accounts and reports effectively creating different realities, depending on the particular professional judgements made by the accountant, the accounting standards applied and so on. Question Can we apply the above perspective to comment on the way accountants have, or have not, accounted for climate change? Further, has the accounting professions’ recognition or non-recognition of climate change added significantly to the environmental problems we now face? Solution Yes, we can. Organisations have, arguably for centuries, been contributing to climate change. But the way we measure ‘profits’, and the way we have treated the air/atmosphere as a ‘free good’, has meant that greenhouse gas emissions have historically been ignored by the accountant (unless things like carbon taxes, or fines, are introduced). They were not measured and therefore, effectively, they did not exist, and the impacts to climate went unrecognised. Because the atmosphere and the ‘environment’ generally are not ‘assets’ of the organisation (they are not ‘controlled’), the reduction in the quality of the air/atmosphere and environment is not an expense, and therefore the emissions, and any increases therein, had no impacts on ‘profits’. What actually was visible, and ‘real’, were the profits being generated, and the dividends and other distributions paid by organisations. Climate change did not exist from an accounting perspective, and did not attract attention, because the accountant did not recognise its existence. Therefore, as decades and centuries passed, and as organisations’ assets grew and their profits grew, a totally unrecognised problem was climate change. It took scientists and other people to highlight climate change before it became an issue of concern; that is, before it
became ‘real’. We can perhaps speculate that if accountants did not use double entry accounting, with its reliance on debits and credits, and if accountants had instead recognised emissions as a ‘cost’ that needed to be reduced, then the planet would not be in the crisis that it is in now. However, under double entry accounting, which has been in use for at least 700 years (and is therefore arguably rather antiquated), a debit has to be matched by a credit, as we know. While we might potentially have been able to notionally come up with some form of cost/expense for the emissions (although it is unclear that accountants would have been happy to estimate such a cost), there would not have been any corresponding/ balancing credit entry given that there would not have been any increase in liabilities (organisations historically had no financial obligations arising from their emissions) and there was no reduction in any asset (as the ‘environment’ is not controlled). Because debit entries must be matched with credit entries, then the double entry system could not incorporate climate change. So, effectively, our double entry accounting system helped to keep climate change unrecognised for centuries. While financial accounting continues to effectively disregard the social and environmental impacts of climate change (unless related fines or taxes are imposed), for a number of decades social and environmental accountants have worked to make the social and environmental impacts of organisations, including those impacts relating to climate change, visible through other forms of reporting. This discussion further emphasises the very real point that accounting is a practice that creates many social and environmental impacts. That is, accounting is both a technical and social practice. Accountants are very powerful members of society. But has this power always been used responsibly?
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Returning to the issue of ‘professional judgement’ in accounting, while one team of accountants may make various accounting assumptions and judgements that lead to a profit being reported, it is possible that another team of accountants will make different assumptions and judgements that lead to the same organisation (with the same transactions and events) reporting a loss. Recording a loss may generate many negative reactions from various stakeholder groups (shareholders, media and analysts) and may cause real, negative cash-flow consequences for the reporting entity. Hines (1991, p. 323) further reflects on the power of the accounting profession: If, say, auditors qualify their report with respect to the going-concern assumption, and/ or insist that a corporation’s financial statements be prepared on the basis of liquidation values, this in itself may precipitate the failure of a company which may otherwise have traded out of its difficulties.
Another point to be made (which is related to the above point), and one that we have already considered briefly and which is discussed further in Chapter 4, is that few, if any, accounting standards are introduced without some form of economic and social impact (which as we know from previous discussion in this chapter is considered by many accounting standard-setters). As an example, consider the various arguments that were raised over the implementation of International Accounting Standard IAS 39 Financial Instruments: Recognition and Measurement by several EU countries, and its equivalent standard, AASB 139, within Australia (this standard was later superseded by IFRS 9). Many Australian and European banks argued that implementation of AASB 139/IAS 39 would require them to value certain financial assets and liabilities in a manner that would not reflect the underlying economic reality of many financial transactions, and this would result in unrepresentative and highly volatile profit or loss figures and substantially weakened statements of financial position (or as they have traditionally been known, balance sheets). It was further argued that these weakened balance sheets and highly volatile reported profits would impact on market perceptions of banks’ creditworthiness, thus increasing their cost of capital. A number of Australian organisations lobbied the AASB and the IASB to change the requirements of IAS 39; however, such lobbying was not successful. As is shown in Chapter 5, as part of its regulatory process the EU established the Accounting Regulatory Committee (ARC), whose task was to scrutinise all international accounting standards and recommend whether they should be enforced in the EU. Successful lobbying by banks in Italy, Spain, Belgium and France led to these countries’ members of the ARC voting against EU adoption of IAS 39 in July 2004, apparently because of its potential negative economic impact. Further lobbying also delayed EU recognition in 2009 of the new IFRS 9 that replaced IAS 39. Because of the wider social and economic impacts that are potentially created by new accounting standards, perspectives of accounting as being neutral in its effects are now widely dismissed (Zeff, 1978). As already noted in this chapter, the IASB (and the many national standard-setting bodies throughout the world that it effectively replaced) explicitly states within its Conceptual Framework that economic and social implications of particular pronouncements must be considered prior to the introduction of new accounting standards. As Zeff (1978, p. 60) states: The issue of economic consequences has, therefore, changed from one having only procedural implications for the standard-setting process to one which is now firmly a part of the standard-setters’ substantive policy framework.
Hence, while the qualitative characteristics of completeness, neutrality and freedom from error (which are attributes of ‘representational faithfulness’) are promoted within various documents such as the IASB Conceptual Framework (perhaps, as Hines suggests, as a means of constructing a perceived legitimacy for the accounting profession), factors such as the possible economic and social implications and the potential influences of management selfinterest (culminating in some form of creative accounting) can lead us to question such claims of 104
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objectivity. Also, despite the various stereotypes of accountants, accountants are actually a very powerful group of individuals. So we, as accountants, should be very proud of the power we hold within society – but we must use our power wisely! Many decisions with real economic and social implications are made on the basis of accounting information. Whether the supply of accounting information should be left to market forces or subject to regulation is an issue that is investigated further in the next chapter.
Why do I need to know that the accountant is arguably a very powerful member of society? Should we practise as accountants, it is important that we appreciate that the information we produce can be used by many different stakeholders to make decisions that might ultimately create various social and environmental impacts. Therefore, we should consider the representational faithfulness of the information we prepare before we release it. As discussed in this chapter, we should also understand that if we, as accountants, ignore an important issue, then other stakeholders might also ignore the issue (we demonstrated this point in this chapter through our discussion of climate change). As accounting practitioners, or as researchers of accounting, we should also understand the importance of the
regulation of accounting. If accounting makes things ‘visible’, and if the use of accounting information has the potential to create social and environmental impacts, then this has implications for the regulation of accounting. Because of the influence of accounting information throughout society, this also has implications for other activities, such as independent auditing of accounting information. If accounting information is important to stakeholders, then we should make every effort to make sure that the information meets certain standards of reliability.
REFLECTION QUESTION 3.4 The objectivity and impartiality of accounting Question Is it in the accounting profession’s best interests for financial accounting to be perceived as a practice built on objectivity, neutrality and impartiality (as the IASB Conceptual Framework projects)? Solution Arguably, as Hines (1988, 1991) notes, it is in the accounting profession’s best interests to project a view that accountants perform their duties objectively, impartially and reliably. These would be attributes that would be expected to differentiate professional accountants from other potential providers of financial information, thereby possibly securing the profession’s position, and associated income streams, within society. These projected qualities are used as a differentiating quality relative to non-professionals. In a sense, projecting such qualitative characteristics will tend to indicate to many people within society that professional accountants, through their training, have access to a body of skills that enables them to provide some form of ‘truth’ about how an organisation has performed financially, that is reliable and therefore can be trusted. Professional accountants therefore would be considered to be essential to a well-functioning and well-informed capital market. Of related interest is terminology used to describe the general purpose financial statements that are required to be
released by large organisations. Specifically, such reports are required to be ‘true and fair’, or ‘present fairly’ the underlying financial performance and financial position (for example, Australia, the United Kingdom, the EU, Singapore and New Zealand all have corporations law requirements that general purpose financial statements must give a ‘true and fair view’ of the financial position and performance of the organisation, while terminology such as ‘presents fairly in accordance with generally accepted accounting principles’ is used within the United States). Being ‘true’ and/or ‘fair’ can be linked to the attributes expected of a professional. The application of such terminology within corporate regulation further reinforces the professional status of accountants. One issue we can speculate about is: if the community was fully aware of the amount of professional judgement involved in preparing financial statements (meaning that different teams of accountants would inevitably produce different measures of financial performance and financial position), or about the research which highlights the amount of ‘earnings management’ and ‘creative accounting’ that occurs within the profession (which we discuss in Chapter 8), then would that undermine the perceptions the community holds about the objectivity, neutrality and impartiality of professional accountants? The answer to this is, ‘Yes, probably’.
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STUDY TOOLS CHAPTER SUMMARY This chapter explored how the output of the financial accounting process is used in many different decisions by parties both within and outside an organisation. Because the financial accounting process provides information to parties external to the organisation who otherwise would not have the information, and because this information is used as the basis for many decisions, it is generally accepted that it is necessary to regulate the practice of financial accounting. Financial accounting practices are heavily regulated. However, in countries dominated by strong capital markets (with large numbers of external investors), the history of financial accounting regulation is relatively recent and there was a general absence of such regulation prior to the twentieth century. In the early parts of the twentieth century, accounting research often involved documenting commonly used financial accounting practices. This research led to the development and acceptance of broad principles of financial accounting that all accountants were expected to follow. Over time, broad principles gave way to the development of specific accounting standards. Accounting standards began to be released by various accounting professional bodies throughout the world around the 1970s and standard-setting activity has tended to increase since then. Financial accounting practices throughout the world today are generally regulated by a large number of accounting standards (or as they are also called, financial reporting standards). The act of regulating accounting practices through the continual release of new and revised accounting standards has led to various arguments for and against regulation. The arguments range from the belief that there is no need to regulate accounting practices (the ‘free-market’ approach) to a view that regulation is necessary to protect the interests of those parties with a stake in a reporting entity. Those who argue against regulation often rely on the view that the output of the financial accounting system should be treated like any other good, and if the market is left to operate freely, optimal amounts of accounting information will be produced. They say that introducing regulation leads to an oversupply of accounting information and can cause organisations to use accounting methods that do not efficiently reflect their actual operations, financial position and financial performance. As will be seen in subsequent chapters, such ‘free-market’ arguments are challenged by many people. This chapter has also briefly considered various theories about who is likely to benefit from regulation once it is introduced (Chapter 4 extends much of this discussion). Public interest theory proposes that regulation is introduced to protect the public and, when putting regulation in place, regulators seek to maximise the overall welfare of the community (which obviously requires trade-offs of particular costs and benefits). Capture Theory proposes that while regulation might initially be introduced for the public’s benefit, ultimately the group that is regulated will gain control of the regulation process. That is, the group will eventually ‘capture’ the regulatory process. Private interest theories of regulation propose that the regulators introduce regulation that best serves the regulators’ own private interest. That is, regulators are motivated not by the public interest but by their own self-interest. For example, politicians will introduce regulation likely to generate enough support to ensure their re-election. The chapter also considered issues associated with the ‘power’ of accountants. Arguments were advanced to support a view that accountants hold a very powerful position in society (which is in contrast to how they are often portrayed in the media). Accountants provide information that is used in many decisions, and they are able to highlight or downplay particular facets of an organisation’s performance.
ANSWERS TO THE OPENING QUESTIONS At the beginning of the chapter, we asked the following two questions. As a result of reading this chapter, you should be able to provide informed answers to these questions – ours are shown below. 1 Through such mechanisms as conceptual frameworks for financial reporting, accounting professions throughout the world promote a view that accounting reports, when prepared
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properly, will be objective and will faithfully represent the underlying transactions and events of the reporting entity. Is it in the interests of the accounting profession to promote this view of objectivity and neutrality, and if so, why? As indicated in the answer to ‘Reflection question 3.4’, by promoting the virtues of objectivity and representational faithfulness, this will tend to bring credibility and trust to the profession with results that professional members might be able to derive an income that they might otherwise not derive. Promoting such attributes would also tend to project the view that professional accountants uniquely have access to some form of ‘truth’ – which can be shared with others that provides representationally faithful insights into an organisation’s financial performance; insights that otherwise not be available, but are necessary for a well-functioning society. 2 Many different types of stakeholders make various decisions (for example, investment or consumption decisions) based – at least in part – on information generated by accountants, and these decisions can in turn create social and/or environmental impacts. Different accounting information is expected to create different decisions, and therefore, different impacts. Because of the potential economic and social impacts created by the accountants’ choice of accounting methods (for example, decisions that involve choosing one method of accounting in preference to another), and because accounting standard-setters take such economic and social impacts into account when developing new accounting standards (accounting standard setters consider the various costs and benefits that might arise from the introduction of an accounting standard), then it can be argued that standard-setters themselves are not developing accounting standards that lead to representationally faithful (and therefore, neutral or balanced) accounts of organisational performance. Do you agree or disagree with this view, and why? We might tend to agree with this view. If there is a correct and objective way to account for something, and if representational faithfulness is a required attribute of general purpose financial reporting, then a method of accounting should be applied regardless of any consequential social and environmental implications that might follow. That is, objectivity should not be swayed by other considerations. For example, if we prioritised the qualitative characteristics of relevance and faithful representation, and if a new accounting standard on, for example, financial instruments required many financial instruments that had been included within corporate balance sheets to subsequently be expensed (perhaps meaning that many billions of dollars of financial instruments will be expensed across the respective corporate sectors), and this new approach provided the best measure of the value of financial instruments, then it would be implemented, despite the fact this could result in the demise of many organisations. However, under the cost versus benefit approach to standard setting that exists, and which is applied by organisations such as the IASB, a judgement might be made that the social costs of potential corporate collapses is too great to ignore, thereby persuading the regulator to abandon the introduction of the new accounting standard. Whenever costs such as these are considered as part of the standard setting process, there is a chance that accounting standards that otherwise would improve financial reporting will not be approved. This has implications for the relevance and reliability of financial reports.
QUESTIONS 3.1 3.2 3.3
3.4
What expectations do accounting standard-setters have about the accounting knowledge of financial statement readers? LO3.7 Do you think that users of financial reports should have a sound working knowledge of the various accounting standards in use? Explain your answer. LO3.7 Do you believe that the media portray accounting numbers, such as profits, as some sort of ‘hard’ and objective performance indicator? Why do you think they might do this, and, if they do, what are some of the implications that might arise as a result of this approach? LO3.1 Do you think it is realistic to expect that accountants are always objective when it comes to the practice of preparing financial statements? Explain your answer. LO3.4 LO3.5 107
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3.5 3.6 3.7 3.8
3.9 3.10 3.11 3.12 3.13 3.14
3.15
3.16 3.17
3.18
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3.20
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3.22 3.23
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What is ‘creative accounting’ and why does it occur? LO3.1 LO3.5 Briefly outline some arguments in favour of regulating the practice of general purpose financial reporting. LO3.1 Why would developing accounting regulation based upon a survey of what most accountants currently do not necessarily lead to best possible practice? LO3.2 LO3.3 What is the difference between general purpose financial reports and special purpose financial reports? Why is it accepted to be relatively less important to regulate the practice of special purpose financial reporting? LO3.1 LO3.3 Why is management accounting not regulated in the same manner as financial accounting? LO3.1 Why does general purpose financial reporting tend to disregard the social and environmental impacts created by reporting entities? LO3.2 Is it appropriate to look at changes in corporate profits over time without making any adjustments? Explain your answer. LO3.2 Briefly outline some arguments in favour of eliminating the regulation pertaining to financial accounting. LO3.1 LO3.3 What are two possible motivations for regulators to introduce new regulation? LO3.1 LO3.2 LO3.3 LO3.4 Do you think that a general increase in the extent of separation between the ownership and management of organisations leads to a greater or a lesser amount of accounting regulation? Why? LO3.3 In the early part of the twentieth century accounting rules were developed based upon largescale analysis of what methods accountants were using, and on the basis of the assumptions and conventions that they were adopting. What are some criticisms of adopting this approach to develop accounting rules and related theory? LO3.2 LO3.3 Pursuant to Capture Theory, how, by whom and why would a regulator be captured? LO3.4 Stigler (1971) proposes a theory (private interest theory) in which regulatory bodies (including accounting standard-setters) are made up of individuals who are self-interested, and these individuals will introduce regulation that best serves their own self-interest. Under this perspective, the view that regulators act in the public interest is rejected. From your experience, do you think this is an acceptable assumption? Would rejecting this central assumption have implications for whether you would be prepared to accept any predictions generated by the theory? LO3.4 LO3.5 If regulators acted in accordance with predictions provided by the private interest theory of regulation, which assumes that all individuals (including politicians and regulators) are motivated by their own economic self-interest, what is the likelihood of the introduction of regulations aimed at reducing the problems associated with climate change, particularly if business corporations opposed such regulations? LO3.3 LO3.4 Prior to recent decades, was the role of financial reporting in European countries different to the role of financial reporting in countries such as the United States, the United Kingdom, Australia or Canada? If so, why was this the case, and what implications did it have for the regulation of financial reporting? LO3.1 LO3.2 If you believed that regulators acted in accordance with either Capture Theory or the private interest theory of regulation, would you believe that accounting standard-setters will develop accounting standards that most fairly present information about the financial position or performance of a reporting entity? LO3.3 LO3.4 Because accounting standard-setters throughout the world typically consider the potential economic and social consequences of the accounting standards they develop, it has been argued that the general purpose financial reports developed in accordance with the accounting standards cannot be considered neutral or unbiased. Do you agree with this perspective? Is this perspective consistent with the qualitative attributes promoted within the IASB Conceptual Framework for Financial Reporting? LO3.2 Why would ‘free-market’ advocates argue that the regulation of financial reporting leads to an oversupply of accounting rules and standards? LO3.1 What is the basis of an argument that states that accounting regulation can act to undermine the efficiency with which the reporting entities present information about their financial performance and position? LO3.1 LO3.3
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3.24 According to Hines (1991), it is in the interest of the accounting profession to promote publicly a view that the information it generates is ‘objective’. Why do you think this is the case? LO3.1 LO3.2 LO3.3
LO3.4
LO3.6
3.25 Solomons (1978, p. 69) quotes the American Accounting Association: Every policy choice represents a trade-off among differing individual preferences, and possibly among alternative consequences, regardless of whether the policy-makers see it that way or not. In this sense, accounting policy choices can never be neutral. There is someone who is granted his preference, and someone who is not.
Evaluate this statement.
LO3.3
LO3.4
LO3.5
LO3.6
3.26 ‘While it is difficult to criticise a process that considers potential economic and social impacts on others, at the same time it is difficult to accept that accounting standards are neutral or unbiased.’ Evaluate this statement. LO3.4 3.27 Hines (1991, p. 313) stresses a view that ‘financial accounting practices are implicated in the construction and reproduction of the social world’. What does Hines mean by this statement? Do you agree or disagree with her, and why? LO3.6 3.28 Provide an example of a situation when the release of a new accounting standard could create social or economic effects that reverberate throughout society. LO3.4 LO3.6 3.29 Why might accountants be construed as being powerful individuals? LO3.6 3.30 Explain what the following statement by Handel (1982, p. 36) means and provide an argument to either support or oppose the contention. LO3.6 Things may exist independently of our accounts, but they have no human existence until they become accountable. Things may not exist, but they may take on human significance by becoming accountable … Accounts define reality and at the same time they are that reality … The processes by which accounts are offered and accepted are the fundamental social process.
REFERENCES Akerlof, G. A. (1970), ‘The market for “lemons”: quality uncertainty and the market mechanism’, Quarterly Journal of Economics, 84, pp. 488–500. Arnold, P. J. (2009), ‘Global financial crisis: the challenge to accounting research’, Accounting, Organizations and Society, 34(6–7), pp. 803–9. Beard, V. (1994), ‘Popular culture and professional identity: accountants in the movies’, Accounting, Organizations and Society, 19(3), pp. 308–18. Boer, G. (1994), ‘Five modern management accounting myths’, Management Accounting (January), pp. 22–7. Bougen, P. D. (1994), ‘Joking apart: the serious side to the accountant stereotype’, Accounting, Organizations and Society, 19(3), pp. 319–35. Chartered Accountants Australia and New Zealand (2016), The Rise and Rise of Non-GAAP Disclosure, Sydney: CAAANZ. Christensen, M. & Rocher, S. (2020), ‘The persistence of accountant beancounter images in popular culture’, Accounting, Auditing and Accountability Journal, 33(6), pp. 1395–422. Cooper, K. & Keim, G. (1983), ‘The economic rationale for the nature and extent of corporate financial disclosure regulation: a critical assessment’, Journal of Accounting and Public Policy, Elsevier, vol. 2(3), pp. 189–205. Cory, S. N. (1992), ‘Quality and quantity of accounting students and the stereotypical accountant: is there a relationship?’, Journal of Accounting Education, 10, pp. 1–24. Dimnik, T. & Felton, S. (2006), ‘Accountant stereotypes in movies distributed in North America in the twentieth
century’, Accounting, Organizations and Society, 31(2), pp. 129–55. G-20 (2008a), ‘Declaration: Summit on Financial Markets and World Economy’, in G-20, Washington. G-20 (2008b), ‘Washington Summit: Action Plan to Implement Principles for Reform’, in G-20, Washington. G-20 (2010), ‘Annex II (Financial Sector Report) to the G-20 Toronto Summit Declaration’, in G-20, Toronto. Gilman, S. (1939), Accounting Concepts of Profits, New York: Ronald Press. Goldberg, L. (1949), ‘The development of accounting’, in C. T. Gibson, C. G. Meredith & R. Peterson (eds), Accounting Concepts Readings, Melbourne: Cassell. Gray, R. (1992), ‘Accounting and environmentalism: an exploration of the challenge of gently accounting for accountability, transparency and sustainability’, Accounting, Organizations and Society, 17(5), pp. 399–426. Handel, W. (1982), Ethnomethodology: How People Make Sense, Hemel Hempstead: Prentice Hall. Hatfield, H. R. (1924), ‘An historical defense of bookkeeping’, Journal of Accountancy, 37(4), pp. 241–53. Hendriksen, E. S. & Van Breda, M. F. (1992), Accounting Theory, 5th edn, Homewood: Irwin. Hines, R. (1988), ‘Financial accounting: in communicating reality, we construct reality’, Accounting, Organizations and Society, 13(3), pp. 251–62. Hines, R. (1991), ‘The FASB’s conceptual framework, financial accounting and the maintenance of the social world’, Accounting, Organizations and Society, 16(4), pp. 313–51. © Elsevier
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Holt, P. E. (1994), ‘Stereotypes of the accounting professional as reflected in popular movies, accounting students and society’, New Accountant, April, pp. 24–5. Hopwood, A. G. (2009), ‘The economic crisis and accounting: implications for the research community’, Accounting, Organizations and Society, 34(6–7), pp. 797–802. International Accounting Standards Board (2002), Preface to International Financial Reporting Standards, London: IASB. International Accounting Standards Board (2008), Exposure Draft of an Improved Conceptual Framework for Financial Reporting, London: IASB. International Accounting Standards Board (2022), Conceptual Framework for Financial Reporting, London: IASB. International Federation of Accountants (2019), The Global Accountancy Profession’s Call to Action for G20 Leaders: Counting on Society 5.0, New York: IFAC, https://www. ifac.org/system/files/publications/files/GAP-Counting-onSociety-5.0-paper-v4.pdf International Federation of Accountants (2022), ‘Why global accounting standards?’, https://www.ifrs.org/usearound-the-world/why-global-accounting-standards Jensen, M. C. & Meckling, W. H. (1976), ‘Theory of the firm: managerial behavior, agency costs and ownership structure’, Journal of Financial Economics, 3(October), pp. 305–60. Laux, C. & Leuz, C. (2009), ‘The crisis of fair-value accounting: making sense of the recent debate’, Accounting, Organizations and Society, 34(6–7), pp. 826–34. Mathews, M. R. & Perera, M. H. B. (1996), Accounting Theory and Development, 3rd edn, Melbourne: Thomas Nelson. Molotch, H. L. & Boden, D. (1985), ‘Talking social structure: discourse, domination and the Watergate hearings’, American Sociological Review, pp. 477–86. Paton, W. A. (1922), Accounting Theory, Kansas: Scholars Book Co., reprinted 1973. Paton, W. A. & Littleton, A. C. (1940), An Introduction to Corporate Accounting Standards, USA: American Accounting Association. Peltzman, S. (1976), ‘Towards a more general theory of regulation’, Journal of Law and Economics (August), pp. 211–40.
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Posner, R. A. (1974), ‘Theories of economic regulation’, Bell Journal of Economics and Management Science, 5 (Autumn), pp. 335–58. Ray, D. D. (1960), Accounting and Business Fluctuations, USA: University of Florida Press. Roberts, J. & Jones, M. (2009), ‘Accounting for self interest in the credit crisis’, Accounting, Organizations and Society, 34(6–7), pp. 856–67. Sanders, T. H., Hatfield, H. R. & Moore, U. (1938), A Statement of Accounting Principles, reprinted AAA 1959 edn, USA: American Institute of Accountants. Scott, W. R. (2003), Financial Accounting Theory, 3rd edn, Toronto: Pearson Education. Securities and Exchange Commission US (2012), Final Staff Report: Work Plan for Consideration of Incorporating International Financial Reporting Standards in the Financial Reporting System for US Issuers, Washington: SEC. Sikka, P. (2009), ‘Financial crisis and the silence of the auditors’, Accounting, Organizations and Society, 34(6–7), pp. 868–73. Smith, M. & Briggs, S. (1999), ‘From beancounter to action hero’, Charter, 70(1), pp. 36–39. Solomons, D. (1978), ‘The politicisation of accounting’, Journal of Accountancy, 146(5), pp. 65–72. Stigler, G. J. (1971), ‘The theory of economic regulation’, Bell Journal of Economics and Management Science (Spring), pp. 2–21. Taylor, S. (2009), ‘Capital markets regulation: how can accounting research contribute?’, Australian Accounting Review, 51(19), pp. 319–25. Unerman, J. & O’Dwyer, B. (2004), ‘Enron, WorldCom, Andersen et al.: a challenge to modernity’, Critical Perspectives on Accounting, 15(6–7), pp. 971–93. Walker, R. G. (1987), ‘Australia’s ASRB: a case study of political activity and regulatory capture’, Accounting and Business Research, 17(67), pp. 269–86. Watts, R. & Zimmerman, J. (1978), ‘Towards a positive theory of the determination of accounting standards’, The Accounting Review, 53(1), pp. 112–34. Zeff, S. A. (1972), Forging Accounting Principles in Five Countries, Champaign, IL: Stipes Publishing Co. Zeff, S. A. (1978), ‘The rise of economic consequences’, Journal of Accountancy, 146(6), pp. 56–63.
CHAPTER
4
THE REGULATION OF FINANCIAL ACCOUNTING LEARNING OBJECTIVES On completing this chapter, readers should: LO4.1
understand the meaning of ‘regulation’ together with some of the various theoretical arguments for regulating the practice of financial accounting and reporting
LO4.2
understand some of the theories that explain why regulation is initially introduced
LO4.3
understand various theoretical perspectives that describe the parties who are likely to gain the greatest advantage from the implementation of accounting regulation
LO4.5
understand that financial reporting standard-setting is a very political process which seeks, and responds to, the views of a broad cross-section of financial statement users
LO4.6
understand the relevance to the financial reporting standard-setting process of potential economic and social impacts arising from accounting regulations.
LO4.4 understand some of the various theoretical arguments that have been proposed in favour of reducing the extent of regulation of financial accounting and reporting
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OPENING QUESTIONS Before reading this chapter, please consider how you would answer the following two questions. We will return to these questions at the end of the chapter, where we suggest some answers. 1 When widely publicised accounting-related ‘scandals’ occur in respect of high-profile organisations (such as Lehman Brothers, Enron and WorldCom), regulators often respond by increasing the amount of accounting regulation. What might motivate regulators to introduce additional regulation to restrict the accounting practices available to corporate managers? 2 If corporate financial reporting was to be deregulated, what market-based incentives or mechanisms might operate to motivate managers to produce publicly available financial reports? Would these mechanisms operate to ensure that an optimal amount of relevant and reliable information is produced? What is an ‘optimal’ amount of information?
Introduction Regulation is clearly a large part of all of our lives. For example, the construction of the homes in which we live is regulated through various building and zoning regulations; renting or buying a home is subject to various regulations; what and where we eat and drink is subject to many health regulations; how we travel is subject to a great deal of regulation whether it relates to the cars we drive or the public transport we use; the health services we use are regulated; the news media we read, watch or listen to are regulated; where we and our children are educated is subject to various regulation; and the toys our children, and us, play with are regulated. Regulation really is a very pervasive aspect of all our lives, and this raises various issues: • Does all this regulation actually improve our lives or is there regulation overload? • Does regulation impede economic growth or innovation? • Is there an appropriate amount of regulation from a societal perspective? • Should regulation always be developed and enforced by government or do professional bodies have a role in developing and enforcing regulation? • What factors influence the final regulations that are mandated by particular regulators? The external reporting of information by organisations, particularly larger organisations, is subject to regulation. For example, throughout the world, larger organisations are required to report information about aspects of their: • social performance (for example, occupational health and safety-related performance, and the risks that modern slavery exists within their supply chains) • environmental performance (for example, larger highly polluting organisations are required to report information about their greenhouse gas emissions, releases of other toxic chemicals and compliance with environmental laws) • financial performance (for example, general purpose financial reports that comply with financial reporting standards). We consider the regulation of social and environmental reporting in Chapter 10. In this chapter, we consider the regulation of financial accounting. As we know, financial reporting, particularly by larger organisations, is subject to a great deal of regulation. As we shall learn, there are various theories of regulation that either prescribe how and when government should regulate or provide an explanation of what government actually does. Chapter 3 briefly considered a number of theories to explain the existence of accounting regulation. This chapter extends that discussion.
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While financial reporting is quite heavily regulated in many countries, with the level of regulation generally increasing in the aftermath of the recent sub-prime banking crisis1 and high-profile alleged accounting failures at many large multinational companies (such as Enron, WorldCom, HIH Insurance and Parmalat), it is nevertheless interesting to consider arguments for and against the continued existence of, and general growth in, regulation. It is also useful to look at various theories that explain what drives the imposition of regulation. By considering various regulation-related theories we will be better placed to understand why some accounting and reporting prescriptions ultimately become formal regulations, while others do not ultimately get approval from regulators. Perhaps some proposed accounting regulations did not have the necessary support of parties that have influence (or power) over the regulatory process. At issue here is whether the ‘power’ of particular constituents could, or should, be allowed to impact upon the implementation of regulations, including accounting regulations. Is it realistic to expect that the interests of various affected parties will not impact on the final regulations? We will see that the financial reporting standard-setting process is a very political process. While some proposed requirements might appear technically sound and logical, we will see that this is not always sufficient for them to be mandated. What often seems to be important is whether various parts of the constituency, who might be affected either socially or economically by the regulations, are in favour of them. In considering accounting and reporting regulations, this chapter examines arguments for reducing or eliminating regulation, many of which propose that accounting information should be treated like any other good and that forces of demand and supply should be allowed to freely operate to determine the optimal amount of information to be produced. Proponents of this ‘free-market’ approach (that is, proponents of the view that the provision of accounting information should be based on the laws of supply and demand rather than on regulation) have at times relied on the work of the eighteenth-century economist Adam Smith and his much-cited notion of the ‘invisible hand’. However, as we discuss, Smith actually proposed the need for some regulation to support the interests of those individuals who would otherwise be disadvantaged by the functioning of unregulated market systems. The chapter also considers a number of perspectives that explain why regulation might be necessary. The public interest theory of regulation is reviewed. Public interest theory provides an explanation of why regulation is necessary to protect the rights of ‘the public’ and why it is often introduced in an apparent response to perceived ‘market failures’, whereas there are other theories (for example, Capture Theory and economic interest theory of regulation) that provide explanations for why regulations might be put in place that actually serve the interests of some groups at the expense, or detriment, of others (rather than serving the ‘public interest’). The chapter looks at how perceptions about the economic and social consequences of potential accounting requirements affect the decisions of financial reporting standard-setters. It also discusses whether, in the light of regulators considering the economic and social consequences of potential regulation, financial accounting can ever be expected to generate financial statements that meet the test of ‘representational faithfulness’ (and for a faithful representation, a depiction would be complete, neutral and free from error as noted in the IASB Conceptual Framework for Financial Reporting). As with many other chapters of this book, in this chapter we are considering multiple theories about ‘regulation’. As we have already emphasised in previous chapters, there are multiple ways, and different theories, to explore particular phenomena, and therefore it is arguably inappropriate to believe there is a single way to explore a particular ‘reality’. Different theories provide a partial and incomplete depiction of a particular ‘reality’, and as Laughlin (2007) suggests, there is arguably ‘no absolute truth’. Therefore, consistent with this, we apply different theoretical ‘lenses’ to explore the issue of accounting regulation. 1
Sub-prime A classification of borrowers with a tarnished or limited credit history.
Free-market approach An approach wherein somebody believes that how and whether a good or service is produced should be left to market forces of supply and demand.
Chapter 3 provided a brief explanation of ‘sub-prime lending’ and the sub-prime banking crisis.
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LO4.1
What is regulation?
As this chapter considers various theories of regulation, and various arguments for and against regulation, it is useful to first define what we actually mean by ‘regulation’ and ‘regulator’. The Oxford English Dictionary defines regulation in terms of a prescribed rule, or authoritative direction. Specifically, the Oxford English Dictionary defines a regulation as: A rule or principle governing behaviour or practice; esp. such a directive established and maintained by an authority.
The Oxford English Dictionary further defines a regulator as: An official or agency responsible for the control and supervision of a particular industry, business activity, area of public interest, etc.
The above definition of regulation is similar to the definition provided by the Macquarie Dictionary, which defines regulation as ‘a rule of order, as for conduct, prescribed by authority; a governing direction or law’. Therefore, on the basis of these definitions, we can say that regulation is designed to control or govern conduct. Hence, in discussing regulations relating to financial reporting, we are discussing rules that have been developed by an independent authoritative body that has been given the power to govern how financial statements are to be prepared, and the actions of the authoritative body will have the effect of restricting the accounting options that would otherwise be available to the managers of an organisation.2 The regulation would also be expected to incorporate a basis for monitoring and enforcing compliance with the specific regulatory requirements. Regulation without associated monitoring and enforcement mechanisms will be rendered ineffective. While there is a multitude of regulations governing various aspects of behaviour, there are many people who argue against the intervention of government and who propose that markets be allowed to operate in an environment that is not regulated. We now consider some of these arguments. LO4.3
The ‘free-market’ perspective
As indicated in Chapter 3, a fundamental assumption underlying a ‘free-market’ perspective on accounting regulation is that accounting information should be treated like other goods, and demand and supply forces should be allowed to freely operate so as to generate an optimal supply of information about an entity. A number of arguments have been used in support of this perspective. One such argument, based on the work of authors such as Jensen and Meckling (1976), Watts and Zimmerman (1978), Smith and Warner (1979) and Smith and Watts (1982), is that, even in the absence of regulation, there are private economics-based incentives for the organisation to provide credible information about its operations and performance to certain parties outside the organisation, otherwise the costs of the organisation’s operations would rise. The basis of this view is that, in the absence of information about the organisation’s operations, other parties, including the owners of the organisation (for example, shareholders) who are not involved in the management of the organisation, will assume that the managers might be operating the business for their own
2
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While our definition of reporting regulation refers to an independent authoritative body, capture theory (to be discussed shortly) would question whether, in the longer run, regulators will be able to maintain their independence from those individuals or groups that are subject to the regulations.
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benefit.3 That is, rather than operating with the aim of maximising the value of the organisation, the managers will be assumed to be operating for their own personal gain (there is assumed to be a lack of alignment of goals between the external owners and the managers).4 It is further assumed that potential shareholders will expect the managers to be opportunistic, and in the absence of safeguards will reduce the amount they will pay for the shares. Likewise, under this economics-based perspective of ‘rationality’ (self-interest), potential lenders (such as banks and bondholders) are assumed to expect managers – like everybody else – to undertake opportunistic actions with the funds the lenders might advance, and therefore in the absence of safeguards the lenders will charge the organisation a higher price for their funds.5 That is, the lenders will ‘price-protect’, such that the higher the perceived risk, the higher the demanded return in the form of higher interest rates in order to compensate the lenders for the higher risk exposure. The expectations noted above (which are based on the rather pessimistic assumption that all parties will assume that others will work in their own self-interest unless constrained to do otherwise) will have the effect of increasing the operating costs of the organisation – the cost of attracting capital will increase and this will have negative implications for the value of the organisation.6 In situations where managers have large investments in their organisation’s shares (that is, where they are a type of ‘internal’ shareholder), it will be in the interests of the managers to maximise the value of the organisation, as they will often gain more economically from an increase in the value of their investment than they would gain in direct ‘spoils’ from opportunistic behaviour. To achieve this maximisation of share value, managers will voluntarily enter into contracts with shareholders and lenders that make a clear commitment that certain management strategies, such as those that might be against the interests of other shareholders and lenders, will not be pursued. For example, management might make an agreement with debtholders that they will keep future debt levels below a certain percentage of total assets (the view being that, all things being equal, the lower the ratio of debt to assets, or debt to total equity, the lower the risk that the organisation will default on paying the debtholders). To safeguard the debtholders’ assets further, the managers might agree to ensure that profits will cover interest expense by a specified number of times (referred to as an ‘interest coverage clause’, and might require, for example, that ‘profit’ should cover interest expense a minimum of, say, five times). In relation to concerns that the manager might ‘shirk’ (which might be of particular concern to shareholders, given that shareholders will share in any profits generated by the actions of the managers), the organisation might require managers to be rewarded on the basis of a bonus 3
4
5
6
The costs that arise from the perspective of the owner when the owner (or principal) appoints a manager (the agent) include those associated with the agent shirking (being idle) or consuming excessive perquisites (using the organisation’s funds for the manager’s private purposes). These are called agency costs. Agency costs can be defined as costs that arise as a result of the delegation of decision making from one party, for example the owner, to another party, for example the manager (representing an agency relationship). Agency costs are more fully considered in Chapter 8, which discusses Agency Theory. Another agency cost that might arise when decision making is delegated to the agent is the cost associated with the manager using information that is not available to the owners for the manager’s personal gain. Smith and Watts (1982) provide an overview of the various conflicts of interest that arise between managers and owners. What should be appreciated at this point is that these arguments are based on a central assumption that individuals will act in their own self-interest, which, in itself, is a cornerstone of many economic theories. If an individual acts with the intention of maximising personal wealth, this is typically referred to as being ‘economically rational’. ‘Economic rationality’ is a theoretical assumption and, as might be expected, it is challenged by advocates of alternative views about what drives or motivates human behaviour. In considering the relationship between managers and lenders, actions that would be detrimental to the interests of lenders include managers paying excessive dividends; taking on additional and possibly excessive levels of debt; and using the advanced funds for risky ventures, thereby reducing the probability of repayment. Smith and Warner (1979) provide an overview of some of the conflicts of interest that arise between managers and lenders. This is based on the assumption that the value of an organisation is the present value of its expected future net cash flows. A higher cost of capital will result in a decreased net present value of future cash flows.
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tied to profits, so the higher the organisation’s profit (which is in the interests of shareholders and lenders), the higher the rewards that will be paid to managers. Most business organisations give their managers (particularly the more senior managers) some form of profit share (Deegan, 1997) as well as being involved in negotiated agreements with lenders (such as debt to asset constraints and interest coverage requirements). What should be noted from this discussion is that such contractual arrangements are tied to financial accounting numbers (for example, paying the manager a bonus based on a percentage of profits), and therefore to financial accounting reports. Hence the argument by some advocates of the ‘free-market’ perspective is that in the absence of regulation there will be private incentives to produce accounting information. That is, proponents of this view (based on Agency Theory, which is more fully discussed in Chapter 8) assert that there will (naturally) be conflicts between external owners (such as shareholders) and internal managers (because it is assumed that everybody acts in their own self-interest), and the costs of these potential conflicts will be mitigated through the process of private contracting and associated financial reporting.7 Organisations that do not produce relevant and representationally faithful accounting information will be penalised by higher costs associated with attracting capital, and this will damage the financial interests of those managers who own shares in their organisation. Further, depending on the parties involved and the types of assets in place, the managers within the organisation will be best placed to determine what information should be produced to increase the confidence of external stakeholders (thereby decreasing the organisation’s cost of attracting capital), rather than relying on a ‘one-size-fits-all’ approach to reporting that can be associated with financial reporting regulation. Imposing regulation that restricts the available set of accounting methods (for example, banning a particular method of depreciation or amortisation which has previously been used by some organisations) will potentially decrease the efficiency with which negotiated contracts will reduce agency costs.8 Given the theoretical economics-based assumption that managers (and indeed, everybody else also) will act in their own self-interest (which does represent a rather pessimistic view of humans, but is a maintained assumption of many economic theories), there will also be a contractual demand to have the accounting reports audited by a credible independent external party. Such an activity will increase the perceived reliability or representational faithfulness of the data, and this in turn is expected to reduce the perceived risk of the external stakeholders, thus further decreasing the organisation’s cost of capital (Francis and Wilson, 1988; Watts, 1977; Watts and Zimmerman, 1983). That is, financial statement audits can also be expected to be undertaken, even in the absence of regulation, and evidence indicates that many organisations did have their financial statements audited prior to any legislative requirement to do so (Morris, 1984).9 Hence, if we accept these arguments, we can propose that, in the presence of a limited number of contracting parties, reducing regulation might seem reasonable given the view that various items of financial information (as negotiated between the various parties) will be voluntarily provided. Further, such information will be expected to be subject, where deemed necessary by the contracting parties, to an audit by an independent third party. However, in the presence of many different parties, this argument that private incentives will lead to optimal amounts 7
8
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This is consistent with the usual notion of ‘stewardship’ wherein management is expected to provide an account of how it has used the funds that have been provided. It has also been argued that certain mandated disclosures will be costly to the organisation if they enable competitors to take advantage of certain proprietary information. Hakansson (1977) used this argument to explain costs that would be imposed as a result of mandating segmental disclosures. As Cooper and Keim (1983, p. 199) indicate, to be an effective strategy ‘the auditor must be perceived to be truly independent and the accounting methods employed and the statements’ prescribed content must be sufficiently well-defined’. Public perceptions of auditor independence are damaged as a result of revelations linking audit firms to various corporate collapses (Unerman and O’Dwyer, 2004), and this could have implications for the benefits a company derives from having its financial statements audited by a third party.
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of accounting information (and a reduced need for regulation) seems to break down. As Scott (2003, p. 416) states: Unfortunately, while direct contracting for information production may be fine in principle, it will not always work in practice ... In many cases there are simply too many parties for contracts to be feasible. If the firm manager were to attempt to negotiate a contract for information production with every potential investor, the negotiation costs alone would be prohibitive. In addition, to the extent that different investors want different information, the firm’s cost of information production would also be prohibitive. If, as an alternative, the manager attempted to negotiate a single contract with all investors, these investors would have to agree on what information they wanted. Again, given the disparate information needs of different investors, this process would be extremely time-consuming and costly, if indeed, it was possible at all. Hence, the contracting approach only seems feasible when there are few parties involved.
Market-related incentives While the ‘free-market’ (or anti-regulation) arguments above are based on a private contracting perspective, there are further arguments that support reducing or eliminating accounting regulation which are based on various market-related incentives, principally tied to the ‘market for managers’ and the ‘market for corporate takeovers’.
The ‘market for managers’ argument The ‘market for managers’ argument (see Fama, 1980) relies on an assumption that there is an efficient ‘market for managers’, and that managers’ previous performance will impact on how much remuneration (payment for services) they are able to command in future periods, either from their current employer or elsewhere. Adopting this perspective, it is assumed that, even in the absence of regulations controlling management behaviour and in the absence of other contractual requirements, managers will be encouraged to adopt strategies to maximise the value of their organisation (which provides a favourable view of their own performance) and these strategies would include the manager providing an optimal amount of financial accounting information. However, arguments such as this are based on assumptions that the managerial labour market operates efficiently and that information about past managerial performance will not only be known by other prospective employers, but will also be fully impounded in future salaries. It also assumes that the capital market is efficient when determining the value of the organisation and that effective managerial strategies will be reflected in positive share price movements. In reality, these assumptions will clearly not always be met. Markets will not always be efficient. The arguments can also break down if the managers involved are approaching retirement, in which case future market prices for their services in the ‘market for managers’ may be irrelevant to them, meaning that the potential disciplining effect of the ‘market’ does not apply for retiring managers.
Market for managers A market in which managers negotiate their salaries on the basis of their ability and performance. Information about past performance is assumed to be known by participants in this market.
The ‘market for corporate takeovers’ argument The ‘market for corporate takeovers’ argument works on the assumption that an under-performing organisation will be taken over by another entity that will see opportunities for financial gain and who will subsequently act to replace the existing management team. With such a perceived threat, managers would be motivated to maximise organisational value to minimise the likelihood that outsiders motivated by maximising their own wealth could seize control of the organisation at low cost. The ‘market for corporate takeovers’ and the ‘market for managers’ arguments assume that information will be produced to minimise the organisation’s cost of capital and thereby increase the value of the organisation. Therefore, the arguments assume that management will know the marginal costs and marginal benefits involved in providing information, and, in accordance with economic theories about the production of other goods, management will provide information to
Market for corporate takeovers A market in which corporations are bought and sold. Managers will try to maximise firm value to minimise the likelihood that outsiders could seize control of the organisation at low cost.
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the point where the marginal cost equals the marginal benefit. While the disclosure of accounting information will be in the interests of shareholders, it will also be in the interests of managers – there will be an alignment of interests. However, working out the marginal costs and marginal benefits of information production will be difficult, and to assume that the majority of corporate managers have the expertise to determine such costs and benefits is, again, somewhat unrealistic.
The ‘market for lemons’ argument There is also a perspective that, even in the absence of regulation, managers would still be motivated to disclose both good and bad news about their organisations’ financial position and performance. Such a perspective is often referred to as the ‘market for lemons’ perspective (Akerlof, 1970), the view being that in the absence of disclosure, the capital market will assume that the organisation is a ‘lemon’.10 That is, the failure to provide information is viewed in the same light as providing bad information. Hence, even though the organisation may be worried about disclosing bad news, the market may make an assessment that silence implies that the organisation has very bad news to disclose (otherwise it would disclose it). This ‘market for lemons’ perspective provides an incentive for managers to release information in the absence of regulation, as failure to do so will have implications for managers’ wealth (perhaps in the form of current lower remuneration and a decreased value in the market for managers). That is, ‘nonlemon owners or managers have an incentive to communicate’ (Spence, 1974, p. 93). Drawing on arguments such as those adopted in the ‘lemons’ argument and applying them to preliminary profit announcements, Skinner (1994, p. 39) states: Managers may incur reputational costs if they fail to disclose bad news in a timely manner. Money managers, stockholders, security analysts, and other investors dislike adverse earnings surprises, and may impose costs on firms whose managers are less than candid about potential earnings problems. For example, money managers may choose not to hold the stocks of firms whose managers have a reputation for withholding bad news and analysts may choose not to follow these firms’ stocks ... Articles in the financial press suggest that professional money managers, security analysts, and other investors impose costs on firms when their managers appear to delay bad news disclosures. These articles claim that firms whose managers acquire a reputation for failing to disclose bad news are less likely to be followed by analysts and money managers, thus reducing the price and/or liquidity of their firms’ stocks.
Reviewing previous studies, Skinner (p. 44) notes that there is evidence that managers disclose both good and bad news forecasts voluntarily. These findings are supported by his own empirical research, which shows that when companies are performing well managers make ‘good news disclosures’ to distinguish their companies from those doing less well, and when companies are not doing so well managers make pre-emptive bad news disclosures consistent with ‘reputational-effects’ arguments (p. 58). Evidence provided by Barton and Waymire (2004) showed that shareholders of US companies that made higher quality disclosures preceding the stock-market crash of 1929 experienced significantly smaller losses during the crash. Prior to the crash, there was a general absence of disclosure regulation. In an argument that supports a ‘free-market’ (anti-regulation) approach to accounting regulation, Barton and Waymire state (p. 69): Viewed collectively, our evidence suggests that managers respond to investor demand for information and that managers’ voluntary financial reporting choices can promote investor
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Something is a ‘lemon’ if it initially appears or is assumed (due to insufficient information) to be of a quality comparable to other products but later turns out to be inferior. Acquiring the ‘lemon’ will be the result of information asymmetry in favour of the seller.
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protection. That is, economic forces in advanced markets provide managers with incentives for beneficial financial reporting even in the absence of regulatory mandate.
These authors argue that economic forces operate to motivate managers to provide information to investors even in the absence of regulation. Arguments that the market will penalise organisations for failure to disclose information (which may or may not be bad) of course assume that the market knows that the manager has particular information to disclose. As has been seen with the many apparently unforeseen accounting failures in recent years (such as Enron, WorldCom and Parmalat), this expectation might not always be realistic, as the market will not always know that there is information available to disclose. That is, in the presence of information asymmetry (unequal distribution of information), the manager might know of some bad news, but the market might not expect any information disclosures at that time. However, if it does subsequently come to light that news had been available that was not disclosed, we could perhaps expect the market to react (and in the presence of regulation, we could expect regulators to react, as failure to disclose information in a timely manner may be in contravention of particular laws in that jurisdiction). Also, at certain times, withholding information (particularly of a proprietary nature) could be in the interests of the organisation. For example, the organisation may not want to disclose information about certain market opportunities for fear of competitors using such information.
The role of the courts Building on early work from Coase (1960), and accepting that instances will occur where market competition and private contracting do not provide optimal outcomes, advocates of a free market (anti-regulation) approach argue that courts can be used as impartial arbiters to provide solutions between market participants and thereby enforce aspects of the privately negotiated contracts. In doing so, courts are argued to restore efficiency to the market through application of appropriate case law. The expectation that the courts will award in favour of harmed plaintiffs is assumed to discourage potential ‘contract-breakers’ from not complying with the market-based negotiated agreements or contracts. However, the belief that courts will always make ‘fair and just decisions’ for all participants can be challenged. Court decisions are known to often favour those parties able to acquire better legal representation, and it is not always clear that court representatives will be unbiased or incorruptible. So, in summary to this point, there are various arguments or mechanisms in favour of reducing accounting regulation (including private contracting, markets for managers, markets for corporate takeovers, the ‘market for lemons’ and well-functioning courts), as even in the absence of regulation, managers and their organisations will have incentives to make disclosures. We now consider some counterarguments in favour of regulating financial reporting practices. LO4.1
LO4.2
The ‘pro-regulation’ perspective
We have considered a number of reasons in favour of reducing or eliminating financial reporting regulation. One of the simplest arguments is that if somebody really desired information about an organisation, then they would be prepared to pay for it (perhaps in the form of reducing their required rate of return in exchange for receiving relevant and credible information about the organisation), and the forces of supply and demand should be allowed to freely operate to ensure an optimal amount of information is produced.11
11
For example, if a lender is able to receive relevant and credible information about the financial position and financial performance of an organisation, then this will act to reduce the risk inherent in providing funds to the organisation. With reduced risk, the lender would expect and demand a lower rate of interest than it otherwise would. This is in accordance with the general principle that the lower the risk, the lower the expected rate of return.
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Public good Something that can be used by people without having to pay for it. Generally, use by one party does not affect the ability of others to use the particular item.
Free riders Parties that use goods or services without contributing to costs that are borne by other people.
Market failure A situation where market forces of supply and demand do not lead to economically or socially optimal levels of production.
Another perspective is that if information is not produced, there will be greater uncertainty about the performance of the entity and this will translate into increased costs of attracting financial capital for the organisation. (For example, in the absence of sufficient information about an organisation, such an organisation will be considered to be of higher risk, and riskier organisations find it relatively more expensive to attract financial capital.) With this in mind, organisations would, it is argued, elect to produce information to reduce costs. However, arguments in favour of a ‘free market’ rely on users paying for the goods or services that are being produced and consumed. Such arguments tend to break down when we consider the consumption of ‘free’ or ‘public’ goods. Accounting information is a public good – once available, people can use it without paying and can pass it on to others. Parties that use goods or services without incurring some of the associated production costs are referred to as ‘free riders’. In the presence of free riders, true demand is understated, because people know that they can obtain the goods or services without paying for them. Few people will then have an incentive to pay for the goods or services, as they know that they themselves might be able to act as free riders. This dilemma is argued to provide a lack of incentive for producers of the particular good or service, which in turn leads to an underproduction of information. As Cooper and Keim (1983, p. 190) state: Market failure occurs in the case of a public good because, since other individuals (without paying) can receive the good, the price system cannot function. Public goods lack the exclusion attribute, i.e., the price system cannot function properly if it is not possible to exclude non-purchasers (those who will not pay the asked price) from consuming the good in question.
To alleviate this underproduction, regulation is argued to be necessary to reduce the impacts of market failure.12 In specific relation to the production of information, Demski and Feltham (1976, p. 209) state: Unlike pretzels and automobiles, [information] is not necessarily destroyed or even altered through private consumption by one individual ... This characteristic may induce market failure. In particular, if those who do not pay for information cannot be excluded from using it, and if the information is valuable to these ‘free riders’, then information is a public good. That is, under these circumstances, production of information by any single individual or firm will costlessly make that information available to all ... Hence, a more collective approach to production may be desirable.
However, as we often come to expect, there are counterarguments to the perspective that the supply of ‘free goods’ should be regulated. Some economists argue that free goods are often overproduced as a result of regulation. The argument is that segments of the public (the users of the good or service), knowing that they do not have to pay for the free good, will overstate their need for the good or service. This argument can be applied to investment analysts. Investment analysts will typically be a main user of accounting information. If they lobby for additional regulation which requires further disclosure, they will tend to receive a disproportionate amount of the benefits relative to the costs of producing this further information. When considering the consumption of free goods, it is argued by some people that the nonusers of the goods or services effectively subsidise the consumers of the public good as, like other parties, the non-users pay towards the production of the good without benefiting from its consumption. The result of concerted lobbying by particular parties, such as analysts, could in turn lead to the existence of what has been termed an accounting standards overload, which creates 12
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In relation to the supply of information, Scott (1997, p. 329) defines market failure as ‘an inability of market forces to produce a socially “right” amount of information, that is, to produce information to the point where its marginal cost to society equals its marginal benefit’.
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a cost for companies in terms of compliance. However, if we do not regulate, then in the presence of the ‘free riders’ we could arguably have an underproduction of accounting information. Clearly, this is not an easy thing to balance, and we can start to understand the difficult position in which regulators find themselves. As an example of a situation in which an industry body considered that there was ‘regulatory overload’, we can consider a media release by the Institute of Public Accountants (in Australia) in 2019 (IPA, 2019b). In the media release entitled ‘Regulatory overload – a real problem for small business’, and which referred to a report released by the IPA entitled IPA Small Business White Paper: Small Business: Big Visions (IPA, 2019a), the Chief Executive Officer of the IPA stated: When we conducted our nation-wide roadshow to gain direct insight from hundreds of small businesses, dealing with the plethora of compliance was one of the key issues. We also heard of countless stories of the stress of running their businesses and trying to keep up with compliance… We need our small business sector to be productive, to grow and to prosper, so the more we unshackle them from the regulatory burden, the better our economy will be.
While this quote refers to regulatory burden, or regulatory overload, it is always a difficult task to determine the ‘right amount’ of regulation to put in place. For example, there has been a steep growth in the amount of financial reporting standards put in place in recent years, and the reporting requirements of organisations also have been steadily increasing. With this in mind, financial reporting regulators throughout the world have been introducing ‘tier systems’ whereby smaller organisations are provided with relief from complying with various financial reporting requirements. However, the reporting obligations of larger organisations continue to grow and this represents an ongoing problem for standard-setters to explore. Many people believe that there is simply too much reporting being done by large organisations and much of the reporting is of limited benefit to the readers of the reports. Regulators and supporters of regulation often use the ‘level playing field’ argument to justify putting regulations in place. From a financial reporting perspective, this means that everybody should (on the basis of fairness) have access to the same information. This is the basis of laws that prohibit insider trading, which rely on an acceptance of the view that there will not be, or perhaps should not be, transfers of wealth between parties simply because one party has access to information that others do not.13 Putting in place greater disclosure regulations will increase the confidence of external stakeholders that they are playing on a ‘level playing field’. If this helps build or sustain confidence in the capital markets, then it is often deemed to be in ‘the public interest’. However, we will always be left with the issue as to what is the socially ‘right’ level of information. Arguably, such a question cannot be answered with any level of certainty. Opponents of ‘free-market’ arguments also often note that discussions about the virtues of ‘free markets’ and minimal or no regulation are naïve. The reality is that we have many regulations and to expect that these will be taken away in favour of free markets is unrealistic. As Shleifer (2005, p. 441) states: Today we live in a much richer, more benign, but also more regulated society, and that as consumers we are generally happy with most of the regulations that protect us. We are happier knowing that trains and airplanes are safe than savouring the thought of a fortune which our loved ones would collect in a trial should we die in a fiery crash. In securities markets, investors prefer a level-playing regulated field to the prospect of loss recovery through litigation. Indeed, there is strong evidence that regulation is beneficial for the development of financial markets and to public participation in them. 13
There is also the view (Ronen, 1977) that extensive insider trading will erode investor confidence such that market efficiency will be impaired.
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Pro-regulation A position taken by people who favour the use of regulation, rather than market forces, as a means of influencing particular activities.
While proponents of the pro-regulation (anti-free market) view might argue that regulation is necessary to ensure the ethical treatment of various stakeholders, potentially as the result of ‘market failure’, it should also be acknowledged that there can be ‘non-market failure’ (or as it is also called, ‘government failure’). Calls for the intervention of government through regulation seem to implicitly assume that people in government always work in the ‘public interest’, and are well informed about the implications of particular legislation. However, government officials may allow self-interest to dictate their actions and they might introduce legislation to garner support from particular constituents or benefactors (Stigler, 1971). Also, across time, governments can be captured by vested interests who then are able to shape legislation in the best interests of a limited subset of society (Mitnick, 1980). As Andersson (1991, n.p.) states in relation to legislating to improve environmental performance: Governments may respond to political pressure rather than maximize social welfare. Because pollution tends to hurt large unorganized groups, future generations, and those who are uninformed, there is likely to be a ‘government failure’ resulting in too little protection of the environment.
Introducing legislation is also not costless and therefore clear benefits should need to be demonstrated before regulation is introduced. Such regulatory-related costs would include those associated with formulating and explaining legislation, monitoring compliance, imposing and enforcing sanctions, compliance costs for companies and so forth. If government believes that markets are working appropriately and there are no compelling justifications for introducing legislation, then it might be more ‘efficient’ and in the ‘public interest’ to leave various responsibilities effectively in the hands of organisations.
The ‘invisible hand’ Many theories that provide support for free-market approaches to accounting regulation rely on the work of the eighteenth-century economist Adam Smith (originally published in 1776 but republished in 1937). Smith has become famous for his notion of the ‘invisible hand’. The ‘invisible hand’, which was mentioned only once in his five-book treatise, The Wealth of Nations, appears in Book Four, referring to the distribution of capital in society: the annual revenue ... is always equal to the whole product of its industry ... as every individual attempts to employ his [her] capital in the support of the domestic industry and so to direct that industry that its produce may be of the greatest value, every individual necessarily labours to render the annual revenue of the society as great as he [she] can ... he intends only his own security ... he attends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was not part of it. By pursuing his [her] own interest he [she] frequently promotes that of the society more effectually than when he [she] really intends to promote it.14
Subsequent free-market exponents have drawn on the notion of the ‘invisible hand’ to promote a belief in ‘market omnipotence’, arguing against state involvement because it ‘disturbs the spontaneous order and the spontaneous society’ (Lehman, 1991, p. xi). That is, without regulatory involvement, productive resources will, as a result of individuals pursuing their own self-interest, somehow, as if by an ‘invisible hand’, find their way to their most productive uses. Some writers actually went to the next step by arguing that allowing activities to be controlled by market mechanisms will actually protect market participants. For example, Milton Friedman (1962, p. 82) states: 14
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This quote is reproduced from Lehman (1991).
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The central feature of the market organisation of economic activity is that it prevents one person from interfering with another in respect of most of its activities. The consumer is protected from coercion by the seller because of the presence of other sellers with whom he can deal. The seller is protected from coercion by the consumer because of other consumers to whom he can sell.
These views ignore market failures (such as unequal access to information) and uneven distributions of power. Smith was concerned with particular problems that occur in monopolistic situations where prices for needed goods might be driven up by suppliers. According to Collison (2003, p. 864): Smith ... was against legislation that protected the strong and the privileged either by conferring monopoly powers over consumers, or by worsening the already weak position of employees. He did not counsel against steps taken to protect the weak and was not against regulation per se.
Smith did not advocate that there should be no regulatory intervention. He was aware of the problems that might arise in an unregulated free market, and, although it is rarely mentioned by the advocates of the ‘free market’, he actually wrote of the need for the government to be involved in the ‘public interest’ to protect the more vulnerable. As Lehman (1991, p. x) states: Among the passages revealing Smith’s concern for harmful unintended consequences [of the free-market approach] are those appearing in Book V, Chapter 1, where Smith writes that in the progress of the division of labour, the progress of the great body of people will be the man [or woman] who spends much time doing a few simple operations, with no invention, with no tender sentiment, incapable of judging, incapable of defending the country in war. In every society, the great body of people will fall this way, ‘unless the government takes some pains to prevent it’.
This view is also supported by Collison (2003, p. 863), who states: Adam Smith himself was well aware that conditions in the world he inhabited did not conform to the competitive ideal: he was not opposed to government action in pursuit of general welfare; indeed he favoured it, and was acutely conscious of the danger of undue power in the hands of the capitalist class.
So, if we accept that Smith’s work has been misrepresented as a treatise in favour of the ‘free market’ (as a number of authors suggest), why has it been misrepresented? Collison (2003) argues that it is in the interests of many businesses that regulatory interference (such as the introduction of minimum wage controls, or disclosure requirements) be reduced. As such, he provides a view that many businesses used the work of acclaimed economists (such as Adam Smith and Milton Friedman) as a form of ‘propaganda’ to support their arguments for reduced regulation.15,16 According to Collison, arguments such as those presented by famous economists such as Smith or Friedman, and ‘the corporate propaganda which is used to sell it to the public’, were anticipated by Adam Smith, who warned of the negative impacts that could be caused by
Other authors (such as Carey, 1997) have argued that many larger businesses were able to influence academics (through the provision of funding) to support particular views. The results of the academic research studies, which often supported the views held by the groups that provided the research funding, were then provided to government to substantiate or support particular positions. 16 Collison also argues that the works of other well-respected economists have been misrepresented by vested interests. For example, the works of Berle and Means (1937) have ‘become identified with conflicts of interest between owners and controllers of wealth when they explicitly argued that both should be subservient to wider interests ... They commended public policy rather than self-interest as the proper mechanism for allocating corporate income streams. As with Adam Smith, their names have arguably become misleadingly linked with a particular agenda’. 15
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economically powerful interests, particularly when they are unrestrained due to an absence of adequate regulation or competition. According to Smith (as quoted in Collison, 2003): The clamour and sophistry of merchants and manufacturers easily persuade ... that the private interest of a part, and of a subordinate part of the society is the general interest of the whole (Smith, 1776/1880, Bk I, Ch. X, Pt II, p. 101).
In other words, as far back as 1776 Adam Smith wrote that it is predictable that business managers will argue that what is in the interests of the business organisations will actually be in the interests of the society as a whole – an argument that is still heard today, about 250 years later. That is, it is in the interests of managers to argue that if businesses prospers, then society will also prosper. This perspective is consistent with the economic interest theory of regulation, which is discussed later in the chapter. It is also consistent with what is often referred to as the ‘trickledown effect’, or ‘trickle-down theory’, which we explore more fully in Chapter 10. Under this perspective, if large organisations are allowed to freely operate and to grow, thereby making the related investors and managers wealthy, then these wealthy people will spend more, pay more taxes and invest more, and this will create further jobs for others, and the less powerful or less privileged workers would benefit from ‘trickle-down economics’ as production and consumption across the community increases. However, evidence does clearly show that there is still great disparity in wealth within society and that despite increases in productivity, some people remain very poor, so the validity of such claims about ‘trickle-down effects’ are questionable. In relation to how business will oppose the need for regulation on the basis of the argument that ‘what benefits business will also benefit society’, we can consider an Australian Government inquiry into corporate social responsibility and associated reporting. In 2005 the Federal Government established through its Parliamentary Joint Committee on Corporations and Financial Services (PJCCFS) (under the auspices of the Australian Securities and Investments Commission Act 2001) an Inquiry into Corporate Responsibility. Public submissions were invited, with submissions being received up to early 2006. The purpose of the inquiry was to consider the merit of introducing greater regulatory requirements in relation to corporate social responsibility and associated reporting (an issue that is investigated in Chapter 10). Specifically, the government was exploring opinions with regard to whether the Corporations Act 2001 should be amended to include specific corporate social responsibilities and specific social and environmental reporting requirements. Deegan and Shelly (2014) undertook an analysis of the submissions that were made to the inquiry. In summary, their analysis indicated that the managers of business corporations and related associations overwhelmingly favoured an anti-regulation (‘free market’) approach whereby corporations and their managers should be left to voluntarily determine their social responsibilities and their associated accountabilities, the view being that markets will ultimately penalise organisations with poor social and environmental records. (That is, the business organisations argued that if people in the marketplace expect a corporation to perform soundly in relation to its social and environmental activities, and if the organisation subsequently does not perform in accordance with these expectations, then market participants will penalise the organisation.) For example, Deegan and Shelly quoted from the submission made to the inquiry by QBE Insurance, one of Australia’s largest insurance companies. QBE Insurance stated: The market is the natural mechanism under which the issue of corporate social responsibility will continue to thrive.
Seeing the market as ‘a natural mechanism’ is an interesting perspective. In stark contrast, social and environmental groups, consumer associations, employee groups and individuals who made submissions to the inquiry tended to adopt a pro-regulation view; they believed that regulation needs to be put in place to protect the interests of various stakeholders and that, when left to the ‘invisible hand’ of the market, corporations do not operate in the ‘public interest’ (other than perhaps when they are persuaded through ‘enlightened self-interest’). 124
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Deegan and Shelly (2014) made specific reference to statements in various organisations’ submissions to the inquiry. Of particular interest was a submission made by the Chamber of Commerce and Industry of Western Australia. The Chamber of Commerce was particularly critical of calls for the introduction of legislation in relation to corporate social responsibilities and associated reporting, stating: Above all, it (calls for regulation to require corporations to undertake certain social activities and to provide information about their social and environmental performance) is indicative of a lack of faith in the capacity of the ‘invisible hand’ of the free market to deliver a better economic, environmental and social outcome than the good intentions of business leaders, suitably stiffened by laws, incentives and stakeholder responsibilities ... But those who doubt the efficacy of markets have never yet been able to point to an economy or society where a ‘visible hand’ has done better, whether that hand is guided by the state, a plurality of stakeholders, or well-intentioned business leaders. ... The advocates of mandated corporate social responsibility and stakeholder entitlements would impede the business sector’s capacity to make this valuable contribution to the economy and society.
It is interesting that a number of submissions to the inquiry made specific reference to the works of Adam Smith (and the ‘invisible hand’) to justify their particular anti-regulation viewpoint. Deegan and Shelly also found that many of the submissions made by business organisations suggested that the introduction of legislation was against the interests of Australia, as it would ‘stifle’ any form of innovation in social and environmental reporting. For example, the Australian Institute of Company Directors’ submission stated: The AICD believes that reporting on corporate social responsibility in Australia is at a very early stage and mandating any particular approach is likely to stifle innovation and experimentation by companies and to lead to a mentality where directors and management focus on compliance only.
Deegan and Shelly challenged the view that introducing mandatory reporting requirements would stifle innovation. Rather, they believed that regulation would simply establish a minimum level of disclosure which organisations could elect to exceed. Apart from the risk that legislation would ‘stifle innovation’, many of the submissions from business and industry organisations referred to the risk that the introduction of specific legislative requirements pertaining to corporate social responsibilities would tend to engender a compliance mentality and increase compliance costs. Numerous submissions from the business community also stated that a ‘one-size-fits-all’ approach (legislation that applies to all entities) is highly inappropriate and that given market efficiencies and the managers’ quests for maximising shareholder value, these factors alone should lead to innovation and benefits for all (as if by an ‘invisible hand’). Evidence provided by Deegan and Shelly indicates that it is common for business organisations to oppose the introduction of various forms of legislation, and it is also common for business leaders to argue that if society expects corporations to undertake particular actions, then corporations will undertake these actions because failure to do so will impose costs on the organisation. For example, if society expects a company to adopt high standards of environmental performance (it is part of the so-called ‘social contract’ between the organisation and society), and the company is then shown to be damaging the environment, consumers will elect not to buy the company’s products, banks will not lend funds to the organisation, people will not want to work for the company and so forth. The argument is that regulation is not needed and will actually impede the ‘natural functioning’ of the market. The market is seen as the best mechanism to discipline poorly performing managers. 125
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Enlightened self-interest Enlightened self-interest This would be in operation when managers of an organisation respond to community concerns (as if to appear to be caring) in those situations where doing so also fulfils the goal of maximising the value of the organisation, and therefore the wealth of owners and managers.
The above arguments indicate that organisations driven by ‘enlightened self-interest’ will be expected to respond to community concerns.17 Enlightened self-interest is considered to be demonstrated when a person, or an organisation, that appears to be acting in the interests of other stakeholders’ interests ultimately generates outcomes that serve their own self-interest. Interestingly, at the completion of the inquiry into corporate social responsibility, the Australian Government decided against introducing any regulation to specifically identify corporate social responsibilities. In justifying the conclusion that there was no need to introduce additional legislation, the final report of the inquiry made specific reference to the benefits of allowing ‘enlightened self-interest’ to dictate behaviour (PJCCFS, 2006, p. xiv): This ‘enlightened self-interest’ interpretation is favoured by the committee. Evidence received suggests that those companies already undertaking responsible corporate behaviour are being driven by factors that are clearly in the interests of the company ... Maintaining and improving company reputation was cited as an important factor by companies, many of whom recognise that when corporate reputation suffers there can be significant business costs. Evidence also strongly suggested that an ‘enlightened self-interest approach’ assists companies in their efforts to recruit and retain high quality staff, particularly in the current tight labour market.
Hence, in relation to corporate social responsibilities, the government clearly favoured an anti-regulation approach, driven perhaps by ‘free market’ arguments, as discussed in this chapter. Not surprisingly, there were many individuals and groups that criticised the decision made by the government and that favoured the introduction of regulation, perhaps driven by ‘proregulation’ perspectives, as discussed also in this chapter.18 Again, as emphasised throughout this book, there will be different views about different issues – in this case, about the advantages or disadvantages of regulation. Whether we personally favour one approach or the other will be based on our own values and whether we are prepared to accept the arguments (and theories) proposed by ‘free market’ proponents or those proposed by ‘pro-regulation’ proponents. It is of interest that the ultimate position taken by the Australian Government in relation to the PJCCFS was similar to the position of the government in Britain in regards to its Operating and Financial Review (OFR) and the introduction of mandatory corporate social responsibility reporting. Under the proposed OFR regulations, a company would have been required to provide information on its policies towards employees, customers and suppliers, as well as its impact on the environment, on society and on the wider community where the information was necessary for an assessment of the company (Department of Trade and Industry, 2004, in Cooper and Owen, 2007, p. 651). Owen, Shaw and Cooper (2005) investigated whether the mandatory reporting requirements of the OFR would provide the catalyst for improving corporate disclosure of social and environment information and they concluded that for already active social and environmental disclosers, the mandatory reporting requirement would have limited effect. However, for current non disclosers the OFR requirements ‘may mean that As an example of the ‘enlightened self interest’, Deegan and Shelly (2014) note that Origin Energy made the following submission to the inquiry: ‘Successful companies can obtain competitive advantage by being considerate of wider ‘duties’ that may not be the subject of specific legislation. Companies that ignore these wider duties may suffer disadvantage in their product or investment markets and may suffer loss of value through damage to their reputation.’ 18 As an example of the ‘pro-regulation’ perspective, Deegan and Shelly (2014) note that Amnesty International made the following submission to the inquiry: ‘There are numerous cases of Australian companies that have acted with gross disregard of the environment and the communities in which they operate. It is also apparent that none of the supposed controls on corporate malfeasance – enlightened self interest, enlightened shareholder value, corporate reputation, voluntary commitments, personal ethics – were sufficient to prevent these events.’ 17
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social and environmental issues become more mainstream in strategic terms’ (Owen, Shaw and Cooper, 2005, p. 8). However, after a six-year consultation period and less than a year after the introduction of the OFR, the legislation was repealed on the basis of concerns by the business community about the additional ‘administrative costs of the gold-plated regulatory requirements’ and the view that market mechanisms adequately ensure that corporations attend to their social responsibilities therefore making the OFR requirements redundant (Brown, 2005, as cited in Cooper and Owen, 2007, p. 664). We have discussed how various people have used the work of Adam Smith to support their arguments. Of interest is that reference to the work of Smith continues to be made in the news media to support or justify calls for removal of regulation and ‘government interference’ (although, as we noted, Smith also wrote of the need for regulation to moderate adverse impacts caused by large organisations). As a recent example of this, in an article entitled ‘WA government, Lib MPs slam push for $250b mining back-up’ (Coorey, 2021), a state politician criticised potential federal government intervention into the mining industry. Arguing against federal government intervention into the funding of mining activities, the politician stated that there was ‘already plenty of finance’ and that ‘Adam Smith told us the free market will drive investment towards what’s needed’, thereby justifying the argument that no federal government intervention was warranted. Free-market versus pro-regulation debates are ongoing in respect of many activities and industries, with various vested interests putting forward many different and often conflicting arguments for or against regulation. It is an argument that is often the subject of heated debate within university economics and accounting departments throughout the world. What do you think? Should financial accounting be regulated, and, if so, how much regulation should be put in place? Figure 4.1 provides a summary of some of the various arguments for and against regulation of financial reporting, and some of the assumptions adopted by the advocates of free markets and the advocates of regulation. Having discussed the arguments for and against regulation, we now consider a number of theories that describe why regulation is put in place, and discuss which stakeholders are expected to benefit from regulation. The following theories might assist our understanding of why, in particular situations, decisions were made for legislative reform. For example, according to Barton and Waymire (2004, p. 67): The October 1929 market crash is seen as among the most significant financial crises in US history (Galbraith, 1972) and was followed within five years by the most extensive changes in financial reporting requirements in US history.
Why would there be such reform? Barton and Waymire further state (2004, p. 69): Regulators often cite investor protection as a basis for more stringent financial reporting requirements enacted after financial crises. The investor protection justification has a long history dating back at least to British legislation passed in the wake of corporate bankruptcies in the 19th century (Littleton, 1933, pp. 272–87). Investor protection arguments surfaced in the US after the 1929 stock market crash as justification for the financial reporting requirements embodied in the Securities Act of 1933 and the Securities Exchange Act of 1934 (Pecora, 1939; Parrish, 1970). The intent of the Securities Acts was to protect investors from exploitation by informed traders in the large-scale securities markets that developed to support financing of enterprises with diffuse ownership structures (Berle & Means, 1932). More recently, the US Congress and Securities and Exchange Commission (SEC) have cited investor protection as the basis for recent reporting rules following the market decline of the past few years (US House, 2002). Implicit in the investor protection justification for financial reporting
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FIGURE 4.1 Summary of free market and pro-regulation arguments ‘Free market’ perspective
Pro-regulation perspective
The nature of accounting information
Accounting information is like any other good, and forces of supply and demand should be left to operate in an unhindered manner to provide optimal amounts of information.
Information is a ‘public good’ and due to ‘free riders’ will be under-produced in unregulated markets. Regulatory intervention is therefore necessary.
The nature of markets
Markets are efficient and provide disciplining mechanisms for managers who do not produce the information that is required by the market. Managers know that should they fail to provide demanded information then their cost of attracting financial capital will increase.
Markets are not efficient or equitable and therefore regulation is supplied in response to the need for a correction of inefficient or inequitable market practices.
The nature of government
Government regulators are not objective, but like everybody else, are driven by their own self-interest. They will introduce regulation that ultimately benefits them, or particular vested interests.
Government regulators act in the public interest.
The beneficiaries of regulation
Regulation, if introduced, will ultimately serve the interests of politically effective groups as well as potentially the regulators themselves.
Regulation will serve the general interests of society.
The role of government in developing regulation
There are government failures that provide inefficient outcomes. Government intervention will lead to regulation overload as well as many costs associated with regulatory compliance.
Government is a relatively costless and dependable vehicle for altering market behaviour in a way that is in the public interest.
The independence of the regulator
The political process of regulation will ultimately be captured by the industry that is being regulated or, alternatively, legislation will be introduced to serve the interests of powerful groups who are able to reward regulators.
Regulation will not be captured as this would be against the public interest. Regulators will remain independent in the interests of serving the public.
regulation is that higher quality reporting would have lessened investor losses during the recent crisis and that managers lacked incentives to supply higher quality financial information voluntarily.19,20
Legislators might have justified the introduction of new legislation in terms of protecting investors, but does this mean that investor protection was their real motivation? Or did they have other private incentives? The following theories provide different perspectives on why the ‘extensive changes’ were made. For example, public interest theory of regulation would propose that such regulatory changes were brought about in the interest of the public, which would be consistent with an ‘investor protection’ style of argument. By contrast, economic interest theories of regulation would suggest that the regulations might have been put in place so that regulators themselves, who would have been under pressure due to the large losses that had been suffered, Consistent with a free-market approach to accounting information, Barton and Waymire (2004, p. 70) note: ‘of course, mandatory disclosure requirements need not be the sole source of investor protection – self-interested managers supply information voluntarily to reduce agency costs (Jensen and Meckling, 1976; Watts and Zimmerman, 1986) and information costs in securities markets (Dye, 2001; Verecchia, 2001)’. 20 Interestingly, the US Securities and Exchange Commission website (as accessed November 2021) states: ‘The mission of the U.S. Securities and Exchange Commission is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation’. It is interesting that the mission of the SEC does not embrace a responsibility to stakeholders other than investors, such as local communities, employees and so forth. Perhaps there is a view that if ‘investors’ are protected the rest of society will benefit. This issue is explored more fully in Chapter 10. 19
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looked like they were doing something and this might help them retain their positions as regulators (and therefore help them retain their related income stream). In such an explanation, the introduction of the legislation is not so much about the public interest as about the private interests of those in charge of introducing the legislation. Again, as emphasised throughout this book, there are different ways of looking at the same phenomenon: some researchers may view the introduction of legislation as being in the public interest (a view embodied within public interest theory), whereas other researchers, viewing things through an alternative ‘theoretical lens’, may consider that the same action was taken because it best served the private interests of those in control of introducing the legislation (economic interest group theory of regulation).
Why do I need to know about the arguments for and against the introduction of regulation? Throughout our lives, we will all be exposed to a great deal of regulation. It is inescapable. We might also have a role that requires us to generate, or read, financial reports, which in themselves are subject to much regulation. Rather than simply accepting that all regulations are beneficial, we should attempt to critically evaluate whether regulations are necessary or whether other, perhaps marketrelated, mechanisms should have been allowed to operate to provide the optimal amount of a particular product or service.
By knowing about theories of regulation, we will be able to make more sense of the world in which we live – a highly regulated world. Also, in the future, we might find ourselves in a role that involves developing regulation, or supporting or opposing regulation. The insights provided within this chapter will allow us to perform our role more effectively and with greater insight.
REFLECTION QUESTION 4.1 To regulate, or not to regulate, accounting practice? Question Given everything you have just read, should financial reporting be regulated or left to market forces? Solution We will likely have different views about this issue depending upon the extent to which the ‘free market’ or ‘pro-regulation’ arguments resonate with us. In answering this question, we need to consider the merits of the arguments provided by different researchers (as discussed in this chapter); whether we are prepared to believe that freely operating ‘market forces’ generate outcomes that are equitable to all stakeholders (do we believe that there is some form of ‘invisible hand’ that moves things towards equitable outcomes?); or, whether we have faith in those parties potentially charged with developing regulation (are the regulators likely to act in the public interest or in their own self-interest?). It is the opinion of the author of this text that some financial reporting regulation is necessary to protect the interests of different market participants, particularly those people who have much of their wealth invested in organisations with which they have no direct relationship, other than being an investor. Also, other stakeholders (such as
employees, consumers and local communities) arguably have a right to receive information about an organisation’s financial performance, and these rights might not be addressed in the absence of regulation. But it would be naïve to believe that the benefits of all regulations exceed the associated costs or that regulations are never established to promote the vested interests of some people over and above the interests of others. As members of society, and as accountants, we need to critically review, and possibly challenge, the regulations that act to control our behaviour or to define our rights. However, we need to understand that regulatory overload and accounting standard overload can exist, and therefore we should consider whether any proposed regulations we support are likely to provide sufficient benefit (which in itself raises questions about how these costs and benefits would be determined and from whose perspective). So, while it is probably easy to justify that some regulation is needed, it becomes tricky when deciding what the optimal amount of regulation is and from whose perspective an optimal amount of regulation should be determined. Like the practice of accounting itself, the regulation of financial reporting is indeed a fascinating topic!
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LO4.2
Public interest theory A theory of regulation which suggests that regulation is developed in the ‘public interest’. Regulators are assumed to be motivated by the ‘public interest’ and will select regulation on the basis that the social benefits of the regulation exceed the social costs.
Public interest theory
Public interest theory was the dominant theory of regulation until the 1960s, and still has many
supporters. According to Posner (1974, p. 335), public interest theory ‘holds that regulation is supplied in response to the demand of the public for the correction of inefficient or inequitable market practices’. That is, regulation is initially assumed to be put in place to benefit society as a whole, rather than particular vested interests, and the regulatory body is considered to be a neutral arbiter that represents the interests of the society in which it operates, rather than the private interests of the regulators.21 The enactment of legislation is considered a balancing act between the social benefits and the social costs of the regulation. Applying this argument to financial accounting and reporting, and accepting the existence of a capitalist economy, society needs confidence that capital markets efficiently direct (or allocate) resources to productive assets. Regulation is deemed to be an instrument to create such confidence. As a past high-profile example of regulation being introduced in the ‘public interest’, and therefore consistent with the public interest theory of regulation, we can consider the introduction in 2002 of the Sarbanes-Oxley Act in the United States – an Act that was developed following the collapses of large corporations such as Enron and WorldCom and because of the apparent failures at the (then) leading accounting firm, Arthur Andersen. The Sarbanes-Oxley Act (often simply referred to as SOX) was developed to try to reduce the possibility of large-scale corporate collapses and poor accounting and auditing practices, and to increase the confidence of investors. Increased confidence within capital markets was considered to be in the ‘public interest’. The Act was named after its sponsors, US Senator Paul Sarbanes and US Representative Michael G. Oxley. Following SOX, senior corporate management within the US must individually certify the accuracy of financial information, and penalties for fraudulent financial activity are now stronger. The independence of outside auditors has also been enhanced, as has the oversight role of boards of directors. Various requirements have also been introduced in relation to corporate governance, internal control assessment and enhanced financial disclosures. In response to global perceptions that stricter financial governance laws were needed, similar laws were introduced in Japan, Germany, France, Italy, Australia, Israel, India, South Africa and Turkey. As might be expected, there is still some debate over the costs and benefits of SOX. Opponents of the Act, who tended to favour ‘free-market’ mechanisms as described earlier in this chapter, argue that it has reduced the United States’ ability to be competitive internationally because it has introduced an overly complex regulatory environment that creates high compliance costs. Supporters of the Act argue, however, that SOX has had an important hand in improving the confidence that investors and other parties have in corporate financial statements. Many people are critical of the perceived simplistic ‘public interest’ perspective of why regulation is introduced (for example, Peltzman, 1976; Posner, 1974; Stigler, 1971). Posner (1974) questions the ‘assumptions that economic markets are extremely fragile and apt to operate very inefficiently (or inequitably) if left alone; the other questionable assumption being that government regulation is virtually costless’ (p. 336). Posner also criticises arguments that suggest legislation is typically initially put in place for ‘the public good’ but only fails to achieve its aims due to government ineptitude, mismanagement or a lack of funds. As he states (p. 337): [There is] a good deal of evidence that the socially undesirable results of regulation are frequently desired by groups influential in the enactment of the legislation
21
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This perspective would not be accepted by advocates of the ‘rational economic person’ assumption, as they would argue that all activities, including the activities of regulators and politicians, are primarily motivated by a desire to maximise personal wealth rather than any notion of acting in the public interest.
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setting up the regulatory scheme ... Sometimes the regulatory statute itself reveals an unmistakable purpose of altering the operation of markets in directions inexplicable on public interest grounds ... The evidence that has been offered to show mismanagement by the regulatory body is surprisingly weak. Much of it is consistent with the rival theory that the typical regulatory agency operates with reasonable efficiency to attain deliberately inefficient or inequitable goals set by the legislature that created it.
Laughlin (2007) also noted that while governments might argue they are putting regulations in place for the ‘public interest’, they might actually be introducing regulations or legislation that best serve their particular political interests or ideologies. As a case in point, Laughlin (2007) noted the initial support for a report in the United Kingdom known as The Corporate Report (1975), which had proposed that accounting, and accounting regulation, needed to serve the information needs of many different stakeholders and not just shareholders and lenders. The Corporate Report led to a UK Government Green Paper that supported the development of accounting frameworks which would have a broader stakeholder (as opposed to a narrow shareholder) focus. However, when a new government was elected in the United Kingdom, it embraced a view that supported the information needs of the providers of financial capital over and above the needs, or information rights, of other stakeholders. As Laughlin (2007, p. 278) states: The new Conservative Government, led by Margaret Thatcher, banished such a compassionate understanding of stakeholders, and their information needs, and put in their place the information needs of finance capitalists – notably shareholders and other finance providers…. Had the Conservative Government, in 1979, wanted to, they could have supported the work that the previous Labour administration had started and accounting regulation could have been totally different. They didn’t and they didn’t because they believed it would not be in the ‘public interest’ to develop a stakeholder emphasis… Government can and does allow quasi-independence of the accounting regulators to regulate the profession, both generally as well as specifically, providing it is working in whatever they deem to be the ‘public interest’. Where this is perceived not to be occurring then they will intervene, and these interventions cannot and should not be ignored.
Proponents of the economics-based assumption of ‘self-interest’ would argue against accepting that any legislation was put in place by particular parties because they genuinely believed that it was in the public interest. Rather, they consider that legislators will put in place legislation only because it might increase their own wealth (perhaps through increasing their likelihood of being re-elected), and people will lobby for particular legislation only if it is also in their own self-interest. Obviously, as with most theoretical assumptions, this self-interest assumption is one that (hopefully!) does not always hold. The private interest group theory of regulation, which assumes self-interest, is considered later in the chapter. In the next section, the regulatory Capture Theory of regulation is discussed. Unlike the private interest group theory of regulation, Capture Theory admits the possibility that regulation might initially be put in place for the public interest. However, it argues that the regulation will ultimately become controlled by those parties whom it was supposed to control.
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REFLECTION QUESTION 4.2 The public interest perspective Question If government has said that an accounting regulation was introduced for the ‘public interest’, would you believe them? Solution Our answer to such a question will be influenced by our own assumptions about what motivates government regulators – is it public interest, self-interest or perhaps a mixture of both? We can consider the evidence of research that has investigated people in governments’ motivation for particular decisions. Broadly speaking, the evidence is mixed – some points to selfinterest and some points to public interest. Another point to be noted is that we will all potentially have different views about what is in the ‘public interest’. Some people might believe in the ‘trickle-down effect’ such that any regulation which directly supports or protects the interests of investors will likely be in the broader public interest, because confidence in the capital markets benefits everybody.
LO4.2
Capture Theory This theory suggests that although regulation is often introduced to protect the public, the regulatory mechanisms are often subsequently captured so as to protect the interests of particular self-interested groups within society, typically those whose activities are most affected by the regulation.
LO4.3
Conversely, other people, on the basis of their own research or evidence, might dispute such flow-on effects and argue that the government is simply supporting already rich investors because such investors have the financial means to help reelect the government. As we have also discussed, different political parties have different ideologies and will have different views about the responsibilities and accountabilities of organisations, and what is in the ‘public interest’. Therefore, it is very possible that different political parties will have diametrically opposing views on the needs for particular regulation, including the regulation of corporate reporting, but all will be arguing that their views are in the ‘public interest’. Therefore, the solution to this question is clearly not an easy ‘Yes’ or ‘No’ answer. We need to consider existing research, the philosophical views of the researchers involved and our own notions about what represents the ‘public interest’.
Capture Theory
Researchers who embrace Capture Theory (capture theorists) would typically argue that, although regulation might be introduced with the aim of protecting the ‘public interest’ (as argued in public interest theory described above), this laudable aim will not ultimately be achieved because, in the process of introducing regulation, the organisations that are subject to the regulation will ultimately come to control the regulator. The regulated industries will seek to gain control of the regulatory body because they know that the decisions made by the regulator will potentially have a significant impact on their industry. The regulated parties or industries will seek to take charge of (capture) the regulator with the intention of ensuring that the regulations subsequently released by the regulator (postcapture) will be advantageous to their industry. Regulatory capture is a common phenomenon in which regulators, governments, regulatory authorities and professional bodies come to identify more with the interests of the people they are supposed to be regulating than with the interests of the people they are supposed to protect. This capture might occur in the following situations: • Particular industry bodies, or large organisations within an industry, are known to offer jobs to people who previously worked within regulatory bodies. This strategy might encourage people within such regulatory bodies to be ‘friends’ of their future potential employers. As an example of this, we can refer to an Australian Financial Review article entitled ‘Bank boards are full of former regulators’ (Kehoe, 2018). In this article, it was reported that Graeme Samuel, former chairperson of the Australian Competition and Consumer Commission (ACCC), had stated that Australian economic regulators are ‘at risk of capture from the financial services industry because of the potential lure of working in a highly paid and powerful job at a big bank in their post-public service career’. It was also reported that Samuel was of the view that: there is a risk that regulatory personnel may pull their regulatory punches, knowing a future employer could be on the receiving end. Samuel said there was a danger of the ‘vulnerable regulator’ – junior or senior – ‘feeling the need to be liked’ and wanting to
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feel they are ‘mixing it with the big end of town’. ‘The most serious risk for regulators is industry capture,’ said Samuel. ‘Industry is adept at implementing regulatory capture strategies.’
Applying such concerns to the Australian corporate regulator, an article that appeared in The Australian entitled ‘Overseas watchdogs can end “cosy” alliance’ (Rodden, 2019, p. 2) argued that senior representatives in the Australian Securities and Investments Commission (ASIC) became too close to the banking sector and, as a result, Australia’s corporate watchdog ‘too often failed to regulate the banking sector properly because they were captured by the industry’. The concerns were raised because many senior officers within ASIC were ultimately offered senior appointments within banking organisations, and therefore, knowing that banks would make such appointments, the senior ASIC officials were perceived to be less inclined to make tough decisions against the industry when acting as regulators, because to do so might mean they would be shunned from appointments on leaving ASIC. • From the reverse perspective, regulatory bodies often offer jobs to people who held senior roles in the industries being regulated. This might occur when, for example, a large corporate regulator such as the Securities and Exchange Commission (SEC) in the United States, or ASIC in Australia, offers jobs to former members of industries or organisations that it used to regulate. These potential new employees will likely have close relationships with the people and organisation they would thereafter be regulating. As an example of this form of industry capture, we can consider a Washington Post article entitled ‘Watchdog’s report raises concerns about SEC’s revolving door’ (Elboghdady, 2013). The report described the possible capture of the SEC – a very important body in terms of regulated corporate disclosures within the United States. A newly appointed head of the SEC had previously been a private sector lawyer acting on behalf of large companies, large banks and large accounting firms. Of concern was that she would be regulating many organisations with whom she had previously developed a close working relationship. Within the newspaper article, a senator was reported as saying:
It’s especially important for the SEC to fix this problem with the arrival of a new chairman who, if confirmed, would bring a lot of good things to the commission but also a lot of connections to the securities industry she’d be regulating.
• When industry bodies or particular organisations provide certain benefits of value to individuals
within regulatory bodies. As an example of this, we can consider the contents of a report in the West Australian entitled ‘Crown Perth paid for casino watchdog boss Barry Sergeant to travel to Macau’ (Moulton, 2021), in which reference was made to a report from the Perth Casino Royal Commission that noted the large casino, Crown Perth, paid for the Chairperson of the state’s Gaming and Wagering Commission (GWC) to accompany senior executives of Crown to travel to Macau and stay in premium accommodation, all for the supposed purpose of ‘educating’ the Chairperson about the work of Crown. This ‘education’ was reported as coming at the same time that Crown was lobbying the government to reduce the tax being imposed upon the casino, which it subsequently did one year later. In the article, the Interim Report of the Perth Casino Royal Commission (issued 4 August 2021) was reported as stating: ‘The preliminary view ... is that the capability and effectiveness of the GWC may have been hampered,’ the report said. Significantly, the report said on first look, major relaxations of rules governing the Perth casino could have been influenced by ‘regulatory capture’ – where a regulator becomes dominated by the industry it oversees.
• When industry bodies partner with government regulators to tackle particular problems.
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• When industry bodies or large organisations make donations to government to support their
electoral campaigns. Financial support might encourage any elected regulator to be favourable towards donors. ASIC also has recognised the risk of it being the subject of regulatory capture. The Final Report of the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry, in relation to the proposal to establish a new enforcement body within ASIC, noted (Hayne, 2019, p. 441): The risk of regulatory capture is well acknowledged. One means of avoiding regulatory capture affecting enforcement decisions is to have the enforcement arm of ASIC separated from day-to-day dealings with the entities it regulates to the greatest possible extent. Enforcement staff will have to meet with regulated entities to discuss enforcement decisions. So, for example, enforcement staff will have to negotiate about litigation that is on foot. But those meetings should be conducted through the parties’ legal representatives and with appropriate formality. Enforcement staff should not be responsible for the general relationship between the regulator and the regulated entity. Their involvement with an entity should be matter-specific. Within the regulator, enforcement officers must be relied upon for clear and objective advice and action. Those responsible for continuing supervision of an entity may give too much weight to past good conduct, or may – even subconsciously – explain away conduct that would otherwise raise a red flag.
Obviously, there are economic benefits to an entity if it is able to ‘capture’ the body that regulates it. According to Mitnick (1980), and consistent with some of the material discussed above, there are at least five ways in which a regulated entity or industry will be able to capture a regulatory body (Mitnick, 1980, p. 95, as reproduced in Walker, 1987, p. 281): 1 Capture is said to occur if the regulated interest controls the regulation and 2 3 4
5
the regulated agency; or if the regulated parties succeed in coordinating the regulatory body’s activities with their activities so that their private interest is satisfied; or if the regulated party somehow manages to neutralise or ensure nonperformance (or mediocre performance) by the regulating body; or if in a subtle process of interaction with the regulators the regulated party succeeds (perhaps not even deliberately) in co-opting the regulators into seeing things from their own perspective and thus giving them the regulation they want; or if, quite independently of the formal or conscious desires of either the regulators or the regulated parties, the basic structure of the reward system leads neither venal nor incompetent regulators inevitably to a community of interests with the regulated party.
Thus, while the introduction of regulation can in many cases be explained in terms of protecting the ‘public interest’, it is argued that inevitably it will be difficult for a regulator to remain independent of those parties or industries being regulated, as the survival of the regulatory body over a period of time often depends on satisfying the expectations of those parties or groups being regulated. Further, the greater the industry’s total resources relative to those of the regulator, the greater will be the chance that the regulator will ultimately be unable to remain independent. By contrast, non-industry members, inclusive of consumers and the general public, could individually be impacted relatively minimally by proposed legislation and therefore will have little incentive to act. Further, even if they are particularly concerned by 134
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potential legislation, to the extent that they act individually or within small groups, their ability to influence the legislation might be low. As with various industries, including those discussed above, at various times and in various jurisdictions, it has been argued that large accounting firms have captured the accounting standard-setting process. This was of such concern in the United States that in 1977 the US Congress investigated whether the (then) Big Eight accounting firms had ‘captured’ the standardsetting process (Metcalf Inquiry). In the Australian context, Walker (1987) argued that the Australian Accounting Standards Review Board (ASRB) (which was subsequently replaced by the Australian Accounting Standards Board) was apparently ‘captured’ by the accounting profession.22 He cites a variety of evidence in support of this argument, concluding that within two years of its formation: the profession had managed to influence the procedures, the priorities and the output of the Board. It was controlling both the regulations and the regulatory agency; it had managed to achieve coordination of [its] activities; and it appears to have influenced new appointments so that virtually all members of the Board might reasonably be expected to have some community of interests with the professional associations. (Walker, 1987, p. 282)
As we know, proponents of Capture Theory typically argue that regulation is usually introduced, or regulatory bodies are established, to protect the public interest. For example, from an accounting perspective, new regulatory systems and regimes are often established in response to high-profile accounting failures, where members of the public are perceived to have suffered a financial loss and it is argued that new regulations will help prevent a repeat of the accounting failures. This happened with the establishment of: • the SEC in the United States in the early 1930s, which was formed in response to the Wall Street Crash of 1929 • the UK Accounting Standards Steering Committee in the early 1970s following negative publicity over accounting failures at some large UK companies in the late 1960s • the Accounting Standards Board in the United Kingdom in 1990 following further large-scale accounting failures in the late 1980s • many tighter accounting and corporate governance regulations being imposed in many countries following the accounting failures at Enron, WorldCom, Parmalat and other companies in the early 2000s • recent high-level political pressures for global convergence on a single set of high-quality accounting standards following the sub-prime banking crisis and ensuing global financial crisis (GFC). While the resultant regulatory bodies are often portrayed as ‘objective’ and ‘independent’, in the past their members have predominantly been professional accountants and finance directors (the preparers of accounts whom these regulatory bodies are meant to be regulating!), which Walker (1987) argues is an important component of regulatory capture. However, mechanisms have been put in place to help ensure greater independence of accounting regulators. For example, the International Accounting Standards Board (IASB) has 16 members, of whom all but three have to work full-time and exclusively for the Board, and are required to sever their ties with previous employers. They are also appointed by the board of 22 Trustees of the International Financial Reporting Standards (IFRS) Foundation who have all agreed that they will act in the public (not their own private) interest and whose appointments must in turn be approved by a ‘Monitoring Board’ that represents a broad cross-section of interests. While this may help in giving an image of detached and impartial objectivity to the 22
Walker was a member of the ASRB from 1984 to 1985. In commenting on his motivation for documenting the case study of the ASRB, Walker states (p. 285) that: ‘The main concern was to highlight the way that a set of standard setting arrangements designed to permit widespread consultation and participation were subverted by some likeable, well-meaning individuals who were trying to promote the interests of their fellow accountants’.
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IASB standard-setting process (which is discussed in the next chapter), it should be remembered that the members of the IASB are still mostly professionally qualified accountants whose views are bound to be conditioned to a certain extent by their previous experiences and training. Furthermore, the constitution of the IFRS Foundation, whose Trustees appoint IASB members, stipulates that: ‘The mix of Trustees shall broadly reflect the world’s capital markets and diversity of geographical and professional backgrounds to ensure a broad set of skills, experience and perspectives. The Trustees shall be required to commit themselves formally to acting in the public interest in all matters’ (IFRSF, 2021, paragraph 7). In these circumstances, it is reasonable to question how independent and impartial the accounting standard-setting process can be. Returning to Walker’s analysis of the ‘capture’ of financial reporting standard-setting within Australia, Walker argues that prior to the establishment of the ASRB, accounting standards were issued by the accounting profession and sanctions for non-compliance (which were very rarely imposed) could only be made against members of the profession. Walker (p. 270) notes that throughout the 1970s (which was prior to the establishment of the ASRB in 1984), monitoring activities by government agencies revealed a high incidence of non-compliance with profession-sponsored accounting rules.23 This non-compliance was argued to reduce the confidence of the public in the capital market, which was not in itself deemed to be in the public interest. Government-sponsored standards, with associated legal sanctions, should, it was thought, increase the level of compliance and hence the confidence of the public in company reporting practices. Interestingly, in the 1970s the profession acknowledged the high level of non-compliance but argued that the best alternative was to give automatic statutory backing to professionally developed standards (thereby increasing the ‘force’ of the standards, but leaving the standard-setting process in the hands of the profession). While discussions proceeded relating to the establishment of the ASRB (a government body), suggestions were received by government from various sources that the possibility of statutory accounting standards being developed other than by the accounting profession should be considered. It was also suggested that the ASRB be given the power to determine the priorities of various standard-setting issues, as well as to appoint a ‘research director’. The accounting profession was quite vocal in its opposition to such moves, as it was against the idea of government itself (through the ASRB) being involved in the actual development of accounting standards. The accounting profession wanted to retain control over the standard-setting rather than having the power transferred to government. According to Walker (1987, p. 271): The accounting profession strongly opposed the ‘costly and possibly bureaucratic step’ of involving government in the preparation of accounting rules. It publicised counter-proposals that existing rules contained in the Companies Act and Codes should be scrapped and that legislative backing be extended to the profession’s own standards. The files of the Commonwealth Attorney-General’s Department relating to the establishment of the ASRB (copies of which were obtained in terms of Commonwealth Freedom of Information legislation) record that National Companies and Securities Commission Chairman Leigh Masel referred to a ‘concerted lobby by the accounting profession’ on these matters.
According to Walker, Masel contacted members of the Commonwealth Government’s Ministerial Council advising that the National Companies and Securities Commission (NCSC) had received submissions opposing the profession’s proposals. Part of the message stated: A particular concern expressed in discussions with some respondents was that, if the accounting profession’s proposals are accepted, the status and income on the profession 23
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According to Walker, the New South Wales Corporate Affairs Commission reviewed the financial statements of 8699 companies during the period 1978–82, and found that 3528 (41%) had failed to comply with one or more professionally sanctioned accounting standards.
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would, effectively, be accorded statutory protection without any corresponding requirement for public reporting and accountability by that profession. For reasons readily apparent, there are many in the profession who would welcome the safe harbour which legislative recognition would provide. (Walker, 1987, p. 271)
After reviewing the available evidence, Walker argues that ‘the ASRB’s early history can be considered a case study in regulatory capture’. He provides the following evidence (p. 282): 1 Before the board was established the accountancy bodies lobbied to ensure that the government body (the ASRB) would not have an independent research capability, would not have an academic as chairperson, and would be provided with an administrative officer rather than a research director (all of which would undermine its capabilities); all of these objectives were achieved. 2 In 1984 the board established its priorities on the basis of public submissions; by November 1985 its agenda represented the standards that the Australian Accounting Research Foundation intimated it was prepared to submit (the AARF was a professionally sponsored body funded by the accounting profession – that is, it was under the direct control of the accounting profession); in December 1985 new ASRB procedures ensured that ‘priorities would only be set after consultation with the Australian Accounting Research Foundation’ (the profession’s own research body). 3 In 1984 the board published a set of procedures (Release 200) which placed the AARF and other interests groups on a similar footing. Accordingly, the board refused to place a standard submitted earlier by the Australian Shareholders’ Association on its agenda, on the ground that the association had not provided all the supporting documentation and an assignment of copyright as required by Release 200. Yet in November 1985 an ASRB advertisement announced that the board would be reviewing a series of standards yet to be submitted by the AARF; the board, while abandoning the requirement of Release 200 for the AARF, continued to impose it on the Australian Shareholders’ Association. In December 1985 the ASRB reported that it had adopted ‘fast-track’ procedures for handling standards, but after six months had applied these only to submissions from the AARF, while it imposed more stringent requirements on submissions from other sources. 4 Prior to its establishment, it was suggested that the ASRB would be independent of the accounting profession and representative of a wide range of community interests. In 1984 the board membership included nominees of the Australian Council of Trade Unions, the Australian Shareholders’ Association and (it is understood) the Australian Merchant Bankers Association. The 1986 membership consisted of two former national presidents of the Australian Society of Accountants (which is now CPA Australia) - including one who was then a member of AARF’s Accounting Standards Board), a former national president of the Institute of Chartered Accountants in Australia (which is now Chartered Accountants Australia and New Zealand), a former state president of the Australian Society of Accountants, a state councillor of the Australian Society of Accountants (and former chairperson of the AARF), an academic active in committee work for the Australian Society of Accountants, and only one other (the executive director of the Australian Associated Stock Exchanges). 137
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In providing a concluding comment on the ASRB’s ‘capture’, Walker (p. 282) states: During 1984–5 the profession had ensured the non-performance of the ASRB, and by the beginning of 1986 the profession had managed to influence the procedures, the priorities and the output of the Board. It was controlling both the regulations and the regulatory agency; it had managed to achieve co-ordination of the ASRB’s activities; and it appears to have influenced new appointments so that virtually all members of the Board might reasonably be expected to have some community of interests with the professional associations. The ASRB had been ‘captured’ by the profession within only 24 months.
Chand and White (2007) also consider the issue of regulatory capture. In doing so, they explain government involvement in the accounting standard-setting process and explain why, in the Australian context, the Financial Reporting Council was established to oversee the activities of the AASB. Chand and White (p. 612) state: Some jurisdictions, notably the US and Australia, have taken the regulatory process under the wing of a government agency, to efface or avoid its being captured by the profession. For example, the US has taken steps through the Sarbanes-Oxley legislation to strengthen the regulator’s independence (Herz, 2002; Schipper, 2003). Similarly, in Australia the new standard setting arrangements were introduced in 1997, including the Financial Reporting Council to oversee the Australian Accounting Standards Board (Haswell and McKinnon, 2003, p. 10). Such remedial measures were seen as necessary in these countries, demonstrating that the regulatory process may have been captured.
We can also consider what happened when the IASB, and its predecessor, the International Accounting Standards Committee (IASC), attempted to develop the accounting standard for the extractive industry some years later. In 1998, due to concern about the lack of uniformity in accounting for pre-production costs, the IASC proposed the development of an international accounting standard that would improve consistency and comparability of reporting practices in the extractive industries internationally. To do this, it sought to reduce the available alternatives by supporting the use of the successful-efforts method (which is very similar to the area-ofinterest method) and the discontinuation of the full-cost method. As part of the process of developing the accounting standard, submissions were sought. In relation to the submissions, Cortese, Irvine and Kaidonis (2007, p. 2) report: There was overwhelming support for the use of the successful efforts method of accounting with 87 percent of respondents commenting on this issue indicating a preference for the successful efforts method only. In contrast, only 13 percent of respondents commenting on this issue indicated their support for having the option of both the successful efforts and full cost methods. Thus, the Steering Committee’s tentative view on this issue was supported, with the majority of respondents preferring a single method of accounting for pre-production costs consistent with the successful efforts concept.
However, when the accounting standard IFRS 6 Exploration for and Evaluation of Mineral Resources was issued in December 2004, the contents were not as expected. Rather than reducing the number of alternative accounting treatments, and thereby moving towards the goals of comparability and consistency that were previously promoted, the accounting standard effectively allowed organisations to use whatever was their preferred approach for accounting for exploration and evaluation expenditure. Therefore, IFRS 6 effectively ‘codified existing industry practice, perpetuating the disparate methods of accounting for exploration and evaluation, and maintaining the status quo for extractive industries companies’ (Cortese, Irvine and Kaidonis, 138
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2007, p. 3). IFRS 6 provides organisations with flexibility by virtue of paragraph 7 of IFRS 6, which states: Paragraphs 11 and 12 of IAS 8 specify sources of authoritative requirements and guidance that management is required to consider in developing an accounting policy for an item if no IFRS applies specifically to that item. Subject to paragraphs 9 and 10 below, this IFRS exempts an entity from applying those paragraphs to its accounting policies for the recognition and measurement of exploration and evaluation assets.
The paragraphs within IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors that are referred to above, which IFRS 6 specifically says do not need to be followed in relation to exploration and evaluation assets, would otherwise require an organisation to comply with IFRS that deal with ‘similar and related issues’, as well as requiring compliance with the IASB Conceptual Framework. This effectively provides entities applying IFRS (other than those within Australia, given that the Australian equivalent – AASB 6 – deviates from IFRS 6 as a result of the insertion within Australia of paragraphs that require the use of the area-of-interest method) with the flexibility to account for their exploration and evaluation assets in the manner they prefer. If, by contrast, it had been required that the Conceptual Framework be followed (as would be usual practice), then this would have meant the use of the full-cost method would have been eliminated. In trying to explain the apparent ‘backflip’ of the IASB, Cortese, Irvine and Kaidonis (2007, 2010) and Cortese (2013) point to the political power of the extractive industries and how that power arguably helped them ultimately see their preferred accounting standard be released. In explaining this power, Cortese, Irvine and Kaidonis (2007) note that the functioning of the IASB is dependent upon funding from external sources and that among those sources are significant contributions from the minerals and petroleum industry, which lobbied on the standard. They also point to the fact that the major companies in the extractive industries are richer and more powerful than many of the states and countries that seek to regulate them, and this in itself brings great influence. Cortese, Irvine and Kaidonis (2007) note that in their submissions to the IASC/IASB, both the American Petroleum Institute (a USA-based lobbying group for the extractive industries) and the Oil Industry Accounting Committee (a UK-based lobbying group) argued strongly for the retention of both the full-cost and successful-efforts methods of accounting. Cortese, Irvine and Kaidonis (2007, p. 9) argue that it was the power of the industry that contributed to the outcome, and that the result was: consistent with Mitchell and Sikka’s (1993, p. 29) observation that the ‘institutions and practices of accountancy are collusive and undemocratic’ and that institutions, such as the IASC/IASB, are ‘dedicated to defending the status quo and sectional interests rather than wider interests’.
Cortese (2013, p. 55) further reflects on this outcome and cautions that: This places in doubt the proclaimed transparency and independence of the IASB as a standard setting institution, and although it is widely acknowledged that the accounting standard setting process is political, this research highlights the source, nature and effect of this politicisation . . . The potential for the IASB to be ‘captured’ by those companies that are intended to be bound by the standards it issues is of particular concern given that the IASB claims to be an independent organisation acting in the public interest seeking worldwide diffusion of its accounting standards that will, ultimately, affect global capital markets.
These results are consistent with Watts and Zimmerman (1979) who argued, consistent with their maintained economic assumption that individuals seek to maximise their own wealth, that 139
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managers will lobby for those accounting standards that benefit them most and that regulators will also respond in a way that provides the greatest economic benefits to themselves. The results are also consistent with those generated some years earlier by Hansen (2010), who found that the level of financial contributions made by lobbyists influenced the decisions made by the IASB. As we discuss in Chapter 5, there were efforts to converge the accounting standards of the IASB and the US Financial Accounting Standards Board (FASB) some years ago, but for various reasons, this did not proceed. One consideration of the SEC was whether the ‘IASC Foundation, which oversees the IASB, has a secure, stable funding mechanism that permits it to function independently and that enhances the IASB’s standard setting process’ (SEC, 2008). Perhaps the SEC made the judgement that such independence was problematic. As is emphasised in a number of chapters in this book, the material discussed here again highlights the political nature of the accounting standard-setting process and how various stakeholders might try to influence the standard-setting process so as to achieve results that are advantageous to themselves. Of course, not all people will believe that the IASB was ‘captured’, or that it can be influenced by organisations and industries that provide funding to it. Nevertheless, authors such as Cortese, Irvine and Kaidonis highlight the possibility of political interference within standard-setting – something that is always possible. While a particular theory, such as Capture Theory, may be embraced by some researchers, there will be others who oppose such theories. Posner (1974), an advocate of the economic (private interest) theory of regulation (which we shall look at next), argues against a regular sequence wherein the original purposes of a regulatory program are subsequently thwarted through the efforts of the regulated group. He states (p. 340): No reason is suggested as to why the regulated industry should be the only interest group to influence an agency. Customers of the regulated firm have an obvious interest in the outcome of the regulatory process – why may they not be able to ‘capture’ the agency as effectively as the regulated firms, or more so? No reason is suggested as to why industries are able to capture only existing agencies – never to procure the creation of an agency that will promote their interests – or why an industry strong enough to capture an agency set up to tame it could not prevent the creation of the agency in the first place.
A key component underlying all the perspectives on regulatory capture is that different groups will have different interests and that accounting regulations will have an impact on these social and/or economic interests. If particular groups did not perceive a potential threat (or opportunity) from a regulator to their specific social or economic interests, why would they devote resources to attempting to capture the regulator? The remainder of this chapter discusses perspectives on the impact of these private interests on the regulatory process.
Why do I need to know about theories of regulation? The practice of financial reporting is heavily regulated. As students of accounting, it is important that we understand some of the potential reasons why regulation might have been introduced, or why regulation might have been introduced and subsequently amended or removed. As we have learned, while
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regulation is often assumed to be in place for the ‘public interest’, this is not always the case. To be able to critically evaluate the practice of accounting and to exercise our need to be critical thinkers, we need to be aware of these insights.
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Economic and social impacts of accounting regulation LO4.3
LO4.4
LO4.5
LO4.6
Before further examining various theories that address the influence of private interests on the accounting regulatory process, it is necessary to establish whether accounting regulations, such as financial reporting standards, can and do have a social and/or economic impact on the interests of preparers or users of accounts. Although many people might argue that accounting regulations only affect how underlying economic transactions and events are reflected in the financial reports, without any impact on the nature or shape of this underlying economic reality, there is a considerable body of evidence that accounting regulations actually have real social and economic consequences for many organisations and people. For example, an accounting standard issued by the IASB some years ago dealt with the accounting treatment of share options (IFRS 2 Share-based Payment). Although many companies use large numbers of share options as part of their management remuneration and incentive plans, prior to the release of IFRS 2 in 2005 most companies simply ignored the costs associated with issuing share options to employees when calculating their annual profit or loss. The justification for this practice was that when executives exercised the share options, and the company issued new shares to these executives at below market value, this did not apparently cost the company itself anything, despite it diluting the value of existing shareholders’ investments. However, the IASB view was that, by granting valuable share options to employees, companies were able to pay these employees a lower amount of money than if they had not been granted the share options. As the company receives valuable services from employees in exchange for these options, which would have been recorded as an expense if they had been paid for in cash, under IFRS 2 (AASB 2 in Australia), the fair value of share options now has to be recognised as an expense in the statement of profit or loss and other comprehensive income. Although implementation of IFRS 2 should have had no direct impact on underlying cash flows, during the development of IFRS 2 it was extensively argued that it would have many indirect negative economic and social consequences for a multitude of people. As some companies would be required to recognise a potentially large share option expense each year, some people maintained that these companies would be less likely to use share options as part of their pay and rewards packages. If valuable share options are an effective way to motivate managers and help align their self-interests with those of shareholders, a reduction in use of this form of incentive could lead to less-motivated executives (or a less-motivated workforce overall if share options were granted to many employees). This could lead to a reduction in underlying company performance, simply because IFRS 2 changed the manner in which a specific item was reflected in the financial statements. Therefore, while it was argued that IFRS 2 (in common with most, if not all, other accounting standards) should not lead to any direct changes in underlying business performance or cash flows, its indirect economic consequences could be potentially large and negative. As another example, with the adoption of IFRS in many countries, companies were required to follow IAS 38 Intangibles (which in Australia is known as AASB 138 Intangibles). This standard is particularly harsh on assets such as internally developed brand names, mastheads and research expenditure. Effectively, it requires expenditure on such internally developed intangible assets to be written off as an expense when incurred. Previously, within many countries, including Australia, there was no accounting standard preventing such expenditure from being recognised as an asset. As a result of the introduction of this accounting standard, many accounting commentators argued that expenditure on such items would be expected to reduce given the adverse impact that such expenditure would have on reported profits. It can be imagined how a reduction in expenditure on research could cause social and economic impacts that would flow throughout the society. Before the release of the standard, it was argued that its introduction would ‘reverberate’ throughout society and would impact on the ability of companies to pay dividends and also affect corporate relationships with banks. As a reflection of this, a newspaper 141
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article published in The Australian and entitled ‘Firms to fight writedown rules – new standards could wipe $50 billion from balance sheets’ (West, 2004) reported: Australia’s biggest companies are fighting a rearguard action to win an exemption from new international accounting rules that will carve up to $50 billion off the value of corporate balance sheets next year…. The reforms would reverberate all the way down the corporate food chain to smaller companies, whose return on equity, return on assets, debt gearing levels and banking covenants could be affected. A reduction in retained profits caused by the removal of intangible assets could also affect a company’s ability to pay dividends, which could hit its share price.
As a more recent example, there has been some evidence that the release of IFRS 16 Leases (effective from 2020) created changes in the ways organisations funded their acquisition of property, plant and equipment, with organisations more likely to acquire assets through loans rather than by way of leasing arrangements. This change in funding policies would have created social and financial impacts for various stakeholders. There are many other examples of accounting standards that have potential indirect economic and social impacts. Indeed, some people might argue that all accounting regulations will have an impact on managerial decisions (as managers will seek to manage their business so as to optimise their reported accounting numbers), and the resulting changes in managerial decisions will have a social and/or economic impact on those affected by the decisions. Several academic studies, which are discussed in the next section, have illustrated how the consideration of the potential economic consequences of proposed accounting standards motivated particular organisations to lobby regulators either in opposition to particular accounting standards or in support. This lobbying attempts to shape the regulations in a manner that will maximise the expected positive, or minimise the expected negative, economic consequences from the new accounting regulations for the lobbying organisations. In Chapter 8, through the theoretical lens of Positive Accounting Theory, we further examine how managers lobby accounting standard setters because of concerns of how new or revised accounting standards might impact the contractual arrangements that managers have negotiated with parties, such as lenders.
Lobbying and the economic interest group theory of regulation LO4.2
LO4.3
LO4.5
The economic interest group theory of regulation (or, as it is sometimes called, the private interest theory of regulation) assumes that groups will form to protect particular economic interests. Different groups, with incompatible or mutually exclusive interests and objectives, are viewed as often being in conflict with each other and they will lobby government or other regulators to put in place legislation that economically benefits them (at the expense of the others). As an example, consumers might lobby government for price protection or producers might lobby government for tariff protection. This theoretical perspective adopts no notion of public interest – rather, private interests are considered to dominate the legislative process.24 Within this perspective, regulation is effectively viewed as a product which is allocated to particular constituents in accordance with the basic principles of supply and demand. This theory directs our attention to factors that influence the value of regulation to particular individuals or groups. The expectation is that the product – in this case regulation – will ultimately be demanded by, and supplied to, those parties who value it the most. In relation to financial accounting, particular industry groups may lobby the regulator (the accounting standard-setter) to accept or reject a particular accounting standard. For example, 24
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As Posner (1974) states, ‘the economic theory of regulation is committed to the strong assumptions of economic theory generally, notably that people seek to advance their self-interest and do so rationally’.
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Hope and Gray (1982) show how a small number of aerospace companies were successful, during a consultation process, in changing the detailed requirements of a UK accounting standard on research and development in favour of their (private) interests. This was despite the overwhelming majority of participants in the consultation process not sharing the objections that had been made to the original proposals by the aerospace companies. These original proposals required all research and development expenditure to be charged as an expense in the year in which it had been incurred. The aerospace companies successfully argued that in certain circumstances they should be allowed to treat development expenditure as a form of capital expenditure, and charge it as an expense in future years by matching it against the income that it eventually generated. Although the impact on reported profits over the life of a project would be nil (the accounting treatment simply allowed a deferral of the expenditure between years), this accounting treatment resulted in higher net assets being reported in the balance sheet (statement of financial position) each year during a project than would have been the case if the development expenditure had been expensed in the year it was incurred. At the time, the prices that these aerospace companies could charge the UK Government for large defence contracts was based on a percentage return on the organisations’ net assets. Clearly, the higher the reported net assets in any particular year, the more a company could charge the government for a contract, so it was clearly in the private interests of the aerospace companies that the accounting standard permitted deferral of development expenditure. Another example of successful lobbying of an accounting regulator by an industry group, apparently seeking outcomes that were in the industry’s own interests, was the lobbying by some European banks against revised requirements in International Accounting Standard (IAS) 39 Financial Instruments: Recognition and Measurement. Banks in several European countries, as in Australia, argued that some of the provisions of IAS 39 (which has now been superseded by IFRS 9 Financial Instruments) would result in their accounts showing significant volatility that did not reflect the underlying economic reality, and this could be damaging to a bank’s perceived financial stability. The IASB made some limited changes in response to the banks’ concerns, but refused to change IAS 39 substantially. As shown in the next chapter, from 1 January 2005 accounting standards issued by the IASB became the accounting regulations that must be followed by companies in many countries including all companies that have their shares traded on any securities exchange in the European Union (EU). However, as part of the EU accounting regulatory process, for any accounting regulation to be mandated for use by EU companies it has first to be endorsed by the European Commission. The endorsement of each IAS/IFRS follows advice from the Accounting Regulatory Committee (ARC), which has one member from each of the 27 EU member states. At a meeting of the ARC in July 2004, four member states (out of the 25 that were then members) voted against full EU endorsement of IAS 39 and a further six states abstained, principally objecting to the elements of IAS 39 that banks in their countries had lobbied against. The 15 states that voted in favour of full endorsement were insufficient to form the two-thirds majority of the ARC required for approval by the EU of an IAS/IFRS.25 Subsequently, the IASB replaced IAS 39 with IFRS 9 Financial Instruments. The implementation of changes that IFRS 9 made to the provisions of IAS 39 were accelerated in response to pressure from the G-20 following the sub-prime banking crisis and ensuing GFC.26 However, in response In recent years, environmental groups have also lobbied government to introduce requirements for organisations to report various items of social and environmental information. Such submissions could perhaps prove a problem for advocates of the view that lobbying behaviour is dictated by private concerns about wealth maximisation (the rational economic person assumption). Perhaps (and we are clutching at straws here!) to maintain support for their ‘self-interest’ view of the world, proponents of the economic interest theory of regulation might argue that the submissions are made by officers of the environmental and social lobby group in an endeavour to increase their probability of reappointment. Alternatively, they might be lobbying because they believe that they have a moral obligation to do so. 26 The G20 is a group of finance ministers and central bank governors from 20 major economies: 19 countries plus the European Union, which is represented by the President of the European Council and by the European Central Bank. 25
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again to lobbying from interests in certain EU member states, the EU delayed recognition of IFRS 9 so companies listed on securities exchanges within the EU could not initially use it in preparing their financial statements. While some companies in EU countries were opposed to the provisions of IFRS 9, others supported them and were not happy with the EU’s actions. By comparison, while Australian banks lobbied against AASB 139 within the Australian context, the full requirements of IAS 39 were incorporated within AASB 139. Hence, unlike their European counterparts, Australian banks were unable to coerce the local regulator into amending the requirements of IAS 39. In an early study on lobbying of accounting regulators, Watts and Zimmerman (1978) reviewed the lobbying behaviour of US corporations in relation to a proposal for the introduction of general price level accounting – a method of accounting that, in periods of inflation, would lead to a reduction in reported profits. They demonstrated that the managers of large politically sensitive companies favoured the proposed method of accounting, which led to reduced profits. This was counter to normal expectations that managers generally would prefer to show higher rather than lower earnings. It was explained on the (self-interest) basis that it was the larger companies that could be subject to negative public sentiment (and pressures for regulation of their prices) if their profits were seen to be abnormally high, and they might therefore be seen more favourably if they reported lower profits. Hence, by reporting lower profits there was less likely to be negative wealth implications for the organisations (perhaps in the forms of government intervention, consumer boycotts or claims for higher wages). Accounting firms also make submissions as part of the accounting standard-setting process. If we were to apply the economic interest group theory of regulation, we would argue that these submissions can be explained as efforts to protect the interests of professional accountants. Perhaps auditors favour rules that reduce the risk involved in an audit, as more standardisation and less judgement reduces the risk of an audit and therefore the potential for costly lawsuits. Evidence in Deegan, Morris and Stokes (1990) supports the view that audit firms are relatively more likely to lobby in favour of particular accounting methods if those methods are already in use by a number of their clients. Analysts also frequently lobby regulators for increased disclosure, perhaps because they can use the information in their job but pay only a very small amount for it (other non-users will effectively subsidise the costs of the information – part of the free-rider issue discussed earlier in the chapter). Under the economic interest group theory of regulation, the regulator itself is an interest group – one that is motivated to embrace strategies to ensure re-election or to ensure the maintenance of its position of power or privilege within the community. For example, Broadbent and Laughlin (2002) argue that in the UK lobbying surrounding the development of accounting regulations applicable to governmental accounting for projects involving private sector provision of public services (known as Private Finance Initiative projects, or public private partnerships), various regulatory bodies adopted positions that could be interpreted as seeking to defend or enhance their standing with the groups who appoint them and give them legitimacy. It should be remembered that regulatory bodies can be very powerful. The regulatory body, typically government controlled or influenced, has a resource (potential regulation) that can increase or decrease the wealth of various sectors of the constituency. As Stigler (1971, p. 3) states: The state – the machinery and power of the state – is a potential resource or threat to every industry in society ... Regulation may be actively sought by an industry, or it may be thrust upon it ... as a rule, regulation is acquired by the industry and is designed and operated primarily for its benefit ... We propose the general hypothesis: every industry or occupation that has enough political power to utilise the state will seek to control entry.
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Under this ‘economic interest’ perspective of regulation, rather than regulation initially being put in place for the public interest (as is initially assumed within Capture Theory and also in public interest theory), it is proposed that regulation is put in place to serve the private interests of particular parties, including politicians who seek re-election. According to Posner (1974, p. 343),
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economic interest theories of regulation suggest that economic regulation serves the private interests of politically effective groups. Further, Stigler (1971, p. 12) states: The industry which seeks regulation must be prepared to pay with the two things a party needs: votes and resources. The resources may be provided by campaign contributions, contributed services (the businessman heads a fund-raising committee), and more indirect methods such as the employment of party workers. The votes in support of the measure are rallied, and the votes in opposition are dispersed, by expensive programs to educate (or uneducate) members of the industry and other concerned industries ... The smallest industries are therefore effectively precluded from the political process unless they have some special advantage such as geographical concentration in a sparsely settled political subdivision.27
Under the economic interest theory of regulation, the regulation itself is considered to be a commodity subject to the economic principles of supply and demand. According to Posner (1974, p. 344): Since the coercive power of government can be used to give valuable benefits to particular individuals or groups, economic regulation – the expression of that power in the economic sphere – can be viewed as a product whose allocation is governed by laws of supply and demand ... There are a fair number of case studies – of trucking, airlines, railroads, and many other industries – that support the view that economic regulation is better explained as a product supplied to interest groups than as an expression of the social interest in efficiency or justice.
Posner’s position is consistent with that adopted by Peltzman (1976), who states (p. 212): The essential commodity being transacted in the political market is a transfer of wealth, with constituents on the demand side and their political representatives on the supply side. Viewed in this way, the market here, as elsewhere, will distribute more of the good to those whose effective demand is the highest ... I begin with the assumption that what is basically at stake in the regulatory process is a transfer of wealth.
The idea being promoted by the advocates of economic interest group theories of regulation is that if a particular group (perhaps a minority) does not have sufficient power (which might be reflected by the numbers of controlled votes or by the potential funds available to support an election campaign) then that group will not be able to successfully lobby for regulation that might protect its various interests. This view is compatible with some of the arguments used by a number of critical theorists (discussed in Chapter 13), who often contend that the legislation supporting our social system (including corporations law and financial reporting standards) acts to protect and maintain the position of those with power (financial capital) and suppresses the ability of others (those without financial wealth) to exert a great deal of influence within society. Consistent with this view, advocates of the economic interest group theory of regulation would also argue that regulators will use their power to regulate to transfer wealth from those people with low levels of political power (and who have a limited ability to influence the appointment of the regulator) to those parties with greater levels of political power. Reflective of this possibility, in a review of the US Securities Acts of 1933 and 1934, Merino and Neimark (1982, p. 49) conclude that ‘The security acts were designed to maintain the ideological, social and economic status quo while restoring confidence in the existing system and its institutions’. They further state (p. 51) that the establishment of the Securities Acts ‘may have further contributed to the 27
As an example, Stigler (1971, p. 8) refers to the railroad industry: ‘The railroad industry took early cognizance of this emerging competitor, and one of the methods by which trucking was combated was state regulation. By the early 1930s all states regulated the dimensions and weights of trucks.’
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virtual absence of any serious attempts to ensure corporate accountability by broadening the set of transactions for which corporations are to be held accountable’. The works of some critical theorists are discussed in greater depth in Chapter 13.
REFLECTION QUESTION 4.3 Public interest or private interest? Question Having just read the above material, do you believe that accounting standard-setters would put the ‘public interest’ before their own ‘self-interest’ when developing financial reporting standards? Solution This is another one of those questions where we might all have different opinions depending upon the ‘theoretical lens’ through which we view the world. Our own views will be influenced by our beliefs about what motivates people in general, and regulators in particular. If we believe that regulators are not motivated by their own selfinterest, then we might believe that they will have the ‘public interest’ in mind when supporting particular regulation. However, if we believe that individuals will generally be motivated by their own self-interest – which is a maintained
assumption of many economics theories – then we must accept that accounting standard setters will consider their own self-interests when developing regulation. Further, the evidence provided by critical theorists (the focus of Chapter 13) suggests that those in charge of developing regulations will support rules that tend to sustain current social systems (which critical theorists argue tend to favour those constituents already with wealth and economic power), rather than regulation that tends to be equitable to all society members. Critical theorists would therefore also caution us not to simply accept that regulators act at all times in the public interest. As critical thinkers, we need to consider the evidence at hand and accept that it is very possible that some regulators will not always be objective when making decisions about accounting regulation.
Accounting regulation as an output of a political process LO4.5
Due process A process wherein the regulator involves those parties likely to be affected by the proposed regulation in the discussions leading to the regulation; it provides an opportunity to ‘be heard’.
LO4.6
If we accept that accounting standard-setting is a political process, then the view that financial reporting should be objective, neutral and apolitical (as espoused internationally within the IASB’s Conceptual Framework for Financial Reporting) is something that can be easily challenged. As seen in the previous section, because financial reporting affects the distribution of wealth within society, it consequently will be political.28 Standard-setting bodies typically encourage various affected parties to make submissions on draft versions of proposed accounting standards. This is deemed to be part of the normal ‘due process’.29 If the views of various parts of the constituency are not considered, the implication might be that the very existence of the regulatory body could be challenged. As Gerboth (1973, p. 497) states: When a decision making process depends for its success on the public confidence, the critical issues are not technical; they are political ... In the face of conflict between competing interests, rationality as well as prudence lies not in seeking final answers, but rather in compromise – essentially a political process.
In the earlier example of objections made by banks in some EU countries to certain detailed provisions of IAS 39, the failure of the IASB to compromise or concede to the wishes of these banks, and the willingness of certain EU governments to fight the banks’ case, led to a For example, whether dividends are paid to shareholders will be dependent on whether there are reported profits. Further, whether a company incurs the costs associated with defaulting on an accounting-based debt agreement (such as a debt-to-asset constraint, or an interest coverage requirement) can be dependent on the accounting methods it is permitted to apply. 29 The ‘due process’ can be defined as a process wherein the regulator involves those parties likely to be affected by the proposed regulation in the discussions leading to the regulation; it provides an opportunity to ‘be heard’. 28
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confrontation between two regulators – the EU and the IASB. At the time, this confrontation was seen as potentially highly damaging to both regulators. If the EU endorsed a revised EU regulation on accounting for financial instruments that had important (although possibly only small) differences from IAS 39, then rules underlying the accounts of EU companies would be different from the rules underlying the accounts of non-EU companies, and this would frustrate the objectives of international accounting standardisation (which is discussed in the next chapter). A common accounting regulation required both sides to compromise. An obstacle to reaching compromise between two powerful (and sometimes apparently intransigent) international regulatory bodies is that, as discussed earlier in the chapter, financial reporting standards (and therefore financial reports themselves) are the result of various social and economic considerations.30 Hence, they are very much tied to the values, norms and expectations of the society in which the standards are developed. Therefore, it is questionable whether financial accounting can ever claim to be neutral or objective (Hines, 1988, 1991). While it is frequently argued within conceptual frameworks that proposed disclosures should be useful for decision making, this in itself is not enough. The proposed requirements must be acceptable to various parts of the constituency, and the benefits to be derived from the proposals must, it is argued, exceed the costs that might arise. Obviously, determining these costs and benefits is very problematic and this is an area where academic advice and academic research are often used. According to Beaver (1973, p. 56): without a knowledge of consequences ... it is inconceivable that a policy-making body ... will be able to select optimal accounting standards.
May and Sundem (1976, p. 750) take the argument further, stating: If the social welfare impact of accounting policy decisions were ignored, the basis for the existence of a regulatory body would disappear.
As noted above, while accounting standard-setters need in principle to consider the potential costs and benefits of particular financial reporting requirements before they are put in place, this is not a straightforward exercise. As the IASB stated in an exposure draft released in 2008 (released as part of a joint process between the IASB and the US FASB to develop a new conceptual framework of financial reporting – the joint working relationship has since been abandoned): The boards (IASB and FASB) observed that the major problem for standard-setters in conducting rigorous cost–benefit analyses in financial reporting is the inability to quantify the benefits of a particular reporting requirement, or even to identify all of them. However, obtaining complete, objective quantitative information about the initial and ongoing costs of a requirement, or the failure to impose that requirement, would also be extremely difficult. Regardless of the difficulty, standard-setters should endeavour to take into account both the benefits and the costs of proposed financial reporting requirements. (p. 61)
Any consideration of possible economic and social consequences (the costs and the benefits) necessarily involves a trade-off between the various consequences. For example, if neutrality/ representational faithfulness is sacrificed to reduce potential negative impacts on some parties (for example, preparers who might have otherwise been required to disclose proprietary information or to amend their accounting policies with the implication that they will default on existing debt contracts), this may have negative consequences for users seeking to make decisions on the basis of information provided. While it is accepted that accounting standards are developed having regard to social and economic consequences, it is also a requirement in many jurisdictions, such as Australia, that corporate financial statements be ‘true and fair’. Australian research indicates (Deegan, Kent and Lin, 1994) that auditors 30
The perspective adopted by the economic interest group theory of regulation will not be pursued at this point. If we had persisted with this perspective, we would argue that the standard-setters would support those submissions which best served the standard-setters’ self-interest.
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generally consider that compliance with accounting standards is necessary and often sufficient for them to decide that the auditee’s financial statements are true and fair. But can we really say they are true when the development of financial reporting standards has been influenced by judgements about various economic and social consequences? Perhaps it is easier to say they are fair in the sense that they are drawn up in accordance with the rules incorporated within financial reporting standards. ‘Truth’ itself is obviously a difficult concept to define and this might explain why in some jurisdictions it was decided that ‘true and fair’ was achieved if financial reports simply complied with relevant accounting regulations and generally accepted accounting practice. As another issue to consider, would it be reasonable to assume that readers of financial reports generally know that financial reports are the outcome of various political pressures, or would they expect that the reports are objective and accurate reflections of an organisation’s underlying performance and financial position? There could in fact be a financial reporting expectations gap in this regard, although there is limited evidence of this.31 According to Solomons (1978, p. 71): It is perfectly proper for measurements to be selected with particular political ends if it is made clear to users of the measurement what is being done.
However, is it realistic or practical to assume that users of financial statements would be able or prepared to accept that financial accounting necessarily needs to accommodate political considerations? Further, could or would users rely on financial reports if they had such knowledge? Would there be a reduction of confidence in capital markets? The argument that economic consequences need to be taken into account before new rules are introduced (or existing rules are changed) also assumes that in the first instance (before any amendments are to be made) there was some sort of equity that did not need addressing or rebalancing. As Collett (1995, p. 27) states: The claim that all affected parties such as the preparers of reports are entitled to have their interest taken into account in deciding on a standard, and not only dependent users, assumes that the position immediately prior to implementing the standard was equitable. If, however, users were being misled prior to the standard – for example, because certain liabilities were being kept off the balance sheet – then the argument that the interests of preparers of reports were being neglected in the standard-setting process would lose its force.
This was the case at Enron, where substantial liabilities were ‘hidden’ from users of the financial accounts through complex financial arrangements which resulted in these liabilities ‘being kept off the balance sheet’. As Unerman and O’Dwyer (2004) explain, the false image portrayed by Enron’s financial statements led many people, including Enron’s employees, to lose money which they would probably not have invested if they had been aware of the true extent of Enron’s liabilities. The senior executives ultimately responsible for preparing Enron’s financial statements appear to have provided misleading information, which resulted in the economic resources of external parties being allocated in a highly inefficient manner – but a manner that might have been perceived at the time by Enron’s senior executives as being in their own personal interests. Perhaps the absence of adequate regulation had very real and significant economic consequences in this case, which potentially demonstrates that regulation might be needed in some instances to protect the interests of less powerful stakeholders. As a further related issue for readers to ponder, is it appropriate for regulators to consider the views of financial statement preparers when developing financial reporting standards, given that accounting standards are put in place to limit what preparers are allowed to do, that is, to regulate their behaviour in the public interest? As we can see, regulating accounting practice requires many difficult assessments.
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Liggio (1974) and Deegan and Rankin (1999) provide definitions of the expectations gap. An expectations gap is considered to exist when there is a difference between the expectations users have with regard to particular attributes of information and the expectations preparers believe users have in regard to that information.
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Why do I need to know that financial reporting standards are the output of a political process? As students of accounting, we will likely prepare or be users of financial reports that are prepared in accordance with financial reporting standards. As such, it is important that we understand the processes through which financial reporting standards are developed. Such knowledge allows us to understand the context of both financial reporting standards and general purpose financial reports. It also allows us to understand why some proposed financial reporting standards fail to ultimately be released or take many years to be finalised – perhaps they were particularly contentious with various constituents. Knowing that financial reporting standards are developed through a political process that seeks input from constituents
and encourages lobbying, and which considers the various costs and benefits likely to flow from the release of a standard, allows us to critically evaluate guidance included in documents such as the IASB Conceptual Framework for Financial Reporting. For example, the Conceptual Framework identifies ‘representational faithfulness’ as a fundamental qualitative characteristic of useful financial information, which is explained in terms of financial information necessarily being complete, neutral and free from error. As critical thinkers, and with the knowledge we have, we can now question whether financial reports prepared in accordance with financial reporting standards that have been developed through a political process can really be considered ‘neutral’.
REFLECTION QUESTION 4.4 Will compliance with financial reporting standards lead to organisations producing ‘representationally faithful’ financial information? Question The IASB Conceptual Framework prescribes that useful financial information should be both relevant and provide a faithful representation of the phenomena that it purports to represent. To be representationally faithful, the Conceptual Framework tells us that information needs to be complete, neutral and free from error. Given what you have just read about the political nature of the accounting standard-setting process, do you believe that general purpose financial reports prepared in conformity with financial reporting standards can be ‘representationally faithful’? Solution Arguably, a faithful representation of a particular transaction or event would require that the most objective process be pursued when determining how to disclose a particular transaction or event. An objective, or neutral, process would seek the best way to recognise, measure and disclose a particular transaction or event regardless of the social or economic consequences associated with providing particular information. That is, a ‘truly objective’ approach would determine what disclosures best reflect particular transactions and events and would require such disclosures, even if it means many companies might breach borrowing agreements or it leads to negative consequences for the share prices of
many organisations or particular stakeholders within the community. However, a balancing of the ‘public interest’ could justify a consideration of the concerns of different constituents and therefore a move away from otherwise objectively determined standards. Pragmatically, if financial reporting standard-setters did not consider potential financial and social impacts, and if the likely impacts were potentially significant throughout various parts of the community, then we could expect significant lobbying against the standard-setter, and this would have implications for the survival of that standard-setter. Governments that oversee standard-setters could, in the interests of their own political survival, likely take actions against standard-setters if those standard-setters become unpopular with voters. In conclusion, the more we open the standard-setting process up to lobbying from constituents, and therefore the more ‘political’ we make the standard-setting process, then we must accept that financial reporting standards are the outcome of a political process. Financial reports developed by applying these standards are therefore also influenced by a political process, meaning that consequently there are implications for a potential reduction in the ‘representational faithfulness’ of financial statements. Again, we see that the process of accounting is indeed a fascinating one!
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STUDY TOOLS CHAPTER SUMMARY This chapter considered various arguments that either supported or opposed the regulation of financial reporting. Advocates of the ‘free-market’ (anti-regulation) approach argue that there are private economic incentives for organisations to produce accounting information voluntarily, and imposing accounting regulation leads to costly inefficiencies. To support their argument for a reduction in financial reporting regulation, the ‘free-market’ advocates rely on such mechanisms as private contracting (to reduce agency costs), the market for managers and the market for corporate takeovers. By contrast, advocates of the ‘pro-regulation’ perspective argue that accounting information should not be treated like other goods. As it is a ‘public good’, it is unrealistic to rely on the forces of supply and demand. Because users of financial information can obtain the information at zero cost (they can be ‘free riders’), producers will tend to produce a lower amount of information than might be socially optimal (which in itself is obviously difficult to determine). Further, there is a view that the stakeholders of an organisation have a right to various information about an entity, and regulation is typically needed to ensure that this obligation is adhered to by all reporting entities. Regulation itself is often introduced with a related justification that it is in the ‘public interest’ to do so, the view being that regulators balance the costs of the regulation against the economic and social benefits that the legislation will bring. Clearly, assessments of costs and benefits are difficult to undertake and will almost always be subject to critical comment. There are alternative views as to why regulation is introduced in the first place. There is one perspective (referred to above) that legislation is put in place for the public interest by regulators who are working for the interests of the constituency (public interest theory). Public interest theory does not assume that individuals are primarily driven by their own self-interest. Hence, public interest theory makes assumptions that are not in accordance with economic theories that have as their core assumption that all individuals are driven by self-interest, with this self-interest being tied to efforts to maximise personal wealth. However, an assumption of self-interest is made by other researchers who argue in favour of an economic interest theory of regulation. They argue that all action by all individuals can be traced back to self-interest in which all people will be seeking to increase their own economic wealth.32 Under this perspective, regulators will be seeking votes and election funding/support, and through embracing self-interest will tend to provide the legislation to groups who can pay for it in terms of either providing votes or providing funds to support the regulators’ re-election. Capture Theory provides another perspective on the development of regulation. It argues that, while regulation might initially be put in place for well-intentioned reasons (for example, in the ‘public interest’), the regulated party will, over time, tend to gain control of (or capture) the regulator so that the regulation will ultimately favour those parties that the regulation was initially intended to control. We referred to many ‘real life’ examples of possible regulatory capture. This chapter has also considered how perceptions about potential economic and social consequences impact the development of financial reporting standards. In the light of this, the chapter has questioned whether financial reports can really be considered as neutral, objective and representationally faithful, as the IASB Conceptual Framework for Financial Reporting would suggest.
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There are, of course, many researchers who oppose this (rather cynical) view of human behaviour. Authors such as Gray, Owens and Adams (1996) refer to this perspective as being ‘morally bankrupt’ and providing very little hope for efforts to address pressing global problems, such as issues surrounding sustainable development, modern slavery, and climate change. Some of these alternative perspectives are discussed in Chapters 9 and 10.
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ANSWERS TO THE OPENING QUESTIONS At the beginning of the chapter, we asked the following two questions. As a result of reading this chapter, you should be able to provide informed answers to these questions – ours are shown below. 1 When widely publicised accounting-related ‘scandals’ occur in respect of high-profile organisations (such as Lehman Brothers, Enron and WorldCom), regulators often respond by increasing the amount of accounting regulation. What might motivate regulators to introduce additional regulation to restrict the accounting practices available to corporate managers? As we learned in this chapter, there are different theories to explain why regulators might introduce regulations. Some of the different perspectives are: a Regulation is introduced because regulators believe it is in the public interest to do so (public interest theory). However, what represents the ‘public interest’ from the perspective of regulators will be influenced by a variety of factors, such as their respective political ideologies. b Regulation might be introduced because it favours particular constituents over and above others. As we learned in this chapter, ‘regulatory capture’ is a common phenomenon in which regulators, governments, regulatory authorities and professional bodies come to identify more with the interests of the people they are supposed to be regulating than with the interests of the people they are supposed to protect (Capture Theory). c Another perspective is that regulators will introduce regulations if it benefits them. That is, their support for regulation will be motivated by self-interest. Under this perspective (economic interest group theory of regulation), the regulator itself is an interest group – one that is motivated to embrace strategies to ensure re-election, or to ensure the maintenance of its position of power or privilege within the community. 2 If corporate financial reporting was to be deregulated, what market-based incentives or mechanisms might operate to motivate managers to produce publicly available financial reports? Would these mechanisms operate to ensure that an optimal amount of relevant and reliable information is produced? What is an ‘optimal’ amount of information? As this chapter has indicated, researchers have suggested a number of mechanisms that can operate to motivate managers to produce financial information about the organisation, even in the absence of regulations requiring them to do so. Some of these mechanisms include: • the market for managers • the market for corporate takeovers • the market for lemons • efficiently operating courts Whether mechanisms, such as those above, will lead to optimal levels of information being produced will depend upon the theoretical perspective adopted. One of the key problems with this argument is that accounting information is effectively a ‘free good’ and market mechanisms do not tend to work when it comes to free goods. Also, the above market mechanisms rely upon the ‘markets’ operating efficiently, but there is much evidence to suggest that these markets do not operate efficiently in all circumstances. In theory, an optimal amount of information will be produced if the benefits generated by each additional amount of information exceed the costs. Information should continue to be produced up to the point where the marginal cost of the additional information equals the marginal benefit of that information. As long as the benefit exceeds the cost, more information should be produced. But, in practice, this is very hard to determine. How do we actually measure such costs, and from whose perspective are we making such an assessment? So, in reality, it would be very hard to win an argument about what is the precise amount of information necessary to reach optimality. Nevertheless, all decisions about producing information need to consider information costs and benefits.
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QUESTIONS 4.1 4.2
4.3 4.4
4.5
What is regulation? LO4.1 As this chapter indicates, some people argue that the extent of regulation relating to financial accounting is excessive and should be reduced. a What arguments do these people use to support this view? b How would you rate the arguments in terms of their logic? LO4.4 What is the basis of the ‘market for lemons’ argument? LO4.4 Given the process involved in developing accounting standards, do you believe that financial reporting standards can be considered to be ‘neutral’ (that is, not serving the interests of some constituents over others)? LO4.3 LO4.5 In the IFRS Foundation’s 2020 publication International Accounting Standards Board and IFRS Interpretations Committee Due Process Handbook, paragraph 1.2 states: The IFRS Foundation Constitution (Constitution) gives the Board full discretion in developing and pursuing its technical programme and in organising the conduct of its work. The Trustees and the Board have established consultative procedures with the objective of ensuring that, in exercising its independent decision-making, the Board conducts its standard-setting in a transparent manner, considering a wide range of views from interested parties throughout all stages of the development of International Financial Reporting Standards (IFRS Standards). The Board uses these procedures to gain a better understanding of different accounting alternatives and the potential effect of the proposals on affected parties. A comprehensive and effective due process is essential to developing high-quality IFRS Standards that serve investors and other primary users of financial statements.
Do you believe that the IASB will always act in an independent manner? Further, will the engagement with various stakeholders have any potential implications for claims that IFRS Standards are developed to provide financial information that is representationally faithful? Clearly identify the theoretical basis that you have applied in arriving at your answer. LO4.2 LO4.3 LO4.6 4.6 4.7 4.8 4.9 4.10 4.11
4.12 4.13
4.14
What is meant by saying that financial accounting information is a ‘public good’? LO4.1 LO4.3 Is regulation more likely to be required in respect of public goods than other goods? Why? LO4.2 What is ‘accounting standards overload’ and why might it occur? LO4.3 LO4.4 Can regulatory intervention be explained on fairness or equity grounds? If so, what is the basis of this argument? LO4.1 LO4.2 Try to summarise the concept of the ‘invisible hand’. Do you think that the invisible hand actually ‘works’? LO4.5 It is argued by some researchers that even in the absence of information, organisations have an incentive to provide credible information about their operations and performance to certain parties outside the organisation; otherwise the costs of the organisations’ operations would rise. What is the basis of this belief? LO4.4 Would you expect independent financial statement audits to exist for listed companies even in the absence of regulation requiring them to be undertaken? Why? LO4.1 LO4.4 Some companies argue that introducing mandatory reporting requirements will tend to stifle innovation in relation to the reporting. Do you believe that the introduction of mandatory reporting requirements in relation to a particular area of reporting (for example, social and environmental reporting) will act to stifle innovation in reporting? Explain your view. LO4.1 LO4.4 Read and evaluate the following paragraph extracted from Cooper and Keim (1983, p. 202): It should also be noted that the nature and degree of the effect of disclosure requirements (and other aspects of security regulation) on public confidence in the financial markets is unknown. Investors who have never read a prospectus or even thumbed through a 10-K report may have a great deal more confidence in the capital markets because the SEC and its regulations are an integral aspect of the financial system. The salutary effect of such enhancement of the perceived integrity and credibility of the investment process is to reduce the cost of capital for all firms, and the magnitude of this effect may be quite significant. LO4.1 LO4.2 LO4.3
4.15 Private contractual incentives will assist in ensuring that, even in the absence of regulation, organisations will provide such information as is demanded by their respective stakeholders. Evaluate this argument. LO4.1 LO4.4
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4.16 Why would the managerial labour market motivate the manager to provide information voluntarily to outside parties? LO4.4 4.17 What is the ‘market for corporate takeovers’ and how would its existence encourage organisations to make accounting disclosures even in the absence of regulation? LO4.4 4.18 Market failure has been defined as the inability of market forces to produce a socially ‘right’ amount of information; that is, to produce information to the point where its marginal cost to society equals its marginal benefit. While in theory this calculation may be possible, in reality there are problems with applying such a definition of market failure. What are some of the problems? LO4.1 LO4.2 4.19 A newspaper article entitled ‘Westpac insider trading case set for 2023 trial date’ (Shapiro, 2021) reported a case allegedly involving traders at one of Australia’s leading banks being engaged in insider trading. In part, the article stated: On May 5, the Australian Securities and Investments Commission filed a civil claim in the Federal Court alleging that Westpac’s interest rate traders engaged in insider trading in the hours leading up to the announcement of the October 2016 $16 billion Ausgrid privatisation. The case relates to interest rate trades enacted by Westpac traders on the morning of October 20, 2016, before an announcement that a consortium would buy a 50.4 per cent stake in Ausgrid for $16.2 billion. Westpac was awarded the mandate to hedge the $12 billion of debt from adverse interest rate movements. But ASIC alleges the traders jumped the gun, and in doing so locked in a certain profit. The allegations include insider trading, unconscionable conduct and breaching financial services licensee obligations. (p. 21)
a Which of the theoretical perspectives of regulation reviewed in this chapter might best explain the existence of laws that prohibit insider trading? b How would advocates of a ‘free-market’ approach justify the removal of legislation pertaining to insider trading? LO4.1 LO4.2 4.20 Do you believe that the members of the IASB are guided by ‘public interest’ when developing international financial reporting standards? LO4.5 LO4.6 4.21 Explain why a well-functioning court system is an important aspect of a free market approach to financial reporting. LO4.4 4.22 What assumptions are made about the motivations of the regulators in: a the public interest theory of regulation? b the Capture Theory of regulation? c the economic interest theory of regulation? LO4.2 LO4.3 LO4.6 4.23 Given the contents of this chapter, why do you think that corporate managers will make lobbying submissions to the IASB when it is in the process of developing new international financial reporting standards? LO4.5 LO4.6 4.24 Is it realistic to assume, in accordance with ‘public interest theory’, that regulators will not be driven by their own self-interest when designing regulations? LO4.2 LO4.3 4.25 Is it in the public interest for regulators to be driven by their own self-interest? LO4.1 LO4.3 4.26 Identify and evaluate the key negative economic and social consequences that might potentially arise following the introduction of a financial reporting standard with which you are familiar. LO4.6 4.27 Under the economic interest theory of regulation, what factors will determine whether a particular interest group is able to secure legislation that directly favours that group above all others? LO4.2 LO4.3 4.28 What do we mean when we say that financial reporting standards are the outcome of a political process? Why is the process ‘political’? LO4.5 LO4.6 4.29 Provide a comment on the following statement: Accounting information is a ‘public good’ and therefore is likely to be under-produced in the absence of regulation. Therefore, the production of accounting information and financial statements should be regulated. LO4.1 LO4.2
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4.30 Is the fact that financial reporting standard-setters consider the economic and social consequences of potentially introduced financial reporting standards consistent with a view that financial reports, if compiled in accordance with financial reporting standards and other generally accepted accounting principles, will be neutral and objective? LO4.3 LO4.6 4.31 If an accounting standard-setter deems that a particular accounting standard is likely to adversely affect some preparers of financial statements, what do you think it should do? Justify your view. LO4.6 4.32 Earlier in this chapter, we referred to instances where people holding senior positions in corporate regulators were subsequently offered jobs by corporations that they previously acted to regulate or where regulatory bodies offer jobs to people who held senior roles in organisations the regulator used to regulate. From a Capture Theory perspective, would these job offers raise concerns for you? Why? LO4.3 LO4.5 4.33 Assume that a government regulator makes a decision that all companies with a head office in Australia must separately disclose, within their annual financial report, the amount of expense incurred in relation to the training of employees. The companies must also spend at least 5 per cent of their reported profits on training employees. You are required to: a explain the decision made by the regulator in terms of public interest theory b explain the decision made by the regulator in terms of the economic interest group theory of regulation. LO4.1 LO4.2 LO4.3 LO4.6 4.34 In this chapter, we discussed how European banks were able to lobby the EU so as to be regulated by a ‘watered-down’ version of the accounting standard IAS 39. In this regard, an article in the Australian Financial Review entitled ‘IAS 39 dawns for local firms’ (Fenton-Jones, 2004) reported: Last Friday, after a year-long impasse, EU member states adopted the International Financial Reporting Standards (IFRS) with a watered-down version of IAS 39. This particular standard deals with accounting for financial instruments such as derivatives, guarantees and loans. The modified version excludes provisions relating to hedge accounting and the fair-value option for financial assets and liabilities. The modified rule will become part of the new IFRS that will come into force for about 7000 EU stockmarket-listed companies on January 1, 2005 … Allen Blewitt, the London-based chief executive of the Association of Chartered Certified Accountants, said the debate around IAS 39 had opened up the scope for lobbying by interest groups and for political interference in the standard-setting process. Opposition to IAS 39 in its original form was driven mostly by the French banks, which were concerned that valuing derivatives at market prices rather than at cost as required by the rule could cause harmful volatility in their accounts.
Explain whether the decision of the EU to embrace a ‘watered-down’ version of the standard is consistent with a ‘public interest theory of regulation perspective’, or whether it can be explained by an alternative theoretical perspective (which you should attempt to identify). LO4.1 LO4.5 4.35 Referring to the lobbying of the EU by certain corporate interests, an article in The Australian, entitled ‘EU defers accounting standards’ (Senior, 2004) reported: THE EU Commission caved in to lobbying from bankers and the French Government yesterday when it pledged to postpone new derivative accounting standards drafted following the Enron affair. Frits Bolkestein, the EU commissioner responsible for leading the drive towards pan-European financial services, said he would shelve plans to impose the two new accounting standards next year if the warring parties could not reach an agreement by next month… Banks and insurers are lobbying against the standards amid fears the new rules would create massive holes in their balance sheets… Mr Bolkestein’s comments follow intense lobbying against the new rules, which has gained the public support of the French Government. President Jacques Chirac wrote to the European Commission last year, saying that the new standards ‘would have harmful consequences on financial stability’. But proponents of the accounting standards say they are essential to understanding companies’ true financial health. They say that the new rules would have made it impossible for Enron, the US energy company, to shift its underperforming assets into private partnerships, known as special purpose
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vehicles. The firm collapsed after the sudden disclosure of huge debts that had not been revealed in its accounts.
Using a particular theory of regulation (choose the most appropriate one), explain what factors might have motivated the then French President Jacques Chirac to lobby against the accounting standards in question. LO4.2 LO4.3 4.36 In a Business Review Weekly article referring to then head of the IASB, and entitled ‘Tweedie the unrelenting’ (Andrews, 2003), it was reported: Global standards will be released early next year come what may, says IASB chairman Sir David Tweedie. European and Australian companies are wary of adopting some of the new international accounting standards, fearing the effects they will have on balance sheets and profit-and-loss statements. However, the chairman of the International Accounting Standards Board (IASB), Sir David Tweedie, is determined to have all the new standards released by the first quarter of next year. He is meeting resistance. The zeal for reform that followed the collapse of companies such as Enron, WorldCom, HIH and One.Tel has slowed in Australia. After compromising with European banks on the standard for financial instruments, Tweedie’s fight to have the rest of the standards adopted without further changes is now against European insurance companies. Tweedie has been in Australia to iron out any misunderstandings in government and business about the standards. The conflict between Tweedie and the big European corporations has created uncertainty about the content of the final standards, making it difficult for accountants to advise their clients. A financialservices partner at PricewaterhouseCoopers, Ian Hammond, says the uncertainty is causing some Australian companies to procrastinate over preparing for the new standards. …. Insurers, encouraged by seeing the banks winning concessions, called for talks of their own. In late July, a group of chief executives from European insurance companies called for a meeting with the IASB to change the standard on financial instruments that the banks had fought over. The insurers are also concerned that the standard will add volatility to their reported profits, because it calls for them to measure investment assets by market value and record the gains and losses from these assets on profit-and-loss statements. Tweedie insists he will not back down to pressure from big business unless he is proved wrong. He says some European companies, unhappy about having to adopt the new standards for financial instruments, are waging a personal campaign against him. ‘They have been telling politicians that I don’t listen, that I don’t understand industry. I understand industry too well.’ Tweedie is also battling the Australian Accounting Standards Board (AASB). Its acting chairperson, Ruth Picker, wants to negotiate with the IASB for an easier transition to the new rules on valuing internally generated intangibles. Australian business supports the board’s efforts. John Stanhope, president of the Group of 100, which represents the chief financial officers of 93 of Australia’s largest companies and government-owned entities, says the group wrote to Tweedie this year to express its members’ concerns about the effect the IASB’s decision on intangibles will have on Australian business. ….Picker says the AASB is being compelled to negotiate with Tweedie and the IASB over the transition to the intangibles standard by founding legislation that says it must act in the best interests of the Australian economy. It does not regard wiping up to $40 billion from Australian balance sheets as in the economy’s best interests. ‘It will affect companies’ abilities to pay dividends ... it might affect share prices, it will affect loan covenants, and it will affect interest deductions,’ Picker says. ….Picker and Stanhope say that Australian companies still support adopting the new standards because of the long-term benefits they will bring. Overseas investors will be more inclined to invest their capital in Australia when they can easily compare the financial reports of Australian and overseas companies. However, Picker says that the European banks’ success in lobbying against the standard on financial instruments might encourage Australian companies to join in the lobbying of Tweedie and the IASB for more changes to the international standards.
a What theory of regulation seems to explain the actions of Sir David Tweedie? b What theories of regulation would appear to explain the lobbying efforts of the European banks? c What theories of regulation would appear to explain the lobbying efforts of the European insurance companies? d Do Ruth Picker’s actions appear to be consistent with a view that she has been ‘captured’ by business organisations? Explain your answer. LO4.1 LO4.3 155
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4.37 Comment on the following statement from Shleifer (2005): The public interest theory of regulation has become the cornerstone of modern public economics, as well as the bible of socialist and other left-leaning politicians. It has been used to justify much of the growth of public ownership and regulation over the twentieth century. LO4.1 LO4.3
4.38 One of the most pressing problems confronting the world is climate change. To effectively address this issue, governments across the world will be required to introduce regulations to mitigate the impacts of business activities on the environment. This regulation would necessarily require organisations to make significant changes to how they operate and this will undoubtedly have negative implications for the profitability of many organisations. (However, in the long run, no organisations will exist and there will be no profits if action is not taken.) You are required to describe whether the various theories discussed in this chapter provide hope, or otherwise, that regulations will be introduced that will ultimately benefit future generations and will require corporations to change how they do business. LO4.1 LO4.2 4.39 Let us assume that the government has become concerned that existing disclosure regulations tend to fixate on the financial performance of organisations but fail to address other aspects of corporate performance, including a failure to provide information about corporate social and environmental impacts as well as about various initiatives and investments an organisation has undertaken to improve its social and environmental performance. As such, the government has decided to introduce legislation that will require business corporations to provide information about the social and environmental impacts of their operations, as well as the social and environmental initiatives undertaken by the corporations. You are required to do the following: a Explain from a public interest theory perspective the rationale for the government introducing the legislation and how the government will ultimately assess whether any proposed legislation should actually be introduced. b Predict from a Capture Theory perspective the types of constituents that will benefit in the long run from any social and environmental disclosure legislation. c Predict from an economic interest group theory perspective of regulation whether any potential legislation to be introduced will lead to an increase in the accountability of corporations in relation to their social and environmental performance despite any implications that this increased corporate accountability might have for the financial success of large but heavily polluting organisations. LO4.1 LO4.3
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IFRS Foundation (2020), International Accounting Standards Board and IFRS Interpretations Committee: Due Process Handbook, https://www.ifrs.org/content/dam/ifrs/ about-us/legal-and-governance/constitution-docs/dueprocess-handbook-2020.pdf IFRS Foundation (2021), Constitution, https://www.ifrs.org/ content/dam/ifrs/about-us/legal-and-governance/ constitution-docs/ifrs-foundation-constitution-2021.pdf Institute of Public Accountants (2019a), IPA Small Business White Paper: Small Business: Big Visions, Melbourne: IPA, https://www.publicaccountants.org.au/media/1992957/ IPA-Report_V101-jan2019.pdf Institute of Public Accountants (2019b), ‘Media release: regulatory overload – a real problem for small business’, Melbourne: IPA, https://www.publicaccountants.org.au/ news-advocacy/media-releases/regulatory-overload%E2%80%93-a-real-problem-for-small-business International Accounting Standards Board (2008), Exposure Draft of an Improved Conceptual Framework for Financial Reporting, London: IASB. International Accounting Standards Board (2022), IFRS 6 Explorations for and Evaluation of Mineral Resources, London: IASB. Jensen, M. C. & Meckling, W. H. (1976), ‘Theory of the firm: managerial behavior, agency costs and ownership structure’, Journal of Financial Economics, 3 (October), pp. 305–60. Kehoe, J. (2018), ‘Bank boards are full of former regulators’, Australian Financial Review, 22 October, https://www.afr. com/companies/financial-services/bank-boards-are-fullof-former-regulators-20181022-h16xxm Laughlin, R. (2007), ‘Critical reflections on research approaches, accounting regulation and the regulation of accounting, The British Accounting Review, 39, pp. 271–89. Lehman, C. (1991), ‘Editorial: the invisible Adam Smith’, Advances in Public Interest Accounting, 4, pp. ix–xiv. Liggio, C. D. (1974), ‘The expectations gap: the accountants’ Waterloo’, Journal of Contemporary Business, 3(3), pp. 27–44. May, R. G. & Sundem, G. L. (1976), ‘Research for accounting policy: an overview’, The Accounting Review, 51(4), pp. 747–63. Merino, B. & Neimark, M. (1982), ‘Disclosure regulation and public policy: a socio-historical appraisal’, Journal of Accounting and Public Policy, 1, pp. 33–57. Mitnick, B. M. (1980), The Political Economy of Regulation, New York: Columbia University Press. Morris, R. (1984), ‘Corporate disclosure in a substantially unregulated environment’, ABACUS (June), pp. 52–86. Moulton, E. (2021), ‘Crown Perth paid for casino watchdog boss Barry Sergeant to travel to Macau’, West Australian, 3 August. Owen, D., Shaw, K. & Cooper, S. (2005), The Operating and Financial Review: A Catalyst for Improved Corporate Social and Environmental Disclosure, ACCA Research Report no. 89, http://www.accaglobal.com/pubs/publicinterest/activities/ research/research_archive/rr-089-001.pdf Parliamentary Joint Committee on Corporations and Financial Services (PJCCFS) (2006), Corporate Responsibility: Managing Risk and Creating Value, Canberra: Commonwealth of Australia, June. Peltzman, S. (1976), ‘Towards a more general theory of regulation’, Journal of Law and Economics (August), pp. 211–40. Posner, R. A. (1974), ‘Theories of economic regulation’, Bell Journal of Economics and Management Science, 5 (Autumn), pp. 335–58.
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CHAPTER
5
INTERNATIONAL ACCOUNTING LEARNING OBJECTIVES On completing this chapter, readers should: LO5.1
understand the background to, and the motivations for, the International Accounting Standards Board implementing a uniform set of financial reporting standards for worldwide use (this set of standards being known as International Financial Reporting Standards [IFRS])
LO5.2
understand some of the perceived advantages and disadvantages for countries that adopt IFRS
LO5.3
appreciate that prior to many countries adopting IFRS there were a number of important differences between the accounting policies and practices adopted within various countries
LO5.4
understand various theoretical insights about why countries might adopt particular accounting practices in preference to others, and be able to evaluate whether, in light of the various theories and related insights, it is appropriate to actually have one globally standardised set of financial reporting standards
LO5.5
be able to explain what is meant by the terms ‘harmonisation’ and ‘standardisation’ of financial reporting
LO5.6
be able to identify and explain some of the perceived benefits of, and obstacles to, standardising financial accounting and reporting practices on an international scale
LO5.7
understand the key factors that are leading to greater international standardisation of financial accounting and reporting.
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OPENING QUESTIONS Before reading this chapter, please consider how you would answer the following two questions. We will return to these questions at the end of the chapter, where we suggest some answers. Since the start of 2005, financial reporting standards issued by the International Accounting Standards Board (IASB) have become the financial reporting standards that are applied within many countries. 1 Do you believe that all countries should adopt the same financial reporting standards – that is, do you think that a world-wide ‘one-size-fits-all’ approach to financial accounting and reporting is appropriate? If not, what might be some reasons against such international standardisation? 2 What are some of the advantages and disadvantages that arise as a result of a country adopting the financial reporting standards issued by the IASB?
Introduction The previous chapters looked at how regulation shapes the practice of financial reporting. We saw that various factors can influence the actions of regulators (for example, the regulators’ perceptions about what is in the ‘public interest’ or about what the economic implications of a newly proposed accounting standard might be), and that various theoretical perspectives can be applied when making a judgement about the factors that are likely to impact upon a regulator’s ultimate decision to support, or oppose, particular financial accounting requirements. Differences in, or changes to, accounting regulations can result in different accounting ‘numbers’ being reported for a given transaction or event, and these differences in reported accounting results can lead to both positive and negative social and economic consequences. Clearly, therefore, any differences in accounting regulations between different countries are likely to result in the accounting outcomes reported from a specific set of transactions and/or events varying from country to country. This chapter discusses theoretical explanations as to why, in the absence of efforts to globally harmonise or standardise financial accounting and reporting practices, accounting regulations and practices could, and perhaps should, be expected to vary between countries. It explains why there was a large degree of variation in accounting practices internationally prior to recent decisions by many countries to adopt the financial reporting standards issued by the International Accounting Standards Board (IASB). In light of previous research that indicates that people in different countries, or from different cultures, will have different information demands and expectations, this chapter also explores the logic of establishing one set of accounting standards for worldwide use. It addresses the question of whether it makes sense that organisations in diverse countries all adopt the same financial reporting standards in an apparent acceptance of a ‘one-size-fits-all’ approach to financial reporting. The chapter provides a discussion of initiatives undertaken, principally driven by the IASB, to establish a uniform set of accounting standards for global use. More than 100 countries have adopted the accounting standards issued by the IASB, even though these standards often represent a significant change to the accounting standards that had been developed domestically and used formerly within the respective countries. A significant exception to this general trend has been the United States, which decided against adopting the accounting standards released by the IASB. To date, the United States continues to use its own domestic standards – those issued by the Financial Accounting Standards Board (FASB) – although the US Securities and Exchange 160
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Commission (SEC) did pass a ruling allowing foreign listed entities that are also listed on the US stock exchange to lodge their reports in accordance with International Financial Reporting Standards (IFRS) without the necessity to provide a reconciliation to US generally accepted accounting procedures. The FASB and the IASB had entered into an arrangement whereby they were trying to eliminate major differences between their respective standards (converge their standards) and, once this had been achieved, it was proposed that the SEC would require US companies to use IFRS. However, as noted in Chapter 4, the SEC subsequently moved away from this direction. The chapter begins with a brief discussion of the international differences that existed between various countries’ accounting practices prior to their recent adoption of IFRS.
Evidence of international differences in accounting prior to recent standardisation initiatives LO5.1
LO5.3
LO5.5
More than 100 countries (including Australia, the United Kingdom, New Zealand, Canada and countries in the European Union [EU]) have elected to adopt the financial reporting standards (or we might just call them ‘accounting standards’) issued by the IASB, with such implementation typically being effective from 2005. However, to understand how different nations’ financial accounting rules had led to vastly different accounting results prior to the standardisation efforts (and hence to put into context some of the arguments for standardisation), it is useful to consider some past examples of how a particular company’s financial results varied dramatically, depending on which nation’s accounting standards were being used to account for its transactions before the adoption of IFRS. In research undertaken prior to the widespread adoption of IFRS, Nobes and Parker (2004, p. 4) compared the results of a small number of European-based multinationals that reported their results in accordance with both their home nation’s accounting rules and US accounting rules. Their comparative analysis showed, for example, that the underlying economic transactions and events of the Anglo-Swedish drug company AstraZeneca in the year 2000 produced a profit of £9521 million when reported in conformity with UK accounting rules, but a profit of £29 707 million when reported pursuant to US accounting rules – a difference of 212 per cent in reported profits from an identical set of underlying transactions and events! Extending this analysis to a subsequent reporting period, the 2006 annual report of AstraZeneca (the final year that companies with a dual home country US listing were required to provide a reconciliation between their results using IFRS and US accounting rules) shows that a profit of $6043 million derived from applying IFRS became a profit of $4392 million when calculated in accordance with US accounting rules – this time a difference of 27 per cent (Nobes and Parker, 2010). In its balance sheet (or, as it is also known, its statement of financial position), AstraZeneca’s shareholders’ equity at 31 December 2006 was $15 304 million when reported in accordance with IFRS, but this became $32 467 million when determined in accordance with US accounting rules, a difference of 112 per cent. Although percentage differences of this size might be unusual, an examination of the past financial reports of almost any company that reported its results in accordance with more than one nation’s set of accounting regulations will have shown differences between the profits reported under each set of regulations and between the financial position reported under each set of regulations. In this regard, consider the following statement from an article in the Australian Financial Review (Hamilton, 1998): From time to time, the fundamental differences in accounting and reporting standards among the various countries of the western world hit the headlines. This was never 161
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more dramatically demonstrated than when Daimler-Benz achieved a listing on the New York Stock Exchange (the first German company to do so) in October 1993. When the group accounts were converted from German accounting rules to US GAAP (generally accepted accounting practice), a DM168 million profit for the first half year became a staggering DM949 million loss. More recently, German conglomerate Hoechst, which had adopted international accounting standards (IAS) in 1994, also listed in New York. In the process of reconciling its accounts with US GAAP an IAS profit of DM1.7 billion became a loss of DM57 million.
In another newspaper article, entitled ‘News learns wealthy lesson: don’t move to US’ (Burke, 2000), it was also illustrated how a large accounting profit according to Australian accounting standards became a significant loss for the Australian company News Corporation Ltd when US accounting standards were applied. As the article stated: US accounting principles have turned The News Corporation Ltd.’s $1.92 billion net profit in fiscal 2000 as reported within Australia into a $329 million loss, according to documents filed with the US Securities and Exchange Commission. Under US Generally Accepted Accounting Principles (US GAAP), companies are not allowed to capitalise start-ups, book abnormal losses or gains, or revalue mastheads or television licences. Depreciation is also treated differently.
A further dramatic example of the existence of differences between the accounting rules of different countries is provided by the US corporation Enron. As Unerman and O’Dwyer (2004) explain, in the aftermath of the high-profile collapse of Enron, many accounting regulators, practitioners and politicians in European countries claimed that the accounting practices that enabled Enron to ‘hide’ vast liabilities by keeping them off their US balance sheet would not have been effective in Europe. In the United Kingdom this explanation highlighted the differences between the UK approach and the US approach to accounting regulation. It was argued that under UK accounting regulations these liabilities would not have been treated as ‘off balance sheet’, thus potentially producing significant differences between Enron’s balance sheet under UK and US accounting practices. Lantto and Sahlstrom (2009) also provide evidence that when Finland adopted IFRS this caused significant changes in the reported financial position and performance of Finnish companies. Because Finnish Accounting Standards were similar to the domestic accounting standards in place in other continental European countries (before adoption of IFRS) the authors argue that their results would also be representative of the changes that would have occurred in the financial statements of other European countries around the time of adopting IFRS.1 We can now consider whether the fact that different countries’ financial accounting rules can generate significantly different profits or losses is a justification for the decision by many countries to adopt accounting standards issued by the IASB. Obviously, if various countries actually adopted the same accounting rules, the differences between the results reported in different countries would disappear. What do you think? Is removing international differences in accounting results sufficient justification for standardising international accounting? Certainly, this justification was used by the IASB and regulators within the EU and in other countries (such as Australia) to justify the use of IFRS. The following section looks at some of the factors that have been used to justify the efforts to standardise financial accounting and reporting internationally. However, it should be appreciated 1
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According to the authors, the main reasons for the changes in accounting results were that IFRS required extensive use of fair values and the rules embodied within IFRS relating to lease accounting, income tax accounting, and financial instruments were very different to the rules previously used in Finland and other continental European countries.
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that there are many accounting researchers who argue that there are very good reasons for accounting rules to be different in different countries (some of these reasons include underlying national differences in culture, legal systems, finance systems and so forth). The theoretical reasons given to explain why international differences are expected to exist, and perhaps should still exist, can in turn be used as possible arguments against the international standardisation of accounting – something that nevertheless has occurred. Towards the end of the chapter, the various theoretical arguments that have been proposed in opposition to standardising international accounting are considered.
Does it really matter if different countries use different financial accounting methods? LO5.1
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Before considering some of the perceived advantages associated with having a standardised system of financial accounting and reporting, it is useful to first clarify some important terminology. Nobes and Parker (2010, p. 80) distinguish between ‘harmonisation’ and ‘standardisation’ of accounting. They define ‘harmonisation’ as ‘a process of increasing the compatibility of accounting practices by setting bounds to their degree of variation’ (p. 80). ‘Standardisation’ of accounting is explained as a term that ‘appears to imply the imposition of a more rigid and narrow set of rules [than harmonisation]’ (p. 80). Therefore, harmonisation seems to allow more flexibility than standardisation, but, as Nobes and Parker (2010) point out, the two terms have been used almost synonymously in international accounting. Nevertheless, what has happened through the efforts of the IASB is standardisation. Nobes and Parker (2010) explain that the reasons for the efforts to increase international standardisation of financial accounting are similar to the reasons previously used to justify standardising financial accounting within an individual country. If investors are increasingly investing in companies from diverse countries, and those investors use financial statements as an important source of information on which to base their investment decisions, there is a view held by many people (but not all people) that standardisation is important to enable them to understand the financial statements and to have a reasonable basis for comparing the financial accounting numbers of companies from different countries. Just as is the case domestically (see the arguments in Chapters 3 and 4), the understandability and interpretation of financial accounting information should be more effective if all accounts are compiled using the same set of underlying assumptions and accounting rules. If an international investor has to understand numerous different sets of financial accounting assumptions, rules and regulations, the task of making efficient and effective international investment decisions becomes considerably more complicated. Further, if the long-term finance needs of a multinational company are too great for the providers of finance in a single country, the company may need to raise finance by listing its securities on the securities exchanges of more than one country. For reasons of domestic investor protection, the securities exchange regulators in a particular country might be reluctant to permit a company’s shares to be traded on its exchange if that company does not produce financial reports that are readily comparable with the financial reports of all other companies whose shares are traded on that exchange – that is, reports that have been prepared using comparable assumptions (or rules). Also, where a company has to produce financial reports in accordance with the financial accounting rules of each of the securities exchanges where its shares are traded, its accounting procedures would be considerably simplified if there was a single set of internationally recognised accounting rules that were acceptable to all the securities exchanges where its shares are traded. It makes sense to use a single set of international financial accounting rules and regulations for all companies listed on any securities exchange.
Harmonisation In relation to accounting, refers to a process of increasing the compatibility of accounting practices by setting bounds to their degree of variation.
Standardisation A process that imposes a given set of rules or requirements on a particular item, process or practice. From an accounting perspective it effectively means that every nation applies the same accounting standards.
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A further reason for the international standardisation of financial reporting provided by Nobes and Parker (2010) is that it will facilitate greater flexibility and efficiency in the use of experienced staff by multinational firms of accountants and auditors. Without standardisation, the different accounting regulations in different countries act as a barrier to the transfer of staff between countries. However, whether such a factor provides real benefits to parties other than large accounting firms and multinational companies is not clear. Reflective of the perceived advantages of international standardisation, the Australian Government was concerned for a number of years about the differences between Australian accounting standards and their international counterparts. In response to this concern, from 1995 Australia was involved in a process that would harmonise (but not initially ‘standardise’) Australian accounting standards with accounting standards being released by the International Accounting Standards Committee (the forerunner to the IASB). The ‘harmonisation process’ required Australian accounting standards to be as compatible as possible with International Accounting Standards (IAS), but still allowed some divergence where the Australian treatment was considered to be more appropriate (that is, provided more relevant and reliable financial information) than the international counterpart. A document released in 1997 as part of the Australian Government’s Corporate Law Economic Reform Program (entitled Accounting Standards: Building International Opportunities for Australian Business) discussed the rationale for the harmonisation efforts. It stated (p. 15): There is no benefit in Australia having unique domestic accounting standards which, because of their unfamiliarity, would not be understood by the rest of the world. Even if those standards were considered to represent best practice, Australia would not necessarily be able to attract capital because foreign corporations and investors would not be able to make sensible assessments, especially on a comparative basis, of the value of the Australian enterprises.2 The need for common accounting language to facilitate investor evaluation of domestic and foreign corporations and to avoid potentially costly accounting conventions by foreign listed companies are powerful arguments against the retention of purely domestic financial reporting regimes.
This view was also consistent with the view provided in Policy Statement 6: International Harmonisation Policy (issued in April 1996 by the Public Sector Accounting Standards Board which was under the auspices of the Australian Accounting Research Foundation), which emphasised the need for international comparability of financial statements. As Policy Statement 6 noted in paragraph 1.2: The globalisation of capital markets has resulted in an increased demand for high quality, internationally comparable financial information. The Boards believe that they should facilitate the provision of this information by pursuing a policy of international harmonisation of Australian accounting standards. In this context the international harmonisation of Australian accounting standards refers to a process which leads to those standards being made compatible, in all significant respects, with the standards of other national and international standard-setters.
Ball (2006, p. 11) identifies a number of other advantages that are often advanced to support the case for the global standardisation of financial reporting. First, the adoption of IFRS might be done on the premise that the decision will lead to more accurate, comprehensive and timely financial statement information, relative to the information that would have 2
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The view that harmonisation might lead to Australia abandoning particular standards that might represent ‘best practice’ is very interesting. It implies that harmonisation might lead to systems of accounting that are less than ideal. Also, moving away from ‘best practice’ obviously has implications for fundamental qualitative characteristics such as representational faithfulness and relevance.
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been generated from the national accounting standards they replaced. To the extent that the resulting financial information would not be available from other sources, this should lead to more-informed valuations in the equity markets, and hence lower the risks faced by investors. Another perceived benefit of adopting IFRS relates to the increased financial information that would be available to small and large investors alike. Small investors might be less likely than larger investment professionals to be able to access or anticipate particular financial statement information from other sources. Improving financial reporting quality will allow smaller investors to compete more equitably with professional (larger) investors, and hence will reduce the risk that smaller investors are trading with better-informed professional investors (such a risk is known as ‘adverse selection’).3 While there are many perceived advantages that could be listed in relation to standardising international accounting, it is obviously very difficult to quantify such benefits or advantages. For example, Australia adopted IFRS because of the perceptions that various economic benefits would follow, but there is no real evidence that the country is any better off economically than it would have been had the use of domestically developed accounting standards been maintained. As Ball (2006, p. 9) states: there is very little empirical research or theory that actually provides evidence of the advantages or disadvantages of uniform accounting rules nationally, or internationally.
Hence, it is not at all clear from an empirical perspective whether the decision made in Australia by the Financial Reporting Council (FRC) back in 2002 (that Australia would adopt IFRS in 2005) was the ‘right’ one, or whether the decision by the EU, or other countries that adopted IFRS, was right. Also, it is a matter of conjecture whether the benefits of adopting IFRS are shared by a majority of corporations within a country or are confined to large multinational corporations. If it is only the larger organisations that benefit, then perhaps we may need to question the equity associated with a process that required all companies within a country (other than small private companies, which typically do not have to apply financial reporting standards) to switch from domestic standards to IFRS. In this regard, Chand and White (2007) question the relevance of IFRS to a small, less-developed country such as Fiji, which has a relatively small capital market. They ask (p. 607): Why would a developing country such as Fiji that does not have a well-established capital market adopt the IFRSs? Questions concerning the effects of harmonized accounting standards on domestic users and local communities have largely been left unanswered.
Having identified some of the perceived advantages relating to standardisation (some perceived disadvantages are discussed later in the chapter), it is useful now to consider the main organisation involved in standardising accounting on an international basis – this being the IASB.
A brief overview of the IASB and its globalisation activities LO5.1
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The following pages describe recent initiatives that have been implemented to standardise financial accounting and reporting on a global basis. A brief description and history of the IASB – the organisation at the centre of the global standardisation of accounting – is provided, along with a brief description of the standardisation efforts in the EU and Australia.
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‘Adverse selection’ is an economics term that represents a situation in a market where buyers cannot accurately gauge the quality of the product they are buying, but where sellers have knowledge about the quality of the product they are selling.
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In describing the history of the IASB, we perhaps need to go back about 60 years and make reference to a former president of the Institute of Chartered Accountants of England and Wales (ICAEW), Henry Benson. Benson was elected president of the ICAEW in 1966. He was the grandson of one of the four brothers who, in 1854, founded the accounting firm Coopers (which through various mergers and so forth has become part of PricewaterhouseCoopers, or PwC). Veron (2007, p. 10) outlines Benson’s influence on international accounting: When elected (in 1966), Benson gave a short address to the Institute’s Council, in which he mentioned invitations he had received to visit his counterparts at the Canadian Institute of Chartered Accountants and the American Institute of Certified Public Accountants. He then added: ‘I have had the feeling for a long time that our relations with those Institutes were very friendly but somewhat remote and, with the Council’s approval, I shall see whether I can perhaps get them on to a more intimate basis’.
These characteristically understated words marked the beginning of international accounting standard-setting. Benson recalls the moment in his autobiography, published in 1989 under the title Accounting for Life: My private but unstated ambition at that stage was to make it, as I think it turned to be, a turning point in the history of the accountancy profession. The United Kingdom, America and Canada were the three most important countries at that time in the world of accountancy, but there was very little dialogue between them. No attempt had been made to make them closer together to advance the interests of the profession as a whole or to get a common approach to accountancy and audit problems. The Canadian institute was closer to the American institute than we were because of their geographical position but each of the three pursued its own policies without reference or collaboration with the other two. I hoped to change this.
Following Benson’s visits, the three bodies jointly established an Accountants’ International Study Group in February 1967, which soon published papers on accounting topics and gradually developed its own doctrinal framework. This then formed the basis for the creation in 1973 of the International Accounting Standards Committee (IASC) by an extended array of accounting bodies from Australia, France, Germany, Japan, Mexico and the Netherlands, in addition to Canada, the United Kingdom (plus Ireland associated with it) and the United States. The IASC’s stated aim was to issue international standards of reference that would guide the convergence of national standards over time. Benson was duly elected the IASC’s first chairman, and opened its offices in London. When the IASC was established in 1973 it had the stated objectives of: formulating and publishing in the public interest accounting standards to be observed in the presentation of financial statements and promoting their worldwide acceptance and observance; and working generally for the improvement and harmonisation of regulations, accounting standards and procedures relating to the presentation of financial statements. (IASC, 1998, p. 6)
Veron (2007, p. 11) provides a description of the work performed by the IASC in the years following its formation in 1973: In the ensuing years, the IASC prepared and published a growing number of documents constituting an increasingly comprehensive body of rules, eventually completed in 1998 as a set of 39 so-called ‘core’ International Accounting Standards (IAS). Simultaneously, its governance evolved constantly to accommodate a growing and increasingly diverse
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stakeholder base. Belgium, India, Israel, New Zealand, Pakistan and Zimbabwe joined as associate members as early as 1974, and many other countries later followed suit. In 1981, the IASC’s Consultative Group was formed with representatives of the World Bank, United Nations, OECD, and various market participants. This group was joined in 1987 by the International Organization of Securities Commissions (IOSCO, which brings together the SEC and its national counterparts around the world), and in 1990 by the European Commission and FASB, the US standard-setting body, as these two organisations joined IASC meetings as observers. In 2000, IOSCO recommended the use of IAS for cross-border offerings or listings. By the same time, a number of developing countries had taken the habit of using them as the reference for drafting their own national standards. Some, like Lebanon and Zimbabwe, had even made their use a requirement for banks or publicly listed companies. Several developed countries, such as Belgium, France, Italy and Germany, had also adopted laws allowing large listed companies to publish consolidated accounts using IAS or standards very similar to them, without having to ‘reconcile’ them with national standards. Following the Asian crisis of the late 1990s, international accounting standards were also endorsed by the G7 Group of industrialised countries and by the Financial Stability Forum, a group of financial regulators hosted by the Bank for International Settlements in Basel.
The IASC’s approach to accounting regulation essentially followed the Anglo-American model (which we explain later in this chapter), but initially many of the International Accounting Standards (IAS) it published permitted a wide range of accounting options. As such, they were not particularly effective at standardising accounting practices internationally, as different companies (or countries) could use substantially different accounting policies while all being able to state that they complied with the single set of IAS regulations. Therefore, compliance with IAS did not ensure or enhance the comparability or understandability of financial statements – a key purpose of financial accounting regulation – and was not accepted by securities exchanges as a basis for the preparation of financial reports to support a listing on their exchange.4 In the late 1980s, the International Organization of Securities Commissions (IOSCO), a body representing government securities regulators worldwide, recognised that to foster a greater number of multinational companies raising funding from securities exchanges in more than one country it would be useful to have a single set of rigorous international accounting standards, compliance with which would be acceptable to any securities exchange regulated by an IOSCO member. This would then reduce the costs of companies that had to produce a different set of financial accounting results for each of the countries in which their shares were listed. However, for IAS to be acceptable for this purpose, it would have to be much more effective at standardising accounting practice, and would therefore need to permit a much narrower set of accounting practices or options. Accordingly, the IASC then embarked on a comparability and improvements project to reduce the range of permitted options in IAS and thereby make them acceptable to IOSCO (Purvis et al., 1991). This project culminated in the publication of a revised core set of IAS by 1999, which was then accepted by IOSCO members, with the important exception of the US Securities and Exchange Commission (SEC). After this endorsement by IOSCO, any company that drew up its financial reports in accordance with the revised IAS could use this single set of IAS-based accounts to support its listing on any securities exchange regulated by any IOSCO member anywhere in the world – again, with the exception of the United States.
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The IASB’s Conceptual Framework for Financial Reporting identifies comparability and understandability as two ‘enhancing’ qualitative characteristics of financial information (the other two enhancing qualitative characteristics being verifiability and timeliness). Enhancing qualitative characteristics rank after ‘fundamental’ qualitative characteristics, with the IASB Conceptual Framework identifying the fundamental qualitative characteristics of financial information as being relevance and faithful representation.
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After completion of the core of this comparability and improvements project, the IASC was replaced in 2001 by the IASB, which adopted all existing IAS and, from 2001, has published new regulations in the form of IFRS.5 The IASB has a structure that is seen to be considerably more independent and rigorous than the former IASC (although there are still some concerns about the independence of the IASB, as we discuss later in this chapter). The replacement of the IASC by the IASB was one key element of significant changes made in the late 1990s to how the IASC/IASB conducted its operations. The IASC Foundation, through a group of trustees, was established to supervise the operations of the newly created IASB. Subsequently, between February 2008 and January 2010, the IASC Foundation reviewed its constitution, and introduced an amended constitution from 1 March 2010. Further amendments to the constitution were approved and then released in January 2013 (and again in 2018 and 2021). As part of the revised constitution, the IASC Foundation was renamed the International Financial Reporting Standards Foundation (or the IFRS Foundation), and it has the following objectives (IFRS Foundation, 2021a, paragraph 2):6 (a) to develop, in the public interest, a single set of high quality, understandable, enforceable and globally accepted financial reporting standards (referred to as ‘IFRS Standards’) for general purpose financial reporting based upon clearly articulated principles. The IASB is responsible for developing a set of accounting standards (referred to as ‘IFRS Accounting Standards’) and the ISSB is responsible for developing a set of sustainability disclosure standards (referred to as ‘IFRS Sustainability Disclosure Standards’). These complementary sets of IFRS standards are intended to result in the provision of high-quality, transparent and comparable information in financial statements and in sustainability disclosures that is useful to investors and other participants in the world’s capital markets in making economic decisions.7 (b) to promote the use and rigorous application of those standards. (c) in fulfilling the objectives associated with (a) and (b), to take account of, as appropriate, the needs of a range of sizes and types of entities in diverse economic settings. (d) to promote and facilitate adoption of IFRS Standards through the convergence of national accounting standards and IFRS Standards. The revised constitution established a new ‘Monitoring Board’ whose purpose is to ‘provide a formal link between the Trustees and those public authorities that have generally overseen standard-setters’ (IFRS Foundation, 2021a, paragraph 19). In addition, the Monitoring Board is required to approve the appointment of all IFRS Foundation Trustees. The 22 Trustees of the IFRS Foundation are responsible for the IASB’s governance and oversight, including funding (IFRS Foundation, 2021a). However, the Trustees are not to be involved in any technical matters relating to the standards. The responsibility for technical matters associated with accounting standards rests solely with the IASB. The Trustees of the 5
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When the IASC issued accounting standards, they were referred to as International Accounting Standards (IAS). When the IASB now issues accounting standards, they are referred to as International Financial Reporting Standards (IFRS). Many of the IASC standards are still in existence, although many have been modified or updated by the IASB. These modified standards are still referred to as IAS and retain the same title and number, rather than becoming an IFRS, such that at the international level there are many IAS as well as numerous newly released IFRS. A list of the currently applicable accounting standards can be found on the IASB’s website: https://www.ifrs.org. The IFRS Foundation has 22 trustees of which six trustees are appointed from North America, six from Europe, six from the Asia/Oceania region, one from Africa, one from South America and two ‘from any area, subject to establishing overall geographical balance’. As we discuss in Chapter 10, the International Sustainability Standards Board (ISSB) – which is also under the auspices of the IFRS Foundation – was established in 2021 and its purpose is to develop reporting standards with respect to sustainability-related financial disclosures and climate change-related financial disclosures.
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IFRS Foundation also appoint the members of the IASB, the members of the ISSB, the IFRS Interpretations Committee and the IFRS Advisory Council. The IFRS Interpretations Committee is the interpretative body of the IFRS Foundation and its mandate is to ‘interpret the application of IFRSs and provide timely guidance on financial reporting issues not specifically addressed in the Standards, in the context of the Board’s Framework, and undertake other tasks at the request of the Board’ (IFRS Foundation, 2021a, paragraph 43(a)). The Interpretations Committee comprises 14 voting members who are drawn from a variety of countries and between them have a balance of technical expertise. Its interpretations and guidance are subject to IASB approval and have the same authority as a standard issued by the IASB. The IFRS Advisory Council is a forum for the IASB to consult a wide range of representatives ‘with an interest in international corporate reporting, having diverse geographical and functional backgrounds’ (IFRS Foundation, 2021a, paragraph 60). The IFRS Foundation Constitution requires that the IASB shall normally comprise 14 members. Up to three members may be part-time members and shall meet appropriate guidelines of independence established by the Trustees. The remaining members shall be fulltime members. Together, IASB members must: comprise a group of people representing, within that group, the best available combination of technical expertise and diversity of international business and market experience, including auditors, preparers, users, academics and market or financial regulators, in order that the IASB as a group can contribute to the development of high quality, global financial reporting standards. The members of the IASB shall be required to commit themselves formally to acting in the public interest in all matters. No individual shall be both a Trustee and a member of the IASB at the same time. (IFRS Foundation, 2021a, paragraph 26)
According to paragraph 36 of the IFRS Constitution (IFRS Foundation, 2021a), publication of an Exposure Draft or an IFRS Standard shall require approval by eight members of the Board, if there are 13 members or fewer, or by nine members if there are 14 members. Other decisions of the Board, including the publication of a Discussion Paper, shall require a simple majority of the members of the Board present at a meeting that is attended by at least 60 per cent of the members of the Board, in person or by telecommunications. It should be noted, however, that while the IASB develops standards, it does not have any power of enforcement of their use in particular jurisdictions. As we will see later in this chapter, the IASB’s lack of ability to enforce accounting standards has meant that there is a potential that different countries will not enforce the requirements of various IFRS in a uniform manner. In terms of the origin of the membership of the IASB, paragraph 27 of the IFRS Constitution (IFRS Foundation, 2021a) states: In a manner consistent with the ‘Criteria for IASB members’ as set out in the Annex to the Constitution and in order to ensure a broad international balance, there shall normally be: (a) four members from the Asia/Oceania region; (b) four members from Europe; (c) four members from the Americas; (d) one member from Africa; and (e) one member appointed from any area, subject to maintaining overall geographical balance. The work of the IASB shall not be invalidated by its failure at any time to have a full complement of members according to the above geographical allocation, although the Trustees shall use their best endeavours to achieve the geographical allocation. 169
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Despite the reforms to the IASB and the IFRS Foundation discussed above, IFRS/IAS have still not been accepted by the US SEC as an adequate basis for the preparation of financial reports by US companies.8 The IASB and the US standard-setter (the FASB) had been working for a number of years to reduce the differences between international standards and US accounting standards in what was referred to as its ‘convergence project’ (Nobes and Parker, 2010). We return to a discussion of that project shortly.
Why do I need to know about the functionings of the IASB and the IFRS Foundation? Arguably, from a broader corporate accountability perspective, the IASB – which is under the auspices of the IFRS Foundation – is one of the most influential organisations in the world. Many decisions by a multitude of stakeholders worldwide are made on the basis of information about an organisation’s financial performance and position, and these decisions then create many social and environmental impacts (reflecting the fact that accounting is both a technical and social practice).
Therefore, as members of society and as members of the accounting profession, and given the centrality of the IASB (and its governing body, the IFRS Foundation) to financial reporting globally, it seems important that we understand the nature and functioning of the IASB. By knowing about the functioning of the IASB, we can also be better placed to critically evaluate its processes and also its independence, and this allows us to more fully participate in debates about financial reporting at the international level.
Role of the European Union A very significant participant in the process of standardising accounting practices internationally was the EU.9 A key reason for the EU becoming involved in accounting regulation at the EU level (rather than leaving this to individual member states) is that a founding principle of the EU is freedom of movement within the EU of people, goods and capital. As discussed earlier, differing accounting principles in different countries have been noted by various individuals, researchers and organisations as impediments to investors seeking to understand and compare the financial statements of companies in different countries, and thereby acted as impediments to them freely investing their capital in companies from different EU member states (an inhibition to the free movement of capital). The approach towards harmonisation and standardisation of accounting in the EU has historically differed from the IASC/IASB approach. This should be of little surprise, given that most countries in the EU, by definition, follow a continental European system of financial accounting (to be discussed shortly) rather than the Anglo-American model of the IASC/IASB, so the EU approach to accounting harmonisation has historically been through legislation. This legislation has primarily been in the form of EU directives on company law, which have to be agreed upon by the EU and then implemented in the domestic legislation of each EU member state. This is a very lengthy process, and during the 1990s the EU recognised that it was far too inflexible to respond to the requirements of a dynamic business environment where financial accounting practices need to adapt quickly to rapidly changing business practices – especially for companies that rely on ‘outsider’ forms of finance, as an increasing number of the largest companies in many continental European nations do. (‘Outsider forms of finance’ refers to finance received from parties, such as shareholders, that do not get involved in the management of the organisation.) 8
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As noted elsewhere in this chapter, foreign listed companies are allowed to lodge their financial statements within the US in accordance with IFRS. This concession, however, is not extended to US companies. The European Union was formerly known as the European Community (and prior to that it was known as the Common Market). It is an intergovernmental organisation of 27 European nations created by the Maastricht Treaty of December 1993 with its own institutional structures and decision-making framework. It comprises Austria, Belgium, Bulgaria, Croatia, Cyprus, the Czech Republic, Estonia, Denmark, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, the Netherlands, Poland, Portugal, Romania, Spain, Slovakia, Slovenia and Sweden. The United Kingdom was a founding member of the EU, but left the EU in 2020.
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Following proposals made in 2000, the EU agreed in 2002 that from 1 January 2005 companies whose shares were traded on any securities exchange in the EU would have to compile their consolidated accounts in accordance with IAS/IFRS. This was seen as ensuring that accounting rules were flexible enough to suit the needs of a dynamic business environment and that the financial accounts of EU-listed companies maintained international credibility. A press release was issued by the European Commission when this route for accounting regulation was formally adopted in 2002. Because of the importance of this initiative to global financial reporting, the contents of the press release are reproduced below as Figure 5.1. FIGURE 5.1 European Commission view on global financial reporting
Press release of the European Commission regarding IFRS adoption The European Commission has welcomed the Council’s adoption, in a single reading, of the Regulation requiring listed companies, including banks and insurance companies, to prepare their consolidated accounts in accordance with International Accounting Standards (IAS) from 2005 onwards (see IP/01/200 and MEMO/01/40). The Regulation will help eliminate barriers to cross-border trading in securities by ensuring that company accounts throughout the EU are more reliable and transparent and that they can be more easily compared. This will in turn increase market efficiency and reduce the cost of raising capital for companies, ultimately improving competitiveness and helping boost growth. The IAS Regulation was proposed by the Commission in February 2001. It is a key measure in the Financial Services Action Plan, on which significant progress has been made in the last few weeks (see IP/02/796). Unlike Directives, EU Regulations have the force of law without requiring transposition into national legislation. Member States have the option of extending the requirements of this Regulation to unlisted companies and to the production of individual accounts. Although the Commission put forward the IAS proposal long before the Enron affair, this is one of a series of measures which will help to protect the EU from such problems. Others include the Commission’s recent Recommendation on Auditor Independence (see IP/02/723) and its proposal to amend the Accounting Directives (see IP/02/799). Internal Market Commissioner Frits Bolkestein said: ‘I am delighted that the IAS Regulation has been adopted in a single reading and am grateful for the positive attitude of both the Parliament and the Council. I believe IAS are the best standards that exist. Applying them throughout the EU will put an end to the current Tower of Babel in financial reporting. It will help protect us against malpractice. It will mean investors and other stakeholders will be able to compare like with like. It will help European firms to compete on equal terms when raising capital on world markets. What is more, during my recent visit to the US, I saw hopeful signs that the US will now work with us towards full convergence of our accounting standards.’ To ensure appropriate political oversight, the Regulation establishes a new EU mechanism to assess IAS adopted by the International Accounting Standards Board (IASB), the international accounting standard-setting organisation based in London, to give them legal endorsement for use within the EU. The Accounting Regulatory Committee chaired by the Commission and composed of representatives of the Member States, will decide whether to endorse IAS on the basis of Commission proposals. In its task, the Commission will be helped by EFRAG, the European Financial Reporting Advisory Group; a group composed of accounting experts from the private sector in several Member States. EFRAG provides technical expertise concerning the use of IAS within the European legal environment and participates actively in the international accounting standard setting process. The Commission invites all parties interested in financial reporting to contribute actively to the work of EFRAG. The Commission recently proposed amendments to the Accounting Directives which would complement the IAS Regulation by allowing Member States which do not apply IAS to all companies to move towards similar, high quality financial reporting (see IP/02/799). Source: European Commission press release, Reference: IP/02/827, Date: 7 June 2002. CC BY 4.0 Licence (https://creativecommons.org/licenses/by/4.0/)
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The press release demonstrates that the views being embraced in favour of the adoption of IAS/IFRS are based on beliefs about the information people need in making various decisions (which can be tied back to decision usefulness theories – some of which are considered in Chapters 6 and 7), beliefs about how individuals and capital markets react to accounting information (which can be tied back to behavioural and capital markets research – the topics we cover in Chapters 11 and 12 of this book), and a view that the adoption of IAS/IFRS is in the public interest, rather than being driven by the private interests of particular constituents (public interest theories and private interest theories are discussed in Chapter 4). There also appears to be a view that new accounting methods will be embraced in a similar manner across different countries (which perhaps differs from some of the insights to be noted later in this chapter – for example, that religion, culture or taxation systems influence the usefulness of various alternative accounting approaches). Despite the European Commission’s enthusiasm for the adoption of IAS/IFRS, there were concerns that, for both legal and political reasons, the EU could not be seen to endorse in advance regulations that might be developed at any time in the future by an international body not under control of the EU (Nobes and Parker, 2010). That is, the EU was unwilling to give a blanket approval covering all future IFRS (that would apply to many EU companies) without considering the details of those IFRS. Therefore, as can be seen in the press release, the EU established a mechanism whereby each IAS/IFRS would have to be endorsed separately by the EU before becoming mandatory for listed companies in the EU. This endorsement process involves a 17-member Board of the European Financial Reporting Advisory Group (EFRAG – see https:// www.efrag.org), whose members are drawn from the preparers and users of financial statements, and who comment on each IAS/IFRS to a new EU Accounting Regulatory Committee (ARC). According to the website of EFRAG (n.d.): EFRAG’s mission is to serve the European public interest by developing and promoting European views in the field of financial reporting and ensuring that these views are properly considered in the IASB’s standard-setting process and in related international debates. EFRAG ultimately provides advice to the European Commission on whether newly issued or revised IFRS Standards meet the criteria of the IAS Regulation for endorsement for use in the EU, including whether endorsement would be conducive to the European public good ... EFRAG seeks input from all stakeholders, and obtains evidence about specific European circumstances, throughout the standard-setting process and in providing its endorsement advice. Its legitimacy is built on transparency, governance, due process (which may include field tests, impact analyses and outreaches), public accountability and thought leadership. This enables EFRAG to speak convincingly, clearly and consistently, and be recognised as the European voice in financial reporting.
The ARC, which receives recommendations from EFRAG, has a member from each EU state, and the members vote on whether to recommend approval of the IAS/IFRS to the EU Commission, with a two-thirds majority of the 27 members being required to recommend approval. This mechanism was used in 2004 to block recommendation of full EU endorsement of IAS 39 (on financial instruments) by governments who argued that aspects of IAS 39 were unrealistic and would have potentially significant negative economic consequences on banks in their nations. It is interesting to speculate whether this action by the EU to modify an accounting standard issued by the IASB (and thereby move away from full standardisation) undermined the efforts that were being undertaken by the IASB to encourage other countries, most notably the United States, to adopt IFRS. The benefits of international standardisation are potentially reduced when some countries, such as the member countries of the EU, decide to make alterations to the standards issued by the IASB. 172
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Australia adopts IFRS The efforts undertaken within Australia to harmonise or standardise Australian accounting practice with international practice are now considered. As indicated earlier, from the mid-1990s Australia adopted a policy of harmonisation. This process led to revised Australian accounting standards which, although not the same, were very comparable with those issued by the IASC. Once these revisions were almost complete and many revised accounting standards had been issued, a decision was made in 2002 by the Financial Reporting Council (FRC) that Australia would ‘adopt’ accounting standards being issued by the IASB and no divergence was to be acceptable (that is, there was a shift from harmonisation to standardisation).10 This led to yet another set of accounting standards being released, for application in 2005. This was a very frustrating time for Australian accountants. Just as they were getting used to a new set of accounting standards that had been released to harmonise Australian accounting standards with IAS, the revised (harmonised) standards were dumped in favour of a standardisation process that involved the adoption of IAS/IFRS. The Bulletin released by the FRC outlining its direction on the adoption of international accounting standards is reproduced in Figure 5.2. As can be seen, there is much FIGURE 5.2 Bulletin released by the Financial Reporting Council (Australia) in 2002
Adoption of International Accounting Standards by 2005 The Chairman of the Financial Reporting Council (FRC), Mr Jeffrey Lucy, AM, today announced that the FRC has formalised its support for the adoption by Australia of international accounting standards by 1 January 2005. Subject to the Government’s support at the appropriate time for any necessary amendments of the Corporations Act, this will mean that, from 1 January 2005, the accounting standards applicable to reporting entities under the Act will be the standards issued by the International Accounting Standards Board (IASB). After that date, audit reports will refer to companies’ compliance with IASB standards. The FRC considered the issue at its meeting on 28 June and formally endorsed the 2005 objective, in line with statements made recently by the Parliamentary Secretary to the Treasurer, Senator the Hon. Ian Campbell. Mr Lucy paid tribute to the Government’s strong leadership over the last five years in pressing for the international convergence of accounting standards. This objective is reflected in the Government’s 1997 Corporate Law Economic Reform Program initiative (CLERP 1) and amendments made in 1999 to the Australian Securities and Investments Commission Act 2001. The FRC fully supports the Government’s view that a single set of high-quality accounting standards which are accepted in major international capital markets will greatly facilitate crossborder comparisons by investors, reduce the cost of capital, and assist Australian companies wishing to raise capital or list overseas. Mr Lucy said he understood that the 1 January 2005 timing is somewhat later than the Government would have liked. However, it is determined by the decision of the European Union to require EU listed companies to prepare their consolidated accounts in accordance with IASB standards from that date, in support of the EU single market objective. Australia certainly cannot afford to lag [behind] Europe in this regard, Mr Lucy said. He also expressed his support for efforts to encourage the United States to further converge its standards with IASB standards with a view to eventual adoption. Mr Lucy was pleased to note that the Chairman of the IASB, Sir David Tweedie, had issued a statement in London welcoming the FRC’s decision. Sir David said that the FRC’s announcement demonstrates growing support for the development and implementation of a single set of highquality global accounting standards by 2005.
10
The FRC has an oversight function in regard to the Australian Accounting Standards Board (and the Australian Auditing Standards Board) and appoints members of the AASB (other than the chairperson). There are nine members on the FRC inclusive of the chairperson. See https://www.frc.gov.au for more details about the FRC.
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‘This vote of confidence is a reflection of the leadership role that Australia continues to play in standard-setting, and will increase momentum for convergence towards high-quality international standards. The input and active participation of interested parties in Australia and the Australian Accounting Standards Board (AASB), under the leadership of Keith Alfredson, are and will remain a vital element in ensuring the IASB’s success. It is through national standard-setters, such as the AASB, and the members of our various committees that we are able jointly to develop high-quality solutions to accounting issues, leverage resources to research topics not yet on the international agenda so as to expedite conclusions, reach interested parties throughout the world and better understand differences in operating environments, thus fulfilling our role as a global standard-setter.’ The full statement is available on the IASB’s website www.iasb.org.uk. While there will be a need for business and the accounting profession to adapt to significant changes in some standards, and to some complex new standards, the AASB has been harmonising its standards with those of the IASB for some years, resulting in substantial synergies between the two. Nevertheless, Mr Lucy urged the accounting bodies to prepare for the changeover through their programs of professional development and their influence on accounting education. He also urged the business community to participate fully in commenting on exposure drafts of IASB standards issued in Australia in the period ahead. Mr Lucy noted that implementation issues would also need to be considered by the FRC (to the extent they did not involve the content of particular standards) and the AASB between now and 2005. These could relate, for example, to the timing of introduction of particular IASB standards in Australia before 1 January 2005 (which would be AASB standards until that date), as well as to issues of interpretation. The FRC and AASB will be doing everything they can to keep constituents informed about these issues and to communicate an overall strategy for adoption, Mr Lucy said. Mr Lucy also confirmed that Australia would be making a substantial financial contribution, through the FRC, to the International Accounting Standards Committee (IASC) Foundation in 2002–03. This contribution will be sourced from funds available to the FRC for the standardsetting process contributed by the Commonwealth, State and Territory governments, the three accounting bodies, the Australian Stock Exchange, and from the Financial Industry Development Account (as announced by Senator Campbell on 12 June). Among the FRC’s functions are to further the development of a single set of accounting standards for world-wide use and to promote the adoption of international best practice accounting standards in Australia if doing so would be in the best interests of both the private and public sectors in the Australian economy. The IASB, which is based in London, is committed to developing, in the public interest, a single set of high-quality, global accounting standards that require transparent and comparable information in financial statements. In pursuit of this objective, the IASB cooperates with national standard-setters, including the AASB, to achieve convergence in accounting standards around the world. The AASB has been harmonising its standards with IASB standards for a number of years and is now working in close partnership with the IASB as a liaison standard-setter, aligning its work program with that of the IASB and standing ready to allocate resources to lead or support projects on the IASB agenda. Recently, the AASB issued to its Australian constituents invitations to comment on a number of exposure drafts of IASB standards. Australians are actively involved in the work of the IASB. Mr Ken Spencer is a member of the oversight body for the IASB, the IASC Foundation Trustees (and Chairman of the Foundation’s Nominating Committee). Mr Warren McGregor is a member of the IASB, also designated the Liaison Member for Australia and New Zealand. Mr Kevin Stevenson, a former director of the Australian Accounting Research Foundation, is the IASB’s Director of Technical Activities. Australians are also on the IASB’s Standards Advisory Council (Mr Peter Day and Mr Ian Mackintosh) and its Interpretations Committee (Mr Wayne Lonergan). Source: Bulletin of the Financial Reporting Council, 2002/4, 3 July 2002 Based on © Commonwealth of Australia material
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REFLECTION QUESTION 5.1 To accept international standardisation, or not? Question Do you think it is a good idea that a country, such as Australia, New Zealand or Singapore, effectively allows its financial reporting standards to be developed by a standard-setting body in another country? Solution This is a very interesting question with no clear answer. As we read through this chapter, we will be better able to provide a critically considered response to this question. One of the key rationales for why a country should adopt IFRS in preference to its own nationally developed standards is that having a globally standardised set of financial reporting standards will enhance financial report comparability internationally. This in turn is expected to lead to increased flows of financial capital internationally and reduced costs of capital for those organisations able to produce financial reports in compliance with IFRS. However, there is no clear evidence that these enhanced capital flows actually occurred or that the cost of attracting capital declined. Also, it has been frequently argued that some national accounting standards were superior to their replacement IFRS (a case in point within Australia was that the domestic standard on intangible assets was widely considered to be superior to its IFRS equivalent yet the domestic standard was ‘dumped’ in the pursuit of greater international comparability). In this chapter, we discuss the fact that many countries have relatively poor mechanisms to enforce compliance with IFRS, and such countries also often have low-quality auditing practices. This undermines international comparability of
financial reporting – which was one of the justifications the IASB used to explain the need for standardisation. Comparability is also an enhancing qualitative characteristic within the IASB Conceptual Framework for Financial Reporting. Further, we also discuss research that shows that when IFRS are translated from their initial English form into various domestic languages, meanings of key terms are often changed, also undermining comparability. We will also learn that some countries make changes to IFRS before endorsing them locally, which further undermines the international comparability of financial reports. Apart from these issues, there are other broader issues to consider. Does it make sense to have one set of financial reporting guidance for all countries – that is, to have a ‘onesize-fits-all’ approach to financial reporting? We see in this chapter that various researchers question whether people within different nations and different cultures have the same information needs and expectations. As we read through the chapter, we discuss how issues such as culture, legal systems, financing systems, taxation systems, language, political systems and religion influence demands for information, including financial information. A system of standardised reporting effectively ignores such important differences. So, in terms of our question about whether it is a good idea that a country adopts IFRS, different people have different views. However, generally speaking, the majority view would arguably be that the efforts undertaken to standardise financial reporting practices has created more benefits than costs – but the argument is far from settled.
similarity between the arguments in favour of standardisation provided in the press release from the European Commission and the supporting arguments expressed in the press release from the FRC. However, as has already been mentioned, there have been no known attempts to quantify the costs and benefits of these standardising activities.
The United States’ role in the international standardisation of financial accounting LO5.1
LO5.7
The major event that triggered the adoption of IFRS by more than 100 countries was the decision taken by the EU to adopt IFRS as the accounting standards to be used for preparing the consolidated financial statements of publicly listed companies from 2005.11 In Australia, the FRC followed the lead of the EU, and in 2002 decided that Australia would adopt IFRS from 2005. Prior to the adoption of IFRS, these countries used accounting standards that were typically developed on a domestic basis. 11
The proposal to adopt IFRS was confirmed in a regulation of the European Parliament and European Council released on 19 July 2002. IFRS and IFRIC interpretations, once adopted by the IASB, need to be specifically acknowledged (and translated into various languages) by the European Commission to become part of EU law. National standards are still commonly used in European countries for individual (non-consolidated) financial statements.
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One notable exception to the global adoption of IFRS is the United States. But before considering the US position on global standardisation, it is useful to briefly consider the two main bodies responsible for accounting regulation within the United States – the SEC and the FASB. In relation to their history, following the US stock-market crash of 1929, newly established US securities legislation of 1933 and 1934 led to the creation of the SEC. The SEC was given the authority to develop accounting regulation, but it decided to rely on the expertise of the US accounting profession to develop accounting standards. Over the following decades, the US accounting profession developed various documents that became known as ‘generally accepted accounting principles’ (GAAP). In 1973 the SEC entrusted the task of developing accounting standards to the newly formed FASB.12 The FASB is a private-sector body that was established to act in the ‘public interest’. While the FASB was established as an independent body, the SEC has the power to override the accounting standards issued by the FASB should it see fit to do so.13 In the United States, reliance is still placed on accounting standards issued by the FASB, rather than on the standards issued by the IASB. That is, unlike many other countries, the United States did not adopt IFRS. Given that the United States represents the world’s major capital market, its non-involvement represents a significant limitation in the global acceptance of IFRS. The United States was, for many years, very strong in its resolve not to adopt IFRS, believing that its ‘rules-based’ standards were superior to the more ‘principlesbased’ standards of the IASB.14 However, this resolve appeared to diminish around 2001–02 with the various ‘accounting scandals’ involving organisations such as Enron.15 As Veron (2007, p. 23) states: The context was profoundly modified by the Enron bankruptcy in December 2001 and other accounting scandals that erupted in 2002, following the bursting of the late-1990s stock market bubble. Before this wave of controversy, specific US GAAP standards had been occasionally criticised but overall it was widely considered, in the US and elsewhere, that US GAAP as a whole were the best available set of accounting standards … But Enron’s collapse shattered the perception of high quality. It exposed the shortcomings of some detailed US GAAP rules, most notably those on consolidation which gave Enron enough leeway to hide its now famous ‘special-purpose entities’ (with their funny names such as Chewco, Raptor, Jedi, or Big Doe) off its balance sheet, packing them with real debts backed by flimsy assets … In February 2002, a Senate Committee investigating the Enron debacle heard the testimony of IASB Chairman Prior to this time, the Accounting Principles Board (a committee of the American Institute of Certified Practicing Accountants) was responsible for developing US GAAP. 13 See the following websites for further information about the SEC and FASB respectively: https://www.sec.gov and https://www.fasb.org. 14 In basic terms, rules-based accounting standards tend to be relatively lengthy and provide explicit guidelines on how to account for specific attributes of different transactions and events. By contrast, principles-based accounting standards tend to be less detailed and more concise. Rather than providing detailed rules for particular transactions and events, in principles-based standards reference is made to general principles that should be followed. These principles might be incorporated within a conceptual framework of accounting. Principles-based accounting standards require the exercise of greater levels of professional judgement relative to rules-based accounting standards. As an example of the difference, a rules-based accounting standard might say that a particular type of intangible asset should be amortised over twenty years, whereas a principles-based standard might require that the intangible assets be amortised to the extent that the economic value of the asset has declined since the beginning of the accounting period. Accounting standards released by the FASB are generally considered to be more rules-based than accounting standards issued by the IASB (which are considered to be principles-based). 15 Enron was an energy company based in Texas. Prior to its bankruptcy in late 2001, it employed approximately 22 000 people and was one of the world’s leading electricity, natural gas, pulp and paper, and communications companies, with reported revenues of $111 billion in 2000. At the end of 2001, it became apparent that the company’s financial position was generated through extensive accounting fraud. Enron represented one of the biggest and most complex bankruptcy cases in US history. 12
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David Tweedie who explicitly criticised the rules-based approach which is prevalent in US GAAP, contrasting it with the more principles-based stance adopted by the IASB. Shortly thereafter, the Sarbanes-Oxley Act specifically mandated the SEC to study how a more principles-based system (such as IFRS) could be introduced in the United States.
With the perceived limitations of some US accounting requirements in mind, the FASB and the IASB entered a joint agreement in 2002 to converge and improve the standards of both the IASB and the FASB. The intended consequence of the Convergence Project would be that the United States would ultimately adopt IFRS. As Veron (2007, p. 24) states: Since the early 2000s the FASB has been working with the IASB to narrow the differences between US GAAP and IFRS – a process they call ‘convergence’, but which in fact is very different from the unilateral convergence of, say, Australian or South Korean accounting standards towards IFRS. The premise, enshrined in the so-called Norwalk Agreement of September 200216 and renewed by an FASB–IASB Memorandum of Understanding in February 2006, is that both the FASB and the IASB would need to move some way towards each other. In this process, on some issues FASB adopts standards identical or near identical to existing IFRS (e.g. for stock option expensing); on other issues the IASB adopts standards identical or near identical to existing US GAAP rules, as with the IFRS 8 standard on ‘operating segments’; and on yet other issues the two bodies jointly develop entirely new projects.
Although there appeared to be a long-term aim that ultimately there will be one set of standards used internationally, including within the United States, this now appears unlikely – at least in the relatively near future. Obviously, for the IASB – and its governing body, the IFRS Foundation – to achieve their aim of developing ‘a single set of high-quality, understandable, enforceable and globally accepted accounting and sustainability disclosure standards – IFRS Standards – and to promote and facilitate adoption of the standards’ (IFRS Foundation, 2021c), it needed to encourage the United States to adopt its standards. Nevertheless, from late 2007 the SEC adopted rules that permit foreign private issuers (but not US domestic companies) to lodge, with the SEC, their financial statements prepared in accordance with IFRS without the need to provide a reconciliation to GAAP as used in the United States. That is, foreign companies that are listed across a number of securities exchanges internationally, including within the United States, can lodge their reports in the United States even though the reports have not been prepared in accordance with US accounting standards and do not provide a reconciliation to US GAAP. The ruling of the SEC requires that foreign private issuers that take advantage of this option must state explicitly and unreservedly in the notes to their financial statements that such financial statements are in compliance with IFRS as issued by the IASB (without modifications), and they must also provide an unqualified auditor’s report that explicitly provides an opinion that the financial statements have been compiled in accordance with IFRS as issued by the IASB. In explaining the basis for its decision to provide this concession to foreign companies, the SEC stated (2007, p. 16): We believe that investors can understand and work with both IFRS and U.S. GAAP and that these two systems can co-exist in the U.S. public capital markets in the manner described in this rule making, even though convergence between IFRS and U.S. GAAP is not complete and there are differences between reported results under IFRS and U.S. GAAP.
16
It was signed in the FASB’s home city of Norwalk, Connecticut, hence becoming known as the Norwalk Agreement.
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Hence, effectively there are two types of financial statements being lodged within the United States (as is the case in many other countries). Foreign companies can lodge their reports within the United States in accordance with IFRS, whereas domestic US companies must lodge their reports in accordance with US GAAP. It is interesting that the SEC states that these two systems can co-exist. If different systems can co-exist, does that question the need for all countries to adopt IFRS? What do you, the reader, think? Does the US position of supporting dual reporting systems undermine the view of the FRC in Australia, which argued back in 2002 that if Australia retained its own accounting standards (which were fundamentally similar to IFRS) it would be damaging to Australian capital markets? In terms of some of the opposition within the US to adoption of IFRS, we can consider some of the issues raised by the US Financial Accounting Foundation (FAF).17 The FAF was particularly concerned about the perceived independence of the IASB, and it wanted certain changes to be made to the governance policies of the IASB before the United States would be willing to adopt IFRS (which emanate from the IASB). Of particular concern was the uncertain nature of the funding being received by the IASB and the fact that a great deal of the funding comes from the ‘Big 4’ accounting firms (Deloitte, PricewaterhouseCoopers (PwC), KPMG and Ernst & Young), which each donate annual funding to the IASB and are organisations that are directly affected by the operations of the IASB (and therefore have an incentive to ‘capture’ the IASB).18 The FAF (2007, p. 8) called for mechanisms to be established ‘to provide the IASB with sufficient and stable funding and staffing levels, thereby ensuring its sustainability as an independent setter of high-quality accounting standards’. The FAF further stated (2007, p. 8) that it did not ‘support moving U.S. public companies to IFRS until mechanisms to adequately fund the IASB’s activities over the long term are developed’.19 The FAF was also concerned that in many jurisdictions amendments are being made to IFRS at a local level before the standards are used in that particular country. This has the obvious implications of undermining the consistency of financial accounting being undertaken across countries that otherwise state they have adopted IFRS. As the FAF (2007, p. 3) states: Agreements are needed to eliminate the separate review and endorsement processes that various jurisdictions apply to each IFRS after it is issued by the IASB. These afterthe-fact jurisdictional processes are inconsistent with the objective of a single set of high-quality international accounting standards, as evidenced by the local variants of IFRS that have developed in some jurisdictions.
In 2008 the IASC Foundation proposed a number of changes to the IASB’s organisational and governance practices, which were later implemented. However, such changes were not sufficient to lead to the United States adopting IFRS.
The Financial Accounting Foundation was established in 1972 and is the independent, private-sector organisation with responsibility for the oversight, administration and finances of the FASB. It also selects the members of the FASB. 18 A review of the IFRS Foundation Annual Report 2021 (IFRS Foundation, 2021b) shows that each of the ‘Big 4’ international accounting forms donated US$550 000 in 2021. See https://www.ifrs.org/content/dam/ifrs/ about-us/funding/2021/ifrs-annual-report-2021.pdf. 19 In Chapter 4 we discussed some research which noted concerns around the possible ‘capture’ of the IASB in relation to decisions it made in relation to some accounting standards, the concern being that some stakeholders that made significant financial contributions to the IASB might have been able to influence the contents of certain accounting standards. 17
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Does the international standardisation of accounting standards necessarily lead to the international standardisation of accounting practice? LO5.2
LO5.6
LO5.7
The international adoption of IFRS is claimed by the IASB as a means of improving the reporting practices of organisations in many countries and improving the ability of report readers to compare the financial performance and position of organisations in different countries. A document entitled ‘Use of IFRS Standards around the world, 2018’ (IFRS Foundation, 2018) referred to the benefits of IFRS in a diagram that is reproduced in Figure 5.3. FIGURE 5.3 IASB’s perspective of the role of IFRS
Source: IFRS Foundation (2018), Use of IFRS standards around the world, https://www.ifrs.org/content/dam/ifrs/ around-the-world/adoption/use-of-ifrs-around-the-world-overview-sept-2018.pdf.
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The standardisation of accounting standards by a multitude of different countries, with different enforcement mechanisms, different forms of capital markets, different cultures and so forth, might be considered to lead to the standardisation of accounting practice. Certainly, this seems to be a central assumption of the IASB. But is this a realistic belief? Will international standardisation of accounting standards lead to international standardisation of accounting practice? Evidence provided by Kvaal and Nobes (2010) indicates that where there will still be flexibility within options provided by individual IFRS and IAS, companies in different countries tend to choose the options that reflect the requirements within their previous (pre-IFRS adoption) national accounting regulations. As such, Kvaal and Nobes (2010, pp. 173–4) indicate that despite the international standardisation intended by the widespread adoption of IFRS, national differences still persist and limit the international comparability of financial statements drawn up by companies in different countries: We document formally that there are different national versions of IFRS practice. Related to this, we show that companies not only have an opportunity to pursue pre-IFRS practices originating in their national GAAP, but also extensively use this opportunity. These findings are important for several reasons. For financial statement users, they imply that full international comparability has not yet arrived. Therefore, it has been suggested, investors might be misled by an apparent uniformity (Ball, 2006: 15). As long as accounting standards contain options and require use of judgment, some variation in accounting practice is inevitable. However, the existence of systematic differences in practice related to national borderlines is clearly in conflict with the objective of international harmonisation and may mislead financial statement users who do not pay attention to them. Some differences within IFRS practice are observable and can be adjusted for by alert analysts (e.g. the location of dividends in a cash flow statement); other differences are easily observable but cannot be adjusted for without a large degree of estimation (e.g. the effects of the inventory flow method on profit, or the absence of a gross profit figure in a by-nature income statement); yet others are not observable (e.g. the application of criteria for making impairments or for capitalising development costs). Some users of financial statements might be misled by even the first type of differences, but many might be misled by the third type. The second and third types create difficulties for international comparative analysis.
Nobes (2013) also notes that although Australia claims to have adopted IFRS, some disclosure requirements have been added, other material has been added to make the standards applicable to not-for-profit organisations, and for those organisations not deemed to have ‘public accountability’, reduced disclosure requirements have been included within the standards. Further, in some countries, only consolidated financial statements are required to comply with IFRS, some countries provide exemptions for certain companies, and in some countries IFRS are only required for listed companies. The discussion that follows shows that there are a number of reasons why the standardisation of accounting standards will not necessarily lead to standardisation in practice. Hence, consistent with Nobes (2006), the study of international differences in accounting (and the reasons and motivations for them) will remain an important area of research despite the ongoing standardisation efforts of the IASB.20 It will be seen that there are various reasons why international differences will survive beyond the introduction of IFRS. 20
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As Nobes (2006) noted, there has historically been a number of accounting researchers who specialised in studying the reasons and rationale for differences in the accounting methods or practices adopted in different countries. Many such researchers considered that their area of specialisation might become defunct as a result of the global adoption of IFRS. However, as this chapter demonstrates, despite the widespread adoption of IFRS there will continue to be many differences in the accounting methods adopted across different countries, and hence many areas to consider for research into international accounting differences.
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Differences in taxation systems Nobes (2006, p. 235) uses a comparison of differences in taxation systems between Germany and the United Kingdom to identify why financial reporting practices in the two countries might be systematically different despite both countries adopting IFRS. As he states: In Germany, companies are required to continue to prepare unconsolidated financial statements under the conventional rules of the Handelsgesetzbuch (HGB) for calculations of taxable income and distributable income. This is irrespective of any use of IFRS for consolidated or unconsolidated statements (Haller and Eierle, 2004). In some areas, the tax-driven accounting choices of the unconsolidated statements might flow through to consolidated IFRS statements. For example, asset impairments are tax deductible in Germany (but not in the UK), so there is a bias in favour of them. They might survive into IFRS consolidations in Germany, given the room for judgment in IFRS impairment procedures. In the UK, IFRS is allowed for individual company financial statements and therefore as a starting point for calculations of taxable income. The tax authorities generally expect the statements of a parent and other UK group members to use the same accounting policies as group statements. To take an example, the recognition and measurement of intangible assets has tax implications. Consequently, given that IFRS requires considerable judgment in this area, individual companies using IFRS will have an incentive to make interpretations of IAS 38 (Intangible Assets) in order to minimise capitalisation and therefore tax, and then these will flow through to consolidated financial statements.
Differences in economic and political influences on financial reporting There is also an expectation that differences in the economic and political forces operating within a country will have implications for various decisions and judgements made throughout the accounting process regardless of whether IFRS have been adopted. As Ball (2006, p. 15) states: The fundamental reason for being sceptical about uniformity of implementation in practice is that the incentives of preparers (managers) and enforcers (auditors, courts, regulators, boards, block shareholders, politicians, analysts, rating agencies, the press) remain primarily local. All accounting accruals (versus simply counting cash) involve judgments about future cash flows. Consequently, there is much leeway in implementing accounting rules. Powerful local economic and political forces therefore determine how managers, auditors, courts, regulators and other parties influence the implementation of rules. These forces have exerted a substantial influence on financial reporting practice historically, and are unlikely to suddenly cease doing so, IFRS or no IFRS. Achieving uniformity in accounting standards seems easy in comparison with achieving uniformity in actual reporting behaviour. The latter would require radical change in the underlying economic and political forces that determine actual behaviour.
Nobes (2013) also refers to the various professional judgements in IFRS (which are deemed to be more principles-based than US financial reporting standards), such as judgements about useful lives, residual values, existence of impairment losses, and depreciation methods and notes that many of these differ at a national level. As Nobes (2013) notes, many of these accounting differences might be influenced by the same forces that drove national financial reporting practices to be different in the first place. Nobes (2013) also notes that there seem to be differences in the determination of ‘fair values’, which can be explained through national differences, as well as differences in the selection of options relating to balance sheet and income statement presentation. 181
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Modifications made to IFRS at a national level As indicated earlier, an issue that was of concern to the FAC in the United States and perhaps contributed to the decision of the United States to step away from the adoption of IFRS, is that the IASB has no ability to enforce the application of its accounting standards in countries that have made the decision to adopt IFRS. The effect of this is that regulatory bodies in particular countries might make a decision to modify a particular IFRS before it is locally released. This was the case in the EU in relation to its acceptance of IFRS 39 (which has since been replaced by IFRS 9). If modifications to IFRS are made at a national level, the result will be international inconsistencies in accounting practice. As Ball (2006, p. 16) states: The most visible effect of local political and economic factors on IFRS lies at the level of the national standard adoption decision. This already has occurred to a minor degree, in the EU ‘carve out’ from IAS 39 in the application of fair value accounting to interest rate hedges. The European version of IAS 39 emerged in response to considerable political pressure from the government of France, which responded to pressure from domestic banks concerned about balance sheet volatility. Episodes like this are bound to occur in the future, whenever reports prepared under IFRS produce outcomes that adversely affect local interests.
In relation to local modifications to IFRS, Veron (2007, p. 41) also makes the following comment: If implementation is guided by nationally determined recommendations, then they may gradually diverge from one country to another … The main promise of IFRS, of making the accounts of companies comparable for investors to make the right choices across countries and sectors, would be in jeopardy. The SEC’s Chairman recently insisted that ‘We have got to be able to demonstrate that IFRS is indeed a single set of international accounting standards, and not a multiplicity of standards going by the same name’.
Issues of translation IFRS are initially developed in English. They are then translated to various other languages for local use. But how accurate are such translations? Nobes (2013) notes that there are some ‘clear errors’ in many translations of IFRS. Dahlgren and Nilsson (2012) also note many errors in translation. Of course, if there are errors in translation, this effectively means that different countries are using different accounting standards. In a study of errors in translation, Nobes and Stadler (2018) specifically focused on how the term ‘impairment’ was translated by various national financial reporting standard-setters. In the context of IAS 36 Impairment of Assets, they found many errors in translation. In part, some of these problems were potentially related to the failure of the IASB to define ‘impairment’ within IAS 36.
Differences in implementation, monitoring and enforcement The argument here is that unless there is consistency in the implementation of accounting standards and subsequent enforcement mechanisms, we cannot expect accounting practices to be uniform despite the actions of the IASB. For example, Australia made the decision to adopt IFRS from 2005. However, the IASB has no power or authority within Australia (or elsewhere) to enforce standards. Rather, accounting standards are required to be followed by Australian companies by virtue of the Corporations Act 2001, and it is the Australian Securities and Investments Commission (ASIC) that has the power to enforce compliance with the requirements of the Act. It is generally accepted that compliance with IFRS is fairly strongly enforced within Australia as a result of the actions of ASIC and a high-quality independent auditing profession. However, in other countries that adopted IFRS there might not be the same level of monitoring and enforcement, meaning that while companies in a particular country might say they have 182
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adopted IFRS, we really cannot be sure that the level of compliance is consistent internationally. That is, inconsistencies internationally in how the adoption of accounting standards are implemented, monitored and enforced will lead to inconsistencies in how the standards are applied, which in turn will diminish the international comparability of financial reports. In relation to the implementation of accounting standards, different countries will have varying levels of expertise in applying IFRS. Using China as an example, Veron (2007, p. 20) states: In China as in other developing economies, any reference to financial statements prepared ‘in accordance with IFRS’ needs to be taken with a pinch of salt. The most daunting challenge there is not the standards’ adoption, but their proper enforcement in a context of massive underdevelopment of the accounting profession, both quantitatively and qualitatively: China has no more than 70,000 practising accountants (many of them poorly trained), while the size of its economy would probably require between 300,000 and one million.
As Nobes (2006, p. 242) explains when considering differences between accounting practice in Germany and the United Kingdom: Enforcement (including monitoring) of compliance with IFRS remains a national matter within the EU. It has been suggested (La Porta et al., 1997) that enforcement of accounting rules is stronger in the UK than in Germany. Hope (2003) constructed an index of compliance and registered Germany substantially lower than the UK. Furthermore, a great deal of evidence has been amassed that compliance by German groups with international standards was lax despite an audited statement of compliance by directors (e.g. Street and Bryant, 2000; Street and Gray, 2001). By contrast, compliance with standards in the UK since the creation of the Financial Reporting Review Panel (FRRP) in 1990 is generally regarded as having been high (Brown and Tarea, 2005).
Questioning the logic behind any belief that the efforts of the IASB will realistically lead to international consistencies in accounting practice, Ball (2006, p. 16) states: Does anyone seriously believe that implementation will be of an equal standard in all the nearly 100 countries that have announced adoption of IFRS in one way or another? The list of adopters ranges from countries with developed accounting and auditing professions and developed capital markets (such as Australia) to countries without a similarly developed institutional background (such as Armenia, Costa Rica, Ecuador, Egypt, Kenya, Kuwait, Nepal, Tobago and Ukraine). Even within the EU, will implementation of IFRS be at an equal standard in all countries? The list includes Austria, Belgium, Cyprus, Czech Republic, Denmark, Germany, Estonia, Greece, Spain, France, Ireland, Italy, Latvia, Lithuania, Luxembourg, Hungary, Malta, Netherlands, Poland, Portugal, Slovenia, Slovakia, Finland, Sweden and the UK. It is well known that uniform EU economic rules in general are not implemented evenly, with some countries being notorious standouts. What makes financial reporting rules different? Accounting accruals generally require at least some element of subjective judgment and hence can be influenced by the incentives of managers and auditors. Consider the case of IAS 36 and IAS 38 which require periodic review of long-term tangible and intangible assets for possible impairment to fair value. Do we seriously believe that managers and auditors will comb through firms’ asset portfolios to discover economically impaired assets with the same degree of diligence and ruthlessness in all the countries that adopt IFRS? Will auditors, regulators, courts, boards, analysts, rating agencies, the press and other monitors of corporate financial reporting provide the same degree of oversight in all IFRS-adopting countries? In the event of a severe economic downturn creating widespread economic impairment of companies’ assets, will the political and regulatory sectors of all countries be equally likely to turn a blind eye? 183
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Will they be equally sympathetic to companies failing to record economic impairment on their accounting balance sheets, in order to avoid loan default or bankruptcy (as did Japanese banks for an extended period)? Will local political and economic factors cease to exert the influence on actual financial reporting practice that they have in the past? Or will convergence among nations in adopted accounting standards lead to an offsetting divergence in the extent to which they are implemented?
Ball (2006) also discusses how the general trend inherent within IFRS of adopting asset measurement bases tied to ‘fair value’ will in itself create inconsistencies, because in many countries there is an absence of markets for many types of assets, including financial assets. In countries with ‘thinly trading markets’, relatively more estimation of ‘fair values’ will be required. Ball (2006, p. 17) states: To make matters worse, the countries in which there will be greater room to exercise judgment under fair value accounting, due to lower-liquidity markets and poorer information about asset impairment, are precisely the countries with weaker local enforcement institutions (audit profession, legal protection, regulation, and so on). Judgment is a generic property of accounting standard implementation, but worldwide reliance on judgment has been widely expanded under IFRS by the drift to fair value accounting and by the adoption of fair value standards in countries with illiquid markets.
The ultimate implication of the potential variation in accounting practice (for the reasons discussed in this section) is that investors might be misled into believing that IFRS adoption has created a consistency in international accounting practices. That is, the adoption of IFRS might (incorrectly) be construed as a signal that a country has improved its quality of reporting. In a sense, the adoption of IFRS brings a level of legitimacy to a country’s financial reporting despite any limitations in the level of enforcement of the standards. Ball (2006, pp. 22–3) states: Substantial international differences in financial reporting quality are inevitable, and my major concerns are that investors will be misled into believing that there is more uniformity in practice than actually is the case and that, even to sophisticated investors, international differences in reporting quality now will be hidden under the rug of seemingly uniform standards … But the problem with IFRS adoption, as a signal to investors about the financial reporting quality of a preparer, is that it is almost costless for all countries to signal that they are of high quality: i.e., to adopt the highest available accounting standards on paper. Worse, IFRS adoption most likely costs less to the lower-quality countries, for two reasons. First, the lower-quality regimes will incur fewer economic and political costs of actually enforcing the adopted standards. It is the higher quality reporting regimes that are more likely to incur the cost of actually enforcing IFRS. Because they have the institutions (such as a higher-quality audit profession, more effective courts system, better shareholder litigation rules) that are more likely to require enforcement of whatever standards are adopted. Second, by wholesale adoption of IFRS, the lower-quality regimes can avoid the costs of running their own standard-setting body, which likely are proportionally higher than in larger economies.
Ball discusses the ‘free rider’ problem associated with IFRS.21 If a ‘symbol of legitimacy’ – such as IFRS – can be acquired at low cost, some countries with low levels of financial accounting proficiency will make the choice to adopt IFRS because of the reputational benefits such a choice may generate. However, such a choice will have costly implications for countries with higher 21
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As explained in Chapter 3, a free rider can be defined as a party that takes advantage of particular goods or services without incurring some of the associated production or establishment costs.
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levels of accounting proficiency and who put in place appropriate implementation, monitoring and enforcement mechanisms. As Ball (p. 23) states: A classic ‘free rider’ problem emerges: it is essentially costless for low-quality countries to use the IFRS ‘brand name,’ so they all do. If IFRS adoption is a free good, what companies or countries will not take it? When it is costless to say otherwise, who is going to say: ‘We will not adopt high standards’?
As a potential solution to the problem, Ball (2006, p. 24) makes the following proposal: The only way to make the IFRS signal informative about quality is for the worldwide financial reporting system to incorporate a cost of signalling that the lower-quality agents are not prepared to pay. This would necessitate an effective worldwide enforcement mechanism under which countries that adopt but do not effectively implement IFRS are either penalised or prohibited from using the IFRS brand name. In the absence of an effective worldwide enforcement mechanism it is essentially costless for low-quality countries to use the IFRS brand name, and local political and economic factors inevitably will exert substantial influence on local financial reporting practice, IFRS adoption notwithstanding. If allowing all countries to use the IFRS label discards the information in accounting standards about reporting quality differences, then the available quality signal could become the quality of the enforcement of standards, not standards per se.
In subsequent research undertaken by Ball (Ball, 2016), his concerns had not diminished. Ball (2016) raises further issues associated with the ongoing international differences in reporting within countries claiming to adopt IFRS. He notes (p. 556): One potential effect is dilution of the IFRS brand name. Another is that a uniform IFRS label discards information about reporting quality differences.
Ball (2016) also raises other concerns relating to having a centralised accounting standardsetting body. One concern is the possible implications for reducing innovation in reporting. As he states (p. 556): Competition among alternative economic systems, including financial reporting systems, is conducive to healthy innovation. History is replete with examples of one system learning from the institutional structure of a competing system, the most famous example in accounting being the near worldwide adoption of the Italian method of double entry bookkeeping … In my view, adopting uniform worldwide standards invites risky centralisation and reduced innovation.
Another concern raised by Ball (2016) is that the standardised set of financial reporting standards (IFRS) does not support effective debt contracting. Some of these concerns particularly relate to the reliance of IFRS on ‘fair values’, which can be subject to much professional judgement and potentially ‘creativity’. As he states (p. 560): Relative to the prior domestic standards of IFRS-adopting countries, the new standards provide borrowing firms with more discretion over the reported numbers than would be used in accounting-based debt covenants. First, IFRS make considerably more use of fair value accounting measurements. The subjectivity involved in estimating fair values, particularly for longer-cycle assets, impairs contractibility. Second, many IFRS standards provide borrowers with choice among accounting methods, as documented in Nobes (2013). Third, IFRS are principlesbased, providing fewer implementation rules and accordingly giving managers wide discretion in implementation. 185
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With the above concerns in mind, Ball (2016) notes that the use of accounting-based debt covenants could decrease. He states (p. 560): For many firms, the more efficient response would be to simply reduce the use of accounting-based covenants such as leverage and interest coverage restrictions, and perhaps substitute non-accounting covenants such as restrictions on new investment, assets sales, and new debt issuance. What is the evidence? A study of 3037 new debt issuances over 2001–2010 investigated how their contractual terms changed after the 2005 IFRS adoption date. It compared 1362 new issuances in 22 IFRS-adopting countries (the treatment sample) with 1675 new issuances in 21 non-IFRS-adopting countries (the control sample). There was a substantial fall of approximately 50% in accounting covenant use post-adoption. Conversely, there was an increase in no-accounting covenant use.
Another factor contributing to varying levels of compliance are the auditing standards or principles being applied in different countries. As Nobes (2013) notes, corporations law in many countries that adopt IFRS does not require financial statement auditors to report whether the respective financial statements and supporting notes comply with IFRS. Given the material in this section, the belief that the global adoption of IFRS will lead to consistency in international financial reporting practices could, and arguably should, be questioned. There will continue to be international differences in accounting practice and such differences provide an ongoing and interesting area of research for accounting academics. However, at a more fundamental level, is it really a good idea to have global consistency in accounting practice anyway? That is, is the central quest of the IASB that there be global standardisation of accounting standards logically flawed? Is it appropriate to have a global ‘one-size-fits-all’ approach to financial reporting when there are international differences in the nature of capital, labour and product markets; differences in monitoring and enforcement mechanisms; differences in economic and political influences; and differences in cultures? The next section explores various reasons why, in the absence of globalisation efforts such as those being undertaken by the IASB, we would expect to find international differences in accounting practices.
Why do I need to know that the international adoption of IFRS does not necessarily lead to internationally standardised financial reports? In our daily lives, we often hear, or read about, the profits being reported by large organisations in different countries. Often these profit numbers are translated into our own currency before being reported to us so that we can notionally compare them with the profits of local organisations. By knowing that the ‘standardisation’ of IFRS is somewhat problematic – as the research we have been discussing shows – then we can understand that we need to undertake such comparisons with caution. It also alerts us to the need to carefully review the accounting policy notes being reported by organisations, and also to consider the auditors involved, as well as the local corporate regulators. This knowledge allows us to place the reported financial performance and financial position
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of organisations from different countries into their appropriate context. As accounting researchers, we need to understand the problematic nature of financial accounting numbers being reported internationally. For example, if we are using large data sets in which we pool such numbers as ‘profits’, ‘sales’ or ‘total assets’ from organisations from different countries, then we need to understand that these numbers might not be as directly comparable as we might otherwise believe. Perhaps some form of notional adjustment is necessary before we consider particular variables (independent variables) that might be influencing, or driving, these accounting numbers.
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LO5.2
LO5.4
Explanations of differences in accounting
Will financial reporting standards developed in London by the IASB necessarily meet the information needs of financial report users in all countries? Does it make sense that a given suite of financial reporting standards will be equally applicable for a service company operating in South America as it would for a mining company operating in Australia or a manufacturing company in China? What do you, the reader, think? In this regard, Chand and White (2007, p. 606) make the following comment: Once the IFRSs are adopted by a particular country, both the multinational and domestic enterprises may be required to follow the standards. A suite of standards developed with the needs of international users of financial reports in mind, specifically those seeking international comparability, will not necessarily meet the needs of users in a particular jurisdiction. The IASB cannot take cognisance of the individual national, cultural and political factors of all its member nations while preparing IFRSs. Transporting IASB standards to developing countries – which have their own disparate group of external information users that operate within internationally diverse cultural, social, and political environments – should not be expected to have optimum results (Hopwood, 2000; Ngangan et al., 2005). Therefore, of critical importance is the fundamental question, who gains the most from harmonization/convergence?
Chand and White’s point is interesting and reflects some of earlier discussion within this chapter. Given that more than 100 countries have now adopted IFRS, is there any clear evidence that all countries have benefited from the adoption, or that the benefits are spread across different types or sizes of organisations within particular countries? Authors such as Perera (1989) have argued that accounting practices within particular countries have traditionally evolved to suit the circumstances of a particular society at a particular time. While there was a large variation in accounting systems used in different countries prior to 2005 (from 2005 many, but not all, countries adopted IFRS), it has been commonly accepted that there were two main models of financial accounting that had evolved within economically developed countries: the Anglo-American model and the continental European model (Mueller, 1967; Nobes, 1984).22 The Anglo-American model is characterised by a system of accounting that is strongly influenced by professional accounting bodies rather than government; it emphasises the importance of capital markets (the entities within the countries that use this model of accounting are typically very reliant on public sources of equity and debt finance), and relies on terms such as ‘true and fair’ or ‘presents fairly’, which in turn are based on considerations of economic substance over and above legal form (legal form being bound by legislation). The continental European model of accounting, on the other hand, typically is characterised by a relatively small input from the accounting profession, little reliance on qualitative requirements such as true and fair, and stronger reliance on government. The accounting methods tend to be heavily associated with the tax rules in place, and the information tends to be of a nature that protects the interest of creditors rather than investors per se. (The entities within countries that use the continental European model have historically tended to obtain most of their long-term funds from family sources, governments or lenders, often banks rather than through issuing shares to the public.) Over time, numerous reasons have been given for the differences in the accounting methods of different countries. Mueller (1968) suggests that such differences might have been caused 22
Anglo-American model An approach to accounting embraced within the United Kingdom and United States (and some other countries) where accounting practices are oriented towards meeting the general decision-making needs of large numbers of investors, lenders and creditors who are not directly involved in the management of the organisation.
Continental European model An approach to accounting where financial accounts are primarily prepared for an environment in which funding mainly comes from lenders and there are relatively low numbers of outside investors, and where financial reports are prepared primarily with taxation and other statutory requirements in mind rather than other qualitative requirements, such as truth and fairness.
For example, France, Italy, Spain and Germany are often presented as examples of the continental European group, while countries such as the United States, the United Kingdom, Ireland, the Netherlands, Canada, Australia and New Zealand are often presented as examples of the Anglo-American group.
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by differences in the underlying laws of the country, the political systems in place (for example, a capitalistic/free-market system versus a centralised/communistic system), or their level of development from an economic perspective. As Mueller (p. 95) explains: In society, accounting performs a service function. This function is put in jeopardy unless accounting remains, above all, practically useful. Thus, it must respond to the ever-changing needs of society and must reflect the social, political, legal and economic conditions within which it operates. Its meaningfulness depends on its ability to mirror these conditions.
Other factors such as tax systems, level of education and level of economic development have also been suggested as explanations for historical differences in accounting practices (Doupnik and Salter, 1995). At present there is no single clear theory that explains why, in the absence of efforts to standardise accounting, we would expect to find international differences in accounting practices. Many different causes have been suggested. Nobes (1998) reviewed the literature and confirmed that numerous reasons have been proposed to explain differences in financial reporting practices. These reasons are given in Figure 5.4. According to Nobes, many of the factors are interrelated. A number are deemed to be ‘institutional’, and a number relate to the broader notion of culture. The next sections look more closely at some of these factors. Again, it is emphasised that many differences in financial FIGURE 5.4 Possible reasons for differences in financial reporting practices
Invasions
Language
Geography Age and size of accountancy profession
Colonial inheritance
Nature of business ownership and financing system
Legal systems
Taxation
Inflation
Reasons for difference in financial reporting practices
Level of education
Culture Stage of economic development
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History
Influence of theory
Religion
Political systems, social climate
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accounting practices have been eliminated (but not all, as we have discussed earlier) due to many countries adopting IFRS. After reading the material, readers might question whether it is appropriate for such a diverse group of countries to adopt one set of accounting standards in a ‘one-size-fits-all’ approach.
Culture Culture is a broad concept that would be expected to impact on legal systems, tax systems, the way businesses are formed and financed, and so on. For many years culture has been used in the psychology, anthropology and sociology literatures as the basis for explaining differences in social systems (Hofstede, 1980). In recent decades, it has also been used to try to explain international differences in accounting systems. An early paper that considered the impact of culture on accounting was one by Violet (1983), who argued that accounting is a ‘socio-technical activity’ (which is consistent with what we noted previously – that accounting is both a technical and social practice) that involves interaction between both human and non-human resources. Because the two interact, Violet claims that accounting cannot be considered culture-free. Relating accounting to culture, Violet (p. 8) claims:
Culture The collective programming of the mind which distinguishes the members of one human group from another. According to Takatera and Yamamoto (1987) culture can be defined as ‘an expression of norms, values and customs which reflect typical behavioural characteristics’.
Accounting is a social institution established by most cultures to report and explain certain social phenomena occurring in economic transactions. As a social institution, accounting has integrated certain cultural customs and elements within the constraints of cultural postulates. Accounting cannot be isolated and analyzed as an independent component of a culture. It is, like mankind and other social institutions, a product of culture and contributes to the evolution of the culture which employs it. Since accounting is culturally determined, other cultural customs, beliefs, and institutions influence it.
Takatera and Yamamoto (1987) defined culture as ‘an expression of norms, values and customs which reflect typical behavioural characteristics’. Hofstede (1980, p. 25) has defined culture as ‘the collective programming of the mind which distinguishes the members of one human group from another’. It describes a system of societal or collectively held values (Gray, 1988, p. 4) rather than values held at an individual level. ‘Values’ are deemed to determine behaviour. Gray (p. 4) explains that the term ‘culture’ is typically reserved for societies as a whole, or nations, whereas ‘subculture’ is used for the level of an organisation, profession (such as the accounting profession) or family. It is expected that different subcultures within a particular society will share common characteristics. In the discussion that follows, the work of Professor Sid Gray is explored in some depth. This work is generally acknowledged as constituting some of the most rigorous research into accounting’s relationship to, and to some extent dependence on, national culture. Gray (1988, p. 5) argues that ‘a methodological framework incorporating culture may be used to explain and predict international differences in accounting systems and patterns of accounting development internationally’. Any consideration of culture necessarily requires difficult choices as to the aspects of culture that are important to the issue under consideration, and, in turn, how one goes about measuring the relevant cultural attributes. As Perera (1989, p. 43) states, ‘the study of culture is characterized by a unique problem arising from the inexhaustible nature of its components’.23 Accounting researchers who have examined the possible impact of culture on the financial accounting practices in different countries have tended to draw on the work of Hofstede (1980, 1983) and Hofstede et al. (2010) to understand differences in national cultures. Gray (1988, p. 5) explains: 23
Perera (1989, p. 43) further states that ‘it is essential, therefore, that in analysing the impact of culture upon the behaviour of the members of any particular subculture, a researcher must select the cultural components or dimensions most pertinent to the particular facet of cultural behaviour being studied’. This is clearly not a straightforward task.
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Hofstede’s (1980, 1983) research was aimed at detecting the structural elements of culture and particularly those which most strongly affect known behaviour in work situations in organizations and institutions. In what is probably one of the most extensive cross-cultural studies ever conducted, psychologists collected data about ‘values’ from the employees of a multinational corporation located in more than fifty countries. Subsequent statistical analysis and reasoning revealed four underlying societal value dimensions along which countries could be positioned. These dimensions, with substantial support from prior work in the field, were labelled Individualism, Power Distance, Uncertainty Avoidance, and Masculinity. Such dimensions were perceived to represent a common structure in cultural systems. It was also shown how countries could be grouped into culture areas, on the basis of their scores on the four dimensions.24
Gray argues that the value systems of accountants in each country will be derived from and related to the societal values of that country (which are reflected by Hofstede’s initial cultural dimensions of Individualism, Power Distance, Uncertainty Avoidance and Masculinity, to which Hofstede later added a fifth dimension of Long-Term Orientation).25 These social values that are also held by accountants (which Gray terms the ‘accounting subculture’) will in turn, it is believed, impact on the development of the respective accounting systems at the national level. Therefore, at this point we can perhaps start to question whether accounting systems should be developed in a ‘one-size-fits-all’ perspective – the approach that the IASB has adopted. However, while it is argued that there should be some association between various value systems and accounting systems, many events would typically have occurred over time that confound this possible relationship. For example, in relation to developing countries, Baydoun and Willett (1995, p. 72) state: It is quite possible that had accounting systems evolved independently in developing countries they would have a rather different form from any we now witness in present day Europe. However, most accounting systems used in developing countries have been directly imported from the West through a variety of channels: by colonialism in the past; and through Western multinational companies, the influence of local professional associations (usually founded originally by Western counterpart organizations) and aid and loan agencies from the industrialised countries.
Furthermore, as with any theoretical perspectives in social sciences, we need to bear in mind that Hofstede’s propositions regarding the presence, nature and influence of ‘cultural dimensions’ are themselves open to challenge. For example, McSweeney, who is one of the most high-profile and influential critics of Hofstede’s findings (see, for example, McSweeney 2002a, 2002b, 2009a, 2009b), has argued that the ‘national cultural model’ proposed by Hofstede was developed using flawed research methods and questionable assumptions. In one paper, McSweeney (2009a, p. 934) posed the question: In the face of extensive empirical data of variations within countries across social and geographical contexts and also across time, how does the national culturalist literature continue to rely on spatial reductionism: on the ‘fallacious assumption of cultural homogeneity within nations’ (Tung, 2007: 41)?
Hofstede’s work is based on international surveys conducted within IBM. The attitude surveys were conducted between 1967 and 1973 and resulted in 117 000 responses from 88 000 employees in 61 countries (Baskerville, 2003). Hofstede was the senior researcher in charge of the survey. 25 Hofstede’s theory, while being applied to accounting issues, is from the cross-cultural psychology literature and was of itself not directly concerned with accounting. 24
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McSweeney (2009a, p. 934) proceeded to provide, in great depth, the following reasons in response to the above question: It does so by making the following problematic moves. I: By denying agency. This is achieved by assuming that national culture is: (a) coherent; (b) stable; (c) pure; (d) by excluding any independent role of other cultural influences; and (e) excluding any independent role of non-cultural influences. II: By unwarranted depictions. This is done by: (a) conflating nation and state; (b) making unwarranted generalizations from singular instances and/or treating unrepresentative averages as nationally representative; and (c) confusing statistical averages with causal forces. And, III: By ignoring prior and pertinent intellectual developments elsewhere, it fails to engage with the peripheralization in anthropology and cultural geography (and in other disciplines) of the assumptions of national and other spatial cultural uniformity.
Specifically from the perspective of accounting research, Baskerville (2003) raises similar concerns about the validity and reliability of Hofstede’s national cultural dimensions. In his study, Baskerville identifies and explores a number of theoretical and methodological issues in prior studies that, he concludes, have been problematic in developing reliable insights in the role of national cultures, including (p. 1): (i) the assumption of equating nation with culture (ii) the difficulties of, and limitations on, a quantification of culture represented by cultural dimensions and matrices; and (iii) the status of the observer outside the culture.
Despite these issues, McSweeney (2009a) notes that the ‘national cultural model’ continued to be used in many areas of organisational studies (and we might include accounting as one such discipline). He comments that the national cultural model (associated most commonly with Hofstede, but augmented by many other researchers) was, in the past, also used by researchers within several different social science disciplines. However, he highlights that in many of these disciplines, this model’s explanations of the development, presence and influence of national cultural differences have now been largely found to lack credibility. McSweeney (2009a, p. 949) argues that the persistence of the national cultural model in organisation studies research, despite it being discredited in other disciplines, seems to be due to many researchers in sub-disciplines within organisation studies (such as accounting) being unwilling to engage with critiques of the model, and thus ignoring clear flaws in the model:26 Within organization studies, a knowledge community has been built around the model. It [the national cultural model] has achieved a scholarly identity, being employed in papers across a wide range of peer-reviewed journals. The consensus on fundamentals within the community and the embeddedness it has achieved within areas of organization studies have created defences against the impact of critiques. It is rare for users of the model to acknowledge critiques – far less to engage with them. Two characteristics of organization studies which enable the advocates of the model to avoid engagement with critique are described here. First, disregard is facilitated by the fragmentation of organization studies into many relatively autonomous communities with a high degree of internal consensus and self-referentiality (March, 2004, Whitley, 2000). The balkanization of organization studies is arguably greater than in many other disciplines (Pfeffer, 1993) and is certainly far in excess of the 26
As we have emphasised throughout this book, just about all research can, and should be, open to critical analysis. Knowledge develops as a result of different people challenging accepted ideas and research, and proposing their own ideas which in turn will be subject to critical review.
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degree of separateness which existed in anthropology at the time of the model’s demise in that discipline. Secondly, while it is, of course, not possible to examine a situation uninfluenced by categories, theories and hunches, a tendency to build one-sided stories has been a powerful factor. Such bias is a deleterious tendency to search for or interpret new information in a way that confirms one’s preconceptions and avoid information and interpretations which contradict them (Nickerson, 1998). It is widely tolerated in organization studies (Miles and Michael, 1984). Within the national cultural community this bias includes a tendency not to consider alternative explanations and a widespread readiness to cite, or to generally refer to, studies which support the model but neglect contradictory studies.
Consistent with these observations from McSweeney, researchers who have drawn on and applied Hofstede’s propositions about national cultures as part of their research into international differences in financial accounting have tended to do so largely uncritically. Specifically, from an accounting perspective, Baskerville (2003, p. 11) raises similar concerns to some of those raised by McSweeney, and urges greater criticality by accounting researchers: Such problems have ramifications for the utilization of Hofstede’s cultural indices, and implications for cross-cultural accounting research which should not be ignored. The use of Hofstede’s indices of cultural dimensions appeared to give cross-cultural studies in accounting stature and scientific legitimacy, and respectability within accounting research. Those researchers who utilize these dimensions successfully should be prepared to include in their application of the cultural indices a consideration of how their research addressed the problems of the concept of nations versus cultures, and the problems inherent in the universalist approach as debated earlier last century during the formative years in anthropology.
Despite various criticisms, Hofstede’s propositions have been influential in developing comparative international accounting research. We will now explain key aspects of the theories in this area. But when reading about and considering these theories, you should bear in mind the criticisms we have just outlined of some of the assumptions underlying these theories. Again, please always remember that theories are ‘lenses’ through which to make sense of the world and, in doing so, theories should not be expected to provide perfect, or complete, explanations. Financial accounting theories in this area have principally used the initial four societal value dimensions identified by Hofstede. These can be summarised as follows (quoted from Hofstede, 1984): • Individualism versus collectivism Individualism stands for a preference for a loosely knit social framework in society wherein individuals are supposed to take care of themselves and their immediate families only. Its opposite, Collectivism, stands for a preference for a tightly knit social framework in which individuals can expect their relatives, clan, or other in-group to look after them in exchange for unquestioning loyalty (it will be clear that the word ‘collectivism’ is not used here to describe any particular social system). The fundamental issue addressed by this dimension is the degree of interdependence a society maintains among individuals. It relates to people’s self concept: ‘I’ or ‘we’. (p. 83)
With regard to the cultural dimension of individualism versus collectivism, it is interesting to note that a great deal of economic theory is based on the notion of self-interest and the rational economic person (one who undertakes action to maximise personal wealth at the expense of others). This is very much based in the individualism dimension. In a culture that exhibited
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collectivism, it is expected that members of the society would look after each other and issues of loyalty would exist.27 • Large versus small power distance Power Distance is the extent to which the members of a society accept that power in institutions and organisations is distributed unequally. This affects the behaviour of the less powerful as well as of the more powerful members of society. People in Large Power Distance societies accept a hierarchical order in which everybody has a place, which needs no further justification. People in Small Power Distance societies strive for power equalisation and demand justification for power inequities. The fundamental issue addressed by this dimension is how a society handles inequalities among people when they occur. This has obvious consequences for the way people build their institutions and organisations. (p. 83)
• Strong versus weak uncertainty avoidance Uncertainty Avoidance is the degree to which the members of a society feel uncomfortable with uncertainty and ambiguity. This feeling leads them to beliefs promising certainty and to sustaining institutions protecting conformity. Strong Uncertainly Avoidance societies maintain rigid codes of belief and behaviour and are intolerant towards deviant persons and ideas. Weak Uncertainty Avoidance societies maintain a more relaxed atmosphere in which practice counts more than principles and deviance is more easily tolerated. The fundamental issue addressed by this dimension is how a society reacts to the fact that time only runs one way and that the future is unknown: whether it tries to control the future or to let it happen. Like Power Distance, Uncertainty Avoidance has consequences for the way people build their institutions and organisations. (p. 83)
• Masculinity versus femininity Masculinity stands for a preference in society for achievement, heroism, assertiveness, and material success. Its opposite, Femininity, stands for a preference for relationships, modesty, caring for the weak, and the quality of life. The fundamental issue addressed by this dimension is the way in which a society allocates social (as opposed to biological) roles to the sexes. (p. 84)
Again, when countries are given scores on the four value dimensions, a number of countries can be clustered together, reflecting that they have similar cultural values.28,29 Having considered Hofstede’s value dimensions, the next step for Gray was to relate them to the values that he perceived to be in place within the accounting subculture. Gray developed four
Positive Accounting Theory, a theory developed by Watts and Zimmerman (and which is discussed in depth in Chapter 8), attempts to explain and predict managers’ selection of accounting methods. In developing their theory, Watts and Zimmerman assume that individuals will always act in their own self-interest. Such an assumption would be invalid in a community that embraces a collectivist perspective. In a similar vein, Hamid, Craig and Clarke (1993) suggest that finance theories developed in Western cultures will not apply in Islamic cultures. According to these authors, the Islamic principles do not allow the payment of interest. They argue (p. 146) therefore that ‘much of Western finance theory, in particular the capital asset pricing model, which draws upon interest-dependent explanations of risk, cannot be part of the (Islamic) accounting and finance package’. 28 For example, of the many groups, one group with similar scores on each of the four societal values comprises Australia, Canada, Ireland, New Zealand, the United Kingdom and the United States. Another group is Denmark, Finland, the Netherlands, Norway and Sweden, while another group comprises Indonesia, Pakistan, Taiwan and Thailand. The view is that people within these various groupings of countries share a similar culture and therefore share similar norms and value systems. 29 As we know, a number of authors have been critical of Hofstede’s work. One particular criticism is that Hofstede equated nations with cultures (that is, each nation was deemed to be one culture), when in fact numerous cultures can exist within a particular country (Baskerville, 2003). 27
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accounting values that were deemed to relate to the accounting subculture, with the intention that the accounting values would then be directly linked to Hofstede’s four societal values (discussed above). Gray’s four accounting values (1988, p. 8) were defined as shown in Figure 5.5. Gray (1988, pp. 9–11) then developed a number of hypotheses relating Hofstede’s four societal cultural dimensions to each one of his four accounting values.30 His first hypothesis was: FIGURE 5.5 Gray’s four accounting values
Professionalism versus statutory control A preference for the existence of individual professional judgement and the maintenance of professional self-regulation, as opposed to compliance with prescriptive legal requirements and statutory control.
Secrecy versus transparency A preference for confidentiality and the restriction of disclosure of information about the business only to those who are closely involved with its management and financing, as opposed to a more transparent, open and publicly accountable approach.
Uniformity versus flexibility A preference for the enforcement of uniform accounting practices between companies and the consistent use of such practices over time, as opposed to flexibility in accordance with the perceived circumstances of individual companies.
Conservatism versus optimism A preference for a cautious approach to measurement so as to cope with the uncertainty of future events, as opposed to a more optimistic, laissez-faire, risk-taking approach.
Source: Based on Gray, S. J. (1988), ‘Towards a theory of cultural influence on the development of accounting systems internationally’, ABACUS, 24(1), pp. 1–15, p. 5.
30
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Although Gray (1988) developed four hypotheses, he did not test them empirically. To test them, as others have subsequently done, one must determine whether an accounting subculture scores high or low in a particular country on the four dimensions developed by Gray.
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H1: The higher a country ranks in terms of individualism and the lower it ranks in terms of uncertainty avoidance and power distance, then the more likely it is to rank highly in terms of professionalism.
The basis for the first hypothesis was that a preference for applying judgement (for example, determining whether something is ‘true and fair’) rather than strict rules is more likely where people tend to be individualistic, where people are relatively more comfortable with people using their own judgement, rather than conforming to rigid codes of rules, and where different people are allowed to make judgements rather than relying on strict rules ‘from above’ (lower power distance). Gray’s second hypothesis was: H2: The higher a country ranks in terms of Uncertainty Avoidance and Power Distance and the lower it ranks in terms of Individualism, then the more likely it is to rank highly in terms of Uniformity. (emphasis added)
The basis for the second hypothesis is that communities that prefer to avoid uncertainty prefer more rigid codes of behaviour and greater conformity. A desire for uniformity is also deemed to be consistent with a preference for Collectivism (as opposed to Individualism) and an acceptance of a relatively more Power Distance society in which laws are more likely to be accepted. Gray’s third hypothesis was: H3: The higher a country ranks in terms of Uncertainty Avoidance and the lower it ranks in terms of Individualism and Masculinity, then the more likely it is to rank highly in terms of Conservatism. (emphasis added)
Individualism Stands for a preference for a loosely knit social framework in society wherein individuals are supposed to take care of themselves and their immediate families only.
Uncertainty avoidance The degree to which the members of a society feel uncomfortable with uncertainty and ambiguity.
Power distance The extent to which the members of a society accept that power in institutions and organisations is distributed unequally.
Professionalism A preference for professional judgement and self-regulation as opposed to compliance with legal requirements enforced through statutory control.
As noted previously, Conservatism implies that accountants favour notions such as prudence (which traditionally means that profits and assets are calculated in a conservative manner with a tendency towards understatement rather than overstatement). The basis for the third hypothesis is that communities that have strong Uncertainty Avoidance characteristics tend to prefer a more cautious approach to cope with existing uncertainties. On the other hand, Conservatism is expected to be associated with communities that care less about individual achievement. Communities that tend to demonstrate masculine tendencies emphasise achievement – hence the expectation that lower levels of Masculinity will lead to higher preferences for conservative accounting principles. A more highly masculine community would be deemed to prefer to use methods of accounting that lead to higher levels of performance being reported. Gray’s fourth hypothesis was: H4: The higher a country ranks in terms of Uncertainty Avoidance and Power Distance and the lower it ranks in terms of Individualism and Masculinity, then the more likely it is to rank highly in terms of Secrecy. (emphasis added)
The basis for the fourth hypothesis is that communities that have a higher preference for Uncertainty Avoidance prefer not to disclose too much information because this could lead to conflict, competition and security problems. Also, communities that accept higher Power Distance would accept restricted information, as this acts to preserve power inequalities. Also, a community that prefers a collective approach, as opposed to an individualistic approach, would prefer to keep information disclosures to a minimum to protect those close to the organisation and to reflect limited concern for those external to the organisation. A more Masculine community would be expected to provide more information about its financial position and performance to enable comparisons of the level of performance of different entities. (Masculine communities would be deemed to be more concerned with issues such as ranking the performance of one entity against another.) However, as a caveat to the general position that more Masculine communities disclose more accounting information, Gray (1988, p. 11) argues that 195
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a significant but less important link with Masculinity also seems likely to the extent that more caring societies, where more emphasis is given to the quality of life, people and the environment, will tend to be more open, especially as regards socially related information.31 Table 5.1 summarises the hypothesised relationships between Gray’s accounting values and
Hofstede’s cultural values. TABLE 5.1 Summary of the hypothesised relationships between Gray’s accounting values and Hofstede’s cultural values Cultural values (from Hofstede)
Accounting values (from Gray) Professionalism
Uniformity
Conservatism
Secrecy
Power Distance
-
+
?
+
Uncertainty Avoidance
-
+
+
+
Individualism
+
-
-
-
Masculinity
?
?
-
-
Note: ‘+’ indicates a positive relationship; ‘–’ indicates a negative relationship; and ‘?’ indicates that the direction of the relationship is unclear.
Gray (1988) further hypothesised that relationships can be established between accounting values and the authority and enforcement of accounting systems (the extent to which they are determined and enforced by statutory control or professional means), and the measurement and disclosure characteristics of the accounting systems. According to Gray (p. 12): Accounting value systems most relevant to the professional or statutory authority for accounting systems and their enforcement would seem to be the professionalism and uniformity dimensions, in that they are concerned with regulation and the extent of enforcement and conformity ... Accounting values most relevant to the measurement practices used and the extent of information disclosed are self-evidently the conservatism and the secrecy dimensions.
Gray’s linkage between societal values, accounting values and accounting practice are summarised in Figure 5.6. Perera (1989, p. 47) provides additional discussion in respect of the relationships summarised in Figure 5.6. He states: The higher the degree of professionalism the greater the degree of professional self-regulation and the lower the need for government intervention. The degree of uniformity preferred in an accounting sub-culture would have an effect on the manner in which the accounting system is applied. The higher the degree of uniformity the lower the extent of professional judgment and the stronger the force applying accounting rules and procedures. The amount of conservatism preferred in an accounting subculture would influence the measurement practices used. The higher the degree of conservatism the stronger the ties with traditional measurement practices. The degree of secrecy preferred in an accounting sub-culture would influence the extent of the information disclosed in accounting reports. The higher the degree of secrecy, the lower the extent of disclosure. 31
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Socially related information would relate to such issues as health and safety, employee education and training, charitable donations, efforts to eliminate modern slavery, support of community projects and environmental performance. A more Feminine (less Masculine) society would tend to consider these issues to be more important. Hence, while Femininity might be associated with less financial disclosure, it is assumed to be associated with greater social and environmental disclosure and the demonstration of greater social and environmental accountability.
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FIGURE 5.6 Gray’s hypothesised relationships between society values, accounting values and accounting practice Society values
Uncertainty avoidance Individualism Power distance Masculinity
Accounting values
Accounting practice
Professionalism Uniformity
Authority and enforcement
Conservatism Secrecy
Measurement and disclosure
Source: Based on H. H. E. Fechner & A. Kilgore (1994), ‘The influence of cultural factors on accounting practice’, International Journal of Accounting, 29, p. 269.
One objective of Gray’s research was to explain how differences between countries in respect of their culture may either impede any moves towards international harmonisation of accounting standards or bring into question efforts to generate some form of harmonisation or standardisation. While some of the above material might appear a little confusing (perhaps not), it does represent quite an intellectual body of research, which is attempting to relate a fairly difficult-to-measure construct, culture, to differences in values of the accounting subculture, and ultimately differences in the systems of accounting employed. While we might not be able to remember all the hypothesised relationships described, what is important is that we appreciate how researchers have attempted to link cultural measures to accounting practice. Such research is particularly relevant to standard-setters such as the IASB. A number of other authors have also used Hofstede’s cultural dimensions.32 Zarzeski (1996) provides evidence that supports a view that entities located in countries classified as relatively more Individualistic and Masculine and relatively less in terms of Uncertainty Avoidance provide greater levels of disclosure. Zarzeski also considered issues associated with international profile and found that those entities with a relatively higher international profile tend to be less secretive than other entities. Further, entities from continental European countries, such as France and Germany, which have historically tended to rely more heavily on debt financing than, say, Anglo-American companies, have lower levels of disclosure than Anglo-American companies. In relation to the issue of secrecy, Zarzeski shows that local enterprises are more likely to disclose information commensurate with the secrecy of their culture than are international enterprises. In explaining this, she states (p. 20): The global market is just a different ‘culture’ than the one the firm faces at home. When a firm does business in the global market, it is operating in a different ‘culture’ and therefore may need to have different ‘practices’. Higher levels of financial disclosures may be necessary for international survival because disclosure of quality operations 32
Baydoun and Willett (1995, p. 72) identify a number of problems in testing the Hofstede–Gray theory. They emphasise that many accounting systems are imported from other countries with possibly different cultures. As they state: ‘Due to the interference in what would otherwise have been the natural evolution of financial information requirements there are no uncontaminated examples of modern accounting practices in developing countries. Consequently, great care has to be taken in using data from developing countries to draw inferences about relevance on the basis of the Hofstede–Gray framework.’
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should result in lower resource costs. When enterprises from more secretive countries perceive economic gain from increasing their financial disclosures, cultural borrowing may occur. The culture being borrowed will be a ‘global market culture,’ rather than a specific country culture.
Perera (1989) considered both Hofstede’s cultural dimensions and Gray’s accounting subcultural value dimensions and used them to explain historical differences in the accounting practices adopted in continental European countries and Anglo-American countries. According to Perera (p. 51), many countries in continental Europe are characterised by relatively high levels of uncertainty avoidance, where rules or ‘social codes’ tend to shape behaviour, while the opposite applies in Anglo-American countries: The presence of these rules satisfied people’s emotional needs for order and predictability in society, and people feel uncomfortable in situations where there are no rules. Therefore, in general, one can expect more formalization and institutionalization of procedures in strong uncertainty avoidance societies than in weak uncertainty avoidance countries. There is a preference for the existence of individual professional judgement, the maintenance of professional self-regulation, and flexibility in accordance with the perceived circumstances of individual companies in the accounting sub-culture of Anglo-American countries, whereas there is a preference for compliance with prescriptive legal requirements and statutory control, the maintenance of uniform accounting practices between companies, and the consistent application of such practices over time in the accounting sub-cultures of Continental Europe. Also, there is more support in the latter group for a prudent and cautious approach to income measurement to cope with the uncertainty of future events and the confidentiality of the information by restricting disclosures to only those involved with the management and financing of the organization. These characteristics, in turn, tend to influence the degree of disclosure expected in the respective accounting systems or practices. For example, in France and West Germany, where the level of professionalism is relatively low and the preference for conservatism and secrecy is relatively high, the combined effect on the degree of disclosure will be negative. On the other hand, the collectivist or anti-individualist values of the society require business enterprises to be accountable to society by way of providing information. Therefore, it becomes necessary for the Government to intervene and prescribe certain disclosure requirements, including those in regard to social accounting. Furthermore, this situation is not likely to be rejected by the accounting profession, because there is a preference for compliance with prescriptive legal regulation and statutory control in the accounting sub-culture. By comparison, in the United States and U.K., although the relatively high level of professionalism and low level of preference for conservatism and secrecy tend to have a positive combined effect on the degree of disclosure in accounting practices, the individualistic values of the society are more concerned with the provision of information to shareholders or investors than those issues involving accountability to society at large.
Baydoun and Willett (1995) used the Hofstede–Gray theory to investigate the use of the French United Accounting System (which was ranked lowly in terms of Professionalism and highly in terms of Uniformity as well as being considered quite conservative) in Lebanon. According to Baydoun and Willett, following World War I the Allied Supreme Council granted France a mandatory authority over Lebanon. Lebanon was a French colony until 1943 and French troops remained there until 1946. Strong trading relations between France and Lebanon 198
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continued to exist and in 1983 the French Government sponsored the transfer of the French Uniform Accounting System (UAS) to Lebanon. What was of interest was whether the French system was actually suited to the Lebanese cultural environment. Baydoun and Willett provided evidence to suggest that Lebanon and France ranked in a relatively similar manner in terms of Power Distance and Individualism. However, Lebanon was considered to rank lower in terms of Uncertainty Avoidance and higher in terms of Masculinity. On this basis (refer back to Table 5.1), Baydoun and Willett (p. 81) conclude that ‘it would appear that Lebanon’s requirements are for less Uniformity, Conservatism and Secrecy in financial reporting practices’.33 They further state (p. 87): Assuming that cultural relevance is or should be a factor in determining the form of financial statements, we would expect Lebanese financial statements to be less uniform across time and between entities, to contain more market value information and provide more items of disaggregated information. Normal publication dates should be relatively flexible and there should be less call for conservative valuation rules such as lower of cost and market. It would appear that these and other similar prescriptions cannot be tested directly at present. Since 1983 all Lebanese firms have been required to follow UAS and this system has not yet been modified to accommodate any cultural differences between France and Lebanon ... However, our analysis suggests that modifications along the lines described above either will or should take place in Lebanese accounting in the future.
Chand and White (2007) explored various cultural attributes within Fijian society to determine whether the adoption of IFRS within the Fijian context made sense. Their view was that rules-based standards would be more appropriate than the principles-based standards that have been developed by the IASB. As they state (p. 616): Fiji is a society that is dominated by two ethnic groups – indigenous Fijians and IndoFijians. Both groups exhibit cultural characteristics of uncertainty avoidance and a preference for a society that adheres to rules as opposed to one that expects the individual to act appropriately by personal initiative and professional judgment (see Chand, 2005). Fijian society is also characterized by the presence of a strong power distance between leaders in all capacities and their constituents. A number of entities have been established in Fiji with a stated remit to foster the indigenous population’s participation in the economy. Educated and articulate principals who have the temerity to question financial reports are typically reminded that Fijian society does not tolerate such challenges. The adoption of IFRSs leads to principles-based financial reports that require the exercise of professional judgment and introduces ambiguity in the reporting process, thus clouding rather than enhancing accountability (Davie, 1999, 2000). Managers of such entities drawn from the Fijian elite caste, as many are, who are beyond the challenge by non-elites, may ‘request’ the accountant to exercise judgment in such a way that the entity reports a stronger financial position than economic reality. Cultural values would require a Fijian accountant to accede to the ‘request’. Rulebased standards would protect the accountant from such ‘requests’. In Fiji, rule-based standards may reduce the potential relevance of financial reports, but should improve their transparency and the confidence that principals will place in them. 33
In undertaking their work, Baydoun and Willett were, in a number of respects, critical of Gray’s work. For example, they state (p. 82) that ‘all of Gray’s accounting values are defined in terms of preferences for particular courses of action, rather than in terms of apparent attributes of financial statements, such as the qualitative characteristics described in the FASB’s conceptual framework project’. Also they state that Gray’s theory does not clearly indicate what forms of financial statements might be preferred.
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Apart from using culture to explain differences in published financial reports, researchers have also applied culture to explain differences in how managers verbally communicate information about financial results (that is, how culture impacts the provision of a verbal ‘account’). Brochet, Miller, Naranjo and Yu (2019) used managers’ cultural background (based upon their ethnic background and using insights from Hofstede) to explain differences in how corporate executives communicate with capital market participants through the media of ‘earnings conference calls’, which is a conference (meeting) between the management of large organisations and stakeholders, such as analysts, investors and the news media, in which managers discuss the organisation’s financial results for a given financial period. The conference call usually follows the release of a report detailing the financial earnings of an organisation. Brochet et al. (2019, p. 58) state: We hypothesize that managers from cultures that are more individualistic disclose information in a more optimistic and self-referencing manner. The prediction is based on psychology literature findings that in independent cultures (typically Western) there is greater emphasis on influencing individuals through displays of optimism and selfconfidence. Consequently, studies find that people from individualistic cultures have a greater impulse to maximize positive and minimize negative affect than do those from collective cultures. In addition, self-attribution is more prevalent in cultures where independence is highly valued.
In relation to their results, Brochet et al. (2019, p. 79) report: Managers from a more individualistic background use a more positive tone and more singular first-person pronouns relative to managers from a collectivist background. The results are specific to the Question & Answer portion of the conference calls, where individual managers’ cultural roots are more likely to have an effect.
Religion A great deal of the culture-based research, particularly that based on the work of Hofstede and Gray, tends to lead to countries being grouped together in terms of both community and accounting subculture; this is perceived as providing insights into the appropriateness of the harmonisation/standardisation process and, particularly, in identifying limits therein. That is, a feature of the work of Gray is that it relies on indigenous characteristics which are confined within the boundaries of the countries under review. In subsequent work, Hamid, Craig and Clarke (1993) considered the influence of one cultural input or factor, religion, on accounting practices. As they indicate, religion transcends national boundaries. They looked at how Islamic cultures, which exist in numerous countries, had typically failed to embrace ‘Western’ accounting practices, and they reflected on how issues of religion had previously occupied minimal space in the accounting literature. They state (p. 134): The existing literature dealing with the interaction of business activity and Islam needs extending to capture the particular effects which compliance with Islamic beliefs have on the structure of business and finance within an Islamic framework. In particular, the incompatibility of many Western accounting practices with Islamic principles requires explanation. For jurisprudential Islamic law influences the conduct of businesses in a manner not accommodated automatically by Anglo-American accounting practice. And many Western accounting practices draw upon assumptions which conflict with the tenets of Islam ... There seems to be little understanding that, unlike the Western tradition, fundamental business ethics flow automatically from the practices of the religion, rather than from the codes (mainly of etiquette) devised and imposed upon members by professional associations. 200
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Hamid, Craig and Clarke point out that the Islamic tradition does have notions of stewardship, but to God rather than to suppliers of equity or debt capital. That is, Muslims are characterised as believing that they hold assets not for themselves but in trust for God. There are also other fundamental differences – for example, Islam precludes debt financing and prohibits the payment of interest, and this prohibition has significant implications for processes aimed at the international harmonisation of accounting standards, particularly: ... in-so-far as harmonisation is perceived necessary to entail implementation of many standard Western accounting procedures in which interest calculations are integral. Many past and present Western standards entail discounting procedures involving a time value of money concept, which is not admitted by Islam. (p. 144)34
Hence, Hamid, Craig and Clarke appear to provide a logical argument that religion can have a major impact on the accounting system chosen. Religion can potentially affect how people do business and how they make decisions. As is discussed in Chapter 7, the conceptual framework projects developed in countries such as the United States, Australia, Canada, the United Kingdom and New Zealand (which, interestingly, have all been grouped together by Hofstede), and by the IASB’s predecessor (the International Accounting Standards Committee, or IASC), are based on the underlying objective that financial report users require financial information as the basis for making rational economic decisions (and what is ‘rational’ may be culturally dependent). Such rational economic decisions also take into account the time value of money, which necessarily requires considerations of appropriate interest or discount rates. In some societies, such as Islamic states, this may not be a relevant objective. Further, any claims that particular frameworks of accounting are superior to others should only be made after considering the environments in which the frameworks are to be used. Having examined several theoretical perspectives that seek to explain international accounting differences in terms of broad cultural (including religious) influences, we now move on to explore five of the more concrete institutional factors that some theorists believe influence the shape of accounting practices in any nation at any point in time. As you will appreciate when reading the following sections, these institutional factors are interrelated, and they can be linked to the broader cultural influences just examined. A useful exercise to help develop your understanding of both the cultural factors and the institutional factors is for you to attempt, while reading the following sections, to associate (in a broad way) the institutional factors with cultural influences.
Legal systems The legal systems operating in different countries can be divided into two broad categories: common law and Roman law systems. In common law systems, there have historically been relatively fewer prescriptive statutory laws. Instead, the body of law has been developed by judges applying both the limited amount of statutory law and the outcomes of previous judicial decisions to the facts of a specific case. Each judgement then becomes a legal precedent for future cases. Common law originated in England and spread to its former colonies (such as the United States, Canada, Australia and New Zealand). Conversely, in Roman law systems, parliamentary (statutory) law tends to be very detailed and covers most aspects of daily life. The implication of this for accounting is that in common law countries we would expect to find relatively few detailed accounting laws guiding accounting practices, and therefore historically the development of accounting practices would have been left much more to the professional judgement of accountants (and auditors). With Roman law systems, by contrast, we would expect to find a body of codified accounting laws prescribing in
34
Common law system A system where law is made by judges, based upon precedent, where legal judgements on current cases are made by reference to judgements made by judges on past cases of a similar nature.
Roman law A term used to refer to a system of law where detailed laws are developed to apply to potentially all crimes and aspects of daily lives, and where little emphasis is to be placed on professional judgement.
For example, notions of discounting are found in ‘Western’ accounting standards dealing with employee benefits, lease capitalisation, non-current provisions, impairment of assets and general insurers.
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detail how each type of transaction or event should be treated in the accounts. In this type of system there was therefore much less need or scope for the use of professional judgement in preparing accounts or developing accounting practices. As Nobes and Parker (2010) explain, the common law system was developed in England after the Norman Conquest of 1066, whereas the Roman law system was developed in continental European countries and spread to the former colonies of Belgium, France, Germany, Italy, Portugal and Spain. Countries where the development of legal systems and practices were heavily influenced by England tend to have common law systems. Conversely, most continental European countries, along with countries whose legal systems were developed under the influence of these countries, tend to have Roman law systems. Such countries include most members of the EU (other than England, Wales and Ireland) and many countries in other parts of the world that were former colonies of continental European nations.35 Therefore, we would expect England, Wales, Ireland and (partially) Scotland historically to have had relatively few codified accounting laws, with the development of financial accounting practices being left to the professional judgement of accountants. In the EU, we would expect accounting practice to have historically been developed through detailed codified accounting laws (or legally recognised regulations) with relatively little input from professional accountants. The adoption of IFRS, which are often considered to be principles based, would have represented a significant change in practice for countries with Roman law systems relative to countries with common law systems.
Business ownership and financing systems A second key institutional factor that researchers have demonstrated has historically had an impact on the shape of a nation’s accounting practices is the business ownership and financing system. Similarly to legal systems, this factor can be broadly divided into two distinct types – ‘outsider’ systems and ‘insider’ systems. In ‘outsider’ systems, external shareholders (that is, those who are not involved in the management of the company) are a significant source of finance for much business activity. As these external shareholders will not be involved in the detailed management of the company, and will therefore not have access to the company’s detailed management accounting information, they will need to be provided with separate financial accounting information to help them make their investment decisions. They may invest in the shares of a number of companies, and they need a basis on which to evaluate the performance of any company – for example, by comparing it to the performance of other companies. To help ensure an effective and efficient allocation of finance to different companies in this type of outsider-financed system, it is important for external investors (and potential investors) to be provided with financial accounting information that reflects the underlying economic performance of a business in a fair, balanced and unbiased manner. Thus, given the significance of outsider finance, financial accounting will have historically developed with a primary aim of providing this fair, balanced and unbiased information to external shareholders – a process that requires rather extensive use of professional judgement (Nobes, 1998), for example to handle regular developments or innovations in business practices that cannot easily be foreseen when writing accounting codes or legislation. Conversely, in ‘insider’ systems of finance, provision of finance by external shareholders is much less significant. Instead, there has been a dominance of family-owned businesses, and/or the dominant providers of long-term finance have historically been either banks or governments (Zysman, 1983). With family-owned businesses, the owners will tend to have access to the detailed internal management accounting information of the business, so
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Nobes and Parker (2004) point out that a very small number of countries (such as Scotland, South Africa and Israel) have developed legal systems that incorporate aspects of both common law and Roman law.
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there is no obvious need for financial statements to provide information to aid investment decision making by shareholders. In some countries (such as Germany) where banks have historically been the dominant source of long-term finance for large companies (rather than external shareholders), banks and companies have tended to develop long-term supportive relationships. These involve banks having a representative on the supervisory board of companies to whom they are major lenders, and these representatives are provided with the detailed management accounting information available to all members of the supervisory board. In the case of family-owned businesses, given that the predominant providers of finance are effectively ‘insiders’ to the business and have access to detailed management information, there will have been little pressure for financial accounting to have developed to provide information to aid external investment decisions (Nobes, 1998).36 The relationships between differences in sources of finance and how that flows on to the differences in financial accounting has also been explained by Lantto and Sahlstrom (2009), who state: Prior literature shows that in code-law countries, such as continental European countries, capital provided by the state, banks or families tends to be more important than in common law countries, such as those of North America where firms are mainly financed by a large number of private investors (e.g., La Porta et al., 1997). Therefore, whereas information asymmetry between capital providers and a firm is likely to be resolved in continental European countries by providing accounting information privately to the capital providers, in the North American countries it is likely to be resolved by providing high-quality public financial reporting.
Nobes and Parker (2010) explain that, in systems where governments provide a significant amount of long-term business finance, government representatives will often become directors of the state-funded companies, and will thus have access to the inside management information. Thus, a characteristic shared by all countries in which insider systems of finance predominate is that the primary role of accounting has historically not been to provide fair, balanced and unbiased information to help outside investors make efficient and effective investment decisions. Financial accounting in these countries has developed to fulfil a different role than in outsider-financed countries. One such role, which is explored in the next section, is the provision of information to calculate taxation liabilities. Countries that have historically been dominated by insider systems of finance have tended also to be countries with Roman law systems, while outsider-financed countries usually have common law systems (La Porta et al., 1997). Thus, most continental European countries (a notable exception being the Netherlands, which has a Roman law system but a large amount of outsider finance) have historically relied on insider forms of finance, with the result that financial accounting in these nations did not develop to serve the needs of investment decisions in capital markets. Conversely, the United Kingdom and Ireland (and the United States, Australia and New Zealand among other non-European states) have relied to a much greater extent on outsider forms of finance, with a primary role of accounting historically being to service the information needs of capital markets with fair, balanced and unbiased information.37 As an example of empirical research linking financing systems with differences in accounting practices, Pratt and Behr (1987) compared the standard-setting processes adopted in the United States and Switzerland. Differences in the standards and processes adopted were explained by
As such, the entities would not be considered to be reporting entities. The topic of ‘reporting entities’ is addressed in Chapter 7. Reporting entities produce general purpose financial statements for parties with a stake in the organisation and that are unable to command information to satisfy their specific information needs. 37 As demonstrated in the final chapter of this book, many critical accounting theorists strongly disagree that accounting information is fair, balanced or unbiased. 36
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differences in ‘size, complexity, and diversity of capital transactions, the wide distribution of ownership, and the opportunistic nature of the capital market participants’. Chand and White (2007) consider the ownership and financing systems that are common in Fiji and argue that the recent adoption of IFRS in Fiji created a level of inefficiency not previously experienced. That is, they argue that there is an inappropriate match between IFRS and the financing systems inherent in Fiji. As they state (p. 615): The financial institutions and in particular the commercial banks dominate Fiji’s capital markets. It is on these institutions that almost all of Fiji’s domestically controlled business enterprises rely for financing. Two commercial banks control 75% of the banking market and exercise duopoly powers (Ministry of Finance, 1999). Many business enterprises therefore need to provide financial reports to their banks, the banks being their prime financiers. Banks in Fiji, as in other jurisdictions, are concerned with assessing the financial stability and security that can be offered by prospective borrowers and compliance with loan covenant agreements by established clients. They typically require their borrowers to adopt a conservative approach to asset valuation and gearing measures, inter alia, as a bonding exercise (Watts, 2003). Banks seek reports from their clients that conform to a particular framework and a set of rules that the banks themselves impose. The banks operating in a non-competitive environment are able to require clients to reconstruct their financial reports on terms determined by the banks in order both to secure and retain financing. The banks acquire the accounting information the way they need it, without having to lobby the regulator to set reporting standards that address those needs. Kanaenabogi (2003) provides evidence that banks in Fiji typically take a conservative view of asset valuations offered as security in assessing loan applications. Banks use asset valuations, which are determined by applying conservative assumptions, taking these as proxies for orderly liquidation values, where formal independent valuations have not been secured. Accounting values determined by applying Fiji’s current reporting regulations and IFRS are not accepted in assessing entities’ capacities to repay loans. Therefore, Kanaenabogi argues that complying with two sets of audited financial statements imposes an unnecessary financial burden on business enterprises. Consequently, the more conservative financial reporting models applied by France, Germany and Japan (Briston, 1978; Radebaugh and Gray, 2002) may be more appropriate for Fiji’s domestic economy than the IASB model.
Before leaving the discussion of the impact of different financing systems on the shape of accounting practices, we should emphasise that, with the increasing scale of globalised businesses, multinational corporations based in any country are increasingly relying on financing from more than one nation. The funding needs of many companies in countries that have traditionally relied on insider forms of finance have grown beyond the funding capacity of the insider sources of finance, and several companies are now increasingly also relying on outsider finance, from shareholders in both their home country and other nations. Thus, the information requirements associated with outsider-financed systems are now becoming applicable to many large companies in continental European countries (Nobes and Parker, 2010).
Taxation systems In countries with predominantly outsider systems of finance, financial accounting practices historically developed to provide a fair, balanced and unbiased representation of the underlying economic performance of a business to help improve the effectiveness of investment allocation decisions by external shareholders. Such a system requires that financial accounting reflects 204
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some sort of economic reality; for example, an organisation selects a depreciation method that most closely reflects the manner in which it uses its fixed assets. Conversely, in countries with largely insider systems of finance this pressure for financial reports to have developed to reflect fairly some form of underlying economic reality is not present. Rather, financial reports have developed for different purposes, and one important purpose is the calculation of tax (Nobes and Parker, 2010). In most continental European countries that have traditionally relied heavily on insider forms of finance, for a company to claim an allowance for tax, this allowance must be included in its financial reports. For example, if a company wishes to reduce its tax liability by taking advantage of the maximum permitted taxable depreciation allowances, it has to include the tax depreciation allowances in its financial reports. The tax depreciation allowances will be determined by taxation law, and will not necessarily bear any relationship to the amount of the non-current assets that have actually been used in any particular year. The financial accounting results will therefore be expected to be substantially affected and determined by the provisions of taxation law in many continental European countries that have historically relied on insider systems of finance. In outsider-financed systems, the tax accounts have historically been separated from the financial accounts. Thus, if a company wished to claim the maximum tax depreciation allowances permitted by taxation law in these countries, this would not affect the calculation of its reported profits in its financial statements. These financial statements can therefore include a fair depreciation charge reflecting the utilisation of assets without affecting the company’s ability to claim the maximum tax depreciation allowances in its tax accounts, and the provisions of taxation law have not therefore exerted much influence on the financial statements. Given that there has tended to be a high correlation between insider-financed systems and Roman law countries (La Porta et al., 1997), the detailed provisions of taxation law have effectively become a large part of the detailed accounting regulations in many continental European countries that have codified Roman law systems (with the notable exception of the Netherlands). Again, the adoption of IFRS in such countries represented a significant change to their traditional accounting practices. A further institutional factor that tended to differentiate between, and also reinforce the distinction between, Roman law insider-financed countries and common law outsider financefinanced systems is the strength of the accounting profession.
Outsider-financed system Where longer-term funding comes from parties such as large numbers of shareholders who are not involved in the management of the organisation (they are ‘outsiders’).
Insider-financed system Where organisations are predominantly family owned and where longerterm funding typically comes from banks or government.
Strength of the accounting profession The strength of the accounting profession in any country has historically been determined by, and helped to reinforce, the influence on financial accounting systems of the institutional factors discussed above (Nobes and Parker, 2010). In a common law country, which has a predominantly outsider system of long-term finance and where tax law has had little influence on financial accounting, there will have been relatively few statutory laws determining the contents of financial statements. The primary purpose of these financial statements will have been to provide a fair, balanced and unbiased representation of the underlying economic performance of the business, and this will have required the exercise of professional judgement to cope with each different situation. Thus, in these countries, there will have historically been a demand for a large number of accountants who are able to apply professional judgement to determine the most suitable way of reflecting unique sets of transactions and events in financial accounting reports of companies. This need for accountants who are able to, and have scope to, exercise professional judgement has led to the development of large and strong accounting professions in countries such as the United Kingdom, Ireland, the United States, Canada, Australia and New Zealand. As seen in Chapter 4, strong accounting professions have been effective in lobbying governments to ensure that accounting regulatory systems give scope for the exercise of professional judgement, thus possibly reinforcing the strength and influence of the accounting profession. 205
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Conversely, in Roman law countries that have largely insider systems of finance and where compliance with the details of tax laws exerts a substantial influence on the shape of financial accounts, there will have been little need or scope for the use of professional judgement when drawing up financial accounting statements. There has therefore been much less impetus for the development of accounting professions compared to outsider-financed common law systems. The accounting professions in many continental European countries have historically been smaller and weaker (in terms of influence) than their counterparts in the United Kingdom, Ireland, Australia or the United States. Nobes and Parker (2004) argue that these weaker accounting professions have had an impact in reinforcing accounting practices that require little exercise of professional judgement, because the effective implementation of flexible accounting practices requires a reasonably large accounting profession that is comfortable with (and has sufficient experience of) applying professional judgements to complex accounting issues.
Accidents of history As indicated at the beginning of this section, accounting systems tend to be regarded as following either an Anglo-American model or a continental European model. The cultural and institutional differences discussed so far in this chapter support this view, with countries following the AngloAmerican model tending to have common law systems, outsider financing, little influence of taxation law on financial reporting and a strong accounting profession accustomed to exercising a considerable amount of professional judgement – with the opposite applying in countries following the continental European model. If we accept that these influences are significant in shaping a nation’s accounting practices, we should expect accounting practices in countries with Anglo-American systems to have historically been broadly similar. However, this is not consistent with the evidence presented in the first section of this chapter, when, for example, we saw that both the reported profits and the net assets of the multinational pharmaceutical company AstraZeneca were significantly different when calculated in accordance with UK accounting rules than when calculated in accordance with US rules. If the cultural and institutional influences examined so far in this chapter, that are broadly similar in the United Kingdom and the United States, are significant in shaping accounting practices, there must be an important additional influencing factor which varies between the United Kingdom and the United States. Nobes and Parker (2004) point to the importance of the additional factor of ‘accidents of history’, whose influence will be restricted to the accounting systems of the individual countries affected by the accidents. For example, following the Wall Street crash of 1929, the United States established securities exchange legislation aimed at investor protection, while there was no such development at the time in the United Kingdom. This legislation included certain accounting requirements, which have been delegated to private sector accounting standardsetting bodies and produced a detailed set of US accounting rules (as we would expect to see in a Roman law country). In contrast, following a series of high-profile accounting failures in the United Kingdom in the late 1980s, the United Kingdom established a more principles-based system of accounting regulation. As Unerman and O’Dwyer (2004) highlight, in the aftermath of accounting failures at Enron in 2001, it was claimed by many in the United Kingdom that the different regulatory systems would have prevented Enron using the creative accounting techniques in the United Kingdom that it followed in the United States. Going back to the case of AstraZeneca, studying the reconciliation provided in the financial reports between the results calculated using UK accounting rules and those calculated using US accounting rules, it is apparent that a substantial difference between the two sets of accounting regulations (in the case of this company) arises from differences between the US and the UK accounting treatment of mergers and acquisitions (including the calculation of goodwill). Different pressures in the United Kingdom (possibly including different
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lobbying efforts by interested parties in each country) resulted in UK and US accounting rules for mergers and acquisitions being somewhat different. Summarising this chapter so far, a number of reasons have been advanced to explain the accounting systems in place in different countries, including culture, religion (which is a subset of culture) and institutional factors (which we could also imagine would be influenced by culture). The discussion has by no means been exhaustive in identifying the many factors proposed to explain why historically there were international differences in accounting systems; nevertheless, the referenced research indicates that one general approach to financial accounting may suit one particular environment but not others. Therefore, it is probably somewhat naive to claim that there is one ‘best’ system of accounting. With this in mind, we can reflect on the claim by a former chairperson of the US Financial Accounting Standards Board, Dennis Beresford, that the US accounting and reporting system was regarded by many as ‘the most comprehensive and sophisticated system in the world’ (as quoted in Wyatt and Yospe, 1993). Perhaps in some countries (perhaps the majority), the US system would be considered to be sophisticated, but in others it might be considered to be quite irrelevant on cultural, religious or institutional grounds. Despite various factors that provide a logical rationale for international differences in accounting practices, there have been extensive efforts over several decades to reduce the differences between financial accounting systems in different countries. A great deal of this effort culminated in many diverse countries adopting IFRS. The material in this chapter has given the reader a good understanding of why accounting systems in different countries were dissimilar prior to efforts to standardise financial accounting. The reader might also have formed an opinion about whether the global standardisation of financial accounting is appropriate. What do you, the reader, think? Is it appropriate for diverse countries with different cultural attributes, different financing systems, different religions, different taxation systems, different histories and so forth to all adopt the same financial reporting standards?
Why do I need to know some of the reasons that financial reporting might, in the absence of standardisation efforts, differ between different countries or cultures? As we have emphasised several times in this book, the numbers generated through the practice of financial accounting shape all of our lives to some extent. Stakeholder support for organisations, particularly large organisations, is often linked in some respect to their reported financial performance and financial position. For example, if we read or hear that a high-profile company has just reported record profits then that could influence how various stakeholders deal with an organisation. Given the importance that financial accounting numbers have within society, we should understand how those numbers are determined, and what factors shape the rules that have been applied (or perhaps not applied). By knowing some reasons why different cultures or countries might have different information demands or
expectations, and by understanding that different countries will have different enforcement mechanisms, we can understand the obstacles that confront bodies such as the IASB in the quests for standardised financial reporting practice. As a result of reading the material in this chapter, we might logically question any claim that IFRS have created, or are likely to create, full standardisation in financial reporting internationally. Such insights are important, particularly if we ever have the role of comparing the financial performance of different organisations internationally (and as accounting researchers we might do this). By having the insights from this chapter, we will be aware of some reasons, or motivations, that might drive some organisations to depart from IFRS, and if needed, we would then be better placed to suggest safeguards to combat such incentives.
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REFLECTION QUESTION 5.2 International standardisation of financial reporting information Question So, given what you have read in this chapter, do you think it is sensible or logical that people/stakeholders in different countries – such as Australia and China, for example – which have quite different cultures and regulations, be provided with the same financial accounting information? Solution As a result of reading the material in this chapter, you should understand that there seems to be some logic to the argument that it is inappropriate to provide people from all countries with the same types of financial information. People from different cultures seem to have different needs for information and in this chapter we have linked these differences back to particular cultural attributes. We are not all the same and therefore you
should now be able to provide logical arguments and insights about why a ‘one-size-fits-all’ approach is perhaps rather simplistic and seems to ignore some important research. This would particularly be the case when it comes to reporting by smaller organisations that do not rely so much on global capital markets and whose stakeholders tend to be more local in orientation. However, as organisations get larger, they tend to move towards more of an ‘international culture’ and the arguments against standardisation do tend to decline to some extent. As Newson and Deegan (2002) argue, large multinational organisations make their disclosure decisions in response to global information demands and global cultural expectations, rather than the demands of citizens in the home country.
Impacts of culture on issues beyond financial reporting LO5.4
In Chapter 8, we consider issues to do with executive remuneration. Applying theories known as Positive Accounting Theory and Agency Theory, we learn that researchers explain that management remuneration plans are put in place to align the interests of managers (who are assumed to be motivated by self-interest) with the interests of the providers of financial capital to the organisation (for example, shareholders and lenders). These theories point to the need to have various contractual agreements included within a manager’s remuneration plan (bonus plan) to encourage the manager to work in a way that does not only benefit them individually, but also the shareholders (owners) and the debt-holders. For example, managers might contractually be offered a bonus that is linked to accounting profits or to measures such as return on assets. An ‘efficient’ management remuneration plan is one that includes appropriate clauses to motivate and monitor the (self-interested) manager to work in a way that also benefits other stakeholders. However, and linking the material covered in this chapter, insights from other researchers applying other theories suggest that the development of management remuneration plans might also be influenced by cultural factors as well. That is, we should never assume that one theoretical perspective (for example, from Positive Accounting Theory, as referenced above) provides a full explanation for differences in a particular phenomenon. We can usefully see the world through different theoretical lenses. In this respect, a paper by Free, Yao, Kent and Xin (2021) applied the ‘culture scores’ developed by Hofstede (as discussed earlier in this chapter) to explain how culture also influences Chief Executive Officer (CEO) pay structures. They propose that national culture is associated with different perceptions of the value of money and ‘success’, and that different interpretations of value and success in different cultures are expected to change the extent to which CEO pay is linked to the financial performance of an organisation. In their study of management remuneration plans from a number of culturally diverse countries, Free et al. (2021) found that Power Distance and Uncertainty Avoidance dimensions (from Hofstede) are associated with a lower pay–performance link, while Individualism and Masculinity dimensions are associated with a high pay–performance link. They explain this on
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the basis that managers from countries with higher scores in Power Distance and Uncertainty Avoidance are accepting of less risk, while managers from countries with higher Individualism and Masculinity scores accept more risk. They also find that Long-Term Orientation dimension is associated with higher pay–performance sensitivity.
Concluding comments about obstacles to the ongoing standardisation of financial accounting LO5.2
LO5.4
As discussed, one key obstacle to the establishment and maintenance of the international standardisation of accounting is the international cultural and institutional differences that caused financial accounting to vary in the first place. As argued earlier, if these causal factors continue to vary between countries, it is difficult to see how a single set of financial accounting rules, such as those published by the IASB, will be appropriate or suitable for all countries. That is, as financial accounting traditionally varied between different countries for reasons that could be theoretically explained (such as cultural, religious or institutional reasons), a key impediment to the continued standardisation of financial reporting is the fact that these good reasons for accounting differences arguably continue to exist. While many countries have either adopted IFRS or plan to adopt them in the near term, there is nothing that strictly stops them from abandoning IFRS should it become apparent that they are not very relevant to their countries’ financial accounting information needs. Of course, it would be costly and difficult for a country to abandon IFRS, but it is possible. As an example of the obstacle to maintaining standardisation efforts, Perera (1989, p. 52) considers the success of transferring accounting skills from Anglo-American countries to developing countries. He notes: ‘The skill[s] so transferred from Anglo-American countries may not work because they are culturally irrelevant or dysfunctional in the receiving countries’ context.’ Perera also argues that international financial reporting standards themselves are strongly influenced by Anglo-American accounting models and, as such, they tend to reflect the circumstances and patterns of thinking in a particular group of countries. He argues that these standards are likely to encounter problems of relevance in countries with different environments from those found in Anglo-American countries. Thus, for example, if the majority of German companies continue to rely on ‘insider’ forms of finance, and Germany continues to use a Roman law system, its previously used codified accounting regulations would probably be more appropriate for most German companies than the imposition of a form of the Anglo-American accounting system.38 Nobes and Parker (2010) suggest that in such circumstances it might be more appropriate to have a dual system, where all companies in each country are required to prepare financial reports in accordance with their historically developed domestic system, and companies that raise funds internationally can prepare an additional set of financial reports (probably only the consolidated or group accounts) in accordance with Anglo-American-style international accounting rules.39 A further obstacle to harmonisation, identified by Nobes and Parker (2010), is the lack in some countries of a developed accounting profession. Thus, in countries where strong accounting professions have not developed there are likely to be initial problems implementing international In a similar way, the imposition of a detailed codified accounting system would not be appropriate for Australia, the United Kingdom, the United States or New Zealand, for example, where the ‘outsider’ system of finance requires financial accounts to provide fair and balanced information reflecting some form of underlying economic reality. 39 In this regard, although companies in member states of the EU are required to follow accounting standards released by the IASB for the purposes of their consolidated financial reports, the requirement is restricted to companies listed on a stock exchange. 38
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accounting regulations based on the Anglo-American professional judgement model (such as IFRS). Furthermore, some countries might have nationalistic difficulties in being seen to implement a system of international accounting standards that are regarded as being closely aligned to the Anglo-American systems. A final potential and significant obstacle to the ongoing standardisation of financial accounting is that, as seen in Chapters 3 and 4, accounting regulations can and do have economic consequences (Nobes and Parker, 2010). Across time, governments of individual countries may regret giving the control of a process – financial reporting standard-setting – that has real economic consequences, to an international body (the IASB) over which they have little influence. (Indeed, this was a concern in Australia, where the AASB’s role in developing accounting standards has effectively been transferred to the IASB, although the AASB provides input to the standards being developed by the IASB. It was also cited as a major concern in the United States and this ‘loss of control’ aspect is probably a key reason the United States did not adopt IFRS.) It was seen in Chapter 4 how this can impact on the process of international standardisation, in the recent difficulties experienced with the refusal of some EU countries to endorse fully the provisions of the revised IAS 39, partly because of the potential negative economic impact that these provisions might have on banks in their countries.
STUDY TOOLS CHAPTER SUMMARY This chapter identified and considered historical differences in international financial reporting practices and looked at numerous reasons (generated from different theoretical perspectives) that have been advanced to explain why such differences arose (including differences in culture, religions as a subset of culture, legal systems, financing systems, taxation systems, the strength of the accounting profession and accidents of history). Much of the research into comparative international accounting questions whether it is appropriate to have one system of accounting that is adopted uniformly throughout the world (a long-term objective of the IASB). While many researchers question the relevance of ‘Western-style’ accounting standards for all countries, efforts by a number of international organisations are nevertheless continuing to encourage quite culturally disparate countries to adopt IFRS. This implies that the members of some international organisations are either unaware of the literature or, alternatively, choose to reject it as irrelevant. As efforts by a number of countries continue in relation to the domestic implementation of IFRS, it is to be expected that this debate will continue. In concluding the chapter, we can now make reference to Figure 5.7, which provides a summary of various factors that can influence the practice of financial accounting. As a result of reading the material in this chapter, you will be able to understand the rationale behind including the various potential influences in this diagram. While not represented in the diagram (so as to keep the diagram relatively simple), we can expect that there will be various interrelationships between some of the influences shown within the boxes. For example, the strength of the accounting profession will affect the level of monitoring and enforcement, and the culture and legal systems within a particular country would be expected to be related.
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FIGURE 5.7 Some factors that influence the practice of financial reporting Strength of the accounting profession Business ownership and financing system
Accounting regulations
History
Culture Financial accounting practice Legal system
Economic influences
Level of monitoring and enforcement
Religion Political influences
ANSWERS TO THE OPENING QUESTIONS At the beginning of the chapter, we asked the following two questions. As a result of reading this chapter, you should be able to provide informed answers to these questions – ours are shown below. Since the start of 2005, financial reporting standards issued by the International Accounting Standards Board (IASB) have become the financial reporting standards that are applied within many countries. 1 Do you believe that all countries should adopt the same financial reporting standards – that is, do you think that a world-wide ‘one-size-fits-all’ approach to financial accounting and reporting is appropriate? If not, what might be some reasons against such international standardisation? As a result of reading this chapter, you have been exposed to a number of different arguments about why it is, and why it is not, appropriate that we have a ‘one-size-fits-all’ approach to financial reporting globally. Some of the arguments in favour of the standardisation of financial reporting are that it will enhance international comparability, and this will be good for investors wanting to invest internationally. Relatedly, this will also be good for the reporting organisations, as it has been argued that this will allow them to attract more financial capital from international investors and to attract the funds at a lower cost of capital. The mobility of financial accountants will also increase because of reporting standardisation. However, there are many arguments against standardisation. As we learned in this chapter, people from different countries have, through an analysis of different cultural attributes, been shown to have different information demands and expectations. Further, differences in legal systems, taxation systems, sources of finance and accounting and auditing expertise also all point to the potential inappropriateness of introducing one standardised set of financial reporting standards. Whether we individually accept arguments for or against the international standardisation of financial reporting will be influenced by how prepared we are to accept the arguments of the different researchers, such as those reported in this chapter. In Chapter 1 of this book, we discussed various factors to consider when evaluating the insights provided by different researchers and we emphasised
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that such evaluation is necessary before we ultimately decide to accept the arguments provided by different researchers. 2 What are some of the advantages and disadvantages that arise as a result of a country adopting the financial reporting standards issued by the IASB? Linked to the above answer, some of the advantages relate (supposedly) to increased inflows of capital, lower costs of capital, elimination of costs that might be imposed if investors had to translate financial reports from one set of accounting standards to another, and the use of a better, more efficient set of financial reporting standards. The disadvantages are that the information generated as a result of applying IFRS may not meet the needs of local stakeholders. There is also quite an extensive reporting burden (cost) associated with implementing IFRS. The advantages and disadvantages will be linked to the organisation’s size as it is likely that larger, perhaps multinational, organisations are more likely to benefit from the adoption of a ‘one-sizefits-all’ approach to financial reporting relative to smaller organisations.
QUESTIONS 5.1 5.2
5.3 5.4 5.5 5.6
In the context of financial accounting, what is harmonisation and/or standardisation? LO5.5 Global standardisation of accounting arguably requires the United States to adopt IFRS. Do you think it is likely that the United States will embrace IFRS in the near term, and what do you think are some of the factors that discouraged the country from adopting IFRS? LO5.1 LO5.6 LO5.7 Do you think that the Securities and Exchange Commission’s reluctance to support the adoption of IFRS for US organisations undermines the credibility of the IASB? Why? LO5.1 LO5.3 LO5.5 Identify some factors that might be expected to explain why different countries use different systems of financial accounting. LO5.4 Why would it matter if organisations calculate ‘profits’ differently as a result of applying financial reporting standards? LO5.1 LO5.4 LO5.7 Evaluate the following statement: If various countries adopted the same financial reporting rules, then if the same series of transactions and events occurred within different countries, there would be no differences between the results that would be reported in those different countries. LO5.5
5.7 5.8
5.9
5.10
5.11
5.12 5.13 5.14
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Do you think that the standard-setting processes of the IASB are likely to be ‘captured’ by particular interest groups? LO5.1 Would cultures that rank more highly on Individualism be more or less inclined to support detailed rules for financial reporting, or would they prefer that many accounting-related decisions be left to professional judgement? LO5.4 Nobes and Stadler (2018) provide evidence that when IFRS are translated from English to local languages, errors are sometimes introduced. How might the introduction of such errors undermine the standardisation efforts of the IASB? LO5.1 LO5.2 With the cultural value of ‘Masculinity’ in mind, would you expect people within countries that rank higher, or lower, in terms of Masculinity to prefer the use of profit-related measures of performance that enable the financial performance of different organisations to be benchmarked against each other? LO5.4 Given what you have read in this chapter, would you expect the financial reporting practices in countries that have traditionally relied upon funding from banks and from government to be different to the reporting practices traditionally applied in countries that rely more upon funding received from large numbers of shareholders? LO5.4 Does the adoption of IFRS by different countries necessarily mean that the accounting procedures and practices they adopt will be consistent and comparable internationally? LO5.3 After considering the Hofstede–Gray model, briefly explain the hypothesised link between society values, accounting values and accounting practice. LO5.4 Any effort towards standardising accounting practices on an international basis implies a belief that a ‘one-size-fits-all’ approach is appropriate. Is this naive? LO5.3 LO5.4
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5.15 Continental European countries historically relied upon capital provided by state, banks or families whereas other countries, such as the United States, United Kingdom, Canada and Australia, have relied on receiving funding from a large number of external investors. How would this difference in funding sources impact the type of reporting undertaken and the expertise of the local accounting profession? LO5.4 5.16 While it is often argued that within particular countries there should be some association between various value systems and accounting systems, it is also argued (for example, by Baydoun and Willett, 1995) that over time many events would typically have occurred that confound this expected relationship. What type of events might confound the expected relationship? LO5.4 5.17 Baydoun and Willett (1995, p. 72) identify a number of problems in testing the Hofstede–Gray theory. They emphasise that many accounting systems are imported from other countries with possibly different cultures. As they state: Due to the interference in what would otherwise have been the natural evolution of financial information requirements, there are no uncontaminated examples of modern accounting practices in developing countries. Consequently, great care has to be taken in using data from developing countries to draw inferences about relevance on the basis of the Hofstede–Gray framework.
Explain Baydoun and Willett’s point of view. Do you believe that they are correct?
LO5.4
5.18 As noted in this chapter, Hamid, Craig and Clarke (1993) provide an argument that religion can have a major impact on the accounting system chosen by a particular country and that before ‘Western’ methods of accounting are exported to particular countries it must be determined whether particular religious beliefs will make the ‘Western’ accounting policies irrelevant. Explain their argument. LO5.4 5.19 Nobes (1998) suggests that for countries that have organisations that rely relatively heavily on equity markets, as opposed to other sources of finance, there will be a greater propensity for such organisations to make public disclosures of information. Evaluate this argument. LO5.4 5.20 In the early 1990s, the US Financial Accounting Standards Board’s chairperson Dennis Beresford claimed that the US accounting and reporting system was regarded by many as ‘the most comprehensive and sophisticated system in the world’. Evaluate this statement. How do you think its validity might have changed in the aftermath of accounting failures at Enron, WorldCom and Andersen in 2001–02? Do you think that the US system would be regarded as sophisticated in all cultural contexts? LO5.1 LO5.3 5.21 Do you think it is realistic to expect that there will eventually be an internationally uniform set of accounting standards? What factors would work for or against achieving and maintaining this aim? LO5.1 LO5.2 LO5.4 LO5.6 5.22 Prior to international actions to adopt IFRS, would you expect that large international companies domiciled in a particular country would have adopted different accounting policies from companies that operated only within the confines of that country? Explain your answer. LO5.4 5.23 Evaluate how reasonable it is to assume that the inflow of foreign investment into Australia would have been restricted if Australia, through the decision of the Financial Reporting Council, had not made the decision to adopt IFRS from 2005. LO5.1 LO5.2 LO5.6 5.24 Explain barriers to ongoing standardisation of financial accounting across all EU member states. Given these barriers, do you think that the EU has been naive in embracing the standardisation process for all member states? LO5.1 LO5.2 LO5.3 5.25 What are some perceived benefits that flow from the decision that a country will adopt IFRS? LO5.2 LO5.6 LO5.7 5.26 On the basis of actions to standardise accounting across countries, does it appear that organisations such as the AASB and the IASB are ignoring academic research that signals why we would expect to find international differences in financial accounting practices? LO5.4 LO5.6 5.27 It is often argued that the accounting standards of the FASB are rule-based, whereas the accounting standards issued by the IASB are principles-based. Rules-based standards by their nature can be quite complex, particularly if they seek to cover as many situations as possible. Do you think it would be easier to circumvent the requirements of rules-based or principles-based accounting standards? LO5.1
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5.28 Explain what Ball (2016, p. 556) means within the following quote: Competition among alternative economic systems, including financial reporting systems, is conducive to healthy innovation. History is replete with examples of one system learning from the institutional structure of a competing system, the most famous example in accounting being the near worldwide adoption of the Italian method of double entry bookkeeping….. In my view, adopting uniform worldwide standards invites risky centralisation and reduced innovation. LO5.2
5.29 A concern raised by Ball (2016) is that the reliance of IFRS on ‘fair values’ means that IFRS do not provide an efficient basis for debt contracting. What is the basis of this view? LO5.2 5.30 Is it appropriate for accounting standard-setting bodies to consider culture and religion when devising accounting regulations, particularly given that the output of financial reporting is expected to be objective and unbiased? Explain your view. LO5.4 LO5.6 5.31 What are some possible reasons for historical differences in accounting rules operating within Australia, the United States and the United Kingdom? LO5.4 LO5.7 5.32 Does the standardisation of financial reporting standards on a global basis necessarily equate with a standardisation in financial reporting practice? LO5.3 5.33 The website of the FASB has a section entitled ‘About the FASB’ (Financial Accounting Standards Board, n.d.), in which there is information about how accounting standards are developed. In part, it states: The Mission of the Financial Accounting Standards Board The collective mission of the FASB, the GASB, and the FAF is to establish and improve financial accounting and reporting standards to provide useful information to investors and other users of financial reports and educate stakeholders on how to most effectively understand and implement those standards. The FASB, the GASB, the FAF Trustees, and the FAF management contribute to the collective mission according to each one’s specific role: • The FASB and the GASB are charged with setting the highest-quality standards through a process that is robust, comprehensive, and inclusive. • The FAF management is responsible for providing strategic counsel and services that support the work of the standard-setting Boards. • The FAF Trustees are responsible for providing oversight and promoting an independent and effective standard-setting process. Standards-Setting Process The FASB accomplishes its mission through a comprehensive and independent process that encourages broad participation, objectively considers all stakeholder views, and is subject to oversight by the Financial Accounting Foundation’s Board of Trustees. The Rules of Procedure describe the FASB’s operating procedures, including the due process activities that are to be open to public participation or observation to provide transparency into the standardssetting process. In particular, the Rules of Procedure describe: • The organization in which the FASB operates • The FASB mission, how the mission is accomplished, and related principles that guide the Board’s standards-setting activities • The operating procedures of the FASB, including the responsibilities of the Chairman, the composition of the FASB technical staff, the role of advisory groups including the Emerging Issues Task Force, and public forums in our due process • Our various forms of communications, including the form and content of Accounting Standards Updates, Exposure Drafts, and Concepts Statements • Protocols for meetings of the FASB and voting requirements • Rules governing public announcements and the kinds of information made broadly available to the public. A high-level overview of the standards setting process as established by the Rules of Procedure follows. The nature and extent of the Board’s specific research and outreach activities will vary from project to project, depending on the nature and scope of the reporting issues involved.
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• The Board identifies financial reporting issues based on requests/recommendations from stakeholders or through other means. • The FASB decides whether to add a project to the technical agenda based on a staff-prepared analysis of the issues. • The Board deliberates at one or more public meetings the various reporting issues identified and analyzed by the staff. • The Board issues an Exposure Draft to solicit broad stakeholder input. (In some projects, the Board may issue a Discussion Paper to obtain input in the early stages of a project) • The Board holds a public roundtable meeting on the Exposure Draft, if necessary. • The staff analyzes comment letters, public roundtable discussion, and any other information obtained through due process activities. The Board redeliberates the proposed provisions, carefully considering the stakeholder input received, at one or more public meetings. • The Board issues an Accounting Standards Update describing amendments to the Accounting Standards Codification.
Given the process involved in developing accounting standards, which involves asking constituents to make submissions on exposure drafts, do you think that accounting standards developed within the United States would be the same as accounting standards developed in another country? Provide an explanation for your answer. LO5.4 5.34 The IASC (1998, p. 50) stated that: many developing and newly industrialised countries are using International Accounting Standards as their national requirements, or as the basis for their national requirements. These countries have a growing need for relevant and reliable financial information to meet the requirements both of domestic users and of international providers of the capital that they need.
Do you think that IAS/IFRS will provide ‘relevant and reliable information’ that meets the needs of all financial statement users in all countries? LO5.4 LO5.6 5.35 In considering the relevance of IFRS to developing countries, Chand and White (2007, p. 606) state: While the forces of globalisation and convergence are moving accounting practices towards a unified, or at least harmonised regulatory framework for financial reporting, this is unlikely to best serve the diverse interests of the disparate user groups of financial reports.
Explain the reasons behind Chand and White’s claim.
LO5.4
5.36 Latest evidence suggests that the United States will not adopt IFRS, at least in the near term. Why do you think the United States moved away from the commitment to adopt IFRS? LO5.1 LO5.6 5.37 Ball (2006, p. 17) makes the following comment: In sum, even a cursory review of the political and economic diversity among IFRS-adopting nations, and of their past and present financial reporting practices, makes the notion that uniform standards alone will produce uniform financial reporting seem naive.
Explain the basis of Ball’s comments.
LO5.2
LO5.3
5.38 Irvine (2008, p. 127) makes the following comment: Global accounting technologies, including IFRS, provide developing nations with legitimacy. Similarly, emerging economies, if they wish to gain credence in global capital markets, need to adopt western accounting technologies.
Explain the basis of Irvine’s comments.
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LO5.6
5.39 The website of the FASB says that it considers the views of its constituents. Do you think that the financial information demands or expectations of ‘constituents’ in the United States would be different from the financial information demands or expectations of people in other countries? Why or why not? LO5.4 5.40 In continental European countries, prior to the adoption of IFRS, the domestic accounting rules were typically much more aligned with local taxation regulation than would be the case in countries like the United States, United Kingdom, Canada, Australia or New Zealand. Why do you think this would have been the case? LO5.3 LO5.4
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5.41 Paragraphs 2.42 and 2.43 of the IASB Conceptual Framework for Financial Reporting (IASB, 2022) state: 2.42: In applying the cost constraint, the Board assesses whether the benefits of reporting particular information are likely to justify the costs incurred to provide and use that information. When applying the cost constraint in developing a proposed Standard, the Board seeks information from providers of financial information, users, auditors, academics and others about the expected nature and quantity of the benefits and costs of that Standard. In most situations, assessments are based on a combination of quantitative and qualitative information. 2.43: Because of the inherent subjectivity, different individuals’ assessments of the costs and benefits of reporting particular items of financial information will vary. Therefore, the Board seeks to consider costs and benefits in relation to financial reporting generally, and not just in relation to individual reporting entities. That does not mean that assessments of costs and benefits always justify the same reporting requirements for all entities. Differences may be appropriate because of different sizes of entities, different ways of raising capital (publicly or privately), different users’ needs or other factors.
Do you think that cost–benefit considerations will be different in different countries? If so, how would cost–benefit considerations be determined by a global accounting standard-setter such as the IASB? LO5.2 5.42 Ball (2006, p. 17) states: Under its constitution, the IASB is a standard setter and does not have an enforcement mechanism for its standards: it can cajole countries and companies to adopt IFRS in name, but it cannot require their enforcement in practice. It cannot penalise individual companies or countries that adopt its standards, but in which financial reporting practice is of low quality because managers, auditors and local regulators fail to fully implement the standards. Nor has it shown any interest in disallowing or even dissuading low-quality companies or countries from using its ‘brand name’. Individual countries remain primarily regulators of their own financial markets. EU member countries included. That exposes IFRS to the risk of adoption in name only.
Evaluate Ball’s comments and provide an argument as to whether you agree or disagree with his view. LO5.1 LO5.4 5.43 Ball (2006, p. 22) provides the following statement: In the presence of local political and economic factors that exert substantial influence on local financial reporting practice, and in the absence of an effective worldwide enforcement mechanism, the very meaning of IFRS adoption and the implications of adoption are far from clear. In the enthusiasm of the current moment, the IFRS ‘brand name’ currently is riding high, and IFRS adoption is being perceived as a signal of quality. I am not sure how long that perception will last.
Provide an argument as to whether you are inclined to agree or disagree with Ball’s scepticism about the future ‘value’ associated with embracing IFRS. LO5.1 LO5.4 5.44 The European Commission made the following statement in a press release issued in 2002: European Commission has welcomed the Council’s adoption, in a single reading, of the Regulation requiring listed companies, including banks and insurance companies, to prepare their consolidated accounts in accordance with International Accounting Standards (IAS) from 2005 onwards (see IP/01/200 and MEMO/01/40). The Regulation will help eliminate barriers to cross-border trading in securities by ensuring that company accounts throughout the EU are more reliable and transparent and that they can be more easily compared. This will in turn increase market efficiency and reduce the cost of raising capital for companies, ultimately improving competitiveness and helping boost growth.
Evaluate the above statement. In particular, you should consider whether the adoption of IFRS in different countries, with different overview and enforcement mechanisms, necessarily leads to the generation of financial information that is more ‘reliable’ and ‘comparable’. LO5.2 LO5.4 LO5.6
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REFERENCES Ball, R. (2006), ‘International financial reporting standards (IFRS): pros and cons for investors’, Accounting and Business Research, International Accounting Policy Forum, pp. 5–27. © Taylor & Francis Ball, R. (2016), ‘IFRS – 10 years later’, Accounting and Business Research, 46(5), pp. 545–71. © Taylor & Francis Baskerville, R. (2003), ‘Hofstede never studied culture’, Accounting, Organizations and Society, 28, pp. 1–14. Baydoun, N. & Willett, R. (1995), ‘Cultural relevance of Western accounting systems to developing countries’, ABACUS, 31(1), pp. 67–92. Benson, H. A. (1989), Accounting for Life, London: Kogan Page. Brochet, F., Miller, G., Naranjo, P. & Yu, G. (2019), ‘Managers’ cultural background and disclosure attributes’, The Accounting Review, 94(3), 57–86. Burke, F. (2000), ‘News learns wealthy lesson: don’t move to US’, The Australian, 15 November. Chand, P. & White, M. (2007), ‘A critique of the influence of globalization and convergence of accounting standards in Fiji’, Critical Perspectives on Accounting, 18, pp. 605–22. © 2006 Elsevier Ltd. All rights reserved. Corporate Law Economic Reform Program (1997), Accounting Standards: Building International Opportunities for Australian Business, Canberra: Corporate Law Economic Reform Program. Dahlgren, J. & Nilsson, S. (2012), ‘Can translations achieve comparability? The case of translating IFRS into Swedish’, Accounting in Europe, 9(1), pp. 39–59. Doupnik, T. S. & Salter, S. B. (1995), ‘External environment, culture, and accounting practice: a preliminary test of a general model of international accounting development’, International Journal of Accounting, 30(3), pp. 189–207. EFRAG (n.d.), ‘EFRAG today’, https://www.efrag.org/About/ Facts European Commission (1992), Towards Sustainability: A Community Programme of Policy and Action in Relation to the Environment and Sustainable Development, Brussels: European Commission. European Commission (2002), Press release, Reference: IP/02/827, 7 June. CC BY 4.0 Licence (https://creativecommons.org/licenses/by/4.0/) Fechner, H. H. E. & Kilgore, A. (1994), ‘The influence of cultural factors on accounting practice’, International Journal of Accounting, 29, pp. 265–77. Financial Accounting Foundation (2007), ‘FASB/FAF response to SEC releases – November 2007’, Norwalk, CT: FAF. Financial Accounting Standards Board (2022), ‘About the FASB’, https://www.fasb.org/page/ PageContent?pageId=/about-us/about-fasb.html Free, M., Yao, D., Kent, P. & Xin, Q. (2021), ‘National culture and CEO-pay-performance link: an international perspective’, paper delivered at the Accounting and Finance Association of Australia and New Zealand (AFAANZ) Annual Conference, online, July. Gray, S. J. (1988), ‘Towards a theory of cultural influence on the development of accounting systems internationally’, ABACUS, 24(1), pp. 1–15. Hamid, S., Craig, R. & Clarke, F. (1993), ‘Religion: a confounding cultural element in the international harmonization of accounting?’, ABACUS, 29(2), pp. 131–48. Hamilton, S. (1998), ‘Accountants gather round different standards’, Australian Financial Review, 25 November, https://www.afr.com/politics/accountants-gather-rounddifferent-standards-19981125-jl91i
Hofstede, G. (1980), Culture’s Consequences: International Differences in Work-Related Values, Beverly Hills, CA: Sage Publications. Hofstede, G. (1983), ‘Dimensions of national cultures in fifty countries and three regions’, in J. B. Derogowski, S. Dziurawiec & R. Annis (eds), Expiscations in CrossCultural Psychology, Lisse, The Netherlands: Swets & Zeitlinger. Hofstede, G. (1984), ‘Cultural dimensions in management and planning’, Asia Pacific Journal of Management, 1(2), pp. 81–98. Hofstede, G., Hofstede, G. J. & Minkov, M. (2010), Cultures and Organizations: Software of the Mind, 3rd edn, New York: McGraw Hill. IFRS Foundation (2013), Constitution, Revised and approved by the trustees January 2013, London: IFRS Foundation. IFRS Foundation (2018), Use of IFRS Standards around the world – 2018, London: IFRS Foundation. IFRS Foundation (2021a), Constitution, London: IFRS Foundation. IFRS Foundation (2021b), IFRS Foundation Annual Report 2021, https://www.ifrs.org/content/dam/ifrs/about-us/ funding/2021/ifrs-annual-report-2021.pdf IFRS Foundation (2021c), ‘Who we are’, https://www.ifrs.org/ about-us/who-we-are/. International Accounting Standards Board (2022), Conceptual Framework for Financial Reporting, London: IASB. International Accounting Standards Committee (1998), ‘Shaping IASC for the future’, London: International Accounting Standards Committee. International Accounting Standards Committee (2008), ‘Review of the constitution: public accountability and the composition of the IASB – proposal for change’, London: International Accounting Standards Committee. International Accounting Standards Committee Foundation (2010), IASC Foundation Constitution, London: IASC Foundation. Irvine, H. (2008), ‘The global institutionalization of financial reporting: the case of the United Arab Emirates’, Accounting Forum, 32, pp. 125–42. Kvaal, E. & Nobes, C. (2010), ‘International differences in IFRS policy choice: a research note’, Accounting and Business Research, 40(2), pp. 173–87. Lantto, A. M. & Sahlstrom, P. (2009), ‘Impact of international financial reporting standard adoption on key financial ratios’, Accounting and Finance, 49, pp. 341–61. La Porta, R., Lopez-de-Silanes, F., Shleifer, A. & Vishny, R. W. (1997), ‘Legal determinants of external finance’, Journal of Finance, 52(3), pp. 1131–50. McSweeney, B. (2002a), ‘The essentials of scholarship: a reply to Geert Hofstede’, Human Relations, 55(11), pp. 1363–72. McSweeney, B. (2002b), ‘Hofstede’s model of national cultural differences and their consequences: a triumph of faith – a failure of analysis’, Human Relations, 55(1), pp. 89–118. McSweeney, B. (2009a), ‘Dynamic diversity: variety and variation within countries’, Organization Studies, 30(9), pp. 933–57. McSweeney, B. (2009b), ‘Incoherent culture’, European Journal of Cross-Cultural Competence and Management, 1(1), 22–7. Mueller, G. G. (1967), International Accounting, New York: Macmillan.
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Mueller, G. G. (1968), ‘Accounting principles generally accepted in the United States versus those generally accepted elsewhere’, International Journal of Accounting Education and Research, 3(2), pp. 91–103. Newson, M. & Deegan, C. (2002), ‘Global expectations and their association with corporate social disclosure practices in Australia, Singapore, and South Korea’, The International Journal of Accounting, 37(2), pp. 183–213. Nobes, C. (1984), International Classification of Financial Reporting, London: Croom Helm. Nobes, C. (1998), ‘Towards a general model of the reasons for international differences in financial reporting’, ABACUS, 34(2), pp. 162–87. Nobes, C. (2006), ‘The survival of international differences under IFRS: towards a research agenda’, Accounting and Business Research, 36(3), pp. 233–45. Nobes, C. (2013), ‘The continued survival of international differences under IFRS’, Accounting and Business Research, 43(2), pp. 83–111. Nobes, C. & Parker, R. (2004), Comparative International Accounting, Harlow: Pearson Education Limited. Nobes, C. & Parker, R. (2010), Comparative international accounting, Harlow: Pearson Education. Nobes, C. & Stadler, C. (2018), ‘Impaired translations: IFRS from English and annual reports into English’, Accounting, Auditing and Accountability Journal, 31(7), pp. 1981–2005. Perera, H. (1989), ‘Towards a framework to analyze the impact of culture on accounting’, International Journal of Accounting, 24(1), pp. 42–56. Pratt, J. & Behr, G. (1987), ‘Environmental factors, transaction costs, and external reporting: A cross national comparison’, International Journal of Accounting Education and Research (Spring), pp. 1–24. Public Sector Accounting Standards Board (1996), Policy Statement 6: International Harmonisation Policy, Sydney: Australian Accounting Research Foundation.
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Purvis, S. E. C., Gernon, H. & Diamond, M. A. (1991), ‘The IASC and its comparability project’, Accounting Horizons, 5(2), pp. 25–44. Securities and Exchange Commission (2007), ‘Acceptance from foreign private issuers of financial statements prepared in accordance with International Financial Reporting Standards without reconciliation to U.S. GAAP’, RIN 3235-AJ90, Washington: SEC. Takatera, S. & Yamamoto, M. (1987), ‘The cultural significance of accounting in Japan’, Seminar on Accounting and Culture, European Institute for Advanced Studies in Management, Brussels. Unerman, J. & O’Dwyer, B. (2004), ‘Basking in Enron’s reflexive goriness: mixed messages from the UK profession’s reaction’, paper presented at Asia Pacific Interdisciplinary Research on Accounting Conference, Singapore. Veron, N. (2007), The Global Accounting Experiment, Brussels: Bruegel Publishers. Violet, W. J. (1983), ‘The development of international accounting standards: an anthropological perspective’, International Journal of Accounting Education and Research, 18(2), pp. 1–12. Wyatt, A. R. & Yospe, J. F. (1993), ‘Wake-up call to American business; International Accounting Standards are on the way’, Journal of Accountancy, July, pp. 80–5. Zarzeski, M. T. (1996), ‘Spontaneous harmonization effects of culture and market forces on accounting disclosure practices’, Accounting Horizons, 10(1), pp. 18–37. Zysman, J. (1983), Government, Markets and Growth: Financial Systems and the Politics of Change, Ithaca, NY: Cornell University Press.
CHAPTER
6
MEASUREMENT ISSUES: ACCOUNTING FOR THE EFFECTS OF CHANGING PRICES AND MARKETS LEARNING OBJECTIVES On completing this chapter, readers should: LO6.1
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LO6.3
LO6.4
understand what ‘measurement’ means, why it is a potentially controversial issue, and some of the factors that accounting standard-setters consider when prescribing one particular measurement approach in preference to another be aware of the various measurement approaches currently, and potentially, in use be aware of some particular limitations of historical cost accounting in terms of its ability to cope with various issues associated with changing prices and changing market conditions be aware of a number of alternative methods of asset valuation that have been developed to address problems associated with changing prices and market conditions, including fair value accounting
LO6.5
be able to identify some of the strengths and weaknesses of the various alternative accounting methods and measurement approaches
LO6.6
understand that the calculation of income under a particular method of accounting will depend on the perspective of capital maintenance that has been adopted
LO6.7
be aware of the increasing use of fair value measurement in financial reporting standards, and understand some concerns about, and criticisms of, fair value measurements
LO6.8
be aware of evidence about the demand for, and professional support of, alternative measurement approaches.
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OPENING QUESTIONS Before reading this chapter, please consider how you would answer the following three questions. We will return to these questions at the end of the chapter, where we suggestModule 1 Questions / some answers. Various asset valuation approaches are typically utilised within a set of financial reports. Non-current assets acquired (or perhaps revalued) in different years can be added together to give a total monetary value, even though the various costs or valuations might provide little reflection of the current values of the respective assets. For example, pursuant to IAS 16 Property, Plant and Equipment, it is permissible for some classes of property, plant and equipment to be measured at cost, less accumulated depreciation and impairment losses, whereas another class of property, plant and equipment is allowed to be measured at fair value.1 The different measurements will then simply be added together to give a total monetary value for property, plant and equipment – with the total representing neither cost nor fair value.
Answers
1 What are some of the criticisms that can be made in relation to the practice of accounting wherein assets that have been acquired or valued in different years are added together, without adjustment (as occurs with historical cost accounting), when the purchasing power of the dollar in those years was conceivably quite different? 2 What are some of the alternative methods of accounting (alternatives to historical cost accounting) that have been advanced to cope with the issue of changing prices and market conditions, and what acceptance have these alternatives received from the accounting profession and accounting researchers? 3 What are the perceived strengths and weaknesses of the alternatives to historical cost?
Introduction Chapter 4 considered various theoretical explanations for why regulation might be put in place. Perspectives derived from public interest theory, capture theory and the economic interest theory of regulation did not attempt to explain what form of regulation was most optimal or efficient. Rather, by adopting certain theoretical assumptions about individual behaviour and motivations, the theories attempted to explain which parties were most likely to try to affect the regulatory process, and perhaps succeed in doing so. This chapter considers a number of normative theories of accounting. Based on particular judgements about the types of information people need (which could be different from what they think they want), the various normative theories provide prescriptions about how the process of financial accounting should be undertaken and, in particular, how assets (and liabilities) should be measured.2 The chapter also considers efforts of the International Accounting Standards Board (IASB) and Financial Accounting Standards Board (FASB) to develop appropriate measurement bases as part of the work that was undertaken to develop a revised conceptual framework for financial reporting. What we shall see is that fair value has become the preferred measurement base of the IASB, although there is also an acceptance that fair value is not appropriate in all cases. Across time, numerous normative theories of accounting have been developed by a number of well-respected academics, with these theories providing prescription in relation to measurement. However, these theories typically failed to be embraced by the accounting profession, or to 1
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Throughout this chapter, where reference is made to an accounting standard, reference will be made to the International Accounting Standard/International Financial Reporting Standard. Positive theories, by contrast, attempt to explain and predict accounting practice without seeking to prescribe particular actions. Positive accounting theories are the subject of analysis in Chapters 8 and 9.
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be mandated within financial reporting regulations. Relying in part on material introduced in Chapter 4, this chapter considers why some proposed methods of accounting are ultimately accepted by the profession and/or accounting standard-setters, while many are dismissed or rejected. We can question whether the rejection of a particular approach to financial reporting is related to the merit of the arguments (or lack thereof), or due to the political nature of the standardsetting process, wherein various vested interests and economic implications are considered. The chapter specifically considers various prescriptive theories of accounting (normative theories) that were advanced by various people on the basis that historical cost accounting, which was the dominant measurement basis for centuries, has too many shortcomings. These shortcomings become more apparent as the rate of price rises within the economy increases. As IAS 29 Financial Reporting in Hyperinflationary Economies (IASB 2022d, paragraph 2) states: In a hyperinflationary economy, reporting of operating results and financial position in the local currency without restatement is not useful. Money loses purchasing power at such a rate that comparison of amounts from transactions and other events that have occurred at different times, even within the same accounting period, is misleading. LO6.1
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The process of measurement
As we would appreciate through a study of financial accounting, different assets and liabilities are measured in different ways as a result of the application of different financial reporting standards. For example, inventory is required to be measured at the lower of cost and net realisable value (see IAS 2 Inventories), property, plant and equipment can be measured either at cost or fair value depending upon what election is made by management (see IAS 16 Property, Plant and Equipment), financial assets are generally to be measured at fair value (see IFRS 9 Financial Instruments), and many liabilities are to be measured at present value (see IAS 37 Provisions, Contingent Liabilities and Contingent Assets). This is referred to as a mixed measurement model of accounting wherein no one basis of measurement/valuation (for example, ‘fair value’, ‘present value’ or ‘historical cost’) is prescribed for all classes of assets and liabilities. Using a mixed measurement model provides flexibility for preparers of financial reports. For example, in measuring property, plant and equipment a preparer of financial reports applying IFRS might elect to use fair value to measure assets when an active market exists for the particular class of assets, and where market prices can be easily determined. However, for property plant and equipment that does not have an active market, such as might be the case for specialised machinery, the preparer might elect to utilise historical cost as the basis of measurement.3 Further, when markets become unstable (such as around the time of a severe financial crisis, such as the global financial crisis [GFC]), it might appear inappropriate to base the measurement of an asset on ‘fair value’ because of the uncertainties in the market and the low level of trading that might be occurring with respect to various classes of assets – all of which potentially leads to volatile prices. Therefore, different bases of measurement could be justifiable depending upon the attributes of ‘the market’ at a particular point in time. While there can be good reasons for having a mixed measurement model for accounting, some downsides of allowing a mixture of different measurement approaches include: • it potentially undermines the comparability of financial reports prepared by organisations that use different measurement bases • it leads to what is known as an ‘additivity problem’ wherein the sum of total assets will represent the summation of assets (and liabilities) measured on different bases 3
Fair value The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.
Present value The value of an item to be received or paid for in the future expressed in terms of its value today.
Mixed measurement model of accounting An approach to accounting wherein a variety of measurement approaches are used to measure assets and liabilities.
Active market A market in which transactions for the asset or liability take place with sufficient frequency and volume to provide pricing information on an ongoing basis.
Historical cost Assets are recorded at the amount of cash or cash equivalents paid, or the fair value of the consideration given, to acquire them at the time of their acquisition. Liabilities are recorded at the amount of proceeds received in exchange for the obligation, or in some circumstances (for example, income taxes), at the amounts of cash or cash equivalents expected to be paid to satisfy the liability in the normal course of business.
The use of historical cost or fair value for balance sheet purposes also has implications for the income statement. For example, under IFRS, the recognition of an increase in the fair value of a depreciable non-current asset will lead to an increase in ‘other comprehensive income’ in the year of revaluation but will also lead to increases in depreciation expenses, potential increases in impairment losses and ultimate reductions in the profit on sale.
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• where choice is available, it allows for the possibility that managers will opportunistically
select the measurement basis that best suits them (that is, the method that provides a preferred result). While we have now discussed measurement briefly, we have not defined it. For financial reporting purposes, measurement is the process of determining the monetary amounts at which the elements of the financial statements are to be recognised and carried in the balance sheet (statement of financial position) and income statement (statement of profit or loss and other comprehensive income). This involves the selection of the particular basis of measurement, or the ‘measurement basis’. As paragraphs 6.1 and 6.2 of the IASB Conceptual Framework for Financial Reporting (Conceptual Framework; IASB, 2022c) state: 6.1 Elements recognised in financial statements are quantified in monetary terms. This requires the selection of a measurement basis. A measurement basis is an identified feature – for example, historical cost, fair value or fulfilment value – of an item being measured. Applying a measurement basis to an asset or liability creates a measure for that asset or liability and for related income and expenses. 6.2 Consideration of the qualitative characteristics of useful financial information and of the cost constraint is likely to result in the selection of different measurement bases for different assets, liabilities, income and expenses.
There is generally a sequence of events when recording transactions and events within financial accounts. These are represented in Figure 6.1. In terms of the steps to be undertaken: 1 The financial accountant initially has to consider and apply the respective definitions of the elements of financial accounting. These elements are assets, liabilities, equity, income and expenses (we explore these definitions and their associated recognition criteria in Chapter 7 when we discuss the IASB Conceptual Framework). FIGURE 6.1 A summary of some of the steps undertaken within the financial accounting process
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STEP 1
Definition of an element of financial accounting Does the transaction or event seem to satisfy the definition of either an asset, liability, income, expense or equity item?
STEP 2
Recognition criteria When should the particular transaction or event that satisfies one of the element definitions be recorded within the financial accounting system?
STEP 3
Measurement What financial amount should be recorded for the respective transaction or event that satisfies the definition of an element?
STEP 4
Disclosure and presentation Should the particular item be disclosed separately, and if so, how should the particular item be presented within the financial statement?
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2 Once the financial accountant is satisfied that a transaction or event creates something that
satisfies one of the element definitions, the financial accountant then needs to determine when to actually recognise the transactions or events; that is, they need to determine when to make adjustments to the respective financial accounts that comprise the assets, liabilities, income, expenses and equity of an organisation. 3 Once the financial accountant has determined that they will recognise a transaction or event, they then need to determine how to financially measure the respective transaction or events so that they know the monetary value to assign to the financial accounts. This is the focus of this chapter. 4 Finally, financial accountants then need to determine what to disclose and how to present the respective elements of accounting within the financial statements (and various financial reporting standards will provide guidance here). Measurement is obviously a very fundamental issue within financial accounting. Measurement allows us to attribute monetary amounts to the items that appear within financial reports. Without some form of measurement, we might just simply provide pages of descriptions of the various assets and liabilities that are controlled or payable by the organisation, and this would be very confusing. However, when financial reporting standard-setters prescribe some measurement approaches in preference to others then this can potentially be very controversial as it can have profound effects upon financial reports, and therefore also on agreements, or contracts, that utilise numbers from the financial statements. For example, organisations might be subject to borrowing agreements that only allow additional borrowing by the organisation if specified debt to asset ratios are not breached (and conversely, might require repayment of borrowed funds if the prescribed financial accounting ratios are breached – often referred to as a ‘technical default’ of a borrowing agreement), or perhaps there are requirements that the organisation’s reported profits (with various negotiated adjustments) covers interest expense by a specified number of times (referred to as an ‘interest coverage clause’). Also, management might be paid bonuses tied to some proportion of reported profits, or perhaps government provides funding to the organisation based on some measure of efficiency, such as its ‘return on assets’. What is being emphasised here – and something which is explored in greater depth in Chapter 8 – is that financial accounting numbers are used in many contractual agreements to which an organisation is party. Therefore, how assets and liabilities are measured can be a very political issue as it can have many cash flow implications for an organisation, and therefore for the wealth of many stakeholders. There are various bases of measurement that could be used, including: • historical cost, which will be based on prices paid in the past (and which perhaps are not reflective of current costs and therefore can suffer problems pertaining to ‘relevance’) • current costs, perhaps based on the cost to replace the item with an identical item (and replacement costs can be considered as an ‘entry price’) or on the basis of the amount that would be paid now to replace the future economic benefits expected to be generated by the item • fair value, which represents the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date • net realisable value, for example fair value less the costs of disposal, which can also be considered as an example of an ‘exit value’ • present value, which relies upon various subjective judgements such as expectations about future cash flows and their timing, as well as judgements associated with respect to selecting an appropriate discount rate. ‘Value-in-use’, which is considered when determining the ‘recoverable amount’ of an asset (see IAS 36), relies upon present values • deprival value, which would reflect the loss that would be incurred if an organisation was ‘deprived’ of the asset being measured. It would be determined as the lower of the replacement cost of the asset and its recoverable amount (with recoverable amount being the higher of the asset’s fair value less costs to sell and its value in use).
Measurement The assignment of a quantitative measure to a particular item. In financial accounting it results from the application of a measurement basis – such as historical cost or fair value – to an asset, liability and related income and expenses.
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Why do I need to know about different measurement bases? Because financial reports use various measurement bases for assets and liabilities, we need to appreciate what the various measurement bases actually reflect so that we can understand what the monetary amounts reported within financial reports actually represent, thereby allowing us to more fully understand the contents of financial reports. Understanding the different measurement bases allows us to consider the likely relevance and representational faithfulness of alternative measures.
As researchers, we would need to understand Why the different measurement bases together with their respective strengths and weaknesses so that we can potentially suggest improvements to current practice. Further, across time, there have been controversies and crises (such as the collapse of Enron, and the GFC) that have been linked to various measurement bases. To understand these controversies and how financial accounting might have contributed to the particular events, we need to know the differences between available, and potential, approaches to assets and liability measurement.
REFLECTION QUESTION 6.1 The relationship between measurement and contractual compliance Question How can the selection of a particular measurement basis by an organisation impact on an accounting-based contractual agreement that it is party to, such as ‘debt to asset’ or ‘interest coverage’ debt covenant? Solution As we explain more fully in Chapter 8, most organisations – particularly, larger organisations – agree to certain accountingbased contractual agreements as part of the process of borrowing funds. Such contractual agreements allow them to borrow funds at a cost that is lower than would be the case without such agreements. For example, to satisfy the requirements of lenders, the managers of an organisation might agree to: • keeping the organisation’s reported debt to assets to less than 60 per cent • ensuring that the organisation’s profits covers the total interest expense by 5 times (this is typically referred to as an ‘interest coverage’ requirement). If the organisation breaches the above requirements, then under the terms of the agreement that has been negotiated, the lender might have a contractual right to insist on immediate repayment of the loaned funds. Now let us assume that at the end of the reporting period the organisation’s draft financial reports show total assets of $100 million and total liabilities of $62 million, total interest expenses of $2 million and profits of $12 million. Let us also assume that the organisation has land that cost $3 million
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many years earlier and which is measured at historical cost, but which has a fair value of $8 million. Given the above numbers, we can see that at the present time the organisation is in technical default of the debt to asset covenant negotiated with the lender. The debt to asset ratio is 62 per cent when the organisation agreed to keep it below 60 per cent. The interest coverage requirement has not been breached. Because one of the covenants within the lending agreement has been breached, the organisation could, pursuant to the contract, be forced to pay back the borrowed funds. What can the organisation do to alleviate this problem? Before finalising its financial reports, it could potentially revalue the land to its fair value of $8 million. This would increase total assets to $105 million, meaning that the debt to asset ratio would fall to 59 per cent (62/105) and the organisation would no longer be in technical default. Of course, this assumes that the borrowing agreement permits the organisation to use revaluations for contractual purposes. Assuming that the contract allows such revaluations to fair value, a change in measurement basis from historical cost to fair value for a class of assets (land) has allowed the organisation to comply with a negotiated debt covenant, thereby avoiding either a costly renegotiation with the lenders or having to pay back borrowed funds. While this is a simplified example, it does provide an insight into how an asset measurement choice can have real cash flow consequences for an organisation, and therefore potentially for its shareholders and other stakeholders.
Measurement issues: accounting for the effects of changing prices and markets CHAPTER 6
Determining how an asset or liability should be measured should ideally be linked to the perceived objectives of general purpose financial reporting – something that we explore more fully in Chapter 7. According to paragraph 1.2 of the IASB Conceptual Framework (IASB, 2022c), 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 relating to providing resources to the entity. Those decisions involve decisions about: (a) buying, selling or holding equity and debt instruments; (b) providing or settling loans and other forms of credit; or (c) exercising rights to vote on, or otherwise influence, management’s actions that affect the use of the entity’s economic resources
The balance of the Conceptual Framework is built on this objective. Parts a and b relate to the information needed to help users of financial statements assess the prospects for future net cash inflows to the entity and to inform their future investment or lending decisions (resource allocation decisions) with respect to the reporting entity. This is linked to the notion of ‘decision usefulness’. That is, investors and lenders are perceived by the IASB to find it useful to their resource allocation decisions to have information about an organisation’s financial performance and financial position. When the Conceptual Framework was revised and re-released in 2018, part c was added. This additional component relates to what is known as ‘stewardship’. The IASB’s use of the term ‘stewardship’ is consistent with the general understanding of that term, which means the careful and responsible management of something entrusted to one’s care. From an accounting perspective, ‘stewardship’ refers to the process wherein a manager demonstrates how they have used the resources that have been entrusted to them by others who generally are not directly involved in the management of the entity. That is, the demonstration of ‘stewardship’ requires those who are in control of, and who use resources (managers), to provide an ‘account’ of this control and use to those stakeholders to whom they are accountable (for example, shareholders). Traditionally, stewardship was seen as one of the key roles of historical cost accounting, and some researchers and practitioners questioned the usefulness of fair value measurements for assessing managements’ stewardship of the resources entrusted to them. Relatedly, Ijiri (1975) also noted that to assess the stewardship being demonstrated by managers, it is preferable to use information that is as ‘hard’ as possible, and he defines a hard measure as ‘one that is constructed in such a way that it is difficult for people to disagree’ (p. 36). Ijiri (1975) believed that historical cost – being a relatively ‘hard’ measure – was best for assessing stewardship. However, other researchers, such as Edwards and Bell (1961), note that measurements of current or market (fair) values also provide useful information in assessing management’s past purchasing and production decisions, and therefore also have applicability when assessing stewardship. Therefore, the most recent version of the IASB Conceptual Framework embraces two objectives for financial reporting, these being to provide information that is useful for the decisions being made by financial capital providers in terms of: 1 making decisions regarding the allocation of their economic resources 2 assessing the actions managers have taken with respect to the economic resources that have been entrusted to them. The reinstatement of the notion of stewardship follows its previous removal in 2010 when the IASB and the FASB were jointly developing a revised Conceptual Framework. The Conceptual Framework now notes that users need information to enable them to assess management’s stewardship so that they can hold them ‘to account’ for the resources entrusted to their care.
Stewardship The acceptance of a responsibility to look after, or safeguard, the assets or entitlements of identified parties. Refers to the process whereby a manager demonstrates how they have used the resources that have been entrusted to them by others who generally are not directly involved in the management of the entity.
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This is a broader perspective of accountability than was evident in the 2010 Conceptual Framework. Paragraph 1.22 now states: Information about how efficiently and effectively the reporting entity’s management has discharged its responsibilities to use the entity’s economic resources helps users to assess management’s stewardship of those resources. Such information is also useful for predicting how efficiently and effectively management will use the entity’s economic resources in future periods. Hence, it can be useful for assessing the entity’s prospects for future net cash inflows. (IASB, 2022c)
Relevance Information that will make a difference to a decision maker. From a financial accounting perspective, relevant information will have predictive value, confirmatory value, or both.
Representationally faithful Information is ‘representationally faithful’ if it is complete, neutral and free from error; it depicts what it claims to depict.
Pelger (2016) provides some interesting insights into the previous decision by the IASB and FASB to remove stewardship from the 2010 version of the Conceptual Framework. As he notes, the decision to remove the reference to stewardship was somewhat surprising as stewardship historically was one of the main reasons for the existence of financial accounting and is still considered to shape accounting practices. Pelger (2016) also noted that it was overwhelmingly the US participants from the FASB who were strongly opposed to the retention of stewardship as an explicit part of the objective of general purpose financial reporting. The standard-setters from the United States thought the objective that needed to be focused upon was the information needs of external providers of financial capital – that is, a focus on ‘decision usefulness’. Because the IASB worked on the 2018 version – and subsequent versions – of the Conceptual Framework (without the FASB), the members of the IASB were able to reintroduce stewardship without the previous opposition from US participants. According to the IASB Conceptual Framework, to fulfil the requirement that information is ‘decision useful’, financial information should be both ‘relevant’ and ‘representationally faithful’ and allow financial statement readers to make informed resource allocation decisions (IASB, 2022c). The IASB’s ultimate selection of a particular measurement base will supposedly be tied to whether a particular measurement approach enables the above objective of general purpose financial reporting to be satisfied. The IASB previously identified three fundamental principles of measurement that flow from the objective of financial reporting and the qualitative characteristics of useful financial information as described in Chapters 1 and 3 of the Conceptual Framework. Figure 6.2 details the three principles. FIGURE 6.2 The IASB’s three fundamental principles of measurement
Principle 1
The objective of measurement is to represent faithfully the most relevant information about the economic resources of the reporting entity, the claims against the entity, and how efficiently the entity's management and governing board have discharged their responsibilities to use the entity's resources.
Principle 2
Although measurement generally starts with an item in the statement of financial position, the relevance of information provided by a particular measurement method also depends on how it affects the statement of profit or loss and other comprehensive income and if applicable, the statements of cash flows and of equity and the notes to the financial statements.
Principle 3
The cost of a particular measurement must be justified by the benefits of that information to existing and potential investors, lenders, and other creditors of reporting that information.
Source: Based on IASB (2013b), Staff Paper: Conceptual Framework Draft Discussion Paper: Measurement Principles (paragraph 5).
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Based on the increasing use of fair value in various newly released accounting standards (in preference to other measurement approaches, such as historical cost), it appears that the IASB considers that measuring many classes of assets at fair value will provide more relevant and representationally faithful information than measuring all assets at ‘cost’.4 However, as the objective of general purpose financial reporting also considers stewardship, it is not resolved whether fair value is relatively useful for assessing stewardship. There is some argument that historical cost provides a clearer perspective about what management has done with the funds that were entrusted to it. Demonstrating how funds have been used is a key component of stewardship. However, there is also a counterargument that in assessing the stewardship of management, interested parties would not only want to know about the original amounts spent by managers, but also about how monies spent have increased in value, and historical cost accounting might be deficient in this respect. Arguments regarding what measurement bases best serve ‘decision usefulness’ and ‘stewardship’ roles are therefore far from settled.
Measurement bases utilised within financial reporting standards LO6.2
As already indicated, accounting standards issued by the IASB, and therefore used within many countries globally, use a variety of measurement bases. We have noted that this has been referred to as a mixed measurement model of accounting. While a mixed measurement model provides flexibility for organisations to select those accounting methods that most efficiently represent the underlying facts, it does make comparability between organisations difficult. It also provides managers with the ability to select accounting methods in a manner driven more by opportunism than a desire to produce representationally faithful accounts – something we explore more in Chapter 8. As an example of how comparability between organisations can be difficult, we can consider the measurement rules applicable to property, plant and equipment as reflected in IAS 16 Property, Plant and Equipment. These rules are reflected in Figure 6.3. As Figure 6.3 shows, when it comes to property, plant and equipment we effectively have a mixed measurement model available within the one accounting standard. When items are originally recognised (perhaps on the date of acquisition), they are to be measured at ‘cost’ (with the components of cost being described within the accounting standard). ‘Cost’ on the date of acquisition would often also be the same as fair value. As paragraph 4 of IASB (2013a) states: Most transactions that result in recognition of assets and liabilities involve unrelated parties that are not in financial distress or another form of duress. In such transactions the value of the consideration given is normally equal to the value of the consideration received, and that amount is presumed to be the fair value. Because in most cases, cost is the fair value of the consideration given or received, cost and fair value often are the same at the recognition date. However, the two will begin to diverge immediately, which is why many of the most contentious measurement issues relate to subsequent measurement.
For property, plant and equipment, following initial recognition, the organisation then, in accordance with IAS 16, has a choice to use either the ‘cost model’ or the ‘revaluation model’. Where the revaluation model is chosen then the measurement basis to be employed subsequent to initial
4
The IASB Conceptual Framework for Financial Reporting is explored in depth in Chapter 7. As that chapter discusses, the two fundamental qualitative characteristics that useful financial information possesses are relevance and representational faithfulness – both of which are required before financial information can be considered to be useful.
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FIGURE 6.3 Measurement rules for property, plant and equipment At time of initial acquisition
Item to be measured at ‘cost’
Measurement subsequent to initial recognition
or
Cost model
Revaluation model
Yes
After recognition as an asset, an item of property, plant and equipment shall be carried at its cost less any accumulated depreciation and any accumulated impairment losses.
The fair value of items of plant and equipment is their market value determined by reference to quoted prices in active markets. Referred to as ‘mark-to-market’.
Is market-based evidence available?
No
The entity will need to estimate fair value by using unobservable inputs within a valuation model. Referred to as ‘mark-to-model’.
recognition is ‘fair value’. Hence, at this point we can see there are problems of comparability – some companies might use ‘cost’ and others ‘fair value’ and this will impact numbers such as ‘total assets’ and will also impact various income and expense items, such as depreciation expenses, impairment losses, and gain or loss on disposal of the item. Hence, difficulties will arise in comparing the financial position and financial performance of an organisation that uses the cost model with an organisation that uses the revaluation model. Further complicating matters, an individual organisation can use the cost model for some classes of property, plant and equipment, and the ‘revaluation model’ for other classes. This gives rise to the additivity problem – within a single reporting entity some classes of property, plant and equipment might be measured at cost while other classes might be measured at fair value, meaning that any total for property, plant and equipment provides a number that is neither based on cost or fair value, but a mixture of both. Whether such a total would be relevant or meaningful to many report readers is questionable. Also, as Figure 6.3 shows, when the ‘revaluation model’ is chosen, how fair value is determined will be dependent upon whether market-based evidence of prices is available. If there is an active market for the item, with many similar items being traded, then the market price can be fairly objectively determined. However, if an active market does not exist, then the accounting standard allows fair value to be determined by use of a valuation model, and this will require various judgments to be made. Hence, even when fair value is used as the basis of measurement, there can be a mixture of methods used to determine fair value.
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REFLECTION QUESTION 6.2 Revaluation of assets and the implications for reported profits Question Why will reported profits or losses change as a result of an upward revaluation of an asset, and if they do, so what? Solution To answer this question, let us consider an example. An organisation has an item of machinery with a cost of $10 million and accumulated depreciation of $1 million (therefore having a carrying amount of $9 million). It has an expected remaining useful life of nine years with no expected residual value at the end of its useful life. It is assessed as having a fair value of $15 million and will be revalued. Other comprehensive income As a result of revaluing the asset to its fair value, there will be an increase in the carrying amount of the asset by $6 million. This increment would be recorded, pursuant to IAS 16, as part of ‘other comprehensive income’ and not part of profits. Nevertheless, ‘comprehensive income’, which is the sum of ‘profit or loss’ and ‘other comprehensive income’, will increase by the $6 million. Depreciation expense Had the revaluation not occurred, depreciation would be $9m ÷ 9 = $1m. Following the revaluation, the depreciation expense will be $15m ÷ 9 = $1.67m. Therefore, the revaluation will cause a reduction in profits due to the higher depreciation expenses. Profit on sale If the revalued asset is sold one year after revaluation for $16 million, then the profit on sale will equal the sale price less the carrying amount of the asset which equals $16m– (15m– $1.67m) = $2.67m. Had no revaluation been made, the profit on sale would have been $16m – $8m = $8m. Therefore, as a result of the revaluation, the profit on sale of the asset is lower.
Reflection
So what? So, while the revaluation led to an increase in ‘total other comprehensive income’ in the year of revaluation, it led to a subsequent increase in depreciation expenses (thereby reducing reported profits) and a reduction in profit on sale (also reducing reported profits relative to using historical cost). However, following the upward revaluation, the reported assets would be higher, as would be equity. Pursuant to IFRS, ‘profit or loss’ and ‘total other comprehensive income’ shall be presented separately with the total being ‘comprehensive income for the period’. Many contractual agreements are tied to reported profits. For example, managers are often paid a bonus linked to profits, and managers frequently negotiate borrowing agreements that utilise measures of profits – such as interest coverage clauses (which require profit to exceed interest expenses by an agreed number of times). Therefore, there can potentially be adverse contractual implications associated with a revaluation, as revaluations tend to lead to a reduction in reported profits, and measures of profits are often used within accounting-based contracts. Lending agreements often have restrictions, such as debt to asset agreements which stipulate that debt is not to exceed a certain percentage of assets. An upward revaluation can tend to reduce the possibility of organisations breaching such restrictions. Therefore, from a contracting perspective, whether a revaluation is undertaken can have cash-flow implications for an organisation. Further, the market often has expectations about what the reported profits will be for an organisation. Managers also often make profit forecasts. With all this in mind, managers are sometimes motivated to change the timing of any possible asset revaluations, albeit there is a general principle that revaluations should be undertaken objectively, and once an organisation decides to use the ‘revaluation model’, revaluations are to be undertaken regularly.
Factors to consider when choosing between alternative measurement bases LO6.1
The IASB and the FASB did, as part of their former joint initiative to develop a revised Conceptual Framework, identify a number of factors that need consideration before a preferred approach (or a number of approaches) to measurement is (are) selected. According to the website of the FASB (2021), five factors that might be considered in selecting from among alternative measurement bases are: 1 Value/flow weighting and separation. The relative importance to users of information about the current value of the asset or liability versus information about the cash flows generated by the item, as well as the ease and precision with which the flows can be separated from the value changes (an indication of relevance) 229
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2 Confidence level. The level of confidence that can be placed on alternative measurements as representations of the asset or liability being measured (an indication of faithful representation) 3 The measurement of similar items. Items of a similar nature should be measured in similar ways (an indication of comparability) 4 The measurement of items that generate cash flows together. Items that generate cash flows as a unit should be measured the same way (an indication of understandability) 5 Cost-benefit. An assessment of the ratio of the benefits that would be derived from alternative measurements to the costs of preparing those measurements (an indication of the primary limiting factor in financial reporting).
As we can see from this list, there are a variety of issues that require consideration before standard-setters, such as the FASB or IASB, believe that they can favour particular measurement bases in preference to others. Some of these issues are quite complicated. The IASB and the FASB do not overwhelmingly favour one basis of measurement in preference to other alternatives due to a view that different measurement techniques will be appropriate in different circumstances.
Limitations of historical cost accounting in times of rising prices LO6.3
LO6.4
LO6.5
LO6.6
Until recent decades, historical cost was the dominant method used to measure assets and liabilities for financial reporting purposes. That is, while fair value is currently the measurement method to be applied in many financial reporting standards, this requirement is a relatively recent phenomenon. For many years, historical cost was the major required method for measurement of assets and liabilities. Nevertheless, historical cost is still required, or allowed, in a number of current accounting standards. Where the historical cost basis of measurement is used, the assets and liabilities will be measured on the basis of the transactions that occurred in the past – hence the name ‘historical cost’. The IASB Conceptual Framework (IASB, 2022c) provides a useful definition of historical cost, this being: 6.4 Historical cost measures provide monetary information about assets, liabilities and related income and expenses, using information derived, at least in part, from the price of the transaction or other event that gave rise to them. Unlike current value, historical cost does not reflect changes in values, except to the extent that those changes relate to impairment of an asset or a liability becoming onerous (see paragraphs 6.7(c) and 6.8(b)). 6.5 The historical cost of an asset when it is acquired or created is the value of the costs incurred in acquiring or creating the asset, comprising the consideration paid to acquire or create the asset plus transaction costs. The historical cost of a liability when it is incurred or taken on is the value of the consideration received to incur or take on the liability minus transaction costs.
Over time, criticisms of historical cost accounting have been raised by a number of notable scholars, particularly in relation to its inability to provide useful information in times of rising prices. That is, its ‘relevance’ was questioned. For example, criticisms were raised by Sweeney, MacNeal, Canning and Paton in the 1920s and 1930s. From the 1950s, the level of criticism increased, with notable academics (such as Chambers, Sterling, Edwards and Bell) prescribing 230
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different models of accounting that they considered provided more useful information than was available under conventional historical cost accounting. Such work continued through to the early 1980s, but declined thereafter as levels of inflation throughout the world began to drop. Subsequently, the debate changed to focus on the use of current market values – known as fair values (supposedly reflecting current market conditions at the end of the reporting period) – for valuing assets, rather than amending historic costs simply to take account of inflation.5 Across time, criticisms of historical cost appear to have been accepted by accounting regulators, at least on a piecemeal basis. In recent years, for example, various accounting standards have been released that require or permit the application of fair values when measuring assets. Historical cost accounting assumes that money holds a constant purchasing power. As Elliot (1986, p. 33) states: An implicit and troublesome assumption in the historical cost model is that the monetary unit is fixed and constant over time. However, there are three components of the modern economy that make this assumption less valid than it was at the time the model was developed.6 One component is specific price-level changes, occasioned by such things as technological advances and shifts in consumer preferences; the second component is general price-level changes (inflation); and the third component is the fluctuation in exchange rates for currencies. Thus, the book value of a company, as reported in its financial statements, only coincidentally reflects the current value of assets.
Again, it is emphasised that under our current financial reporting standards, many assets can or must be measured at historical cost. (For example, inventory must be measured at cost – or net realisable value if it is lower – and property, plant and equipment can be valued at cost where an entity has adopted the ‘cost model’ for a class of property, plant and equipment pursuant to IAS 16.) Measures such as the lower of cost and net realisable value can perhaps be justified in terms of conservatism but are very difficult to justify in terms of decision usefulness.
Why do I need to know about the limitations of historical cost? Financial accounting once relied almost entirely on the use of historical costs. To understand the history of financial accounting, we therefore need to understand what ‘historical cost’ represents. Historical costs are still used in relation to various assets and liabilities. Therefore, readers of financial statements need to understand what the associated numbers represent and what are the limitations inherent in such numbers. Further, while there has been an ongoing movement towards the use of fair values rather than historical costs, there has remained debate about whether fair value measurements are more relevant for stakeholders’ decision making relative to historical costs.
5
6
There has also been much debate about whether Why managers’ ‘stewardship’ over the resources that have been entrusted to them is best demonstrated through the use of historical costs or fair values. To understand this debate, we need to understand the strengths and limitations of historical costs and other bases of measurement, such as fair value. Also, if we work as researchers, regulators or teachers of financial accounting, we need to understand the strengths and weaknesses of alternative measurement approaches so that we are able to provide proper advice and guidance in relation to alternative approaches to measurement.
For example, there is a great deal of debate about whether inventory measurement rules (which require inventory to be measured at the lower of cost and net realisable value pursuant to IAS 2) provide relevant information in situations where the market (fair) value of the inventory greatly exceeds its cost. As indicated in Chapter 3, the historical cost method of accounting was documented as early as 1494 by the Franciscan monk Pacioli in his famous work Summa de Arithmetica, Geometrica, Proportioni et Proportionalita.
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While there was much criticism of historical cost accounting during the high-inflation periods of the 1970s and 1980s, there were also many people who supported historical cost accounting. The practice of financial accounting used today still utilises historical cost accounting. Hence, the accounting profession and reporting entities have tended to maintain at least partial support for the historical cost approach. The very fact that historical cost accounting has continued to be applied by business entities for certain items has been used by a number of academics to support its continued use (which in a sense is a form of accounting-Darwinism perspective – the view that those things that are most efficient and effective will survive over time). For example, Mautz (1973) states: Accounting is what it is today not so much because of the desire of accountants as because of the influence of businessmen. If those who make management and investment decisions had not found financial reports based on historical cost useful over the years, changes in accounting would long since have been made.7,8
It has been argued (for example, Chambers, 1966) that historical cost accounting information suffers from problems of irrelevance in times of rising prices. That is, it is questioned whether it is useful to be informed that something cost a particular amount many years ago when its current value (as perhaps reflected by its replacement cost, or current market value) might be considerably different. It has also been argued that there is a real problem of additivity. At issue is whether it is logical to add together assets acquired at cost in different periods when those assets were acquired with dollars of different purchasing power.9 Again, we need to remember that there are still many assets and liabilities measured at historical costs, so many of these concerns expressed decades ago are still pertinent today. In countries that have adopted IFRS, organisations are permitted to revalue their non-current assets. What often happens, however, is that different assets are revalued in different periods (with the local currency – for example, dollars or euros – having different purchasing power in each period), yet the revalued assets might all be added together, along with assets that have continued to be valued at cost, for the purposes of balance sheet (also known as the statement of financial position) disclosure.10
However, because something continues to be used does not mean that there is nothing else that might not be better. This is a common error made by proponents of decision usefulness studies. Such studies attempt to provide either support for, or rejection of, something on the basis that particular respondents or users indicated that it would, or would not, be useful for their particular purposes. Often there are things that might be more ‘useful’ – but they are unknown by the respondents. As Gray, Owen and Adams (1996, p. 75) state: ‘Decision usefulness purports to describe the central characteristics of accounting in general and financial statements in particular. To describe accounting as useful for decisions is no more illuminating than describing a screwdriver as being useful for digging a hole – it is better than nothing (and therefore “useful”) but hardly what one might ideally like for such a task.’ 8 Reflective of the lack of agreement in the area, Elliot (1986) adopts a contrary view. Still relying on metaphors associated with evolution, Elliot (p. 35) states: ‘There is growing evidence in the market place … that historical cost-basis information is of ever declining usefulness to the modern business world. The issue for the financial accounting profession is to move the accounting model toward greater relevance or face the fate of the dinosaur and the messenger pigeon.’ 9 Again, under existing accounting standards, assets such as property, plant and equipment can be measured at fair value or at cost. IAS 16 gives reporting entities the choice between applying the fair value model or the cost model to the different classes of property, plant and equipment. Hence, we are currently left with a situation where, even within a category of assets (for example, property, plant and equipment), some assets might be measured at cost while others might be measured at fair value. 10 In relation to property, plant and equipment, IAS 16 requires that where revaluations to fair value are undertaken, the revaluations must be made with sufficient regularity to ensure that the carrying amount of each asset in the class does not differ materially from its fair value at the end of the reporting period. Nevertheless, there will still be instances where some assets have not been revalued for three to five years but they will still be aggregated with assets that have been recently revalued. 7
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There is also an argument that methods of accounting that do not take account of changing prices, such as historical cost accounting, can tend to overstate profits in times of rising prices, and that distribution to shareholders of historical cost profits can actually lead to an erosion of operating capacity. For example, assume that a company commenced operations at the beginning of the year with $100 000 in inventory comprising 20 000 units at $5.00 each. If at the end of the reporting period all the inventory had been sold, there were assets (cash) of $120 000 and throughout the year there had been no contributions from owners, no borrowings and no distributions to owners, then profit under an historical cost system would be $20 000. If the entire profit of $20 000 was distributed to owners in the form of dividends, the financial capital would be the same as it was at the beginning of the year. Financial capital would remain intact.11 However, if prices had increased throughout the period, the actual operating capacity of the entity may not have remained intact. Let us assume that the company wishes to acquire another 20 000 units of inventory after it has paid $20 000 in dividends, but finds that the financial year-end replacement cost has increased to $5.40 per unit. The company will be able to acquire only 18 518 units with the $100 000 it still has available. By distributing its total historical cost profit of $20 000, with no adjustments being made for rising prices, the company’s ability to acquire goods and services has fallen from one period to the next. Some advocates of alternative approaches to accounting would prescribe that the profit of the period is more accurately recorded as $120 000 less 20 000 units at $5.40 per unit, which equals $12 000. That is, if $12 000 is distributed to owners in dividends, the company can still buy the same amount of inventory (20 000 units) as it had at the beginning of the period – its purchasing power remains intact.12 Despite the problems associated with measuring inventory at historical cost, organisations using IFRS are still required to measure their inventory at cost (or net realisable value if it is lower than cost) pursuant to IAS 2. In relation to the treatment of changing prices, we can usefully, and briefly, consider IAS 41 Agriculture. IAS 41 provides the measurement rules for biological assets (for example, for grapevines or cattle). The accounting standard requires that changes in the fair value of biological assets from period to period be treated as part of the period’s profit or loss. In the development of the accounting standard, there were arguments by some researchers (Roberts, Staunton and Hagan, 1995) that the increases in fair value associated with changing prices should be differentiated from changes in fair value that are due to physical changes (for example, changes in the size or number of the biological assets). The argument was that only the physical changes should be treated as part of profit or loss. Although IAS 41 treats the total change in fair value as part of income, it is interesting to note that IAS 41 ‘encourages’ disclosures that differentiate between changes in the fair values of the biological assets that are based upon price changes, and those based on physical changes. As paragraph 51 of IAS 41 (IASB, 2022a) states: The fair value less costs to sell of a biological asset can change due to both physical changes and price changes in the market. Separate disclosure of physical and price
While it might be considered that measuring inventory at fair value would provide relevant information, IAS 2 Inventories prohibits the revaluation of inventory. Specifically, IAS 2 still requires inventory to be measured at the lower of cost and net realisable value. 12 In some countries, such as the United States, an inventory cost-flow assumption based on the last-in-firstout (LIFO) method can be adopted (this cost-flow assumption is not allowed under IAS 2). The effect of employing LIFO is that cost of goods sold will be determined on the basis of the latest cost, which in times of rising prices will be higher, thereby leading to a reduction in reported profits. This does provide some level of protection (although certainly not complete) against the possibility of eroding the real operating capacity of the organisation. 11
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changes is useful in appraising current period performance and future prospects, particularly when there is a production cycle of more than one year. In such cases, an entity is encouraged to disclose, by group or otherwise, the amount of the change in fair value less costs to sell included in profit or loss due to physical changes and due to price changes. This information is generally less useful when the production cycle is less than one year (for example, when raising chickens or growing cereal crops).
In relation to the above disclosure guidance, it is interesting to consider why the regulators considered that financial statement users would benefit from separate disclosure of price changes and physical changes in relation to agricultural assets when similar suggestions are not provided within other accounting standards relating to other categories of assets. This is somewhat inconsistent and not justifiable from a conceptual perspective. Returning to the use of historical cost in general, it has also been argued that historical cost accounting distorts the current year’s financial results by including in the current year’s income holding gains that actually accrued in previous periods.13 For example, some assets may have been acquired at a very low cost in a previous period (and perhaps in anticipation of future price increases pertaining to the assets), yet under historical cost accounting the gains attributable to such actions will only be recognised in the subsequent periods when the assets are ultimately sold. As an illustration, let us assume that a reporting entity acquired some land in 2019 for $1 000 000. Its fair value increased to $1 300 000 in 2023 and then $1 700 000 in 2026. A decision is made to sell the land in 2027 for its new fair value of $1 900 000. If the land had been measured at cost, the entire profit of $900 000 would be shown in the 2027 financial year even though the increase in fair value accrued throughout the previous eight years. Arguably, placing all the gain in the last year’s profits distorts the results of that financial period as well as the results of preceding periods. Another potential problem of historical cost accounting is that it can lead to a distortion of ‘return-on-asset’ measures. For example, consider an organisation that acquired some machinery for $1 million and returned a profit of $100 000. Such an organisation would have a return on asset of 10 per cent. If another organisation later acquired the same type of asset at $2 million (due to rising prices) and generated a profit of $150 000, then on the basis of return on assets the second organisation would appear less efficient, pursuant to historical cost accounting. There is a generally accepted view that dividends should be paid only from profits (and this is enshrined within the corporations laws of many countries). However, one central issue relates to how we measure ‘profits’. There are various definitions of profits. One famous definition, provided by Hicks (1946), is that profits (or ‘income’, as he referred to it) is the maximum amount that can be consumed during a period while still expecting to be as ‘well off’ at the end of the period as at the beginning of the period. Any consideration of ‘well-offness’ relies on a notion of capital maintenance – but which one? Different notions will provide different perspectives of profit. There are a number of perspectives of capital maintenance. One version of capital maintenance is based on maintaining financial capital intact, and this is the position taken in historical cost accounting. Under historical cost accounting, dividends should normally be paid only to the extent that the payment will not erode financial capital, as illustrated in the earlier example of a company needing to replace 20 000 units of inventory where $20 000 is distributed to owners in the form of dividends and no adjustment is made to take account of changes in prices and the related impact on the purchasing power of the entity. 13
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Holding gains are those that arise while an asset is in the possession of the reporting entity.
Measurement issues: accounting for the effects of changing prices and markets CHAPTER 6
Another perspective of capital maintenance is one that aims at maintaining purchasing power intact.14 Under this perspective, historical cost accounts are adjusted for changes in the purchasing power of the dollar (typically by use of the price index), which, in times of rising prices, will lead to a reduction in income relative to the income calculated under historical cost accounting. As an example, under general price level adjustment accounting (which is considered more fully later in the chapter), the historical cost of an item is adjusted by multiplying it by the chosen price index at the end of the current period, divided by the price index at the time the asset was acquired. For example, if some land, which was sold for $1 200 000, was initially acquired for $1 000 000 when the price index was 100, and the price index at the end of the current period is 118 (reflecting an increase in prices of 18 per cent), the adjusted cost would be $1 180 000. The adjusted profit on sale would be $20 000 (compared with an historical cost profit of $200 000).15 What should be realised is that under this approach to accounting where adjustments are made by way of a general price index, the value of $1 180 000 will not necessarily (except due to chance) reflect the current market value of the land. Various assets will be adjusted using the same general price index. Use of actual current values (as opposed to adjustments to historical cost using price indices) is made under another approach to accounting which seeks to provide a measure of profits which, if distributed, maintains physical operating capital intact. This approach to accounting (which could be referred to as current cost accounting) relies on the use of current values, which could be based on present values, entry prices (for example, replacement costs) or exit prices. Reflective of the attention that the impact of inflation was having on financial statements, Figure 6.4 is an article that appeared in The Australian in April 1975 (a period of high inflation of about 17 per cent and a time when debate in this area of accounting was widespread). In the discussion that follows, a number of different approaches to undertaking financial accounting in times of rising prices are considered. This discussion is by no means exhaustive but does give an insight into some of the models that have been prescribed by various accounting researchers.16 It also provides us with useful insights into many of the issues and suggestions that have been raised over the years, all of which had the intention of improving our system of financial reporting. By reading the following material, it allows us to place into context many of the judgements currently being made by the IASB and FASB in their work to determine appropriate bases of asset and liability measurement.
Gray, Owen and Adams (1996, p. 74) also provide yet another concept of capital maintenance – one that includes ‘environmental capital’. They state, ‘it is quite a simple matter to demonstrate that company “income” contains a significant element of capital distribution – in this case “environmental capital”. An essential tenet of accounting is that income must allow for the maintenance of capital. Current organisational behaviour clearly does not maintain environmental capital and so overstates earnings. If diminution of environmental capital is factored into the income figure it seems likely that no company in the western world has actually made any kind of a profit for many years.’ This issue is considered further in Chapter 10. 15 Hence, if $20 000 is distributed as dividends, the entity would still be in a position to acquire the same land that it had at the beginning of the period (assuming that actual prices increased by the same amount as the particular price index used). 16 For example, we will not be considering one approach to determining income based on present values, which did not have wide support but would be consistent with Hicks’ income definition (and which might be considered as a true income approach). A present value approach would determine the discounted present value of the organisation’s assets and liabilities and use this as the basis for the financial statements. Under such an approach, the calculated value of assets will depend on various expectations, such as expectations about the cash flows the asset would return through its use in production (its value in use) or its current market value (value in exchange). Such an approach relies on many assumptions and judgements, including the determination of the appropriate discount rate. Under a present value approach to accounting, profit would be determined as the amount that could be withdrawn yet maintain the present value of the net assets intact from one period to the next. 14
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FIGURE 6.4 An insight into some past professional initiatives in the area of accounting for changing prices
.
Call for inflated books Brian Mahoney With their capitalist ship slowly sinking from the weight of inflation, company directors and accountants are at last doing something about the problem. They are not exactly finding a way to overcome it, but they have decided on a way of recording the effects of inflation in company accounts. Members of the Institute of Chartered Accountants in Australia at the annual Victorian congress last weekend and a panel of directors at the Institute of Directors in Australia in Sydney on Wednesday called for the introduction of some form of accounting for inflation. At present there is a preliminary exposure draft of one such form of accounting – Changes in the Purchasing Power of Money– distributed by the Institute of Chartered Accountants and the Australian Society of Accountants. Under CPP, figures are adjusted by an index to a constant purchasing power. Another such draft of another form of inflation accounting– Replacement Cost– is expected within a few months and hopefully some decision will be made after that as to what form of accounting will be encouraged. RC accounting aims at showing the replacement value of non-monetary assets expected to be replaced, with consequential adjustments to profits. As the ICAA pointed out at its Victorian meeting, a company reporting a steady profit in times of 20 per cent inflation would show adjusted earnings actually 20 per cent lower under the new schemes. The present historical cost accounting, where companies compared different value dollars without converting them by any ‘inflation exchange rate’, has led some companies effectively to pay dividends out of capital. Over 200 directors at the institute’s seminar at the Wentworth Hotel, Sydney, were told until companies start to show the real effect of inflation on their earnings they could not hope to see any government moves similar to that of Finland where an index of inflation is declared each quarter. Mr R. N. H. Denton, an accountant with Irish, Young and Outhwaite, told them: ‘I prophesise that more and more companies will be seeking capital issues merely to maintain their level of operations. ‘This is in a capital market where confidence has been severely shaken and which is in doubt as to whether industry can now earn an adequate return to service capital in real terms. ‘To add to the problem, no recognition is given to our taxation policy to the effect that inflation exerts. The rate of 45 per cent, after a hopelessly inadequate reduction of 2.5 per cent, is really significantly higher on real earnings,’ he said. Source: Mahoney (1975). The use of this work has been licensed by Copyright Agency except as permitted by the Copyright Act, you must not re-use this work without the permission of the copyright owner or Copyright Agency.
Current purchasing power accounting A method of preparing financial statements wherein adjustments are made to non-monetary assets – initially recorded at historical cost – to reflect changes in the value of money as reflected by changes in general price level indices. Gains and losses recognised will relate to the holding of net monetary assets.
236
(CPPA) LO6.2
LO6.4
LO6.5
Current purchasing power accounting
A model of financial accounting known as current purchasing power accounting (CPPA, or, as it is also called, general purchasing power accounting, general price level accounting or constant dollar accounting) can be traced to the early works of such authors as Sweeney (1964, but originally published in 1936) and was subsequently favoured by a number of other researchers. CPPA has also, at various times, been supported by professional accounting bodies throughout the world (but more in the form of supplementary disclosures to accompany financial statements prepared under historical cost accounting principles). CPPA was developed on the basis of a view that,
Measurement issues: accounting for the effects of changing prices and markets CHAPTER 6
in times of rising prices, if an entity were to distribute unadjusted profits based on historical costs the result could be a reduction in the real value of an entity – that is, in real terms the entity could risk distributing part of its capital. In considering the development of accounting for changing prices, the majority of research initially related to restating historical costs to account for changing prices by using historical cost accounts as the basis, but restating the accounts by use of particular price indices. The literature then tended to move towards current cost accounting (which is considered later in the chapter), which changed the basis of measurement to current values as opposed to restated historical values. Consistent with this trend, the accounting profession initially tended to favour price-level-adjusted accounts (using indices), but then tended to switch to current cost accounting, which required the entity to find the current values of the individual assets held by the reporting entity.17,18 CPPA, with its reliance on the use of indices, was generally accepted as being easier and less costly to apply than methods that rely on current valuations of particular assets.19 It was initially considered by some people that it would be too costly and perhaps unnecessary to attempt to find current values for all the individual assets. Rather than considering the price changes of specific goods and services, it was suggested on practical grounds that price indices be used.
Calculating indices When applying general price level accounting, a price index must be applied. A price index is a weighted average of the current prices of goods and services relative to a weighted average of prices in a prior period, often referred to as a ‘base period’. Price indices may be broad or narrow – they may relate to changes in prices of particular assets within a particular industry (a specific price index) or they might be based on a broad cross-section of goods and services that are consumed (a general price index, such as the Consumer Price Index [CPI] in Australia and the United Kingdom). But which price indices should be used? Should we use changes in a general price index (for example, as reflected in Australia or the United Kingdom by the CPI) or should we use an index that is more closely tied to the acquisition of production-related resources? There is no clear answer. From the shareholders’ perspective, the CPI may more accurately reflect their buying pattern – but prices will not change by the same amount for shareholders in different locations. Further, not everybody will have the same consumption patterns as is assumed when constructing a particular index. The choice of an index can be very subjective. Where CPPA has been recommended by particular professional bodies, CPI-type indices have been suggested. Because CPPA relies on the use of price indices, it is useful to consider how such indices are constructed. To explain one common way that indices might be constructed, we can consider the following example which is consistent with how the Australian and UK CPI is determined. Let us assume that there are three types of commodities (A, B and C) that are consumed in the base year quantities and at the prices shown in Table 6.1.
Price index A weighted average of the current prices of goods and services relative to a weighted average of prices in a prior period, often referred to as a ‘base period’.
General price index A price index calculated for a generally consumed bundle of goods. An example would be a consumer price index.
Current values could be based on entry or exit prices. As we will see, there was much debate as to which ‘current’ value was most appropriate. 18 The professional support for the use of replacement costs appeared to heighten around the time of the 1976 release of ASR 190 within the United States. 19 However, many questions can be raised with regard to what the restated value actually represents after being multiplied by an index such as the general rate of inflation. This confusion is reflected in studies that question the relevance of information restated for changes in purchasing power. 17
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TABLE 6.1 Example of three types of commodities, with base prices and quantities consumed Commodity A Year
Price ($)
Base year (2026)
10.00
2027
12.00
Quantity 100
Commodity B Price ($) 15.00
Quantity
Commodity C Price ($)
200
15.50
Quantity
20.00
250
21.20
From the data in Table 6.1, we can see that prices have increased. The price index in the base year is frequently given a value of 100 and it is also frequently assumed that consumption quantities (or proportions between the different commodities) thereafter remain the same, such that the price index at the end of year 2027 would be calculated as:
(12.00 × 100) + (15.50 × 200) + (21.20 × 250) (10.00 × 100) + (15.00 × 200) + (20.00 × 250) = 106.67100
100 ×
Monetary assets Monetary assets are assets that remain fixed in terms of their monetary value, for example cash and claims to a specified amount of cash (such as accounts receivable and investments that are redeemable for a set amount of cash). These assets will not change their monetary value as a result of inflation.
Non-monetary assets Can be defined as those assets whose monetary equivalents will change over time as a result of inflation, and would include such things as property, plant and equipment and inventory.
Monetary liabilities Liabilities that remain fixed in terms of their monetary value and will not change their monetary value as a result of inflation. Most liabilities are monetary liabilities.
Non-monetary liabilities Liabilities that require the transfer of goods or services in the future, the monetary value of which can change across time.
Net monetary assets Are monetary assets less monetary liabilities.
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From the above calculations, we can see that the prices within this particular ‘bundle’ of goods have been calculated as rising on average by 6.67 per cent from the year 2026 to the year 2027. The reciprocal of the price index represents the change in general purchasing power across the period. For example, if the index increased from 100 to 106.67, as in the above example, the purchasing power of the currency would be 93.75 per cent (100/106.67) of what it was previously. That is, the purchasing power of the currency has decreased.
Performing current purchasing power adjustments When applying CPPA, all adjustments are done at the end of the period, with the adjustments being applied to accounts prepared under the historical cost convention. When considering changes in the value of assets as a result of changes in the purchasing power of money (due to inflation), it is necessary to consider monetary assets and non-monetary assets separately. Monetary assets are those assets that remain fixed in terms of their monetary value, for example cash and claims to a specified amount of cash (such as trade debtors and investments that are redeemable for a set amount of cash). These assets will not change their monetary value as a result of inflation. For example, if we are holding $10 in cash and there is rapid inflation, we will still be holding $10 in cash, but the asset’s purchasing power will have decreased over time. Non-monetary assets can be defined as those assets whose monetary equivalents will change over time as a result of inflation, and would include such things as property, plant and equipment and inventory. For example, inventory might cost $100 at the beginning of the year, but the same inventory could cost, say, $110 at the end of the year due to inflation. Relative to monetary assets, the purchasing power of non-monetary assets is assumed to remain constant even in the presence of inflation. Most liabilities are fixed in monetary terms (there is an obligation to pay a pre-specified amount of cash at a particular time in the future independent of the change in the purchasing power of the particular currency) and hence liabilities would typically be considered as monetary items – that is, as monetary liabilities. Non-monetary liabilities, on the other hand, although less common, would include obligations to transfer goods or services in the future, items that could change in terms of their monetary equivalents. Net monetary assets would be defined as monetary assets less monetary liabilities. In times of inflation, holders of monetary assets will lose in real terms as a result of holding the monetary assets, as the assets will have less purchasing power at the end of the period relative to what they had at the beginning of the period (and the greater the level of general price increases, the greater the purchasing power losses). Conversely, holders of monetary liabilities will gain, given that the
Measurement issues: accounting for the effects of changing prices and markets CHAPTER 6
amount they have to repay at the end of the period will be worth less (in terms of purchasing power) than it was at the beginning of the period. Let us consider a simple example to demonstrate how gains and losses might be calculated on monetary items (and under CPPA, gains and losses will relate to net monetary assets rather than net non-monetary assets). Let us assume that Organisation A holds the assets and liabilities shown in Table 6.2 at the beginning of the financial year. TABLE 6.2 Assets and liabilities held by Organisation A at the beginning of the financial year $ Current Assets Cash
6 000
Inventory
9 000 15 000
Non-current Assets Land
10 000
Total Assets
25 000
Liabilities Bank loan
5 000
Owners’ Equity
20 000
Let us also assume that the general level of prices has increased 5 per cent since the beginning of the year and let us make a further simplifying assumption that the company did not trade during the year and that the same assets and liabilities were in place at the end of the year as at the beginning. Assuming that general prices, perhaps as reflected by changes in the CPI, have increased by 5 per cent, the CPI-adjusted values are given in Table 6.3. TABLE 6.3 CPI-adjusted values for Organisation A’s assets and liabilities at end of financial year Unadjusted $
Price adjustment factor $
Adjusted $
Current Assets Cash Inventory
6 000 9 000
6 000 0.05
9 450 15 450
15 000 Non-current Assets Land
10 000
Total Assets
25 000
25 950
5 000
5 000
20 000
20 950
0.05
10 500
Liabilities Bank loan Owners’ Equity
Again, monetary items are not adjusted by the change in the particular price index because they will retain the same monetary value regardless of inflation. Under CPPA there is an assumption that the organisation has not gained or lost in terms of the purchasing power attributed to the non-monetary assets, but, rather, it will gain or lose in terms of purchasing power changes attributable to its holdings of the net monetary assets. In the above example, to be as ‘well off’ at the end of the period the entity would need $21 000 in net assets (which equals retained 239
Financial Accounting Theory
earnings × 1.05 = $20 000 × 1.05) to have the same purchasing power as it had one year earlier (given the general increase in prices of 5 per cent). In terms of end-of-year dollars, in the above illustration the entity is $50 worse off in adjusted terms (it has net assets with an adjusted value of $20 950, which does not have the same purchasing power as $20 000 did at the beginning of the period). As indicated above, this $50 loss relates to the holdings of net monetary assets and not to the holding of non-monetary assets, and is calculated as the balance of cash, less the balance of the bank loan, multiplied by the general price level increase. That is, ($6000 − $5000) × 0.05. If the monetary liabilities had exceeded the monetary assets throughout the period, a purchasing power gain would have been recorded. If the amount of monetary assets held was the same as the amount of monetary liabilities held, no gains or losses would result. Again, it is stressed that under CPPA no change in the purchasing power of the entity is assumed to arise as a result of holding non-monetary assets. Under general price level accounting, non-monetary assets are restated to current purchasing power and no gain or loss is recognised. Purchasing power losses arise only as a result of holding net monetary assets. As noted at paragraph 7 of Provisional Statement of Standard Accounting Practice 7 (PSSAP 7), issued in the United Kingdom in 1974: Holders of non-monetary assets are assumed neither to gain nor to lose purchasing power by reason only of inflation as changes in the prices of these assets will tend to compensate for any changes in the purchasing power of the pound.
An important issue to consider is how the purchasing power gains and losses should be treated for income purposes. Should they be treated as part of the period’s profit or loss, or should they be transferred directly to a reserve? Generally, where this method of accounting was recommended, it was advised that the gain or loss should be included in income. Such recommendations were found in the US Accounting Research Bulletin No. 6 (issued in 1961), in the Accounting Principles Board (APB) Statement No. 3 (issued in 1969 by the American Institute of Certified Public Accountants [AICPA]), in the Financial Accounting Standards Board’s (FASB) exposure draft entitled ‘Financial Reporting in Units of General Purchasing Power’, and within Provisional Statement of Accounting Practice No. 7 issued by the Accounting Standards Steering Committee (UK) in 1974. One main strength of CPPA is its ease of application. The method relies on data that would already be available under historical cost accounting and does not require the reporting entity to incur the cost or effort involved in collecting data about the current values of the various nonmonetary assets. CPI data would also be readily available. However, and as indicated previously, movements in the prices of goods and services included in a general price index might not be reflective of price movements involved in the goods and services in different industries. That is, different industries may be affected differently by inflation. Another possible limitation is that the information generated under CPPA might actually be confusing to users. They might consider that the adjusted amounts reflect the specific value of specific assets (and this is a criticism that can also be made of historical cost information). However, as the same index is used for all assets this will rarely be the case. Another potential limitation considered at the end of the chapter is that various studies (which have looked at such things as movements in share prices around the time of disclosure of CPPA information) have failed to find much support for the view that the data generated under CPPA are relevant for decision making (the information when released caused little if any share price reaction, and some researchers use such results to claim that the information has no relevance to shareholders). Following the initial acceptance of CPPA in some countries in the 1970s, there was a move towards methods of accounting that used actual current values rather than revised values being based on the application of indices. Support for CPPA declined. However, while support for CPPA has declined, and it is not used today, it is nevertheless useful for us to know some of the 240
Measurement issues: accounting for the effects of changing prices and markets CHAPTER 6
arguments that were raised in the past in support of CPPA. With the debates currently going on about ‘measurement’, it is useful to know some of the history of such debates, and some of the alternatives that have been suggested. Some of the arguments in support of CPPA may very well be raised again in the future if inflation ‘takes off’. In the next section, we consider approaches to accounting that relied upon current values, rather than amounts that were adjusted by way of indices. Again, this provides important insights that can also be used in evaluations of fair value accounting – something currently favoured by the IASB and FASB. LO6.2
LO6.4
LO6.5
LO6.6
Current cost accounting
Current cost accounting (CCA) is one of the alternatives to historical cost accounting that tended to gain the most acceptance back in the times of high inflation. Notable advocates of the approach included Paton (1922) and Edwards and Bell (1961). Such authors decided to reject historical cost accounting and CPPA in favour of a method that considered actual valuations. As we will see, unlike historical cost accounting, CCA differentiates between profits from trading and those gains that result from holding an asset. Holding gains can be considered as realised or unrealised. If a financial capital maintenance perspective is adopted with respect to the recognition of income, then holding gains or losses will be treated as income. Alternatively, they can be treated as capital adjustments if a physical capital maintenance approach is adopted. Some versions of CCA, such as that proposed by Edwards and Bell, adopt a physical capital maintenance approach to income recognition. In this approach, which determines valuations on the basis of replacement costs,20 operating income represents realised revenues, less the replacement cost of the assets in question. It is considered that this generates a measure of income which represents the maximum amount that can be distributed, while maintaining operating capacity intact. For example, assume that an entity acquired 150 items of inventory at a cost of $10 each and sold 100 of the items for $15 each when the replacement cost to the entity had risen to $12 each. Assume also that the replacement cost of the 50 remaining items of inventory at year end was $14. Under the Edwards and Bell approach, the operating profit that would be available for dividends would be $300, which is 100 × ($15 – $12). There would be a realised holding gain on the goods that were sold, which would amount to 100 × ($12 – $10), or $200, and there would be an unrealised holding gain in relation to closing inventory of 50 × ($14 – $10), or $200. Neither the realised nor the unrealised holding gain would be considered to be available for dividend distribution.21 In undertaking CCA, adjustments are usually made at year end using the historical cost accounts as the basis of adjustments. If the Edwards and Bell approach to profit calculation is adopted, profit is derived after ensuring that the operating capacity of the organisation is maintained intact. Edwards and Bell believe that operating profit is best calculated by using replacement costs.22,23 As noted above, in calculating operating profit, gains that accrue from holding an asset (holding gains) are excluded and are not made available for dividends, although
Current cost accounting A method of accounting that measures assets at their current cost and where profits from trading and gains from holding assets (holding gains) are separately disclosed.
Holding gains Increases in the value of assets or reductions in the value of liabilities that arise as a result of holding assets or liabilities over time without transforming or modifying them.
Financial capital maintenance perspective Under this perspective of capital maintenance, a profit is earned if the amount of net assets at the end of the reporting period exceeds the amount at the beginning of the year, excluding any contributions from, or distributions to, owners.
Physical capital maintenance approach Under this perspective, a profit is earned only if the organisation’s productive or operating capacity at the end of the reporting period exceeds the capacity at the beginning of the period, excluding any contributions from, or distributions to, owners.
We will also see later in this chapter that there are alternative approaches to current cost accounting that rely on exit (sales) prices. 21 Comparing this approach to profit calculations under historical cost accounting, we see that, if we add CCA operating profit of $300 and the realised holding gain of $200, this will give the same total as we would have calculated for profit under historical cost accounting. 22 In a sense, the Edwards and Bell approach represents a ‘true income’ approach to profit calculation. They believe that profit can only be correctly measured (that is, ‘be true’) after considering the various asset replacement costs. 23 Those who favour a method of profit calculation that requires a maintenance of financial capital (advocates of historical cost accounting) treat holding gains as income, while those who favour a maintenance of physical capital approach to income determination (such as Edwards and Bell) tend to exclude holding gains from income. A physical capital perspective was adopted by most countries in their professional releases pertaining to CCA. 20
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they are included when calculating what is referred to as business profit. For example, if an entity acquired goods for $20 and sold them for $30, business profit would be $10, meaning that $10 could be distributed and still leave financial capital intact (this would be the approach taken in historical cost accounting). But if at the time the goods were sold their replacement cost to the entity was $23, then $3 would be considered a holding gain, and to maintain physical operating capacity only $7 could be distributed – current cost profit would be $7. No adjustment is made to sales revenue. This $7 distribution can be compared with what could be distributed under historical cost accounting. Because historical cost accounting adopts a financial capital maintenance approach, $10 could be distributed in dividends, thereby maintaining financial capital (but nevertheless causing an erosion in the operating ability of the organisation). In relation to non-current assets, for the purposes of determining current cost profit, depreciation is based on the replacement cost of the asset. For example, if an item of machinery was acquired in 2026 for $100 000 and had a projected life of 10 years and no salvage value, then, assuming the straight-line method of depreciation is used, its depreciation expense under historical cost accounting would be $10 000 per year. If at the end of 2027 its replacement cost had increased to $120 000, then under current cost accounting a further $2000 would be deducted to determine current cost profit. However, this $2000 would be treated as a realised cost saving (because historical cost profits would have been lower if the entity had not already acquired the asset) and would be recognised in business profit (it would be added back below profit), and the other $18 000 would be treated as an unrealised cost saving and would also be included in business profit. As with CPPA, no restatement of monetary assets is required, as they are already recorded in current dollars and hence in terms of end-of-period purchasing power dollars. Consistent with the CCA model prescribed by Edwards and Bell, all non-monetary assets have to be adjusted to their respective replacement costs. Unlike historical cost accounting, there is no need for inventory cost flow assumptions (such as last-in-first-out, first-in-first-out, weighted average). Business profit shows how the entity has gained in financial terms from the increase in cost of its resources – something typically ignored by historical cost accounting. Differentiating profit from holding gains and losses (both realised and unrealised) has been claimed to enhance the usefulness of the information being provided. Holding gains are deemed to be different from trading income as they are due to market-wide movements, most of which are beyond the control of management. Edwards and Bell (1961, p. 73) state: These two kinds of gains are often the result of quite different decisions. The business firm usually has considerable freedom in deciding what quantities of assets to hold over time at any or all stages of the production process and what quantity of assets to commit to the production process itself ... The difference between the forces motivating the business firm to make profit by one means rather than by another and the difference between the events on which the two methods of making profit depend require that the two kinds of gain be separated if the two types of decisions involved are to be meaningfully evaluated.
As with CPPA, the CCA model described above has been identified as having a number of strengths and weaknesses. Some of the criticisms relate to its reliance on replacement values. The CCA model just described uses replacement values, but what is the rationale for replacement cost? Perhaps it is a reflection of the ‘real’ value of the particular asset. If people in the market are prepared to pay the replacement cost, and if we assume economic rationality, then the amount paid must be a reflection of the returns it is expected to generate. However, it might not be worth that amount (the replacement cost) to all organisations – some organisations might not elect to replace a given asset if they have an option. Further, past costs are sunk costs and if the entity were required to acquire new plant it might find it more efficient and less costly to acquire different 242
Measurement issues: accounting for the effects of changing prices and markets CHAPTER 6
types of assets. If it did buy it, this might reflect that it is actually worth much more. Further, replacement cost does not reflect what it would be worth if the organisation decided to sell it. As indicated previously, it has been argued that separating holding gains and losses from other results provides a better insight into management performance, as such gains and losses are due to impacts generated outside the organisation; however, this can be criticised on the basis that acquiring assets in advance of price movements might also be part of efficient operations. Another potential limitation of CCA is that it is often difficult to determine replacement costs. The approach also suffers from the criticism that allocating replacement cost via depreciation is still arbitrary, just as it is with historical cost accounting. An advantage of CCA is better comparability of various entities’ performance, as one entity’s profits are not higher simply because it bought assets years earlier and therefore would have generated lower depreciation under historical cost accounting. Chambers, an advocate of CCA based on exit values, was particularly critical of the Edwards and Bell model of accounting. He states (1995, p. 82) ‘In the context of judgement of the past and decision making for the future, the products of current value accounting of the Edwards and Bell variety are irrelevant and misleading’. Again, while CCA as described above is currently not in use, many of the issues raised are of relevance today in terms of the ongoing discussions being held by accounting standard-setters with respect to developing appropriate accounting measurement bases. For example, today there is still debate about whether replacement costs (entry prices) or fair values in market transactions (exit prices) should be the basis of asset valuation, and whether unrealised holding gains should be included in profit or loss or ‘other comprehensive income’ – issues which were debated decades ago when developing CCA. By knowing about past debates, we can more knowledgeably reflect on current discussions. The next section looks at an alternative accounting model prescribed by Chambers and a number of others – a model that relies on the use of exit values.
Exit price accounting: the case of Chambers’ Continuously Contemporary Accounting LO6.2
LO6.4
LO6.5
LO6.6
Exit price accounting has been proposed by researchers such as MacNeal, Sterling and Chambers. It is a form of current cost accounting that is based on valuing assets at their net selling prices (exit prices) at the end of the reporting period and on the basis of orderly sales. Chambers coined the term ‘current cash equivalent’ to refer to the cash that an entity would expect to receive through the orderly sale of an asset, and he had the view that information about current cash equivalents was fundamental to effective decision making. He labelled his method of accounting Continuously Contemporary Accounting, or CoCoA. Although Chambers generated some much-cited research throughout the 1950s (such as Chambers, 1955) a great deal of his work culminated in 1966 with the publication of Accounting, Evaluation and Economic Behavior. This book stressed that the key information for economic decision making relates to capacity to adapt – a function of current cash equivalents. He considered that the balance sheet (statement of financial position) is the prime financial statement which should show the net selling prices of the entity’s assets. Profit would directly relate to changes in adaptive capital, with adaptive capital reflected by the total exit values of the entity’s assets. As indicated previously, how one calculates income is based, in part, on how one defines wealth. According to Sterling, an advocate of exit price accounting (1970b, p. 189): The present [selling] price is the proper and correct valuation coefficient for the measurement of wealth at a point in time and income is the difference between dated wealths so calculated.
Current cash equivalent Represented by the amount of cash that would be expected to be generated by selling an asset.
Capacity to adapt A measure, promoted by Chambers, tied to the cash that could be obtained if an entity sold its assets. The greater the current cash equivalents of an organisation’s assets, the greater the capacity to adapt to changing circumstances.
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Consistent with the views of Sterling, Chambers (1966, p. 91) states: At any present time, all past prices are simply a matter of history. Only present prices have any bearing on the choice of an action. The price of a good ten years ago has no more relation to this question than the hypothetical price 20 years hence. As individual prices may change even over an interval when the purchasing power of money does not, and as the general purchasing power of money may change even though some individual prices do not, no useful inference may be drawn from past prices which has a necessary bearing on present capacity to operate in a market. Every measurement of a financial property for the purpose of choosing a course of action – to buy, to hold, to sell – is a measurement at a point in time, in the circumstances of the time, and in the units of currency at that time, even if the measurement process itself takes some time. Excluding all past prices, there are two prices which could be used to measure the monetary equivalent of any non-monetary good in possession: the buying price and the selling price. But the buying price, or replace price, does not indicate capacity, on the basis of present holdings, to go into a market with cash for the purpose of adapting oneself to contemporary conditions, whereas the selling price does. We propose, therefore, that the single financial property which is uniformly relevant at a point of time for all possible future actions in markets is the market selling price or realizable price of any goods held. Realizable price may be described as current cash equivalent. What men wish to know, for the purpose of adaptation, is the numerosity of the money tokens which could be substituted for particular objects and for collections of objects if money is required beyond the amount which one already holds.24
We can see that Chambers has made a judgement about what people need in terms of information. Like authors such as Edwards and Bell, and unlike some of the earlier work which documented existing accounting practices to identify particular principles and postulates (descriptive research),25 Chambers set out to develop what he considered was a superior model of accounting – a model that represented quite a dramatic change from existing practice. We call this ‘prescriptive’ or ‘normative’ research. The research typically highlighted the limitations of historical cost accounting and then proposed an alternative on the basis that it would enable better decision making. Chambers adopts a decision-usefulness approach and within this approach he adopts a decision-models perspective.26 Chambers’ approach is focused on new opportunities; the ability or capacity of the entity to adapt to changing circumstances and the most important item of information to evaluate future
As quoted in Riahi-Belkaoui (2004, pp. 496–97). As a specific example of the inductive (descriptive) approach to theory development, consider the work of Grady (1965). This research was commissioned by the American Institute of Certified Public Accountants and documented the generally accepted conventions of accounting at the time. 26 As indicated in Chapter 1, decision usefulness research can be considered to have two branches, these being the decision-makers emphasis and the decision-models emphasis. The decision-makers emphasis relies on undertaking research that seeks to ask decision makers what information they want. Proponents of the decision-models emphasis, on the other hand, develop models based on the researchers’ perceptions about what is necessary for efficient decision making. Information prescriptions follow (for example, that information should be provided about the market value of the reporting entity’s assets). This branch of research typically assumes that different classes of stakeholders have identical information needs. Unlike the decision-makers emphasis, the decision-models emphasis does not ask the decision makers what information they want, but, instead, it concentrates on what types of information are considered by the researcher to be useful for those stakeholders’ decision making. 24
25
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Measurement issues: accounting for the effects of changing prices and markets CHAPTER 6
decisions is, according to Chambers, current cash equivalents. Chambers makes an assumption about the objective of accounting – to guide future actions. Capacity to adapt is the key and the capacity to adapt to changing circumstances is dependent on the current cash equivalents of the assets on hand. The higher the current market value of the entity’s assets, the greater the ability of the organisation to adapt to changing circumstances. As stated previously, in Chambers’ model profit is directly tied to the increase (or decrease) in the current net selling prices of the entity’s assets. No distinction is drawn between realised and unrealised gains. Unlike some other models of accounting, all gains are treated as part of profit. Profit is that amount that can be distributed while maintaining the entity’s adaptive ability (adaptive capital). CoCoA abandons notions of realisation in terms of recognising revenue, and hence revenue recognition points change relative to historical cost accounting. Rather than relying on sales, revenues are recognised at such points as production or purchase. Unlike the Edwards and Bell approach to CCA, within CoCoA there is an adjustment to take account of changes in general purchasing power, which is referred to as a ‘capital maintenance adjustment’. The capital maintenance adjustment also forms part of the period’s income, with a corresponding credit to a capital maintenance reserve (which forms part of owners’ equity). In determining the capital maintenance adjustment, the opening residual equity of the entity (that is, the net assets) is multiplied by the proportionate change in the general price index from the beginning of the period to the end of the reporting period. As an example, if opening residual equity (or owners’ equity, or simply ‘equity’) was $5 000 000 and the price index increased from 140 to 148, then the capital maintenance adjustment (in the case of increasing prices, an expense) would be calculated as $5 000 000 × 8/140 = $285 714. According to Chambers (1995, p. 86): Deduction of that amount, a capital maintenance or inflation adjustment, from the nominal difference between opening and closing capitals, would give the net increment in purchasing power, the real income, of a period. The inflation adjustment would automatically cover gains and losses in purchasing power from net holdings of money and money’s worth. Net real income would then be the algebraic sum of (a) net realised revenues based on consummated transactions, or net cash flows, (b) the aggregate of price variation adjustments, the unrealised changes in value of assets on hand at balance date, and (c) the inflation adjustment. The amount of the inflation adjustment would be added proportionately to the opening balances of contributed capital and undivided surplus, giving closing amounts in units of up to date purchasing power.
Some of the above points are summarised in Figure 6.5, which is an article that appeared in the Australian Financial Review (1973). It reported some of Chambers’ concerns with regard to historical cost accounting. As a simple illustration of CoCoA, consider the following information. Assume that Cocoa Limited had statements of financial position as at 30 June 2027 as shown in Table 6.4, one compiled using historical cost accounting and the other using CoCoA. We assume that in the financial year ending on 30 June 2028, all the opening inventory was sold for $16 000 and the same quantity of inventory was reacquired at a cost of $11 000 (and which had a retail price of $18 000). There were salaries of $2000 and historical cost depreciation was based on 5 per cent of the carrying amount of plant and equipment. Prices rose generally throughout the period by 10 per cent and the net market value of the plant and equipment was assessed as $29 000.
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FIGURE 6.5 Some views of Professor Raymond Chambers Where company reports fail – Prof Chambers Financial reports of companies generally failed to give a fair idea of their financial positions and profits, Professor R. J. Chambers, professor of accounting at the University of Sydney, said last night. He called for amplification of the law on company reporting to ensure that balance sheets recognise changes in the prices of specific assets and profit and loss accounts reflect changes in the general purchasing power of money. The accounting rules used were so different in effect that comparisons between companies were often quite misleading. These rules had been debated for years among accountants but never yet had accountants settled on rules which gave consistent and up-to-date information year by year. Addressing the university’s Pacioli Society, Professor Chambers outlined specific amendments to the Companies Acts which are contained in his new book, ‘Securities and Obscurities’. Professor Chambers’ amendment to the laws governing balance sheet reporting was that no balance sheet should be deemed to give a true and fair view of the state of affairs of a company unless the amounts shown for the several assets were the best possible approximations of the net selling prices in the ordinary course of business. Debts receivable should be the best possible approximations to the amounts expected at the date of the balance sheet to be receivable or recoverable. On the profit and loss account, Professor Chambers urged that it be deemed to give a true and fair view only if the profit or loss was calculated so as to include changes during the year in the net selling prices of assets and the effects during the year of changes in the purchasing power of the unit of account as specified in the Schedule of the Act. Professor Chambers said thousands of shareholders had lost millions of dollars on security investments made on the basis of outof-date information or on fictions which were reported as facts. Source: Australian Financial Review (1973), p. 30. The use of this work has been licensed by Copyright Agency except as permitted by the Copyright Act, you must not re-use this work without the permission of the copyright owner or Copyright Agency.
TABLE 6.4 Cocoa Limited – statements of financial position 30 June 2027 Cocoa Limited Historical Cost Statement of Financial Position as at 30 June 2027 Assets Cash
Cocoa Limited CoCoA Statement of Financial Position as at 30 June 2027 Assets
6 000
Cash
Inventory
10 000
Inventory
16 000
Plant and equipment
24 000
Plant and equipment
28 000
Total Assets
40 000
Total Assets
50 000
Liabilities
Liabilities
Bank loan
10 000
Bank loan
10 000
Net Assets
30 000
Net Assets
40 000
Represented by:
Represented by:
Shareholders’ Funds
Shareholders’ Funds
Paid-up capital
10 000
Paid-up capital
10 000
Retained earnings
20 000
Retained earnings
22 000
Capital maintenance reserve 30 000
246
6 000
8 000 40 000
Measurement issues: accounting for the effects of changing prices and markets CHAPTER 6
The income determined for the year ended 30 June 2028 under historical cost accounting and CoCoA can be calculated as shown in Tables 6.5 and 6.6. TABLE 6.5 Cocoa Limited – profit and loss statements 30 June 2028 Cocoa Limited Historical Cost Profit and Loss Statement for year ended 30 June 2028 Sales
Sale price of inventory
18 000
Cost of inventory
11 000
6 000
Trading income
7 000
Salaries expense
(2 000)
Salaries expense
(2 000)
Depreciation
(1 200)
Increase in exit value of plant
Cost of goods sold Gross margin
16 000
Cocoa Limited CoCoA Profit and Loss Statement for year ended 30 June 2028
(10 000)
1 000
Capital maintenance Adjustment (40 000 × 0.10) Profit
2 800
Profit
(4 000) 2 000
Opening retained earnings
20 000
Opening retained earnings
22 000
Closing retained earnings
22 800
Closing retained earnings
24 000
TABLE 6.6 Cocoa Limited – statements of financial position 30 June 2028 Cocoa Limited Historical Cost Statement of Financial Position as at 30 June 2028 Assets Cash
Cocoa Limited CoCoA Statement of Financial Position as at 30 June 2028 Assets
9 000
Cash
9 000
Inventory
11 000
Inventory
18 000
Plant and equipment (net)
22 800
Plant and equipment
29 000
Total Assets
42 800
Total Assets
56 000
Liabilities
Liabilities
Bank loan
10 000
Bank loan
10 000
Net Assets
32 800
Net Assets
46 000
Represented by:
Represented by:
Shareholders’ Funds
Shareholders’ Funds
Paid-up capital
10 000
Paid-up capital
10 000
Retained earnings
22 800
Retained earnings
24 000
Capital maintenance reserve
12 000
32 800
46 000
What must be remembered is that, under CoCoA, when the inventory recorded above is sold for $18 000, no profit or loss will be recognised. Such gain was recognised when the inventory was purchased, with the gain being the difference between the expected retail price (net of related expenses) and the cost to Cocoa Limited. Hence, it is again emphasised, CoCoA involves a fundamental shift in revenue recognition principles compared with historical cost accounting and current reporting requirement (pursuant to IFRS 15 Revenue from Contracts with Customers), which require that a sale to a customer only be recognised when control of the asset has passed to the customer. As with other methods of accounting, a number of strengths and weaknesses have been associated with CoCoA. Considering the strengths, advocates of CoCoA have argued that by using one method of valuation for all assets (exit value) the resulting numbers can logically be 247
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added together (this is often referred to as ‘additivity’).27 When CoCoA is adopted, there is also no need for arbitrary cost allocations for depreciation as depreciation will be based on movements in exit price. Considering possible limitations, CoCoA never gained widespread acceptance, despite being supported by a small number of widely respected academics (there was more support for replacement costs). Nevertheless, there are still people today who favour Chambers’ model of accounting. Also, if CoCoA was implemented, it would involve a fundamental and major shift in financial accounting (for example, including major shifts in revenue recognition points and major adjustments to asset valuations) and this in itself could lead to many social and economic consequences. The relevance of exit prices has also been questioned, particularly if we do not expect to sell assets (just as the relevance of replacement costs was questioned if we do not expect to replace the asset). Further, under CoCoA, assets of a specialised nature (such as a highly specialised machine that does not have any use outside of the organisation) are considered to have no value because they cannot be separately disposed of. This is an assertion that is often challenged because it ignores the ‘value in use’ of an asset.28 Further, is it appropriate to value all assets on the basis of their exit values if the entity is considered to be a going concern? Determination of exit values can also be expected to introduce a degree of subjectivity into the financial statements (relative to historical cost), particularly if the assets are unique. CoCoA also requires assets to be valued separately with regard to their current cash equivalents, rather than as a bundle of assets. Hence, CoCoA would not recognise goodwill as an asset because it cannot be sold separately. Evidence shows that the value of assets sold together can be very different from the total amount that would be received if they were sold individually (Larson and Schattke, 1966). Reflecting how accounting researchers will have different views, Chambers was critical of the Edwards and Bell model, and Edwards and Bell were also critical of Chambers’ approach. For example, Edwards (1975, p. 238) states: I am not convinced of the merit of adopting, as a normal basis for asset valuation in the going concern, exit prices in buyer markets. These are unusual values suitable for unusual situations. I would not object in principle to keeping track of such exit prices at all times and, as Solomons (1966) has suggested, substituting them for entry values when they are the lesser of the two and the firm has taken a definite decision not to replace the asset, or even the function it performs.
Despite the lack of support at the time for Chambers’ CoCoA model, some of its underlying principles are consistent with the principles proposed by those who today support a move towards using fair values in the statement of financial position. Hence, and as already emphasised in this chapter, in understanding current debates it is useful to also know about the debates that occurred in the past in relation to measurement. The increasing requirements to use fair values as the basis of valuation of assets and liabilities in some accounting standards is a controversial issue in both academic and practitioner debates, and the next section of This can be contrasted with the current situation where it is common to find that various classes of assets are valued using a different approach (for example, for inventory – lower of cost and net realisable value; for marketable securities – at fair value; for buildings – at cost or fair value; for debtors – at face value, less an allowance for doubtful debts), yet they are simply added together to give a total asset amount. 28 In considering ‘value in use’, logically, if an asset’s ‘value in use’ exceeds its market value, it will be retained, otherwise it will be sold. ‘Value in use’ is defined in IAS 36 Impairment of Assets as the present value of the future cash flows expected to be derived from an asset or cash-generating unit. Hence, the point might be that there has actually been a choice not to sell the assets that the entity has on hand because they are more valuable internally (Solomons, 1966). Further, specialised assets might be of particular value to one entity but not to any others. 27
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this chapter focuses on aspects of the debate surrounding the use of fair value accounting – a debate that is far from settled.
REFLECTION QUESTION 6.3 Does a failure to gain widespread support invalidate a theory? Question Does the fact that Chambers’ proposed model of accounting did not gain widespread support mean that it was an inferior method of accounting relative to what was being practised? Solution No, it does not necessarily mean that it is an inferior method of accounting.There could be various reasons why other researchers, and regulators, failed to embrace the theory being proposed by Chambers. Perhaps they did not fully understand it. Perhaps they had private economics-based incentives to support other approaches. As critical thinkers, we must not just dismiss ideas simply because they are dismissed by others. We need to consider the relative merit and associated logic of the arguments being advanced and we should consider the social and economic
Reflection
benefits that might accrue to different stakeholders if a particular method of accounting was introduced. Considering the various possible costs and benefits to different stakeholders is a difficult and rather subjective process, but a proper assessment of alternative accounting approaches requires such an assessment. We should remember that some of the most important developments in knowledge were initially opposed by apparently learned people. For example, Pythagoras’ claim that the Earth was round was challenged for hundreds of years, as was Galileo’s claim that the Earth revolves around the sun (and he was placed under house arrest), with the main belief being that the Earth was at the centre of the universe. So, again, just because everybody seems to deny the validity of a particular claim or theory does not prove that the theory has no merit.
The demand for price-adjusted and value-adjusted accounting information LO6.8
One research method often used to assess the usefulness of particular disclosures, and one that we further explore within Chapter 11, is to look for a share-market reaction (share price reaction) around the time of the release of the information, the rationale being that if share prices react to the disclosures then such disclosures must have information content. That is, the information impacts on the decisions made by individuals participating in the capital market. A number of studies looked at the capital-market reaction to current cost and CPPA information. Results were inconclusive, with studies such as Ro (1980, 1981), Beaver, Christie and Griffin (1980), Gheyara and Boatsman (1980), Beaver and Landsman (1987), Murdoch (1986), Schaefer (1984), Dyckman (1969), Morris (1975) and Peterson (1975) finding limited evidence of any price changes around the time of disclosure of current cost information. (However, Lobo and Song [1989] and Bublitz, Freka and McKeown [1985] provide limited evidence that there is information content in current cost disclosures.) While the majority of share price studies show little or no reaction to price-adjusted accounting information, it is possible that the failure to find a significant share price reaction might have been due to limitations in the research methods used. For example, there could have been other information released around the time of the release of the CCA/CPPA information. However, with the weight of research that indicated little or no reaction by the share market, it would be reasonable to believe that the capital market did not value such information when disclosed within the annual report. Of course, there are a number of issues in why the capital market might not react to such information. Perhaps individuals or organisations were able to obtain this information from sources other than corporate annual reports, and hence, as the market was already aware of the information, no reaction would be expected when the annual reports were released. Apart from analysing share price reactions, another way to investigate the apparent usefulness of particular information is to undertake surveys. Surveys of managers (for example, 249
Financial Accounting Theory
Ferguson and Wines, 1986) indicated limited corporate support for CCA, with managers citing such issues as the expense, the limited benefits from disclosure and the lack of agreement as to the appropriate approach to explain the limited support for CCA. In the United States, and in relation to the relevance of FASB Statement No. 33 (which required a mixture of CCA and CPPA information), Elliot (1986, p. 33) stated: FASB Statement No. 33 required the disclosure of value information on one or two bases, either price level adjusted or current cost. Surveys taken when this rule became effective suggest that users do not find the information helpful, don’t use it, and they say it doesn’t tell them anything they didn’t already know. Preparers of the information complain that it is a nuisance to assemble.
Given the above results, it could be said that, in general, there was limited evidence to support the view that the methods used to account for changing prices had been deemed to be successful in providing information of relevance to financial statement users. This is an interesting outcome, particularly given that many organisations over time had elected to provide CCA/CPPA information in their annual reports even when there was no requirement to do so, and also given that many organisations had actively lobbied for or against the particular methods of accounting. Adopting the method for disclosure purposes, or lobbying for it, implies that corporate management, at least, considered that the information was relevant and likely to impact on behaviour – a view at odds with some of the surveys and share price studies reported earlier. In relation to research that attempted to analyse the motivations underlying the corporate adoption of alternative accounting methods, an influential paper was one prepared by Watts and Zimmerman (1978). That paper is generally considered to be one of the most important papers in the development of Positive Accounting Theory (which is discussed in Chapter 8). The authors investigated the lobbying positions taken by corporate managers with respect to the FASB’s 1974 discussion memorandum on general price level accounting (current purchasing power accounting). As this chapter has discussed, if general price level accounting were introduced, reported profits in times of rising prices would be reduced relative to profits reported under historical cost conventions. The reduction in profits would be due to such effects as higher depreciation and purchasing power losses due to holding net monetary assets. Watts and Zimmerman proposed that the political process was a major factor in explaining which corporate managers were more likely to favour or oppose the introduction of general price level accounting. The perspective of Watts and Zimmerman was that managers from entities deemed to be politically visible were more likely to favour methods of accounting that allowed them to reduce their reported profits. High profitability itself was considered to be one attribute that could lead to the unwanted (and perhaps costly) attention and scrutiny of particular corporations. The corporate lobbying positions in the submissions made to the FASB are explained by Watts and Zimmerman on the basis of self-interest considerations (rather than any consideration of such issues as the ‘public interest’).29 The study suggests that large companies (and large companies are considered to be more politically sensitive) favoured general price level accounting because it enabled them to report lower profits.30,31 As discussed in Chapter 8, and as already mentioned in earlier chapters, one of the central assumptions of Positive Accounting Theory is that all individual action is motivated by self-interest considerations, with that interest being directly tied to the goal of maximising an individual’s own wealth. 30 Ball and Foster (1982), however, indicate that size can be a proxy for many things other than political sensitivity (such as industry membership). 31 Within the Watts and Zimmerman study many of the respondents were members of the oil industry and such industry members were also inclined to favour the introduction of general price level accounting. Consistent with the political cost hypothesis, 1974 (the time of the submissions) was a time of intense scrutiny of oil companies. 29
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Measurement issues: accounting for the effects of changing prices and markets CHAPTER 6
Other research has also shown that companies might support CCA for the political benefits it provides. In times of rising prices, the adoption of CCA (as with general price level accounting) can lead to reduced profits. In a New Zealand study, Wong (1988) investigated the accounting practices of New Zealand companies between 1977 and 1981 and found that corporations that adopted CCA had higher effective tax rates and larger market concentration ratios than entities that did not adopt CCA, both variables being suggestive of political visibility. In a UK study, Sutton (1988) found that politically sensitive companies were more likely to lobby in favour of CCA. Sutton investigated lobbying submissions made in the United Kingdom in relation to an exposure draft of a proposed accounting standard that recommended the disclosure of CCA information. Applying a Positive Accounting Theory perspective, he found support for a view that organisations that considered they would benefit from the requirement tended to lobby in support of it. Those expected to benefit were: • capital-intensive firms, because it was expected that the adoption of CCA would lead to decreased profits (due to higher depreciation) and this would be particularly beneficial if the method was accepted for the purposes of taxation • politically sensitive firms, as it would allow them to show reduced profits. Throughout the 1970s and 1980s, many organisations opposed the introduction of alternative methods of accounting (alternative to historical cost). Corporate opposition to various alternative methods of accounting could also be explained by the notion of self-interest as embraced within the economic interest theory of regulation – a theory we discussed within Chapter 4. Under historical cost accounting, management has a mechanism available to manage its reported profitability. Holding gains might not be recognised for profit or loss purposes until such time as the assets are sold. For example, an organisation might have acquired shares in another organisation some years earlier. In periods in which reported profits are expected to be lower than management wants, management could elect to sell some of the shares to offset other losses. If alternative methods of accounting were introduced, this ability to manipulate reported results could be lost.32 Hence such corporations might have lobbied government, the basis of the submissions being rooted in self-interest. Because there are typically corporate or business representatives on most standard-setting bodies, there is also the possibility that corporations/ business interests were able to capture the standard-setting process (Walker, 1987). The debate is far from settled as to which method of accounting is most appropriate in accounting for changing prices. Different researchers, with different theories, provide various insights into the demand for, or need for, different methods of accounting. While debate in this area has generally abated since the mid-1980s, it is very possible that, if levels of inflation return to their previously high levels, such debates will be reignited. Various authors have developed accounting models that differ in many respects. Some of these differences are due to fundamental differences of opinion about the role of accounting and the sort of information necessary for effective decision making. Because information generated by systems of accounting based on the historical cost convention is used in many decisions, major change in accounting conventions would conceivably have widespread social and economic impacts. This in itself will restrict any major modifications or changes to our accounting system. This perspective was reflected in the 1960s, and arguably the perspective is just as relevant now. As an example of how the profession has typically been reluctant to implement major reforms, consider activities undertaken in 1961 and 1962, when the Accounting Research Division of the American Institute of Certified Public Accountants (AICPA) commissioned studies by Moonitz (1961) and by Sprouse and Moonitz (1962). In these documents, the authors proposed that accounting measurement systems be changed from historical cost to a system based on current 32
In recent years, the discretion of management in relation to the measurement of equity investments has been reduced. IAS 39 and IFRS 9 stipulate a general requirement that such investments shall be measured at fair value.
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values. However, prior to the release of the Sprouse and Moonitz study, the Accounting Principles Board of the AICPA stated in relation to the Moonitz and the Sprouse and Moonitz studies that ‘while these studies are a valuable contribution to accounting principles, they are too radically different from generally accepted principles for acceptance at this time’ (Accounting Principles Board, 1962). While this chapter has emphasised various issues and debates associated with how best to measure the financial performance of an entity in times when prices are changing, it must be remembered that financial performance is only one facet of the total performance of an entity. As is demonstrated in Chapter 10, there is much debate about how to measure and report information on the social and environmental performance of reporting entities, and as with the debate considered in this chapter, that debate is far from settled. The practice of accounting generates a multitude of interesting debates.
Why do I need to know about some of the various approaches to account for changing prices? The normative theories that were developed to address changing prices were once a major focus of accounting research. Indeed, such normative research dominated much of accounting research until the mid-1970s, when positive research took over as the dominant (but not sole) focus of accounting research. Therefore, to understand part of the rich history of accounting research, we arguably need to have some awareness of the research undertaken by leading scholars of the time, such as Chambers, Edwards, Bell, Sweeney and Solomons. Measurement issues are continuously a focus for accounting standard-setters, so the insights provided by early researchers are still relevant today. Many of their concerns about historical costs
LO6.7
are still pertinent today given that historical cost is still Why used to account for various classes of assets and liabilities. With a recent history of lower inflation rates (for example, in 2021 the Australian inflation rate was about 2 per cent), there has been limited demand for accounting practices that adjust for changing prices. However, inflation rates have risen in 2022 (the inflation rate in Australia in mid-2022 had risen to be in excess of 5 per cent), and if inflation should rise to former levels (for example, in the mid-1970s the inflation rates within Australia were around 16 per cent), it is possible that the relevance of this past research would again rise.
Fair value accounting
The previous sections of this chapter discussed approaches to asset and liability measurement that had been developed and debated over past decades. We now shift our attention to contemporary requirements relating to asset and liability measurement. Nevertheless, we should appreciate that much of the past debate helped to shape current reporting practices. As already indicated within this chapter, fair value is an asset (and liability) measurement approach that is now used within an increasing number of financial reporting standards. Some financial reporting standards require particular classes of assets to be recorded initially at cost (although a limited number require initial recognition to be at fair value). For those assets that are initially measured at cost, some financial reporting standards require, or provide an option for, the assets subsequently to be measured at fair value. If we are using fair value and are required to update the fair values of assets (and some liabilities) at the end of each reporting period, then this adjustment has potential implications for reported profits. As we likely know, the basic financial accounting equation on which general purpose financial reporting is based (and has been for hundreds of years) is:
Assets = Liabilities + Equity If, for example, we recognise an increase in the fair value of an asset, this will not directly impact liabilities. Rather, it will increase equity, and the above equation will balance. Equity increases either as a result of income or as a result of contributions from owners (and decreases as a result of expenses and distributions to owners). The recognition of an upward revaluation 252
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to fair value is not an owners’ contribution, and therefore, from a Conceptual Framework perspective, an increase in the fair value of an asset would be considered to constitute ‘income’. In this regard, paragraph 5.4 of the Conceptual Framework (IASB, 2022c) states: the recognition of income occurs at the same time as: (i) the initial recognition of an asset, or an increase in the carrying amount of an asset; or (ii) the derecognition of a liability, or a decrease in the carrying amount of a liability.
As we already know from prior discussion in this chapter, financial reporting standards require some types of assets to be measured at fair value (for example, financial instruments), whereas other accounting standards do not (for example, inventory). Further, when fair-value adjustments are made, some accounting standards require the increase (or decrease) to be included in profit or loss, whereas other accounting standards require gains to go to a measure of income known as ‘other comprehensive income’.33 Therefore, depending upon the assets (or liabilities) in question, the use of fair values can lead to impacts either on profit or loss, or other comprehensive income (the sum of both being ‘total comprehensive income’), both of which lead to an increase in equity. In the IASB’s accounting standard on fair value, IFRS 13 Fair Value Measurement (initially released in May 2011, with a near identical accounting standard published by FASB), fair value is defined as (IASB, 2022b): the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.
The above definition uses a number of terms that require further consideration, in particular ‘orderly transaction’ and ‘market participants’. These terms are defined in IFRS 13 as follows: Orderly transaction: A transaction that assumes exposure to the market for a period before the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities; it is not a forced transaction (eg a forced liquidation or distress sale). Market participants: Buyers and sellers in the principal (or most advantageous) market for the asset or liability that have all of the following characteristics: (a) They are independent of each other, ie they are not related parties as defined in IAS 24, although the price in a related party transaction may be used as an input to a fair value measurement if the entity has evidence that the transaction was entered into at market terms. (b) They are knowledgeable, having a reasonable understanding about the asset or liability and the transaction using all available information, including information that might be obtained through due diligence efforts that are usual and customary. (c) They are able to enter into a transaction for the asset or liability. (d) They are willing to enter into a transaction for the asset or liability, ie they are motivated but not forced or otherwise compelled to do so.
If there is an active and liquid market in which assets are traded that are identical to the asset to be valued, then the fair value will be equivalent to the quoted price (market value) of the asset. 33
For example, pursuant to IAS 16, an upward revaluation in property, plant and equipment will be included in ‘other comprehensive income’, unless the adjustment acts to reverse a previously recognised revaluation decrements for that asset, in which case the subsequent increment would be included within profit or loss.
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However, the IASB and FASB recognise that there will be instances where assets, for which fair value measurements are required, do not have markets where identical assets are actively traded, so a directly comparable market value might not be available. In these circumstances, the market price of a very similar asset or liability can be used or, where there is not an active market for the form of asset that is to be fair valued (so market values for an identical or similar asset cannot be observed), an alternative is to use an accepted valuation model to infer the fair value. As paragraph 3 of IFRS 13 Fair Value Measurement states: When a price for an identical asset or liability is not observable, an entity measures fair value using another valuation technique that maximises the use of relevant observable inputs and minimises the use of unobservable inputs. Because fair value is a marketbased measurement, it is measured using the assumptions that market participants would use when pricing the asset or liability, including assumptions about risk. As a result, an entity’s intention to hold an asset or to settle or otherwise fulfil a liability is not relevant when measuring fair value.
Emphasising that fair value can also be determined by way of valuation models, paragraph 24 of IFRS 13 further states: Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction in the principal (or most advantageous) market at the measurement date under current market conditions (ie an exit price) regardless of whether that price is directly observable or estimated using another valuation technique (emphasis added). Mark-to-market An approach where the value of assets is determined on the basis of observable market values.
Mark-to-model An approach where the value of assets is determined by reference to valuation models.
Techniques that rely upon observable market values (market prices) are often referred to as mark-to-market approaches, whereas techniques that rely upon valuation models are often known as mark-to-model approaches and require the identification of both an accepted valuation model and the inputs required by the model to arrive at a valuation. In practice, the best estimate of the exit price (realisable value), as preferred by Chambers (see the earlier discussion of Continuously Contemporary Accounting), is taken as the fair value of the asset. In comparing fair value to historical cost, fair value is typically considered to be more relevant to the intended users of general purpose financial reports. However, it is a more subjective measurement basis if an active market does not exist for an item. If a valuation model is applied – because there is not an active market – then many assumptions and professional judgements must be made, and this can always admit the potential for ‘creative accounting’ to be employed (which, in the view of some researchers, this basis of measurement undermines its utility in relation to monitoring the stewardship of managers). Determining fair value can also be problematic when markets are volatile, for example when there is a serious financial crisis or when an asset is of a type that is not regularly traded. In such situations, management’s own judgements and assumptions will impact measurement. Ball (2016) refers to the use of fair value in the accounting standards (IFRS) released by the IASB and notes that different jurisdictions will have different markets for assets, and different monitoring and compliance mechanisms. Different countries who might claim to have adopted IFRS will also have different political and economic influences, all of which are expected to influence financial reporting practice. As a result, the use of fair values within IFRS is proposed as potentially contributing towards undermining claims by the IASB that the global adoption of IFRS has led to some form of international standardisation in financial reporting practices (something we explored within Chapter 5). Ball (2016, p. 553) states: IFRS make considerable use of fair value accounting, which books assets and liabilities at amounts that are conceived via hypothetical transactions. Fair values are accounting accruals, not actual arm’s length market transactions,
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allowing implementation differences. Even for short cycle items such as financial instruments, only a minority of the IFRS adopting countries possess deep financial markets. Consequently, the reliability of fair values in many jurisdictions is affected by thin trading, illiquidity, wide spreads, subjective mark to model estimates and even government-administered prices. The jurisdictions in which this is the greatest problem also tend to have the weakest enforcement institutions (audit profession, legal protections, regulation, boards, analysts, press, etc.) and greatest political involvement. For longer-cycle items such as property, plant, and equipment, exercising the option to fair value builds an entirely different level of judgment into the financials. Fair-valuing long-cycle assets involves forecasting cash flows over substantial horizons, an exercise that requires judgment and provides managers with discretion over the private information they reveal. Similarly, asset impairment charges are longcycle accruals and they play a more prominent role in IFRS than in many adopting countries’ prior domestic standards. Because these accruals utilize manager and auditor judgment, they are subject to local political and economic influence. The conclusion is that rules alone do not determine actual reporting practice. Estimation and discretion are required. This point appears to have been underappreciated when expectations of cross-regime comparability were formed around the time of IFRS adoption.
Hence, fair values are seen by some researchers as potential vehicles for manipulating financial reports (and relatively more so in some countries), and this ability is deemed to be greater relative to the use of historical cost. Perhaps responding to some perceived concerns about the representational faithfulness of fair values, the IASB’s (and FASB’s) accounting standard on fair value measurement establishes a ‘fair value hierarchy’ in which the highest attainable level of inputs must be used by preparers of general purpose financial statements to establish the fair value of an asset or liability. As paragraph 72 of IFRS 13 states: To increase consistency and comparability in fair value measurements and related disclosures, this Standard establishes a fair value hierarchy that categorises into three levels (see paragraphs 76–90) the inputs to valuation techniques used to measure fair value. The fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities (Level 1 inputs) and the lowest priority to unobservable inputs (Level 3 inputs).
Levels 1 and 2 in the hierarchy can be referred to as mark-to-market situations, with the highest level, Level 1, being (paragraph 76 of IFRS 13): Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the entity can access at the measurement date.
Level 1 inputs are generally considered to be subject to less potential for manipulation. Level 2 are directly observable inputs other than Level 1 market prices (Level 2 inputs could include market prices for similar assets or liabilities, or market prices for identical assets but that are observed in less active markets). As paragraph 81 states: Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly.
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Level 3 inputs are mark-to-model situations where observable inputs are not available and risk-adjusted valuation models need to be used instead. Level 3 inputs are unobservable inputs for the asset or liability. Paragraph 87 of IFRS 13 states: Unobservable inputs shall be used to measure fair value to the extent that relevant observable inputs are not available, thereby allowing for situations in which there is little, if any, market activity for the asset or liability at the measurement date. However, the fair value measurement objective remains the same, ie an exit price at the measurement date from the perspective of a market participant that holds the asset or owes the liability. Therefore, unobservable inputs shall reflect the assumptions that market participants would use when pricing the asset or liability, including assumptions about risk.
It is interesting to note that the above paragraph makes reference to a ‘market participant’ – basing measurement on a market participant’s perspective is conceptually different to the value that an organisation would attribute to an asset. Reflection question 6.4 provides an illustration of where the fair value hierarchy is assigned to particular valuations. Figure 6.6 summarises some of the details about the fair value hierarchy. FIGURE 6.6 An overview of the IASB fair value hierarchy Less potential for manipulation
More potential for manipulation
Level 1 inputs
∙ Quoted prices (unadjusted) in active markets for identical assets of liabilities that the entity can access at measurement date
Level 2 inputs
∙ Quoted prices for similar assets or liabilities in active markets • Quoted prices for identical or similar assets or liabilities in markets that are not active • Inputs other than quoted prices that are observable for the asset or liability (for example, interest rates and yield curves observable at commonly quoted intervals; implied volatilities; credit spreads) • Market-corroborated inputs
Level 3 inputs
∙ Unobservable inputs for the asset or the liability – the unobservable inputs shall reflect the assumptions that market participants would use when pricing the asset or liabilities, including assumptions about risk
REFLECTION QUESTION 6.4 Reflection Classifying fair-value measurements using the ‘fair-value hierarchy’ Fair Go Company has three classes of assets that it measures at 2 A large truck. It is two years old and in average condition
fair value. The three classes of assets, and the bases of how fair value was determined for each class, are: 1 Shares in a public company listed on a securities exchange. Fair value was determined based upon the market price available from the securities exchange.
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for its age. This particular type of truck does not come onto the market often, but three have been sold in the past 12 months, all of which were aged almost the same as the truck in question.The organisation used the average of the three selling prices as the basis for determining the fair value of the truck.
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3 A specialised piece of equipment that was purpose-built for the organisation. This equipment would not be in demand by other organisations, so has no apparent sales price. The fair-value measurement was based upon determining the net present value of future cash flows, which necessarily required judgements about various factors including future demand, future sales price, future operating costs and appropriate discount rates. Question You are to determine the level of inputs (1, 2 or 3) used for each of the valuations, and decide whether the valuations were based on observable or unobservable inputs.
Solution 1 The shares were measured using Level 1 inputs using observable data. This would be a ‘market approach’ to measurement. 2 The truck was measured using Level 2 inputs using observable data. This would be a ‘market approach’ to measurement. 3 The equipment was measured using Level 3 inputs using unobservable data. This would be an ‘income approach’ to measurement. This would be based upon a great deal of professional judgement, and therefore could potentially be subject to relatively more manipulation.
Permitting, and in some cases requiring, certain categories of assets and liabilities to be valued at fair value has been controversial. Two key features of fair value that have attracted some heated debate are the volatility and procyclicality that some argue can be (and have been) introduced into net asset and profit figures when the underlying markets used to determine an asset’s fair value are themselves volatile. Another criticism relates to the focus on the decision usefulness aspect of financial reporting, rather than the stewardship aspect. As we have discussed already, the decision usefulness (normative) perspective underlying the use of fair values maintains that the role of financial accounting is to provide information that is useful to help stakeholders, such as investors, make certain types of investment decisions (a normative position that is shared with Chambers, who advocated a similar exit value measurement basis). While it is often argued that fair values are more relevant than historical costs, some researchers have indicated that users of financial reports consider the representational faithfulness more important than relevance when it comes to asset measures, and therefore can prefer historical costs particularly in relation to assets that are thinly traded or measured using Level 3 inputs. For example, in a study of the information demands of financial analysts, Georgiou, Mantzari and Mundy (2021, p. 330) note: Our interviewees do not consider relevance to be the ultimate attribute that fair value information should possess, ranking it fourth of the six fundamental and enhancing qualitative characteristics. This is surprising given that relevance is assumed by standard setters to be the utmost quality accounting information should possess in order for it to be decision-useful. The results indicate that faithful representation is regarded as the most important characteristic fair values should possess in order to be decision useful.
Fair value and its relationship to volatility and procyclicality in accounting measures In using market prices, rather than, for example, inflation-adjusted historical costs, fair value measurements provide valuations for assets (and for any fair valued liabilities) that are influenced by the market conditions in place at the end of the reporting period. This is a feature they share with realisable (exit) values – as championed years earlier by Chambers and others – and replacement cost values. One key outcome of this is that if the underlying asset markets that are used to derive the information about fair values are themselves suffering from high levels of volatility, this volatility will be reflected in the values of the fair valued assets (and liabilities) shown in the statement of financial position (balance sheet). In other words, at times, using fair values can result in considerable volatility in the statement of financial position.
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When applying the definitions of the elements of financial reporting (assets, liabilities, equity, income and expenses) as provided within the IASB Conceptual Framework, income and expenses (and therefore profit) reflect differences between the net asset figure in the statement of financial position at the start of the accounting period and the net asset figure at the end of the reporting period (after adjusting for contributions by, and distributions to, owners). Therefore, where use of ‘fair value’ for a particular type of asset or liability introduces volatility into figures in the statement of financial position, this will also lead to volatility in figures in the statement of profit or loss and other comprehensive income (income statement), with the changes in fair value either being reflected in ‘profit or loss’ or in ‘other comprehensive income’ (both of which combine to give ‘total comprehensive income’). The sub-prime banking crisis was a financial crisis that occurred between 2007 and 2010; it created recessional pressures in national economies throughout the world and was initially triggered by falling housing prices in the United States, which in turn led to pressures on various international banking and lending institutions and thereafter across entire economies. During the subprime banking crisis it was claimed by many (especially managers of banks themselves) that accounting requirements – as reflected in various accounting standards – that require reporting entities to measure many of their assets at fair value actually exacerbated the financial crisis (Laux and Leuz, 2009; Power, 2010). This is the phenomenon termed procyclicality (see earlier in this chapter). It is argued that when markets for financial assets (such as shares, bonds and derivatives) are booming, the value of these assets held by banks, and shown at fair value within their statements of financial position, will similarly rise significantly above their historical cost, thus increasing the reported net assets and capital and reserves of the bank. As banking regulations usually set bank lending limits in terms of a proportion (or multiple) of capital and reserves, this increase in the reported fair value of the assets of a bank will enable a bank to lend more. Some of this additional lending will fuel further demand in the markets for financial assets, thus further increasing the market values/prices of these assets held by banks and further increasing their reported capital and reserves. This, it is argued, will enable banks to lend even more, thereby increasing demand further, and thus will help to create an upward spiral in financial assets prices and bank lending that becomes increasingly disconnected from the underlying real economic values of the assets in these markets (Laux and Leuz, 2009). Conversely, it was argued by many at the time of the sub-prime banking crisis that when markets for financial assets are in free-fall (as they were at times during the crisis), fair value accounting exacerbates a downward spiral of asset prices and bank lending that is equally unreflective of (and significantly overstates) decreases in real underlying economic values (Laux and Leuz, 2009). The basis of this viewpoint is that requirements to fair value financial assets held by banks may lead to a rapid erosion in the capital and reserves shown in the banks’ statements of financial position. This will reduce their lending limits (where these are tied to their reported levels of capital and reserves) and will both reduce bank lending (thus reducing demand in financial markets, putting further downward pressure on the asset prices in these markets) and possibly require the banks to sell some of the financial assets they hold to release liquidity. This increased supply will put further downward pressure on the asset prices, leading to a downward price spiral as these reduced prices further reduce the reported net assets of the banks. Views such as these emphasise the key role that financial accounting plays within the broader society, with proponents of the above view emphasising that the choice of an accounting measurement approach such as fair value can, according to them, have widespread negative economic and social implications for society (reinforcing the view provided in Chapter 3 that the accountant is indeed a very powerful member of society). Although these impacts of fair value accounting were widely articulated at the time of the sub-prime banking crisis, Laux and Leuz (2009) argue that many of these claimed empirical effects were not caused by fair value accounting, so the volatility and procyclicality case against 258
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fair value accounting is not as clear-cut as the above arguments indicate. Laux and Leuz (2009, p. 827) indicate that while there are some legitimate concerns about the impact of fair values: the concern about the downward spiral is most pronounced for FVA [fair value accounting] in its pure form but it does not apply in the same way to FVA as stipulated by US GAAP or IFRS. Both standards allow for deviations from market prices under certain circumstances (e.g., prices from fire sales). Thus, it is not clear that the standards themselves are the source of the problem.
The basis of this argument is that, as we saw earlier, both IFRS and US GAAP permit fair values to be determined using data other than direct market observations in many circumstances. These are referred to as Level 2 and Level 3 in the fair value measurement hierarchy. In situations where markets are demonstrably not providing values based on orderly transactions, or are for any other reason not operating efficiently (for example, due to illiquidity in the markets), then rather than using Level 1 fair value measurements (directly observed market prices for identical assets), Level 2 mark-to-market or Level 3 mark-to-model valuations should be used. Laux and Leuz (2009) explain that during the sub-prime banking crisis, many banks moved to using Level 2 and 3 valuations rather than Level 1 valuations for many financial assets, and also took advantage of provisions to allow some assets to be reclassified from fair value to historical cost categories in special circumstances, thus acting as a ‘damper’ and reducing the speed (or acceleration) of any procyclical effects. They also argue that any failure to provide fair values in financial statements during economic downturns could in itself cause markets to overreact and/or misprice company shares: it is also possible that market reactions are even more extreme if current market prices or fair-value estimates are not disclosed to the market. We are not aware of any empirical evidence that investors would be calmer under historical cost accounting. Investors are not naïve; they know about the problems, e.g., in the subprime-loan market, and hence will draw inferences even in the absence of fair-value disclosures (and in that case might assume the worst). Thus, lack of transparency could make matters worse. Furthermore, even if investors were to react more calmly under historical cost accounting, this may come at the price of delaying and increasing the underlying problems (e.g., excessive subprime lending). (Laux and Leuz, 2009, p. 828)
Apart from the mainly empirical question of whether fair values lead to unwarranted volatility in reported assets values, and give rise to undesirable procyclical outcomes, a key normative question is whether the move to use fair values improves the role and functioning of financial accounting. Much of this normative debate focuses on whether the purpose of financial accounting is to provide information to help a range of financial stakeholders make effective economic decisions (which would support the move to use of fair values) or whether financial accounting should serve more of a traditional role of helping existing investors and others assess the effectiveness of the directors’ stewardship of the assets owned by the organisation (which would potentially support greater use of historical cost accounting). In another study that considered how fair value accounting could have contributed to ‘financial crises’, Haswell and Evans (2018) explored fair value accounting as used by the large organisation Enron, the collapse of which caused various economic and social problems. The research followed previous work by Benston (2006) who, unlike many other authors, claimed that fair value accounting at Enron was largely to blame for its ultimate demise. This view was also consistent with Flegm (2005), who claimed that the misuse of fair-valued derivatives was central to the accounting frauds at companies such as Enron, Qwest and Parmalat. Haswell and Evans (2018) point out that in the aftermath of the collapse of Enron, little or no blame was directed towards fair value accounting. Rather, blame was assigned to Enron’s practice of recognising fictitious revenues and other poor governance practices. The authors suggest that 259
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as the standard-setters were, at the time, attempting to garner widespread support for fair value accounting, they were therefore reluctant to identify fair value accounting as contributing to the collapse of Enron. What Haswell and Evans conjecture is that although fair value accounting was used by Enron somewhat opportunistically, and although its opportunistic use significantly contributed to Enron’s collapse, accounting standard-setters preferred not to discuss this matter as that would have been counterproductive to their efforts to obtain widespread constituent support for fair value measurements. As Haswell and Evans (2018, p. 36) state: Arising from the Enron hearings we are left with a choice of two impressions. One is that, in 2002, the technicalities of fair value measurement, those being actually carried out in the workplace, were not well understood by SEC, FASB and many other authorities, nor were the consequences or misuse of fair value accounting (FVA) technology well understood. An alternative impression is that SEC, FASB and other leaders perhaps did understand the use and misuse of FVA rather better than they were willing to say publicly, but in effect these authorities performed a cover-up of what they knew to be problematic about FVA. Either way, it is not hard to see how FVA largely escaped blame for the Enron crash, as suggested by Benston (2006).
The above quote reflects the potentially political nature of accounting standard-setting – something that we have emphasised in previous chapters. Haswell and Evans (2018, p. 37) also reference the use of Enron’s mark-to-model approach to fair value accounting (with its reliance on Level 3 inputs): McLean and Elkind (2003) report that, in 1992, Enron actually sought and obtained the SEC’s approval to use mark-to-model-type calculations, on booking income in advance from natural gas futures contracts; Enron was, therefore, the first company to deploy this type of accounting in the energy industry. By 1997, Enron was using FVA in every aspect of its business (McLean and Elkind, 2003, p. 127). McLean and Elkind make it clear that mark-to-model FVA was the essential accounting conduit for Enron’s measurement malfeasance.
Haswell and Evans (2018) note that Enron made many assumptions (perhaps opportunistically) about what cash flows might, or might not, happen in the future, and they note (p. 37) it would have: been difficult to book these unrealistic revenues without the aid of fair value accounting. While historical cost can also be misused, it is a question of degree; and Enron’s abuses were exceptional.
Haswell and Evans (2018) claim that as a result of Enron’s mark-to-model approach to fair value accounting, some years later the FASB (and the IASB) subsequently introduced the fair value hierarchy that we have already discussed within this chapter. The authors also note many organisations that use fair value measurements opt not to use Level 1 measurement, but prefer to use Level 2 and 3 measurements, given the discretion these provide to managers. Reflecting their concerns that future financial crises are likely to be linked to the growing use of fair value accounting, Haswell and Evans (2018, p. 42) state: In the wider sphere of financial assets, there are presently around $550 trillion of financial derivatives contracts with open positions, world-wide, measured at fair value (Bank of International Settlements, 2017, p. 1). These amounts are so astronomical that any measurement issues affecting these products are likely to have serious consequences. According to some commentators, mark-to-model measured derivatives hang over the world like the ‘sword of Damocles’ (Hera, 2010) waiting for some trigger to cause another global crisis. 260
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The use of the term ‘sword of Damocles’ in the above quote comes from an Ancient Greek parable and refers to a situation where something very bad could happen to people at any time. It reflects a sense of impending doom. We can see that the actions of financial accountants are directly linked by the authors to this potential ‘doom’, again reinforcing the point that we stress throughout this book, that accountants hold much power within society. Therefore, the above quote again emphasises the very real social role that accounting plays within society, and that the use of a particular accounting method could potentially lead to such calamity. In summing up, Haswell and Evans (2018, p. 43) state: Enron and others manipulated mark-to-model FVA for their own corrupt purposes. A study of the Enron hearings of 2001–2002 shows that regulators, standard setters, professionals, and most commentators, in general, either did not understand sufficiently the consequences of FVA and how it was prone to manipulation, or, if they did understand it, chose to remain silent. Later, in the mid-2000s, when more seemed to have been revealed about markto-model problems, the eventual response of standard setters was not to abandon the FVA experiment, but to supposedly toughen it with a new emphasis on ‘mark-tomarket’ accounting, which focuses on observable market transactions-of-the-moment. The latter element fitted nicely with a developing neoliberal attitude toward the supremacy and veracity of (rapidly changeable) market data, as transparent and useful information. Prudence and reliability, by contrast, and along with innate conservatism, seem to have been jettisoned as a consequence. But the new FVA scheme came with a ‘three level hierarchy’ which still contained elements of the failed mark-to-model regime and, in any case, the reliability or efficacy of short-term mark-to-market data had been insufficiently investigated or tested. Despite these criticisms, it seems that nothing could stop the rise of FVA as part of an accounting world view. By the time the GFC arrived in 2008, standard setters were encumbered with an FVA ideological baggage. The response of standard setters to severe criticism of FVA was, first, to deny that mark-to-market FVA (their ideologically preferred option) was problematic when associated with illiquid markets; and second, when politically there was no other option, to fall back upon the already failed mark-to-model version of FVA; a situation that subsists nearly a decade later. Presumably, within standard setter ranks there must exist a denial of these issues, just as was the case when, back in 2001, standard setters denied there was any problem with Enron and FVA. The academic community remains divided on the efficacy of even the supposedly rigorous mark-tomarket version of FVA, and some support the complaint that the short-term approach of mark-to-market FVA is problematic. One could ask if any of the versions of FVA have been, or are likely to be, serviceable and if we should simply return to an historical cost model.
As we can see from the above material, the question about whether historical cost of fair value measurements are ‘better’ is far from settled.
Why do I need to know about some of the critical commentaries of fair value measurements? Fair value measurements are increasingly being used in financial accounting, but their use is not without its critics, as we have shown in this chapter. As critical thinkers, we need to consider
the different viewpoints and decide for ourselves Why whether we believe that fair value measurement of assets and liabilities provides relevant and representationally faithful
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information. If we accept some of the criticisms then, as financial statement readers, we might consider supplementing the information from financial reports with other information gathered beyond the financial reports. As researchers, or as possible future standard-setters, we can consider these criticisms and
perhaps consider identifying potential alternative measurement approaches. As we emphasise throughout this book, before accepting any criticisms of particular practice we need to consider the logic and the evidence used as part of developing these critical commentaries.
Fair value and the decision usefulness versus stewardship role of financial reporting Whittington (2008) distinguished between what he refers to as two competing ‘world views’ underlying present-day normative positions on financial accounting. He terms these the Fair Value View and the Alternative View. He argues that under the Fair Value View, the sole purpose of financial accounting is seen as being to provide information useful for a range of financial stakeholders, such as existing and potential investors, lenders and other creditors, for making economic decisions based on future cash flows. In contrast, proponents of the Alternative View believe that ‘stewardship, defined as accountability to present shareholders is a distinct objective, ranking equally with decision usefulness’ (p. 159). We discuss some of the implications of these different world views in Chapter 8. For the purpose of our examination in this chapter of the use of fair values, a key aspect of Whittington’s critique is that fair values provide information suited for a decision usefulness role for financial accounting whereas historical cost accounting provides information aligned more towards a stewardship role. For the former, where there has to be a trade-off, relevant information (in terms of providing information that helps forecast future cash flows) is considered more important than reliability of accounting information, and it is assumed that: Market prices should give an informed, non-entity specific estimate of cash flow potential, and markets are generally sufficiently complete and efficient to provide evidence for representationally faithful measurement on this basis. (Whittington, 2008, p. 158, emphasis in original)
As market values are generally (but not always) considered to provide the most relevant decision-useful information, fair values in the statement of financial position are considered to be more important than information in the statement of profit or loss and other comprehensive income (or income statement). The former thus becomes the primary financial statement while the statements of profit or loss and other comprehensive income (income statement) just record the difference in net asset (fair) value from one year to the next (Ronen, 2008). In contrast, for a primarily stewardship role, reporting of the impact of transactions entered into by the organisation is considered to be of key importance. This information is captured primarily in the income statement (or statement of profit or loss and other comprehensive income), with the statement of financial position recording the residual amounts of cash flows that have not yet been ‘used up’ (or have been used but not yet received or paid) in accordance with the realisation and matching principles of accrual accounting (such as inventory purchased but not yet sold, the useful lives of tangible non-current assets that have not yet been used and can help generate income in future periods, and so on) (Ronen, 2008). For these purposes, reliability of measurement is important, and the application of prudence is regarded as important in enhancing the reliability of information (Whittington, 2008). In considering issues of relevance versus representational faithfulness in fair value accounting, Ronen (2008, p. 186) argues that fair values do not measure the value of assets to the specific organisation. Therefore, despite the rationale of fair values being that they
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provide relevant decision-useful information, Ronen claims that fair values do not always provide the most relevant measures: Since the fair value measurements … are based on exit values, they do not reflect the value of the assets’ employment within the specific operations of the firm. In other words, they do not reflect the use value of the asset, so they do not inform investors about the future cash flows to be generated by these assets within the firm, the present value of which is the fair value to shareholders. Thus, these exit values fall short of meeting the informativeness objective of financial statements. In a similar vein, they do not do well in serving the stewardship function, as they do not properly measure the managers’ ability to create value for shareholders. Nonetheless, exit value measures have partial relevance. Specifically, they quantify the opportunity cost to the firm of continuing as a going concern, engaging in the specific operations of its business plan; the exit values reflect the benefits foregone by not selling the assets.
The above criticisms, while made relatively more recently, reflect some of the concerns raised about exit prices a number of decades ago – reflecting also that many key issues in financial accounting remain unresolved. In assessing the reliability or representational faithfulness of fair value information, Ronen (2008, p. 186) explains that under fair value accounting, Level 1 measurements can generally be considered reliable, but for Level 2 and 3 measurements: Level 2 involves estimations of fair value based on predictable relationships among the observed input prices and the value of the asset or liability being measured. The degree of reliability one can attach to these derived measures would depend on the goodness of the fit between the observed input prices and the estimated value. Measurement errors and mis-specified models may compromise the precision of the derived estimates. Nonetheless, Level 2 is not as hazardous as Level 3. In the latter, unobservable inputs, subjectively determined by the firm’s management, and subject to random errors and moral hazard,34 may cause significant distortions both in the balance sheet and in the income statement. Moreover, discounting cash flows to derive a fair value invites deception.
Looking at considerations of reliability/representational faithfulness in more depth, Power (2010) argues that reliability is understood differently by different people and is, in effect, socially constructed. He partially explains the rise of fair value accounting in terms of a specific perception of reliability grounded in the developing discipline of financial economics, which has been increasingly drawn upon by accounting regulators to give authority (from outside the discipline of accounting) to their pronouncements. He explains that despite the many unrealistic assumptions underlying financial economics, with these being widely articulated in the wake of the sub-prime banking crisis, financial economics has provided an attractive body of knowledge for accounting standard-setters: Whitley (1986) suggests that the close links [of finance theory] with practice had more to do with financial economics as a reputational system and less to do with the direct applicability of its analytical core. This is consistent with Hopwood’s (2009: 549)
34
‘Moral hazard’ is linked to information asymmetry, a situation in which one party to a transaction has more information than another, and the party with more information about a particular event or item has the potential or incentive to behave inappropriately from the perspective of the party with less information.
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critique of the ‘growing distance of the academic finance knowledge base from the complexities of practice and practical institutions.’ Yet, as Abbott (1988) has argued, purely ‘academic’ knowledge has always played a significant role for professions, providing the rational theorisations need by practice. Financial economics is almost the perfect example of this. (Power, 2010, p. 202) … proponents of fair values in accounting argue for their greater relevance to users of financial information, but the deeper point is that they also redefine the reliability of fair values supported by financial economics, both in terms of specific assumptions and in terms of its general cultural authority. Against sceptics, key accounting policy makers were able to acquire confidence in a knowledge base for accounting estimates rooted in a legitimised discipline. (Power, 2010, p. 205)
Power (2010, p. 201) argues that in this context, fair value – as a measurement basis grounded in financial economics conceptions of the role of accounting as being to provide decision-useful information to a range of financial stakeholders – becomes the ‘acceptable’ measurement basis: once it is admitted that market prices may not reveal fundamental value, due to liquidity issues or other reasons, then it can be argued that the real foundation of fair value lies in economic valuation methodologies; Level 3 methods are in fact the engine of markets themselves, capable of ‘discovering’ values for accounting objects which can only be sold in ‘imaginary markets’. It follows that the [fair value] hierarchy is more of a liquidity hierarchy than one of method, but overall it expresses the imperative of market alignment which informs fair value enthusiasts. The sociology of reliability to emerge from these arguments suggests that subjectivity and uncertainty can be transformed into acceptable fact via strategies which appeal to broader values in the institutional environment which even opponents must accept. Accounting ‘estimates’ can acquire authority when they come to be embedded in taken-for-granted routines. (emphasis in original)
In a study of London-based financial analysts, Georgiou, Mantzari and Mundy (2021) explored the perceived decision usefulness of fair values. The analysts interviewed suggested that fair values did not rank highly in terms of ‘relevance’, particularly with respect to predicting future earnings, with many analysts noting concerns about the representational faithfulness of such measures, particularly when determined on a mark-to-model basis (Level 3). Georgiou, Mantzari and Mundy state (p. 331) that: Fair values do not therefore always provide information that is relevant to future cash flow-oriented decisions as assumed by the IASB. These reflections problematise the view that expectations about the future can be meaningfully incorporated in accounting measurements and result in more useful information for decision making.
Georgiou, Mantzari and Mundy (2021, p. 334) further state: In summary, our findings question that the qualitative characteristics constitute meaningful elements of the decision-usefulness of fair values. Fair values are not considered particularly useful in predicting future performance. The results are surprising given the importance that standard setters assign to relevance as a qualitative characteristic of decision-useful information. Analysts also consider that faithful representation and comparability are important attributes fair values should possess in order to render them decision-useful.
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In another study of the ‘value relevance’ of banks’ financial statements, McInnis, Yu and Yust (2018) also challenged the relevance of fair values relative to historical costs. Their study examined US banks’ financial disclosures. Pursuant to US financial reporting requirements (that is, US GAAP), the majority of banks’ financial instruments are measured at historical cost. However, fair value information is provided within the notes to the financial statements.35 McInnis, Yu and Yust (2018, p. 275) found that: Overall, our results contradict the notion that fair value as a measurement attribute for financial instruments produces a more useful set of financial statements for bank investors. Instead, historical costs required under current GAAP yield financial statements that are more relevant for bank valuation. In some sense, the findings in this study support the current accounting model for the banking industry whereby loans, deposits, and debt are recognized in the financial statements using historical costs, while fair value information is disclosed in the notes. Thus, the main takeaway for scholars, users, and standard setters is that banks’ financial statements based on fair values as currently disclosed seem to provide less useful information for equity valuation compared to current GAAP.
As fair value accounting looks likely to grow in use and influence as an increasing number of accounting standards require it, debates over issues such as the impact of fair values and normative questions about the desirability of different aspects of fair values are also likely to gain even greater prominence. Academic studies examining the reactions of users to fair value accounting disclosures provide important evidence to inform this debate.
REFLECTION QUESTION 6.5 The fair value hierarchy and the relative usefulness of the levels Question As a user of financial reports, and given what you have just read, would you prefer reported fair values to be based upon Level 1 or Level 3? Why? Solution If available, preference would be given to Level 1 inputs. Because Level I inputs are based more upon unadjusted prices in active markets, they tend to be less prone to professional judgements, estimation errors and potential manipulation. However, at times, active markets do not exist, and reliance needs to be placed upon Level 2 and Level 3 inputs. What the research suggests, however, is that as we move towards measurements of fair values based upon Level 2 and Level 3 inputs, various key stakeholder groups – such as investors,
35
Reflection
lenders and investment analysts – tend to place less reliance on the fair value measurements and there tends to be some level of preference towards measurements based upon historical costs. Whether fair values based on ‘mark-to-model’ valuations are more or less ‘useful’ than measurements based upon historical cost is a topic still being debated, so at the moment it really does depend upon whose preference is being examined. Our trust in ‘mark-to-model’ measurements of fair value will also be influenced by our perceptions about the reputation and expertise of the respective managers and the accountants involved in preparing the financial reports, the expertise and independence of the appointed financial statement auditors, and the level of regulatory compliance and oversight being applied within the particular jurisdiction.
While the FASB was initially working with the IASB to introduce fair value measurements for financial instruments, the FASB ultimately did not pursue this direction (unlike the IASB). Rather, the FASB retained historical cost measurements for most financial instruments.
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STUDY TOOLS CHAPTER SUMMARY This chapter explored different models of accounting that have been developed to provide financial information in periods of rising prices and other changing market conditions that impact on asset values. These models have been developed because of the perceived limitations of historical cost accounting, particularly in times of rising prices. Critics of historical cost accounting suggest that, because historical cost adopts a capital maintenance perspective which is tied to maintaining financial capital intact, it tends to overstate profits in periods of rising prices. Historical cost accounting adopts an assumption that the purchasing power of currency remains constant over time. Debate about the best model of accounting to use in periods of rising prices was vigorous in the 1960s through to the mid-1980s. During this time, inflation levels tended to be relatively high. For example, in the mid-1970s the inflation rate in Australia was around 16 per cent. Since then, inflation levels internationally have tended to be low and the debate about which model to adopt to adjust for rising prices has waned. However, in 2022 inflation rates throughout the world were rising, perhaps providing impetus for further debate about how to measure assets in times of rising prices. Regardless, there has been a general movement by regulators such as the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) towards the use of fair values in various accounting standards, although the adoption of fair value tends to be on a piecemeal basis as particular accounting standards are developed. With this said, however, there are still various assets that are measured on the basis of historical costs. A number of alternative models have been suggested. For example, current purchasing power accounting (CPPA) was one of the earlier models to be developed. CPPA was supported by a number of professional accounting bodies during the 1960s and 1970s, although support then shifted to current cost accounting. CPPA uses numbers generated by the historical cost accounting as the basis of the financial statements, and at the end of each period CPPA applies a price index, typically a general price index, to adjust the historical cost numbers. For balance sheet (statement of financial position) purposes, adjustments are made to non-monetary assets. Monetary items are not adjusted by the price index. However, although monetary items are not adjusted for disclosure purposes, holding monetary items will lead to gains or losses in purchasing power that are recognised in the period’s profit or loss. No gains or losses are recorded in relation to holding non-monetary items. One of the advantages of using CPPA is that it is easy to apply. It simply uses the historical cost accounting numbers that are already available and applies a price index to these numbers. A disadvantage is that the adjusted prices may provide a poor reflection of the actual value of the items in question. Another model of accounting is current cost accounting (CCA). It uses actual valuations of assets, typically based on replacement costs, and operating income is calculated after consideration of the replacement costs of the assets used in the production and sale cycle. Non-monetary assets are adjusted to take account of changes in replacement costs, and depreciation expenses are also adjusted on the basis of changes in replacement costs. While not in use today, CCA attracted support from professional accounting bodies in the early 1980s. Opponents of CCA argued that replacement costs have little relevance if an entity is not considering replacing an asset, and, further, that replacement costs might not accurately reflect the current market values of the assets in question. The final model of accounting considered was Continuously Contemporary Accounting (CoCoA). One key objective of CoCoA was to provide information about an entity’s capacity to adapt to changing circumstances, with profit being directly related to changes in adaptive capacity. Profit is calculated as the amount that can be distributed while maintaining the adaptive capital intact. CoCoA does not differentiate between realised and unrealised gains. In support of CoCoA, it requires only one type of valuation for all assets (based on exit prices). There is no need for arbitrary cost allocations, such as for depreciation. Criticisms of CoCoA include the relevance of values based on exit (selling) prices if there is no intention of selling an item. Also, many people have challenged the perspective that if an asset cannot be sold separately it has no value (for example, goodwill). It has also been argued that valuing items on the basis of sales prices can introduce an unacceptable degree of subjectivity into accounting, particularly if the items in question are quite specialised and rarely traded.
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The final issue we considered relating to changing assets values was fair value accounting. This is currently a controversial practice both among professional accountants and researchers, and has generated heated debates over its advantages and disadvantages. However, its use looks set to continue growing. As a result of reading this chapter, we are now better placed to understand the advantages and disadvantages of fair value measurement (a practice that we will increasingly be exposed to), as well as being aware of some potential alternative measurement approaches, which in themselves might have merit as an alternative basis of measurement.
ANSWERS TO THE OPENING QUESTIONS At the beginning of the chapter, we asked the following three questions. As a result of reading this chapter, you should be able to provide informed answers to these questions – ours are shown below.
Module 1 Questions / Answers
Various asset valuation approaches are typically utilised within a set of financial reports. Noncurrent assets acquired (or perhaps revalued) in different years can be added together to give a total monetary value, even though the various costs or valuations might provide little reflection of the current values of the respective assets. For example, pursuant to IAS 16 Property, Plant and Equipment, it is permissible for some classes of property, plant and equipment to be measured at cost, less accumulated depreciation and impairment losses, whereas another class of property, plant and equipment is allowed to be measured at fair value. The different measurements will then simply be added together to give a total monetary value for property, plant and equipment – with the total representing neither cost nor fair value.
1 What are some of the criticisms that can be made in relation to the practice of accounting wherein assets that have been acquired or valued in different years are added together, without adjustment (as occurs with historical cost accounting), when the purchasing power of the dollar in those years was conceivably quite different? As this chapter has discussed, historical cost accounting tends to disregard changes in the purchasing power of a particular currency. Adding together assets that have been acquired in different years, with currencies of different purchasing power, tends to undermine the ‘decision usefulness’ of the aggregated total. A model of accounting – such as historical cost accounting – that assumes a particular currency has constant purchasing power (thereby disregarding price level changes), tends to adopt a financial capital maintenance approach, which means that profits can be paid out as dividends to the extent that it leaves financial capital intact. However, paying out profits as dividends without adjusting for rising prices can undermine an organisation’s operating capacity. It has been argued that it is preferable to make price level adjustments so that dividends are paid only to the point where physical operating capacity has not been eroded. Another key criticism of historical cost accounting is that it is illogical to add together assets that have been acquired in different periods when the amounts paid had different purchasing power. This is the ‘additivity problem’. A further criticism of historical cost accounting is that it is inappropriate to record the gain from the sale of an asset in one year when the holding gains have actually been accruing over several years. 2 What are some of the alternative methods of accounting (alternatives to historical cost accounting) that have been advanced to cope with the issue of changing prices and market conditions, and what acceptance have these alternatives received from the accounting profession and accounting researchers? There have been several alternatives suggested. In this chapter we considered current purchasing power accounting (CPPA), current cost accounting (CCA) and continuously contemporary accounting (CoCoA). These approaches were advanced by leading normative accounting researchers at points in time when inflation was high. These approaches lost
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relevance and support as inflation rates fell. However, they provided useful critiques of historical cost accounting that still have relevance today. The approach favoured by accounting standard-setters in the present day is fair value accounting. However, as this chapter has demonstrated, fair value measurements have their critics. 3 What are the perceived strengths and weaknesses of the alternatives to historical cost? This chapter described various strengths and weaknesses of the alternative models of financial accounting. For example, current CPPA, with its use of indices, was relatively easy to implement. However, there were some concerns about what the asset measurements represented – they were neither cost nor fair value. Various forms of CCA were praised for their use of actual valuations; however, there was much debate about whether asset measurements should be based upon replacement costs or exit values. Fair value measurement has gained much support in recent years. Fair value measurements are deemed to provide more relevant information, which is considered to enhance the ‘decision usefulness’ of financial reports. However, there have been many questions raised about the usefulness of fair values in assessing management’s stewardship of the resources that have been entrusted to it. Fair value measurements have also been implicated in terms of their potential contribution to causing some key financial crises. Further, there have also been some concerns about the representational faithfulness of fair values, particularly those determined by way of the ‘mark-to-model’ valuation approach.
QUESTIONS 6.1 6.2 6.3 6.4 6.5
6.6 6.7
What does ‘measurement’ mean from an accounting perspective? LO6.1 Why is accounting measurement potentially controversial? LO6.1 What assumptions, if any, does historical cost accounting make about the purchasing power of the currency? LO6.2 List some of the criticisms that can be made of historical cost accounting when it is applied in times of rising prices. LO6.3 The IASB and the FASB identified a number of factors that need consideration before a preferred approach (or a number of approaches) to measurement is (are) selected. What are some of these factors? LO6.1 Why do you think that corporate management might prefer to be allowed to use historical costs rather than being required to value assets on the basis of current values? LO6.1 LO6.5 Evaluate the following statement: Measures such as the lower of cost and net realisable value, which is required for inventory, can perhaps be justified in terms of conservatism but are very difficult to justify in terms of decision usefulness. LO6.5
6.8
As shown in this chapter, Mautz (1973) made the following statement: Accounting is what it is today not so much because of the desire of accountants as because of the influence of businessmen. If those who make management and investment decisions had not found financial reports based on historical cost useful over the years, changes in accounting would long since have been made.
Evaluate the statement. 6.9
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From an accounting standard-setting perspective, do you think there should be a relationship between the measurement method that is prescribed for assets and the objective of general purpose financial reporting? LO6.1 What is the ‘additivity’ problem that Chambers refers to? LO6.3 LO6.5 Does a ‘mixed measurement’ approach create relatively more opportunities for managers and their accountants to opportunistically select particular measurement approaches? LO6.5 What is ‘fair value’? LO6.7 Explain the ‘fair value hierarchy’. LO6.7 Should an increase in the fair value of assets be included within profits? LO6.6 LO6.7
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6.15 What fundamental qualitative characteristic – relevance or representational faithfulness – is the most important to consider when deciding whether to support, or oppose, fair values? LO6.7 LO6.8 6.16 Is the summation of assets that are measured using different measurement principles (thereby giving a ‘total assets’ figure) effectively like adding apples and oranges? Explain your answer. LO6.2 6.17 Explain the difference between income derived from the viewpoint of maintaining financial capital (as in historical cost accounting) and income derived from a system of ensuring that physical capital remains intact. LO6.6 6.18 In current purchasing power accounting: a Why is it necessary to consider monetary assets separately from non-monetary assets? b Why will holding monetary assets lead to a purchasing power loss, but holding non-monetary assets not lead to a purchasing power loss? LO6.2 LO6.4 6.19 What is the basis of Chambers’ argument against valuing assets on the basis of replacement costs? LO6.5 6.20 If Continuously Contemporary Accounting is adopted and an organisation is involved with selling goods, when would the profit from the sale of goods be recognised? How does this compare with historical cost accounting? LO6.2 6.21 What are holding gains, and how would holding gains be treated if current cost accounting was applied? Do we need to differentiate between realised and unrealised holding gains? LO6.2 LO6.4 6.22 Do you think that ‘profits’ that result from holding gains should be allowed to be distributed to shareholders? Explain your view. LO6.4 LO6.6 6.23 What are some of the major strengths and weaknesses of historical cost accounting? LO6.3 6.24 Under what circumstances is fair value likely to provide a ‘representationally faithful’ measure of the value of an asset? LO6.7 6.25 What are some of the major strengths and weaknesses of current purchasing power accounting? LO6.5 6.26 What are some of the major strengths and weaknesses of current cost accounting (applying replacement costs)? LO6.5 6.27 What are some of the major strengths and weaknesses of Continuously Contemporary Accounting? LO6.5 6.28 Evaluate the statement of Chambers (1995, p. 82) that: in the context of judgement of the past and decision making for the future, the products of Current Value Accounting of the Edwards and Bell variety are irrelevant and misleading. No budget can properly proceed except from an up-to-date statement of the amount of money’s worth available to enter the budget period. LO6.2 LO6.5
6.29 Evaluate the statement of Edwards (1975, p. 238) that: I am not convinced of the merit of adopting, as a normal basis for asset valuation in the going concern, exit prices in buyer markets. These are unusual values suitable for unusual situations. I would not object in principle to keeping track of such exit prices at all times and, as Solomons (1966) has suggested, substituting them for entry values when they are the lesser of the two and the firm has taken a definite decision not to replace the asset or even the function it performs. LO6.2 LO6.5
6.30 Despite the efforts of authors such as Chambers, Edwards and Bell, and Sterling, historical cost accounting is still used within financial accounting. Why do you think that historical cost accounting has remained an accepted method of accounting? LO6.8 6.31 As indicated in this chapter, various studies have provided support for a view that CCA/CPPA is of little relevance to users of financial statements. Nevertheless, numerous organisations lobbied in support of the methods, as well as voluntarily providing such information in their annual reports. Why do you think this was so? LO6.8 6.32 The IASB Conceptual Framework for Financial Reporting does not prescribe a specific approach to measurement. However, in recent years financial reporting standards have been released which have shown a movement away from historical costs and a movement towards the use of fair values. Why do you think this is occurring? Further, why do you think that conceptual frameworks have not been amended to stipulate an alternative to historical costs, such as the use of fair values? LO6.5 LO6.7
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6.33 According to Watts and Zimmerman (1978), what factors appeared to motivate corporate management to lobby in support of general price level accounting (current purchase power accounting)? LO6.8 6.34 Critically evaluate the claimed procyclical role of fair value accounting. How persuasive are arguments that fair value accounting’s procyclicality should be used as an argument to reduce the use of fair value accounting? LO6.7 6.35 Compare and contrast Level 1, Level 2 and Level 3 fair value measurements. What implications do these different measurement techniques have for the reliability of fair value disclosures? LO6.7 6.36 Two views are provided in the following quote from Haswell and Evans (2018, p. 36). Which view would you be more inclined to support, and why? LO6.8 Arising from the Enron hearings we are left with a choice of two impressions. One is that, in 2002, the technicalities of fair value measurement, those being actually carried out in the workplace, were not well understood by SEC, FASB and many other authorities, nor were the consequences or misuse of fair value accounting (FVA) technology well understood. An alternative impression is that SEC, FASB and other leaders perhaps did understand the use and misuse of FVA rather better than they were willing to say publicly, but in effect these authorities performed a cover-up of what they knew to be problematic about FVA. Either way, it is not hard to see how FVA largely escaped blame for the Enron crash, as suggested by Benston (2006).
6.37 Consider the following quote from Ball (2016, p. 553) and provide an argument about whether you believe that the views of Ball provide a significant argument against the use of fair values within IFRS. LO6.7 LO6.8 IFRS make considerable use of fair value accounting, which books assets and liabilities at amounts that are conceived via hypothetical transactions. Fair values are accounting accruals, not actual arm’s length market transactions, allowing implementation differences. Even for short cycle items such as financial instruments, only a minority of the IFRS adopting countries possess deep financial markets. Consequently, the reliability of fair values in many jurisdictions is affected by thin trading, illiquidity, wide spreads, subjective mark to model estimates and even government-administered prices. The jurisdictions in which this is the greatest problem also tend to have the weakest enforcement institutions (audit profession, legal protections, regulation, boards, analysts, press, etc.) and greatest political involvement.
6.38 Read the following quote from Haswell and Evans (2018, p. 42) and discuss whether you think the authors are being realistic, or not. Justify your answer. LO6.7 In the wider sphere of financial assets, there are presently around $550 trillion of financial derivatives contracts with open positions, world-wide, measured at fair value (Bank of International Settlements, 2017, p. 1). These amounts are so astronomical that any measurement issues affecting these products are likely to have serious consequences. According to some commentators, mark-to-model measured derivatives hang over the world like the ‘sword of Damocles’ (Hera, 2010) waiting for some trigger to cause another global crisis.
6.39 Consider the following quote from McInnis, Yu and Yust (2018, p. 275) and discuss whether accounting standard-setters will, or should, react to such findings. LO6.7 LO6.8 Overall, our results contradict the notion that fair value as a measurement attribute for financial instruments produces a more useful set of financial statements for bank investors. Instead, historical costs required under current GAAP yield financial statements that are more relevant for bank valuation. In some sense, the findings in this study support the current accounting model for the banking industry whereby loans, deposits, and debt are recognized in the financial statements using historical costs, while fair value information is disclosed in the notes. Thus, the main takeaway for scholars, users, and standard setters is that banks’ financial statements based on fair values as currently disclosed seem to provide less useful information for equity valuation compared to current GAAP.
6.40 Provide a one-page critical commentary about the following quote from Haswell and Evans (2018, p. 43). LO6.7 LO6.8 Enron and others manipulated mark-to-model FVA for their own corrupt purposes. A study of the Enron hearings of 2001–2002 shows that regulators, standard setters, professionals, and most commentators, in general, either did not understand sufficiently the consequences of FVA and how it was prone to manipulation, or, if they did understand it, chose to remain silent.
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Later, in the mid-2000s, when more seemed to have been revealed about mark-to-model problems, the eventual response of standard setters was not to abandon the FVA experiment, but to supposedly toughen it with a new emphasis on ‘mark-to-market’ accounting, which focuses on observable market transactions-of-the-moment. The latter element fitted nicely with a developing neoliberal attitude toward the supremacy and veracity of (rapidly changeable) market data, as transparent and useful information. Prudence and reliability, by contrast, and along with innate conservatism, seem to have been jettisoned as a consequence. But the new FVA scheme came with a ‘three level hierarchy’ which still contained elements of the failed mark-to-model regime and, in any case, the reliability or efficacy of short-term mark-to-market data had been insufficiently investigated or tested. Despite these criticisms, it seems that nothing could stop the rise of FVA as part of an accounting world view. By the time the GFC arrived in 2008, standard setters were encumbered with an FVA ideological baggage. The response of standard setters to severe criticism of FVA was, first, to deny that markto-market FVA (their ideologically preferred option) was problematic when associated with illiquid markets; and second, when politically there was no other option, to fall back upon the already failed mark-to-model version of FVA; a situation that subsists nearly a decade later. Presumably, within standard setter ranks there must exist a denial of these issues, just as was the case when, back in 2001, standard setters denied there was any problem with Enron and FVA. The academic community remains divided on the efficacy of even the supposedly rigorous mark-to-market version of FVA, and some support the complaint that the short-term approach of mark-to-market FVA is problematic. One could ask if any of the versions of FVA have been, or are likely to be, serviceable and if we should simply return to an historical cost model.
REFERENCES Accounting Principles Board (1962), ‘Statement by the Accounting Principles Board of the AICPA’, Accountancy, May, pp. 9–10, and entitled Statement by the Accounting Principles Board of the AICPA. Australian Financial Review (1973), ‘Where company reports fail’, Prof Raymond Chambers, 10 May, p. 30. Ball, R. (2016), ‘IFRS – 10 years later’, Accounting and Business Research, 46(5), pp. 545–71. Ball, R. & Foster, G. (1982), ‘Corporate financial reporting: a methodological review of empirical research’, Studies on Current Research Methodologies in Accounting: A Critical Evaluation, supplement to Journal of Accounting Research, 20(Supplement), pp. 161–234. Beaver, W., Christie, A. & Griffin, P. (1980), ‘The information content of SEC ASR 190’, Journal of Accounting and Economics, 2. Beaver, W. & Landsman, W. (1987), ‘The incremental information content of FAS 33 Disclosures’, Research Report, Stamford: FASB. Benston, G. (2006), ‘Fair-value accounting: a cautionary tale from Enron’, Journal of Accounting and Public Policy, 25(4), pp. 465–84. Bublitz, B., Freka, T. & McKeown, J. (1985), ‘Market association tests and FASB statement 33 disclosures: a re-examination’, Journal of Accounting Research (Supplement), pp. 1–23. Canning, J. B. (1929), The Economics of Accountancy: A Critical Analysis of Accounting Theory, New York: Ronald Press. Chambers, R. J. (1955), ‘Blueprint for a theory of accounting’, Accounting Research (January), pp. 17–55. Chambers, R. J. (1966), Accounting, Evaluation and Economic Behavior, Englewood Cliffs, NJ: Prentice Hall. Chambers, R. J. (1995), ‘An introduction to price variation and inflation accounting research’, in S. Jones, C. Romana & J. Ratnatunga (eds), Accounting Theory: A Contemporary Review, Sydney: Harcourt Brace.
Dyckman, T. R. (1969), Studies in Accounting Research No. 1: Investment Analysis and General Price Level Adjustments, USA: American Accounting Association. Edwards, E. (1975), ‘The state of current value accounting’, The Accounting Review, 50(2), pp. 235–45. Edwards, E. O. & Bell, P. W. (1961), The Theory and Measurement of Business Income, Berkeley: University of California Press. Elliot, R. K. (1986), ‘Dinosaurs, passenger pigeons, and financial accountants’, World, pp. 32–5, as reproduced in S. A. Zeff & B. G. Dharan (1996), Readings and Notes on Financial Accounting, 5th edn, New York: McGraw-Hill. Ferguson, C. & Wines, G. (1986), ‘Incidence of the use of current cost accounting in published annual financial statements’, Accounting Forum (March). Financial Accounting Standards Board (2021), ‘Information for observers’, https://www.ifrs.org/content/dam/ifrs/ meetings/2008/november/iasb/conceptual-framework/ ap3-factors-to-consider.pdf Flegm, E. (2005), ‘Accounting at a crossroad’, CPA Journal, December, available at http://www.nysscpa.org/ cpajournal/2005/1205/infocus/p16.htm Georgiou, O., Mantzari, E. & Mundy, J. (2021), ‘Problematising the decision-usefulness of fair values: empirical evidence from UK financial analysts’, Accounting and Business Research, 51(4), pp. 307–46. Gheyara, K. & Boatsman, J. (1980), ‘Market reaction to the 1976 replacement cost disclosures’, Journal of Accounting and Economics, 2(2), pp. 107–25. Grady, P. (1965), An Inventory of Generally Accepted Accounting Principles for Business Enterprises, Accounting Research Study No. 7, New York: AICPA. Gray, R., Owen, D. & Adams, C. (1996), Accounting and Accountability: Changes and Challenges in Corporate Social and Environmental Reporting, London: Prentice Hall.
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Haswell, S. & Evans, E. (2018), ‘Enron, fair value accounting, and financial crises: a concise history’, Accounting, Auditing & Accountability Journal, 31(1), pp. 25–50. © Emerald Publishing Ltd. Hicks, J. R. (1946), Value and Capital, Oxford: Oxford University Press. Hopwood, A. G. (2009), ‘Exploring the interface between accounting and finance’, Accounting, Organizations and Society, 34(5), pp. 549–50. Ijiri, Y. (1975), ‘Theory of accounting measurement’, Studies in Accounting Research, 10, American Accounting Association. International Accounting Standards Board (2001), IAS 41 Agriculture, https://www.ifrs.org/content/dam/ifrs/ publications/pdf-standards/english/2021/issued/part-a/ ias-41-agriculture.pdf International Accounting Standards Board (2013a), Staff Paper: Conceptual Framework Draft Discussion Paper: Initial and Subsequent Measurement, London: IASB. International Accounting Standards Board (2013b), Staff Paper: Conceptual Framework Draft Discussion Paper: Measurement Principles, London: IASB. International Accounting Standards Board (2022a), IAS 41 Agriculture, London: IASB. International Accounting Standards Board (2022b), IFRS 13 Fair Value Measurement, London: IASB. International Accounting Standards Board (2022c), Conceptual Framework for Financial Reporting, London: IASB. International Accounting Standards Board (2022d), IAS 29 Financial Reporting in Hyperinflationary Economies, London: IASB. Larson, K. & Schattke, R. (1966), ‘Current cash equivalent, additivity and financial action’, The Accounting Review, 41(4), pp. 634–41. Laux, C. & Leuz, C. (2009), ‘The crisis of fair-value accounting: making sense of the recent debate’, Accounting, Organizations and Society, 34(6–7), 826–34. Lobo, G. & Song, I. (1989), ‘The incremental information in SFAS 33 income disclosures over historical cost income and its cash and accrual components’, The Accounting Review, 64(2), pp. 329–43. MacNeal, K. (1970), Truth in Accounting, originally published in 1939 edn, Kansas: Scholars Book Company. Mahoney, B. (1975), ‘Call for inflated books’, The Australian, 11 April, p. 12. Mautz, R. K. (1973), ‘A few words for historical cost’, Financial Executive (January), pp. 23–27 and 93–98. McInnis, J., Yu, Y. & Yust, C. (2018), ‘Does fair value accounting provide more useful financial statements than current GAAP for banks?’, The Accounting Review, 93(6), pp. 257–79. Moonitz, M. (1961), The Basic Postulates of Accounting, Accounting Research Study No. 1, New York: AICPA. Morris, R. C. (1975), ‘Evidence of the impact of inflation on share prices’, Accounting and Business Research (Spring), pp. 87–95. Murdoch, B. (1986), ‘The information content of FAS 33 returns on equity’, The Accounting Review, 61(2), pp. 273–87. Paton, W. A. (1922), Accounting Theory, Kansas: Scholars Book Co, reprinted 1973.
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Pelger, C. (2016), ‘Practices of standard-setting: an analysis of the IASB’s and FASB’s process of identifying the objective of financial reporting’, Accounting, Organizations and Society, 50(3), pp. 51–73. Peterson, R. J. (1975), ‘A portfolio analysis of general price-level restatement’, The Accounting Review, 50(3), pp. 525–32. Power, M. (2010), ‘Fair value accounting, financial economics and the transformation of reliability’, Accounting & Business Research, 40(3), pp. 197–210. Riahi-Belkaoui, A. (2004), Accounting Theory, 5th edn, London: Thomson Learning. Ro, B. T. (1980), ‘The adjustment of security returns to the disclosure of replacement cost accounting information’, Journal of Accounting and Economics, 2(2), pp. 159–89. Ro, B. T. (1981), ‘The disclosure of replacement cost accounting data and its effect on transaction volumes’, The Accounting Review, 56(1), pp. 70–84. Roberts, D. L., Staunton, J. J. & Hagan, L. L. (1995), Accounting for Self-Generating and Regenerating Assets, Discussion Paper No. 23, Melbourne: Australian Accounting Research Foundation. Ronen, J. (2008), ‘To fair value or not to fair value: a broader perspective’, ABACUS, 44(2), pp. 181–208. Schaefer, T. (1984), ‘The information content of current cost income relative to dividends and historical cost income’, Journal of Accounting Research, 22(2), pp. 647–56. Solomons, D. (1966), ‘An overview of exit price accounting’, ABACUS (December). Sprouse, R. & Moonitz, M. (1962), A Tentative Set of Broad Accounting Principles for Business Enterprises, Accounting Research Study No. 3, New York: American Institute of Certified Public Accountants. Sterling, R. R. (1970a), ‘On theory construction and verification’, The Accounting Review, 45(4), pp. 444–57. Sterling, R. R. (1970b), Theory of the Measurement of Enterprise Income, USA: University of Kansas Press. Sutton, T. G. (1988), ‘The proposed introduction of current cost accounting in the UK: determinants of corporate preference’, Journal of Accounting and Economics, 10(2), pp. 127–49. Sweeney, H. W. (1964), Stabilised Accounting, originally published in 1936, New York: Holt Rinehart & Winston. Walker, R. G. (1987), ‘Australia’s ASRB: a case study of political activity and regulatory capture’, Accounting and Business Research, 17(67), pp. 269–86. Watts, R. & J. Zimmerman (1978), ‘Towards a positive theory of the determination of accounting standards’, The Accounting Review, 53(1), pp. 112–34. Whitley, R. (1986), ‘The transformation of business finance into financial economics: the roles of academic expansion and changes in U.S. capital markets’, Accounting, Organizations and Society, 11(2), pp. 171–92. Whittington, G. (2008), ‘Fair value and the IASB/FASB Conceptual Framework project: an alternative view’, ABACUS, 44 (2), pp. 139–68. Wong, J. (1988), ‘Economic incentives for the voluntary disclosure of current cost financial statements’, Journal of Accounting and Economics, 10(2), pp. 151–67. Zeff, S. A. & Dharan, B. G. (1996), Readings and Notes on Financial Accounting, 5th edn, New York: McGraw-Hill.
CHAPTER
7
NORMATIVE THEORIES OF ACCOUNTING: THE CASE OF CONCEPTUAL FRAMEWORK PROJECTS LEARNING OBJECTIVES On completing this chapter, readers should:
LO7.1
LO7.5
be aware of some initiatives by the International Accounting Standards Board and the Financial Accounting Standards Board to develop a revised conceptual framework for financial reporting
understand the role that conceptual frameworks have in the practice of financial reporting
LO7.2
be aware of the history of the development of various conceptual framework projects
LO7.6
LO7.3
be able to identify, explain and critically evaluate the various building blocks that have been developed within various conceptual framework projects
be able to identify some factors, including political factors, that might help or hinder the development of a conceptual framework project
LO7.7
be able to explain which groups within society are likely to benefit from the establishment and development of a conceptual framework of accounting.
LO7.4
be able to identify some of the perceived advantages and disadvantages that arise from the establishment and development of a conceptual framework
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OPENING QUESTION Before reading this chapter, please consider how you would answer the following question. We will return to this question at the end of the chapter, where we suggest an answer. Critically evaluate the following statement: high-quality financial reporting practices necessarily require a well-designed conceptual framework for financial reporting.
Module 1 Questions / Answers
Introduction Chapter 6 considered a number of normative theories developed by some notable accounting academics to address various accounting issues associated with how financial accounting should be practised in the presence of changing prices (typically, increasing prices associated with inflation). These theories included current purchasing power accounting, current cost accounting and Continuously Contemporary Accounting (or exit price accounting). As revealed in Chapter 6, these normative theories, which represented quite significant departures from existing accounting practice, failed to be embraced by professional accounting bodies and regulators throughout the world, and with the subsequent decline in levels of inflation within most countries, the debate about the relative benefits of alternative approaches of accounting for changing prices has subsided. However, in recent times there has nevertheless been an increasing propensity for accounting standard-setters to adopt fair value as the basis for measuring many assets and liabilities, and to thereby move away (but not fully) from the use of historical cost accounting. The adoption of fair value measurement will take into account many of the effects of changing prices. While the various normative theories of accounting discussed in Chapter 6, and which were advanced to deal with changing prices, did not ultimately gain the support of accounting professions, professional accounting bodies in countries such as the United States, the United Kingdom, Canada, Australia and New Zealand, as well as the International Accounting Standards Committee (which subsequently became the International Accounting Standards Board [IASB]), had developed conceptual frameworks for accounting, which in themselves can be considered to constitute normative theories of accounting. This chapter considers what is meant by the term ‘conceptual framework’ and explores why particular professional bodies thought there was a need to develop them. There are numerous perceived advantages and disadvantages associated with conceptual frameworks for financial reporting, and this chapter also looks at certain arguments that suggest that conceptual frameworks play a part in legitimising the existence of the accounting profession, or play a part in potentially stifling the introduction of innovative reporting practices (Ball, 2016). At an international level, countries that have adopted International Financial Reporting Standards (IFRS) will also have typically adopted the conceptual framework developed by the IASB. Amendments were recently made to this framework, which was initially published in 1989 by the the International Accounting Standards Committee. A new conceptual framework was released in September 2010 (with subsequent amendments in 2018), at which point it became known as the IASB Conceptual Framework for Financial Reporting. It was previously referred to as the IASB Framework for the Preparation and Presentation of Financial Statements. A number of projects had been undertaken in joint efforts between the IASB and the US Financial Accounting Standards Board (FASB) to develop a new conceptual framework. However, following the release of the revised framework in September 2010 (which was not a full revision of the former framework), the joint work being undertaken by the IASB and FASB stalled, with the result that a revised framework was released by the IASB, without the FASB’s further input, in 2018. 274
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So, what is a conceptual framework of accounting? LO7.1
LO7.4
Conceptual frameworks exist in various disciplines and areas of research. Broadly speaking, a conceptual framework might provide a set of coherent ideas, concepts or principles organised in a manner that makes them easier to communicate to others. A conceptual framework might also provide a way of thinking about how and why particular activities take place, and about how we might understand such activities. A conceptual framework can also guide decisions, or research being undertaken, by clearly enunciating some central assumptions associated with the area of interest, and which have potentially been developed over a large number of years. Just as many areas of activity have a conceptual framework, the practice of financial reporting also has a conceptual framework. However, there is no definitive view of what constitutes a ‘conceptual framework’ of accounting. The FASB in the United States, which developed one of the first conceptual frameworks in accounting (which is comprised of various Concept Statements), now defines its conceptual framework as:1 a body of interrelated objectives and fundamentals. The objectives identify the goals and purposes of financial reporting, and the fundamentals are the underlying concepts that help achieve those objectives. Those concepts provide guidance in selecting transactions, events and circumstances to be accounted for, how they should be recognized, and measured, and how they should be summarized and reported. (FASB, n.d.)
Chapter 1 provided a definition of ‘theory’ (from the Oxford English Dictionary) as ‘a scheme or system of ideas or statements held as an explanation or account of a group of facts or phenomena’. This definition was similar to that provided by the accounting researcher Hendriksen (1970, p. 1). He defined a theory as ‘a coherent set of hypothetical, conceptual and pragmatic principles forming the general framework of reference for a field of inquiry’. Looking at these definitions of ‘theory’ and looking at the FASB’s definition of its conceptual framework, it is reasonable to argue that the conceptual framework attempts to provide a theory of financial accounting, and one that appears quite structured. Because conceptual frameworks provide a great deal of prescription (that is, they prescribe certain actions, such as when to recognise an asset for financial statement purposes) they are considered to be normative in nature. As we know from earlier chapters, a theory that ‘prescribes’ practice is considered to be a normative theory. The Conceptual Framework is a normative theory of accounting. For a number of years until 2010, the FASB and the IASB had been undertaking an initiative to develop, on a joint basis, an improved conceptual framework for financial reporting. In July 2006, the FASB and the IASB jointly published a discussion paper, Preliminary Views on an Improved Conceptual Framework for Financial Reporting: The Objective of Financial Reporting and Qualitative Characteristics of Decision-useful Financial Reporting Information. That paper was the first in a series of publications developed by the two boards as part of the project to create a common conceptual framework for financial reporting. The boards received nearly 200 responses to the discussion paper and, after considering the various comments, they released an exposure draft in May 2008. The document was entitled Exposure Draft of an Improved Conceptual Framework for Financial Reporting and this phase of the project specifically addressed the objective of financial reporting and the qualitative characteristics and constraints of decision-useful financial reporting information. According to the exposure draft, the conceptual framework is: a coherent system of concepts that flow from an objective. The objective of financial reporting is the foundation of the framework. The other concepts provide guidance It needs to be emphasised at this point that a number of countries throughout the world developed conceptual frameworks of financial reporting. However, this work has been abandoned in most countries as, internationally, many countries have now simply adopted the conceptual framework being developed by the IASB.
1
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on identifying the boundaries of financial reporting; selecting the transactions, other events and circumstances to be represented; how they should be recognised and measured (or disclosed); and how they should be summarised and communicated in financial reports.
Financial reporting Can be said to be the periodic process of providing information in financial statements about the financial position and performance of a reporting entity to users external to that entity to assist them in making informed decisions about allocating scarce resources, and assessing managers' stewardship of the resources that have been entrusted to them.
As this definition indicates, the objective of financial reporting was the fundamental building block for the conceptual framework being developed by the IASB and the FASB. Hence, if particular individuals or parties disagreed with the objective identified by the IASB and the FASB, they would most likely disagree with the various prescriptions that follow within the revised conceptual framework. The view taken by people involved in developing conceptual frameworks tends to be that if the practice of financial reporting is to be developed logically and consistently (which is important for creating public confidence in the practice of financial accounting), there first needs to be some consensus on important issues such as what is actually meant by financial reporting and what its scope should be, what organisational characteristics or attributes indicate that an entity should produce general purpose financial statements, what the objective of financial reporting is, what qualitative characteristics financial information should possess, what the elements of financial reporting are, what measurement rules should be employed in relation to the various elements of accounting, and so forth. It has been proposed that unless there is some agreement on fundamental issues, such as those just mentioned, accounting standards will be developed in a rather ad hoc or piecemeal manner, with limited consistency between the various accounting standards developed over time. It is perhaps somewhat illogical to consider how to account for a particular item of expenditure if there has not been agreement in the first place on what the objective of financial reporting actually is, or indeed on issues such as what an asset is or what a liability is. Nevertheless, for many years accounting standards were developed in many countries in the absence of conceptual frameworks. For example, the United Kingdom’s Accounting Standards Board initiated a conceptual framework development project in 1991. Within Australia, the first Statement of Accounting Concept (SAC 1 Definition of the Reporting Entity) was released in 1990. The Australian conceptual framework – until 2005 – was comprised of four Statements of Accounting Concepts (SACs). However, recommendations related to the practice of accounting first started being released in both countries in the 1940s, followed some years later by accounting standards. By the time the United Kingdom’s conceptual framework (entitled The Statement of Principles) was issued in 1999, there were already many accounting standards in place. A similar situation existed within Australia, with many accounting standards already being in place prior to the release of Statement of Accounting Concept (SAC) 1 in 1990. In the absence of a conceptual underpinning for those standards, and reflective of the lack of agreement in many key areas of financial reporting, there was indeed a degree of inconsistency between the various accounting standards that were being released in the United Kingdom and in Australia. This absence of a conceptual framework led to a great deal of criticism. As Horngren (1981, p. 94) stated: All regulatory bodies have been flayed because they have used piecemeal approaches, solving one accounting issue at a time. Observers have alleged that not enough tidy rationality has been used in the process of accounting policymaking. Again and again, critics have cited a need for a conceptual framework.
In developing a conceptual framework for financial accounting, there are a number of ‘building blocks’ that must be developed. The framework must be developed in a particular order, with some issues necessarily requiring agreement before work can move on to subsequent ‘building blocks’. Figure 7.1 provides an overview of the building blocks of a conceptual framework for financial reporting. Review Figure 7.1 and see if you agree with the order in which it is arranged. For example, do you agree that the definition of financial reporting and the users of financial reports should precede the determination of the objective of reporting? 276
Normative theories of accounting: the case of conceptual framework projects CHAPTER 7
FIGURE 7.1 Components of a conceptual framework for financial reporting 1 Definition of general purpose financial reporting
2 Definition of the reporting entity
4 Objectives of general purpose financial reports
3 Definition of users of general purpose financial reports and their information needs
5 Underlying assumptions
6 Qualitative characteristics of useful financial information
8 Recognition criteria
7 Elements of financial statements
9 Measurement basis and techniques
10 What information shall be disclosed and how it shall be presented to users
At this point it should be noted that within Australia the Australian Accounting Standards Board (AASB) had been responsible for the development of a conceptual framework of accounting, with the framework seeking to define the nature, subject, purpose and broad content of general purpose financial reporting. As a result of the 2002 decision by the Australian Financial Reporting Council (FRC) that Australia would adopt accounting standards issued by the IASB from 2005, there was a related requirement that Australia also adopt the IASB Conceptual Framework developed by the IASB. In some respects, this initially represented somewhat of a backward step, as it was generally considered that the Australian conceptual framework was more robust than the IASB framework. However, as IFRS had been developed in accordance with the IASB framework, and as Australia adopted IFRS, then Australia also had to adopt the IASB framework. This has also been the case in a number of other countries that have adopted IFRS. Returning to Figure 7.1, the first issue to be addressed is the definition of general purpose financial reporting. Unless there is some agreement on this, it would be difficult to construct a framework for financial reporting. Having determined what general purpose financial reporting means, attention is then turned to the subject of general purpose financial reporting, specifically
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which entities are required to produce general purpose financial statements2 and the likely characteristics of the users of these statements. Attention is then turned to the objective of financial reporting, which then informs various prescriptions included within the IASB Conceptual Framework. As paragraph 1.1 of the Framework (IASB, 2022) states: The objective of general purpose financial reporting forms the foundation of the Conceptual Framework. Other aspects of the Conceptual Framework – the qualitative characteristics of, and the cost constraint on, useful financial information, a reporting entity concept, elements of financial statements, recognition and derecognition, measurement, presentation and disclosure – flow logically from the objective.
The objective of general purpose financial reporting provided in the current IASB Conceptual Framework is deemed to be: to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions relating to providing resources to the entity. Those decisions involve decisions about: (a) buying, selling or holding equity and debt instruments; (b) providing or settling loans and other forms of credit; or (c) exercising rights to vote on, or otherwise influence, management’s actions that affect the use of the entity’s economic resources
Asset Defined by the IASB Conceptual Framework as a present economic resource controlled by the entity as a result of past events.
Liability Defined by the IASB Conceptual Framework as a present obligation of the entity to transfer an economic resource as a result of past events.
Income Defined by the IASB Conceptual Framework as increases in assets or decreases in liabilities that result in increases in equity, other than those relating to contributions from holders of equity claims.
If it is accepted that this is the objective of financial reporting, the next step is to determine the basic underlying assumptions and qualitative characteristics of financial information necessary to allow users to make economic decisions. These issues are addressed later in the chapter. Over time, it is to be expected that perspectives of the role of financial reporting will change. Consistent with this view, there is an expectation by many people, including accounting standardsetters, that the development and refinement of conceptual frameworks will continue. They will evolve over time. This view is consistent with comments made by the IASB and FASB in relation to the work they had undertaken in developing a revised conceptual framework. They stated (IASB 2008, p. 9): To provide the best foundation for developing principle-based common standards, the boards have undertaken a joint project to develop a common and improved conceptual framework. The goals for the project include updating and refining the existing concepts to reflect changes in markets, business practices and the economic environment that occurred in the two or more decades since the concepts were developed.
Expense Defined in the IASB Conceptual Framework as decreases in assets or increases in liabilities that result in decreases in equity, other than those relating to distributions to holders of equity claims.
Equity Defined by the IASB Conceptual Framework as the residual interest in the assets of the entity after deducting all its liabilities.
In the discussion that follows, the history of the development of conceptual frameworks in different countries is considered. It will be seen that conceptual frameworks are largely prescriptive, or normative in approach, for example indicating how the elements of accounting (the elements being assets, liabilities, income, expenses and equity) are defined and when they should be recognised. However, in certain cases, because of apparent coercion by powerful interest groups, parts of some conceptual frameworks became descriptive of current practice, with limited implications for changing existing accounting practices. A conceptual framework provides guidance at a much broader level than an accounting standard (or as it is also called, a financial reporting standard). The IASB Conceptual Framework for Financial Reporting (which hereafter will simply be referred to as the IASB Conceptual Framework) provides general guidance about such issues as the objective of financial reports, 2
278
Conceptual frameworks of accounting relate to general purpose financial reporting (which meets the needs of a multitude of user groups, many of which have information needs in common) as opposed to special purpose financial reports (special purpose financial reports are specifically designed to meet the information needs of a specific user or group). We consider definitions of general purpose financial reporting in more depth later in this chapter.
Normative theories of accounting: the case of conceptual framework projects CHAPTER 7
which entities should produce general purpose financial reports, the qualitative characteristics that useful financial information will possess, how the elements of financial accounting (assets, liabilities, equity, income and expenses) should be defined, and when they should be recognised. By contrast, accounting standards have a much narrower focus and tend to provide guidance on how particular types of transactions, or how particular assets and liabilities, should be accounted for. For example, different accounting standards will provide guidance on how to account for inventory (IAS 2), property, plant and equipment (IAS 16), biological assets (IAS 41), leases (IFRS 16), financial instruments (IFRS 9) or employee benefits (IAS 19). Such detailed consideration of particular assets or liabilities is not provided in a conceptual framework. Effectively, a central role of accounting standards is to apply the concepts included within a conceptual framework to specific transactions and events.
A brief overview of the history of the development of conceptual frameworks LO7.2
LO7.5
A number of countries, such as the United States, the United Kingdom, Ireland, Canada, Australia and New Zealand, undertook various activities directed towards the development of a conceptual framework for financial reporting. The IASC, the forerunner to the IASB, also undertook work to develop a conceptual framework. There are many similarities in (and some differences between) the various conceptual frameworks developed in the different jurisdictions.3 In a sense, the similarities are expected, as all these countries could be classified as adopting an Anglo-American accounting perspective, were common law countries and had corporations that relied upon receiving funding from large numbers of external investors (these factors were discussed in Chapter 5 and were used as a means to explain why the accounting practices in some countries were similar). It is arguable whether any standard-setter anywhere in the world had developed what could be construed as a complete conceptual framework. One country particularly active in developing frameworks in relation to financial reporting was the United States. Initially, some of the work involved developing prescriptive theories of how accounting should be undertaken, while other research related to the development of descriptive theories of how accounting was generally performed. For example, in 1961 and 1962 the Accounting Research Division of the American Institute of Certified Public Accountants (AICPA) commissioned studies by Moonitz (1961) and Sprouse and Moonitz (1962). These theorists prescribed that accounting practice should move towards a system based on current values rather than historical cost. This work was considered ‘too radically different from generally accepted principles’ (AICPA, 1973) and was abandoned by the profession. The AICPA then commissioned Grady to develop a theory of accounting. Grady’s theory (1965) was basically descriptive of existing practice (it was based on inductive reasoning, as described in Chapter 1 of this book), thereby being quite uncontroversial. His work led to the release of Accounting Principles Board (APB) Statement No. 4, Basic Concepts and Accounting Principles Underlying the Financial Statements of Business Enterprises, in 1970. As it was not controversial 3
This raises issues associated with the possible duplication of effort and whether it might have been more cost-efficient for the various countries to pool their resources and develop one unified conceptual framework. However, as Kenneth Most states in Staunton (1984, p. 87) when comparing the Australian and US conceptual frameworks, ‘a conceptual framework differs from a straight-jacket; one size does not fit all. The kind of doctrinaire thinkers who have dominated the standard-setting process in this country (United States) are not subject to the same economic, sociological, and professional influences that would affect Australians faced with a similar task’. Consistent with this view, Chapter 5 considered how issues such as culture are used to explain differences between the rules released by standard-setters in different countries. However, with the increasing use of IFRS internationally, and the related adoption of the IASB Conceptual Framework, it appears that global uniformity (and therefore a ‘one-size-fits-all’ approach) is deemed by accounting regulators to be more important than the cultural differences that might influence the information requirements of particular nations or cultures.
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and simply reflected generally accepted accounting principles of the time, APB Statement No. 4 always had a high probability of being acceptable to the AICPA’s constituency (Miller and Reading, 1986). While providing descriptions of current practice might likely further increase attributes such as consistency and comparability within financial reporting, it is unclear how providing descriptions of current practice will lead to improvements in such practice. Improvements would likely require suggestions, or prescriptions, which depart from the accepted reporting practices of the day.
The Trueblood Report Although APB Statement No. 4 did not cause great controversy, the accounting profession was under some criticism for the apparent lack of any real theoretical framework.4 The generally accepted accounting principles of the time allowed for much diversity in accounting treatments, and this was seen by many to be a problem. There was an absence of agreement on key issues about the role and objectives of financial reporting, appropriate definition, recognition and measurement rules for the elements of accounting, and so on. Responding to the criticism, the AICPA formed the Trueblood Committee (named after the committee chairperson, Robert Trueblood) in 1971. The committee produced The Trueblood Report (released in 1973 by the AICPA), which listed 12 objectives of accounting and seven qualitative characteristics that financial information should possess (relevance and materiality, form and substance, reliability, freedom from bias, comparability, consistency and understandability). Objective 1 of the report was that financial statements are to provide information useful for making economic decisions. That is, there was a focus on the information needs of financial statement users. This objective, which was carried forward to subsequent documents, indicated that decision usefulness (as opposed to concepts such as stewardship) was a primary objective of financial statements.5,6 This can be contrasted with previous perspectives of the role of accounting. For example, Accounting Terminology Bulletin No. 1, issued in 1953 by the AICPA, made no reference to the information needs of users. It stated: 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.
Objective 2 provided by the Trueblood Committee stated that financial statements are produced primarily to serve those users who have limited authority, ability or resources to obtain information and who rely on financial statements as the principal source of information about an organisation’s activities. This objective, which was also carried forward in subsequent work (and which links to ‘general purpose financial reporting’ and the ‘reporting entity’ concept), was interesting in that it tended to be a departure from much research that was being carried out at the time. A great deal of research being undertaken in the late 1960s and thereafter had embraced the Efficient Markets Hypothesis (discussed more fully in Chapter 11) that markets react quickly to impound the information content of publicly available information, whenever that information first becomes publicly available. Researchers working with the Efficient Markets 4
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In relation to APB Statement No. 4, Peasnell (1982, p. 245) notes that ‘at best it was a defensive, descriptive document’. This focus on decision users’ needs was also embraced in an earlier document, A Statement of Basic Accounting Theory, issued by the American Accounting Association in 1967. It was also embraced in APB Statement No. 4 released in 1970. ‘Decision usefulness’ and ‘stewardship’ are two terms that are often used in relation to the role of financial information. The ‘decision usefulness’ criterion is considered to be satisfied if particular information is useful (decision-useful) for making particular decisions, such as decisions about the allocation of scarce resources. From an accounting perspective, ‘stewardship’ refers to the process wherein a manager demonstrates how he or she has used the resources that have been entrusted to them. Traditionally, this was seen as one of the key roles of historical cost accounting.
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Hypothesis considered that, as long as the information was publicly available to somebody, and given maintained assumptions about market efficiency, the information would quickly be dispersed among all interested users. The Trueblood Committee, and subsequent committees responsible for the development of conceptual frameworks in the United States and elsewhere, did not appear to embrace this view of market efficiency. The Trueblood Committee acknowledged that a variety of different measurement methods were used for different classes of assets and liabilities. This was an issue that had concerned a number of researchers, such as Raymond Chambers (as indicated in Chapter 6). However, the Trueblood Committee considered that different measurement rules were relevant for different classes of assets, thereby ignoring the ‘additivity problem’ raised by individuals such as Chambers (see Chambers, 1966). As will be seen shortly, prescribing a specific valuation or measurement approach is an activity that those responsible for developing conceptual frameworks have been reluctant to undertake.
The FASB conceptual framework project In 1974 the Accounting Principles Board within the United States was replaced by the FASB. The FASB embarked on its conceptual framework project early in its existence and the first release, Statement of Financial Accounting Concepts (SFAC) No. 1: Objectives of Financial Reporting by Business Enterprises, occurred in 1978. This was followed by the release of eight more SFACs, with the latest one, SFAC No. 8: Chapter 1: The Objective of General Purpose Financial Reporting, and Chapter 3, Qualitative Characteristics of Useful Financial Information (a replacement of FASB Concepts Statements No. 1 and No. 2) being issued in 2010, with subsequent amendments in 2018. The initial SFACs were quite normative (that is, they attempted to prescribe how accounting should be undertaken). However, when SFAC No. 5: Recognition and Measurement in Financial Statements of Business Enterprises was released in 1984 the FASB appeared to opt for an approach largely descriptive of current practice. Rather than prescribe a particular measurement approach, the FASB described some of the various measurement approaches commonly used or suggested: historical cost, current cost (replacement cost), current market value (exit value), net realisable value (amount gained from sale, less costs associated with the sale) and the present (discounted) value of future cash flows. The failure to take the lead and actually prescribe a particular measurement approach was referred to as a ‘cop-out’ by Solomons (1986). This view was also embraced by a number of others. For example, Nussbaumer (1992, p. 238) states: … the issuance of SFAC 5 (December 1984) marked the greatest disappointment of the FASB’s project for the conceptual framework. It did nothing more than describe present practice; it was not prescriptive at all. The recognition and measurement issues, which the FASB promised to deal with in SFAC 5, were not settled, and the measurement issue was sidestepped … If the FASB cannot reach an agreement when there are only seven members, it is unlikely that the profession as a whole will come to agreement on these issues either. The FASB should provide leadership to the profession on these issues and not compromise them for the sake of expediency.
In a similar vein, Miller (1990) argued that the FASB conceptual framework initially provided much needed reform to accounting. For example, SFAC No. 1 explicitly put financial report users’ needs at the forefront of consideration. However, when SFAC No. 5 was released, ‘momentum was lost when FASB did not have sufficient political will to face down the counter-reformation and endorse expanded use of current values in the recognition and measurement phase of the project’ (Miller, 1990, p. 32). Interestingly, after SFAC 5 was released there was subsequently very limited activity on the FASB conceptual framework project. SFAC 6 was released in 1985, but this was primarily a replacement of an early statement (SFAC 3). A further SFAC (SFAC 7) was released (in 2000). At the time it appeared that measurement issues represented a real stumbling 281
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block for the project. Had the FASB supported one measurement method over and above others, this would have been a dramatic departure from current accounting practice and may not have been palatable to its constituents.7 Although this is conjecture, perhaps the FASB went as far as it could politically. This issue is considered in more depth later in the chapter. Whatever the case, the FASB’s work on a revised conceptual framework was reinvigorated in recent years due initially to its joint project with the IASB to develop a revised conceptual framework for financial reporting. In 2010 the FASB released Concept Statement 8, which superseded Concept Statement 1, released in 1978. It further revised this Concept Statement in 2018.
The (UK) Corporate Report The degree of progression of other conceptual framework projects had also been slow. In the United Kingdom, an early move towards developing guidance in relation to the objectives and the identification of the users of financial statements, as well as the methods to be used in financial reporting, was provided by The Corporate Report, a discussion paper released in 1975 by the Accounting Standards Steering Committee of the Institute of Chartered Accountants in England and Wales. The Corporate Report was particularly concerned with addressing the rights of the community in terms of access to financial information about the entities operating in the community. The view taken was that if the community gives an organisation permission to operate, then that organisation has an accountability to the community, and this accountability would then include an obligation to provide information about its financial performance. This perspective of financial statement users was broader than that adopted in frameworks being developed in other countries and included groups that did not have a direct financial interest in the organisation but were nevertheless affected by its ongoing operations. The Corporate Report was also part of a UK Government green paper on law reform. The report ultimately did not become enshrined in law and its contents were generally not accepted by the accounting profession. In 1991, the UK Accounting Standards Board embarked on a project to develop a conceptual framework, largely consistent with the main principles underlying the FASB and IASC frameworks, and thereby abandoned the broader notions of stakeholders’ rights to information as raised in The Corporate Report.
Development of conceptual frameworks in Australia and elsewhere Other countries, such as Australia, Canada and New Zealand, also devoted resources to the development of a conceptual framework. In Australia, work on the conceptual framework started in the 1980s, with the first of four Statements of Accounting Concept being issued in 1990. The Australian conceptual framework had a number of similarities to the FASB project and, as with the FASB, prescribing a particular measurement principle was a major stumbling block.8 In Canada, initial efforts were incorporated in a document entitled Corporate Reporting: Its Future Evolution, which was released in 1980. This report was written by Edward Stamp and
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Contemporary financial accounting practice requires that different measurement approaches be used for different classes of assets. For example, the lower of cost and net realisable value is used for inventory, whereas marketable securities are to be valued at fair value. If a conceptual framework was released that required one basis of asset measurement for all assets, this would have significant implications for the revision of various accounting standards. As indicated earlier, since 2005 Australia has embraced the IASB Conceptual Framework. This move was based on the view that as Australia elected to adopt IAS/IFRS from 2005 – many of which represented significant changes from Australian accounting standards – it also had to embrace the IASB Framework, given that IAS, and more recently IFRS, are based, at least in part, on the contents of the IASB Conceptual Framework. As with the loss of control in developing accounting standards, in adopting IFRS Australia has also lost a lot of control in the development of a conceptual framework. Nevertheless, the AASB worked on the ‘reporting entity’ concept and this found its way to the IASB.
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became known as The Stamp Report. The report appeared to rely heavily on The Corporate Report (which was unsurprising, as Stamp was one of its authors), and like The Corporate Report, was not embraced by the accounting profession. Subsequently, further work was undertaken towards developing a conceptual framework with a number of similarities to the FASB project. In 1990, the Accounting Research and Standards Board in New Zealand also commenced work related to a conceptual framework, which has many similarities to other frameworks developed in other countries. At the international level, the IASC published a conceptual framework in 1989, entitled Framework for the Preparation and Presentation of Financial Statements, which was similar in many respects to the conceptual frameworks developed in Australia, Canada and New Zealand. Given the new centrality of International Accounting Standards/International Financial Reporting Standards in European and global financial reporting (particularly since January 2005), many people argued that the IASB needed a more up-to-date conceptual framework to guide its accounting standard-setting process. The IASB responded to this call by jointly undertaking an initiative with the FASB to develop a new conceptual framework. What this information demonstrates is that a number of countries devoted resources to the development of a conceptual framework. What also is apparent is that those parties responsible for the frameworks had either been reluctant to promote significant changes from accounting practice (which obviously limited their ability to generate significant changes in financial reporting) or, where frameworks had suggested significant changes, such changes were not embraced by the accounting professions and many of their constituents. The reasons for this are provided in the discussion that follows.
Recent efforts of the IASB and the FASB From 2005 through to about 2010 the IASB and the FASB were jointly working towards the development of a revised conceptual framework that would be used by both parties and therefore used in an almost global nature. The need for this revised framework had arisen due to the ‘Convergence Project’, in which the IASB and the FASB were working together to converge their two sets of accounting standards. As explained in Chapter 5, the aim of the Convergence Project at the time was that the accounting standards of both the IASB and the FASB would be of such a comparable nature that the United States would ultimately adopt IFRS and there would be one set of accounting standards (IFRS) in use globally. As indicated in Chapter 5, unlike many other countries, the United States has not adopted IFRS and has retained the use of its own domestically developed accounting standards. As Chapter 5 also discussed, it now appears unlikely – at least in the near term – that the United States will adopt IFRS. Prior to the Convergence Project, many differences existed between the respective accounting standards released by the IASB and the FASB. There were also many differences between the conceptual frameworks developed by the respective boards. Given the efforts at the time to converge accounting standards being released by the IASB with those being released by the FASB, there was a need for one uniform conceptual framework. In explaining the need for a revised conceptual framework, the FASB and IASB (2005, p. 2) stated: The Boards will encounter difficulties converging their standards if they base their decisions on different frameworks … The FASB’s current Concepts Statements and the IASB’s Framework, developed mainly during the 1970s and 1980s, articulate concepts that go a long way toward being an adequate foundation for principles-based standards … Although the current concepts have been helpful, the IASB and FASB will not be able to realise fully their goal of issuing a common set of principles-based standards if those standards are based on the current FASB Concepts Statements and IASB Framework. That is because those documents are in need of refinement, updating, completion, and
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convergence. There is no real need to change many aspects of the existing frameworks, other than to converge different ways of expressing what are in essence the same concepts. Therefore, the project will not seek to comprehensively reconsider all aspects of the existing Concepts Statements and the Framework. Instead, it will focus on areas that need refinement, updating, or completing, particularly on the conceptual issues that are more likely to yield standard-setting benefits soon.
In regard to the amount of time it was expected to take to develop a new converged conceptual framework, the FASB and IASB (2005, p. 16) stated: This joint project is a major undertaking for both Boards and will take several years. In the intervening period, the Boards will look to their existing frameworks for guidance in setting standards.
The IASB and FASB were to undertake the work on the conceptual framework in eight phases, as listed in Figure 7.2. However, joint work on the conceptual framework project was suspended in late 2010. In early 2012, the IASB website stated: The IASB and FASB decided that, because of the need to give priority to other projects targeted for completion, the Reporting Entity chapter of the Conceptual Framework was not finalised during the first quarter of 2011, as had been planned previously. FIGURE 7.2 Eight phases of work on the IASB conceptual framework
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Phase A
Objectives and qualitative characteristics
Phase B
Definitions of elements, recognition and derecognition
Phase C
Measurement
Phase D
Reporting entity concept
Phase E
Boundaries of financial reporting, and Presentation and Disclosure
Phase F
Purpose and status of the framework
Phase G
Application of the framework to not-for-profit entities
Phase H
Remaining issues, if any
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In mid-2013, the website of the IASB then stated: The Conceptual Framework project will build on the work previously done before the project was paused in 2010. As part of that work, the IASB completed chapters on the objective of financial reporting and qualitative characteristics of useful information. Restarting work on the Conceptual Framework received overwhelming support from respondents to the IASB’s agenda consultation in 2011. Consequently, the IASB agreed to restart this project in September 2012.
Given the apparent importance of developing a revised conceptual framework, it is interesting that progress was stopped for almost three years. The IASB then went on to release a revised conceptual framework in 2018. Reflecting the fact that the IASB and FASB had gone on to develop their conceptual frameworks independently, the IASB reintroduced the concept of ‘stewardship’ to the 2018 framework, thereby reversing the decision to remove it from the 2010 version of the conceptual framework – a version that had been developed jointly with the FASB. LO7.3
Building blocks of a conceptual framework
This section looks at the contents of the IASB Conceptual Framework. Topics discussed include the definition of a reporting entity, the perceived users of financial statements, the objectives of general purpose financial reporting, the qualitative characteristics that general purpose financial statements should possess, the elements of financial statements, and approaches to recognition and measurement of the elements of financial statements. The focus is on the IASB Conceptual Framework as released in 2018, with subsequent updates, as this is the framework that is guiding accounting practice in the many countries that made the decision to adopt IFRS.
Definition of the reporting entity One key issue in any discussion about financial reporting is what characteristics of an entity provide an indication of an apparent need for it to produce general purpose financial statements. The term general purpose financial statements refers to financial statements that comply with accounting standards and conceptual framework requirements, as well as any other generally accepted accounting principles, and are released by reporting entities to satisfy the information demands of a varied cross-section of users. These financial statements can be contrasted with special purpose financial statements, which are provided to meet the information demands of a particular individual user or small group of users and which do not need to comply with financial reporting standards or prescriptions within the Conceptual Framework. Clearly, not all entities should be expected to produce general purpose financial statements. For example, there would be limited benefits in requiring an owner/manager of a small corner shop to prepare general purpose financial statements (that comply with the numerous accounting standards). There would be few external users with a significant stake or interest in the organisation. The concept of ‘reporting entity’ has been used to identify which entities should produce general purpose financial reports, and therefore, should comply with the requirements of the IASB Conceptual Framework (and also with the requirements of IFRS). Paragraph 1.12 of the IASB Conceptual Framework (IASB, 2022) states: General purpose financial reports provide information about the financial position of a reporting entity, which is information about the entity’s economic resources and the claims against the reporting entity. Financial reports also provide information about the effects of transactions and other events that change a reporting entity’s economic resources and claims. Both types of information provide useful input for decisions about providing resources to an entity. (emphasis added)
Reporting entity When users are said to exist who do not have access to information relevant to decision making and who are judged to be dependent on general purpose financial statements, the entity is deemed to be a reporting entity.
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Therefore, we can see that the IASB Conceptual Framework applies to ‘reporting entities’. But how does the IASB Conceptual Framework define a reporting entity? In the earlier 1989 IASC Framework (withdrawn in 2010), paragraph 8 had stated: The framework applies to the financial statements of all commercial, industrial and business reporting entities, whether in the public or private sectors. A reporting entity is an entity for which there are users who rely on financial statements as their major source of financial information about the entity.
This paragraph was removed when the 2010 IASB Conceptual Framework was issued. This was because Phase D of the Work Program had aimed at defining a ‘reporting entity’, and work on this issue was ongoing. The IASB and FASB had been undertaking work in relation to the reporting entity concept in 2010 before work was stopped (recommenced in 2013 by the IASB). As part of this work, in March 2010 they released an Exposure Draft entitled Conceptual Framework for Financial Reporting: The Reporting Entity. The IASB Exposure Draft released in 2010 provided a draft definition of the reporting entity concept. Specifically, the IASB 2010 Exposure Draft defined a reporting entity as: 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 making decisions about providing resources to the entity and in assessing whether management and the governing board of that entity have made efficient and effective use of the resources provided.
The above definition is consistent with the definition developed within Australia some years earlier (back in 1990). The reporting entity concept was addressed within Australia by virtue of Statement of Accounting Concept (SAC) No. 1: Definition of the Reporting Entity. In the work being undertaken by the IASB and the FASB, Australia’s SAC 1 was used as a valuable frame of reference. As FASB and IASB (2005, p. 13) stated: The Australian Accounting Standards Boards did issue in 1990 a concepts statement, Definition of the Reporting Entity, that defined an economic entity as a group of entities under common control, with users who depend on general purpose financial reports to make resource allocations decisions regarding the collective operation of the group and examined the implications of that concept. The boards may find that Concepts Statement useful in developing a complete, converged concept of reporting entity.
For further clarification of what constitutes a reporting entity, and until further detailed guidance is released by the IASB, we can usefully refer to SAC 1. SAC 1 states that general purpose financial statements should be prepared by all reporting entities. General purpose financial statements are considered to be statements that comply with conceptual framework pronouncements and accounting standards. Paragraph 6 of SAC 1 further defines general purpose financial statements as financial statements ‘intended to meet the information needs common to users who are unable to command the preparation of reports tailored so as to satisfy, specifically, all of their information needs’. Further, paragraph 8 of SAC 1 states that general purpose financial statements should be prepared when there are users ‘whose information needs have common elements, and those users cannot command the preparation of information to satisfy their individual information needs’.
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If an entity is not deemed to be a reporting entity (that is, there is a general absence of users dependent on general purpose financial statements), it will not be required to produce general purpose financial statements – that is, it will not necessarily be required to comply with accounting standards. Hence, whether an entity is classified as a reporting entity is determined by the information needs of the users and relies on professional judgement. When information relevant to decision making is not otherwise accessible to users who are judged to be dependent on general purpose financial statements to make and evaluate resource-allocation decisions, the entity is deemed to be a reporting entity. Where dependence is not readily apparent, SAC 1 suggests factors that may indicate a reporting entity (and hence a need to produce general purpose financial statements). These factors include: • the separation of management from those with an economic interest in the entity (paragraph 20) – as the spread of ownership increases and/or the separation of management and ownership increases, the greater the likelihood becomes that an entity will be considered to be a reporting entity • the economic or political importance/influence of the entity to/on other parties (paragraph 21) – as the entity’s dominance in the market increases and/or its potential influence over the welfare of external parties increases, the greater the likelihood is that an entity will be considered to be a reporting entity • the financial characteristics of the entity (paragraph 22) – as the amount of sales, value of assets, extent of indebtedness, number of customers and number of employees increases, the greater the likelihood is that an entity will be considered to be a reporting entity. Clearly, the approach adopted within Australia towards defining a reporting entity is highly subjective and could lead to conflicting opinions about whether an entity is a reporting entity or not. Interestingly, Australian law developed more objective criteria for determining when a company is required to provide financial statements that comply with accounting standards, and these criteria, which are written within the Corporations Act 2001, are related to measures such as gross revenue, dollar value of assets and number of employees and the notion of ‘public accountability’. Figure 7.3 summarises some of the issues that arise when determining whether an entity is a reporting entity. As Figure 7.3 demonstrates, the first question that would be asked is whether there are existing and potential investors, lenders and other creditors who cannot directly obtain the information they need for making decisions about providing resources to the entity and assessing whether management and the governing board of that entity have made efficient and effective use of the resources provided. If such users of financial reports do not exist, then the entity would not be a reporting entity, and there would therefore not be an expectation that general purpose financial reports would be prepared. Conversely, if existing and potential investors, lenders and other creditors exist who cannot gain access to information to specifically fulfil their needs, then the entity would be a reporting entity and the production of general purpose financial reports would be expected. As Figure 7.3 indicates, reporting entities are expected to produce general purpose financial reports, and these reports are expected to comply with accounting standards, conceptual framework prescriptions and other generally accepted accounting principles. Figure 7.3 also indicates that even if an entity is not considered to be a reporting entity, its management might nevertheless decide to produce general purpose financial reports (perhaps because it is intending to seek funding from multiple external sources). If an entity claims that it is producing general purpose financial reports, then compliance with accounting standards, conceptual framework requirements and other generally accepted accounting principles is expected. The guidance currently provided within the IASB Conceptual Framework states (paragraph 3.10) that a reporting entity is an entity that is required, or chooses, to prepare general purpose 287
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FIGURE 7.3 Determining whether an entity is a reporting entity and therefore required to produce general purpose financial reports No
Are there existing and potential equity investors, lenders and other creditors who cannot directly obtain the information they need in making decisions about providing resources to the entity
Organisation is not a reporting entity
Yes
Organisation is a reporting entity
Does the organisation want to produce general purpose financial reports?
Yes
Organisation to produce general purpose financial reports
No Organisation does not produce general purpose financial reports
Accounting standards conceptual framework and other generally accepted accounting principles
financial statements, and that such an entity need not necessarily be a legal entity. A reporting entity could be a portion of an entity, or comprise more than one legal entity. Paragraph 3.14 of the IASB Conceptual Framework further states that determining the boundary of the reporting entity is driven by the information needs of the primary users of the reporting entity’s financial statements. Specifically: Those users need relevant information that faithfully represents what it purports to represent. Faithful representation requires that: (a) the boundary of the reporting entity does not contain an arbitrary or incomplete set of economic activities; (b) including that set of economic activities within the boundary of the reporting entity results in neutral information; and (c) a description is provided of how the boundary of the reporting entity was determined and of what constitutes the reporting entity.
Having considered the meaning of a reporting entity, and having learned that reporting entities are required to produce general purpose financial statements, we now turn our attention to the perceived ‘users’ of general purpose financial statements.
Users of financial reports In the section of the IASB Conceptual Framework entitled ‘Status and purpose’ it is stated that: The Conceptual Framework for Financial Reporting describes the objective of, and the concepts for, general purpose financial reporting.
But who are the users of the general purpose financial reports? If conceptual frameworks are designed to help meet the needs of ‘users’ of general purpose financial reports, then (somewhat obviously) the framework needs to identify the potential users and their main information needs. In this regard, paragraph 1.5 of the IASB Conceptual Framework states: Many existing and potential investors, lenders and other creditors cannot require reporting entities to provide information directly to them and must rely on general 288
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purpose financial reports for much of the financial information they need. Consequently, they are the primary users to whom general purpose financial reports are directed.
Within the IASB Conceptual Framework there appears to be limited consideration of the ‘public’ being a legitimate user of general purpose financial statements. In the previous conceptual framework released by the IASC, the ‘public’ had been identified as a user of general purpose financial statements. However, in the IASB Conceptual Framework released in 2010, and amended in subsequent years, even though a primary group of users are identified, it is proposed that accounting information designed to meet the information needs of investors, lenders and other creditors will usually also meet the needs of the other user groups identified. As the IASB Conceptual Framework (paragraph 1.10) states: Other parties, such as regulators and members of the public other than investors, lenders and other creditors, may also find general purpose financial reports useful. However, those reports are not primarily directed to these other groups.
In explaining the reasons why the users of financial statements were identified as primarily being investors, lenders and other creditors, the ‘Basis for Conclusions’ that accompanied the release of the IASB Conceptual Framework stated: The reasons why the Board concluded that the primary user group should be the existing and potential investors, lenders and other creditors of a reporting entity are: (a) Existing and potential investors, lenders and other creditors have the most critical and immediate need for the information in financial reports and many cannot require the entity to provide the information to them directly. (b) The Board’s and the FASB’s responsibilities require them to focus on the needs of participants in capital markets, which include not only existing investors but also potential investors and existing and potential lenders and other creditors. (c) Information that meets the needs of the specified primary users is likely to meet the needs of users both in jurisdictions with a corporate governance model defined in the context of shareholders and those with a corporate governance model defined in the context of all types of stakeholders.
If we consider part (a) above, then many of us might question whether investors, lenders and creditors have the ‘most critical and immediate need’ for information. What about other stakeholders, such as employees and their representative bodies (such as unions), or what about particular consumer or environmental groups? As we have already noted, documents such as the UK Corporate Report considered such stakeholders as important, whereas the IASB (and FASB) clearly have a much narrower ‘capital market-centric’ approach to information rights and related accountability. Of interest is the fact that the definition of users as embraced in the revised IASB Conceptual Framework is very similar to that previously incorporated within the US Conceptual Framework. In the FASB’s SFAC 1, the main focus of financial reports was present and potential investors and other users (with either a direct financial interest or somehow related to those with a financial interest, for example stockbrokers, analysts, lawyers or regulatory bodies). Within SFAC 1 there was also limited consideration of the public being a legitimate user of financial reports. It is interesting that the former US definition seems to have taken precedence in the deliberations held between the IASB and FASB (and is perhaps reflective of the concerns of some people that the FASB appeared to be dominating many of the decisions being made as part of the Convergence Project formerly being undertaken between the IASB and FASB). The issue of which groups should be considered to be legitimate users of financial information about an organisation is one that has attracted a great deal of debate. As noted above, many people 289
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would question whether the need for information to facilitate users ‘making decisions about providing resources to the entity’ is the only or dominant issue to consider in determining whether an organisation has a public obligation to provide information about its performance. The activities of organisations, particularly large corporations, impact on society and the environment in many different ways and at many different levels. Such impacts are clearly not restricted to investors or people who are considering investing in the organisation. In large part, the extent to which an organisation impacts on society and the environment, and its ability to minimise harmful impacts, will be tied to the financial resources under its control. As such, a reasonable argument can be made that various groups within society have a legitimate interest, or ‘stake’, in having access to information about the financial position and performance of organisations, and to restrict the definition of users to investors, creditors and other lenders does seem a little too simplistic. Apart from considering the identity of report users, we also need to consider their expected proficiency in interpreting financial accounting information. In considering the level of expertise expected of financial statement readers, it is accepted that readers are expected to have some proficiency in financial accounting. This is not unreasonable. As a result, accounting standards are developed on this basis. The IASB Conceptual Framework (paragraph 2.36) explains that: Financial reports are prepared for users who have a reasonable knowledge of business and economic activities and who review and analyse the information diligently. At times, even well-informed and diligent users may need to seek the aid of an adviser to understand information about complex economic phenomena.
So, financial statements are written for an audience that is educated to some degree in the workings of accounting. It would appear that those people responsible for developing the Conceptual Framework have accepted that individuals without any expertise in financial accounting are not the intended audience of reporting entities’ financial statements (even though such people may have a considerable amount of their own wealth invested). Accounting standards are developed on the basis that readers have reasonable knowledge about financial accounting and financial reporting. Many requirements incorporated within particular accounting standards require that certain assets and liabilities be measured in ways that arguably would not be the same as non-accountants would have thought or assumed. The message that needs to be very clear is that without a sound knowledge of financial accounting, financial statements, such as balance sheets and income statements, can actually be confusing and even potentially misleading documents. Therefore, people without appropriate financial accounting knowledge should not use financial statements as the basis of making investment and other related decisions unless they receive advice from people educated in financial reporting. Having established the audience for general purpose financial statements, and their expected proficiency in understanding financial accounting information, we now move on to the very important issue of the claimed objectives of general purpose financial reporting.
Objectives of general purpose financial reporting Over time, a number of objectives have been attributed to information provided within financial statements.9 A traditionally cited objective was to enable outsiders to assess the stewardship of management – that is, whether the resources entrusted to management have been used for their intended or appropriate purposes. This stewardship focus is also commonly referred to as an accountability focus (although some people also argue there is a difference between stewardship and accountability). 9
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In an FASB discussion memorandum released in 1974, the FASB defines an objective as ‘something toward which effort is directed, an aim, or end of action, a goal’ (Source: eGrove. University of Mississippi. https:// egrove.olemiss.edu/aicpa_sop/656/). It is perhaps questionable whether information itself can have objectives. Certainly, users of information can have objectives that can be achieved (or not) as a result of using information. Nevertheless, it is common for accounting standard-setters to talk about the objectives of financial information and, as such, we maintain this convention.
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Stewardship involves monitoring the past actions of management (which relates to such factors as the integrity of management), as well as providing information to enable predictions about future cash flows, as discussed within Chapter 8. It is generally accepted that historical cost accounting enables management to report effectively on the stewardship of the resources provided to the reporting entity. Another objective of financial reporting, and one that has become a commonly accepted goal of financial reporting, is to assist in report users’ economic decision making. This is often referred to as the ‘decision usefulness’ approach. When the joint work of the IASB and FASB led to a revised version of the Conceptual Framework being released in 2010, the concept of ‘stewardship’ appeared to be abandoned. The apparent abandonment of the stewardship function within the IASB Conceptual Framework had been quite controversial. In justifying the removal of stewardship, the IASB stated in its ‘Basis for Conclusions’ that accompanied a 2006 IASB Discussion Paper (IASB, 2006, paragraphs BC1.40 and BC1.41): The relationship of an entity’s management and its owners is essentially the same as that of an agent (management) that acts on behalf of a principal (shareholders or other owners). The economic interests of management may not always be the same as those of shareholders. Members of management may have the ability to take advantage of their position in various ways, for example, to enrich themselves unjustifiably (that is, beyond agreed-upon remuneration) at the expense of owners. Some of the concern about stewardship seems to stem from the potential tension between the interests of management and those of shareholders. The boards acknowledge that those are important issues that standard-setters need to keep in mind. Financial reports generally are useful to those with the responsibility for making decisions about management remuneration and monitoring management’s dealings with an entity’s owners because financial reports include the effects of all transactions engaged in by management on behalf of owners, as well as transactions between the entity and members of its management. But providing information for the specific purpose of helping to decide what constitutes excessive remuneration or unjust enrichment is not the purpose of financial reporting.
In a study undertaken in 2007 by the UK Accounting Standards Board (ASB) of public submissions made in response to the IASB/FASB Discussion Paper Preliminary Views on an Improved Conceptual Framework for Financial Reporting, the ASB reported that there was broad consensus among the majority of the respondents that the stewardship/accountability objective should – in contrast to the then position of the IASB and the FASB – be a separate objective of financial reporting and should not be subsumed by a decision usefulness focus. The ASB (2007, p. 5) states: In not having stewardship as an objective, there is a danger in the future that information useful for stewardship purposes, for example in an area such as related party disclosures, may not be included in financial statements on the grounds that it is not thought to be ‘decision useful’ for resource allocation purposes…. Stewardship was originally the primary objective of financial reporting which is why company law initially sought to ensure that management provide an account of their performance over a given period and show how they have utilised the resources entrusted to them by the owners. It was only after the development of capital markets that a further focus for financial reporting developed i.e. on cash flow generation that would assist in buy, sell or hold decisions (the main focus of the resource allocation decision usefulness objective as described in the DP).
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The ASB explains that abandoning stewardship had implications for recognition, measurement and presentation. As it notes (2007, p. 14): Asset valuations: Stewardship has relevance for asset valuations. In certain circumstances stewardship as an objective would dictate that entities provide current entity-specific valuation for operational assets. For example, the potential contribution to productivity a company is able to derive from a custom made machine may best be conveyed by measures such as value-in-use and current replacement cost. By contrast, resource allocation might be seen to require a single approach to valuation e.g. marketbased exit value (which may be a scrap value). This approach assumes that investors are only interested in how market participants would value such a machine rather than the potential benefits the company derives from the use of the asset in its day-today business. However, this does not mean that exit price fair value is not the most appropriate basis of measurement for certain types of assets. Another consequence arising from omitting stewardship/accountability would be that the resulting financial reports would not meet all the needs of investors of private entities and the stakeholders of not-for-profit entities. Both of these types of entities prepare financial reports with a stewardship focus, because usually their constituents do not have the option to make the buy, sell and hold decisions resulting from the resource allocation objective. The decision they need information on is whether to intervene in the management of the business, which is only provided if the stewardship objective is retained in the framework.
Whittington (2008) also raised concerns about the potential abandonment of the stewardship principle of financial reporting. As Whittington (2008, pp. 144–5) explains, as part of the IASB/ FASB consultation process it became apparent that: The objection to the subsuming of stewardship into the decision usefulness objective is, as expressed in the alternative view put forward by IASB members, that accountability entails more than the prediction of future cash flows. Its stewardship dimension is concerned with monitoring the past as well as predicting the future and is sometimes as much concerned with the integrity of management as with its economic performance (e.g., with respect to management remuneration and related party transactions). It is therefore concerned more with the past than is decision-usefulness, although the needs of the two typically overlap: information about the past conduct of management may be relevant to predicting future cash flows and the proper assessment of stewardship will entail estimating future prospects in order to evaluate the consequences of management’s past policies. The difference between the two objectives is therefore typically one of emphasis rather than mutual exclusiveness, but both objectives need to be recognized if a proper balance is to be attained.
As already noted when we discussed the perceived ‘users’ of financial reports, within the IASB Conceptual Framework it would appear that those responsible for developing a framework considered that there is a duty to provide an account of the entity’s financial performance to those parties who have a direct financial stake in the reporting entity. Emphasis seems to be placed on economic efficiencies. This can be contrasted with the guidance provided by The Corporate Report (UK), which argues that society effectively allows organisations to exist as long as they accept certain responsibilities, one being that they are accountable for their actions to society generally, rather than solely to those who have a financial stake in the entity. The Corporate Report (Accounting Standards Steering Committee, 1975) made the following statement at paragraph 25:
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The public’s right to information arises not from a direct financial or human relationship with the reporting entity but from the general role played in our society by economic entities. Such organisations, which exist with the general consent of the community, are afforded special legal and operational privileges; they compete for resources of manpower, materials and energy and they make use of community owned assets such as roads and harbours.
Although The Corporate Report emphasised an accountability perspective of financial reporting, it was generally not accepted, and the UK position (through the ASB’s subsequent conceptual framework project) was basically one of acceptance of the decision-makers emphasis, with prime consideration being given to the needs of those with a financial interest or stake in the organisation. This has carried through to the objective of reporting espoused within the IASB Conceptual Framework, as reproduced below. As a normative theory of accounting, whether we are likely to accept the prescriptions provided by a conceptual framework will be dependent on whether we agree with the underlying key assumptions and objectives adopted as the basis of developing the theory. Hence, if we disagree with the objective of financial reporting as noted above, we would probably be inclined to dismiss much of the content of the revised IASB Conceptual Framework. When the IASB released its revised Conceptual Framework in 2018, stewardship was reintroduced, although arguably the attribute of ‘decision usefulness’ is still prioritised within the IASB Conceptual Framework. In terms of the objective of general purpose financial reporting, paragraph 1.2 of the Conceptual Framework states: 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 decisions about: (a) buying, selling or holding equity and debt instruments (b) providing or settling loans and other forms of credit (c) exercising rights to vote on, or otherwise influence, management’s actions that affect the use of the entity’s economic resources.
Parts a) and b) above relate to the information needed to help users of financial statements (which are narrowly defined) to assess the prospects for future net cash inflows to the entity and to inform their future investment or lending decisions (resource allocation decisions) with respect to the reporting entity. This is linked to the notion of ‘decision usefulness’. That is, investors and lenders will find it useful to their resource allocation decisions to have information about an organisation’s financial performance and financial position. When the Conceptual Framework was revised and re-released in 2018, part c) above was added. This additional component relates to ‘stewardship’. The IASB’s use of the term ‘stewardship’ is consistent with the general understanding of that term, which means the careful and responsible management of something entrusted to one’s care. The reinstatement of the notion of stewardship follows its previous removal in 2010 when the IASB and the FASB jointly developed the revised Conceptual Framework. The Conceptual Framework now notes that users need information to enable them to assess management’s stewardship so that they can hold them ‘to account’ for the resources entrusted to their care. This is a broader perspective of accountability than was evident in the 2010 Conceptual Framework. Paragraph 1.22 of the IASB Conceptual Framework as amended in 2018 states: Information about how efficiently and effectively the reporting entity’s management has discharged its responsibilities to use the entity’s economic resources helps users
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to assess management’s stewardship of those resources. Such information is also useful for predicting how efficiently and effectively management will use the entity’s economic resources in future periods. Hence, it can be useful for assessing the entity’s prospects for future net cash inflows.
Pelger (2016) provides some interesting insights into the previous decision by the IASB and FASB to remove stewardship from the 2010 version of the Conceptual Framework. As he notes, the decision to remove the reference to stewardship was somewhat surprising as stewardship historically was one of the main reasons for the existence of financial accounting and is still considered to shape accounting practices. Pelger (2016) also noted that it was overwhelmingly the US participants from the FASB who were strongly opposed to the retention of stewardship as an explicit part of the objective of general purpose financial reporting. The standard-setters from the United States thought the objective that needed to be focused upon was the information needs of external providers of financial capital – that is, they very much embraced a view that prioritised the needs of capital market participants. Because the IASB worked on the 2018 version of the Conceptual Framework (without the FASB), the members of the IASB were able to reintroduce stewardship without the previous opposition from US participants.
Why do I need to know about the objective of general purpose financial reporting as espoused within the Conceptual Framework? Why
The contents of the Conceptual Framework build upon the objective that has been identified above. That is, the contents follow from the objective, so we need to know the objective so as to understand the context of the material that follows within the IASB Conceptual Framework. Whether we tend to accept, or reject, the contents of the Conceptual Framework would be influenced by whether we agree or disagree with the objective of financial reporting on which the balance of the Conceptual Framework is based. For example, if we did not agree with the focus upon providing financial information that is ‘useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity’, then we might tend to reject the remaining contents of the IASB Conceptual Framework.
As critical thinkers, we should evaluate whether we believe the objective identified by the IASB is appropriate to what we see as the required role of financial reporting and with whom we think should be identified as the stakeholders with a right to financial information. If we believe the stated objectives have deficiencies, and we can logically articulate these deficiencies, then we should arguably engage with standard-setters to encourage required change. Further, by understanding the key building block of the Conceptual Framework (the objective of general purpose financial reporting), we can then identify, and potentially highlight, apparent inconsistencies in the prescriptions that follow.
Qualitative characteristics of financial reports If it is accepted that financial information should be useful for economic decision making (that is, be ‘decision useful’) and for assessing the stewardship of managers, then a subsequent issue (or building block) to consider is the qualitative characteristics (attributes or qualities) that financial information should possess if it is to be useful for such purposes (implying that an absence of such qualities would mean that the central objectives of general purpose financial statements would not be met).
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The fundamental qualitative characteristics identified in the IASB Conceptual Framework are ‘relevance’ and ‘faithful representation’. In discussing the need for information to be relevant and faithfully represented, paragraph 2.20 of the IASB Conceptual Framework states: Information must be both relevant and provide a faithful representation of what it purports to represent 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.
Apart from the fundamental qualitative characteristics, the IASB Conceptual Framework also identifies a number of enhancing qualitative characteristics (which are important but rank after fundamental qualitative characteristics in order of importance). These ‘enhancing qualitative characteristics’ are comparability, verifiability, timeliness and understandability. As paragraph 2.23 of the IASB Conceptual Framework states: Comparability, verifiability, timeliness and understandability are qualitative characteristics that enhance the usefulness of information that both is relevant and provides a faithful representation of what it purports to represent. The enhancing qualitative characteristics may also help determine which of two ways should be used to depict a phenomenon if both are considered to provide equally relevant information and an equally faithful representation of that phenomenon.
Faithful representation To be a perfectly faithful representation, a depiction would have three characteristics. It would be complete, neutral and free from error.
Fundamental qualitative characteristics Characteristics or attributes that information must possess if it is to be useful to users of that information.
Enhancing qualitative characteristics Characteristics or attributes that enhance the usefulness of information that otherwise satisfies the fundamental qualitative characteristics of useful information.
Because the qualitative characteristics are to guide what reporting entities disclose, it is important that we understand them. Therefore, we will consider each of these qualitative characteristics (two fundamental, and four ‘enhancing’ qualitative characteristics) in turn below.
Fundamental qualitative characteristics The IASB Conceptual Framework identifies ‘relevance’ and ‘faithful representation’ as fundamental qualititative characteristics.
Relevance Relevance is a fundamental qualitative characteristic of financial reporting. This qualitative characteristic requires that financial statements should only include financial information that could be expected to make a difference to users’ resource allocation decisions (and we have already discussed who are perceived to be the ‘users’). Specifically, paragraph 2.6 of the IASB Conceptual Framework states: Relevant financial information is capable of making a difference in the decisions made by users. Information may be capable of making a difference in a decision even if some users choose not to take advantage of it or are already aware of it from other sources.
There are two main aspects to relevance. For information to be relevant it should have both predictive value and/or confirmatory value (or feedback value). Predictive value might arise, for example, because the information allows a user to predict the future cash flows of the reporting entity. Confirmatory value refers to information’s use in relation to confirming or correcting earlier expectations – for example, whether management has achieved the financial outcomes that were previously advised. Closely tied to the notion of relevance is the notion of materiality. General purpose financial statements are expected to include all financial information that satisfies the concepts of relevance and faithful representation to the extent that such information is material. Paragraph 2.11 of the IASB Conceptual Framework states that an item is material if: omitting it or misstating it could influence decisions that the primary users of general purpose financial reports make on the basis of those reports, which provide
Materiality A threshold concept concerning the relevance of an event or transaction to financial statement users. Something is considered ‘material’ if its omission or misstatement could influence decisions that users of the information make.
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information about a specific reporting entity. In other words, materiality is an entityspecific aspect of relevance based on the nature or magnitude, or both, of the items to which the information relates in the context of an individual entity’s financial report. Consequently, the Board cannot specify a uniform quantitative threshold for materiality or predetermine what could be material in a particular situation.
Considerations of materiality also provide a basis for restricting the amount of information provided to levels that are comprehensible to financial statement users. It would arguably be poor reporting practice to provide hundreds of pages of potentially relevant and representationally faithful information to financial statement readers – this would only result in an overload of information, thereby potentially undermining the usefulness and understandability of the whole ‘package’ of information. Nevertheless, assessing materiality is very much a matter of judgement, and at times we might see the notion of materiality being used opportunistically by managers as a justification for failing to disclose information that could otherwise be deemed to be potentially harmful, or legitimacy threatening, to the reporting entity. In deciding whether an item or an aggregate of items is ‘material’, the nature and amount of the items usually need to be evaluated together. It might be necessary to treat as material an item or an aggregate of items that would not be judged to be material on the basis of the amount involved, because of their nature. An example is where a change in accounting method has taken place that is expected to affect materially the results of subsequent financial years, even though the effect in the current financial year is negligible. As another example, information that an organisation has made a payment which is construed as a ‘bribe’ might be material because of the political and associated financial problems it could create, even if the monetary amount involved is relatively modest.
Faithful representation The second fundamental qualitative characteristic of useful financial information is ‘faithful representation’. According to the IASB Conceptual Framework, to be useful, financial information must not only represent relevant phenomena, but it must also faithfully represent the phenomena that it purports to represent. According to paragraph 2.13 of the IASB Conceptual Framework: To be a perfectly faithful representation, a depiction would have three characteristics. It would be complete, neutral and free from error. Of course, perfection is seldom, if ever, achievable. The Board’s objective is to maximise those qualities to the extent possible.
We consider these attributes of faithful representation below. Completeness
In terms of the characteristics of ‘completeness’ referred to above, paragraph 2.14 of the IASB Conceptual Framework states: A complete depiction includes all information necessary for a user to understand the phenomenon being depicted, including all necessary descriptions and explanations. For example, a complete depiction of a group of assets would include, at a minimum, a description of the nature of the assets in the group, a numerical depiction of all of the assets in the group, and a description of what the numerical depiction represents (for example, historical cost or fair value). Neutrality
In terms of the characteristics of ‘neutrality’, paragraph 2.15 of the IASB Conceptual Framework states: A neutral depiction is without bias in the selection or presentation of financial information. A neutral depiction is not slanted, weighted, emphasised, de-emphasised or otherwise manipulated to increase the probability that financial information 296
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will be received favourably or unfavourably by users. Neutral information does not mean information with no purpose or no influence on behaviour. On the contrary, relevant financial information is, by definition, capable of making a difference in users’ decisions.
When the IASB released the revised Conceptual Framework in 2018, it reintroduced the concept of ‘prudence’ (it was removed from the 2010 version), which it directly related to the characteristic of neutrality. Neutrality is supported by the exercise of ‘prudence’, where prudence represents the exercise of caution when making judgements under conditions of uncertainty. Paragraph 2.16 states: The exercise of prudence means that assets and income are not overstated and liabilities and expenses are not understated. Equally, the exercise of prudence does not allow for the understatement of assets or income or the overstatement of liabilities or expenses. Such misstatements can lead to the overstatement or understatement of income or expenses in future periods. Freedom from error
In terms of the characteristics of ‘freedom from error’, paragraph 2.18 of the IASB Conceptual Framework explains that faithful representation does not mean total absence of error in the depiction of particular transactions, events or circumstances. The economic phenomena presented in financial statements are often, and necessarily, measured under conditions of uncertainty. Hence, most financial reporting measures involve various estimates and instances of professional judgement. To faithfully represent a transaction or event, an estimate must be based on appropriate inputs and each input should reflect the best available information. For example, determining the depreciation expense for a reporting period requires various judgements to be made about the life of the asset, the expected pattern of the benefits to be generated from the asset and the ultimate residual value of the asset. These judgements are based upon the best available information and cannot be determined with certainty. Nevertheless, if the judgements are based on careful research and consideration, then this is acceptable. Of some interest is the fact that when the IASB Conceptual Framework was released in 2010, it identified representational faithfulness as a fundamental qualitative characteristic, rather than using the qualitative characteristic of ‘reliability’ that had been used in the former IASB Framework (that is, relevance was replaced by representational faithfulness when the 2010 document was released by the IASB and it has since been retained). In explaining the rationale for this replacement, paragraphs BC3.23 and 24 of the ‘Basis for Conclusions’ that accompanied the release of the IASB Conceptual Framework in 2010, and subsequently the release of the revised framework in 2018 (IASB, 2018) stated: BC2.25 Unfortunately, neither the IASB or FASB framework clearly conveyed the meaning of reliability. The comments of respondents to numerous proposed standards indicated a lack of a common understanding of the term reliability. Some focused on verifiability or free from material error to the virtual exclusion of faithful representation. Others focused more on faithful representation, perhaps combined with neutrality. Some apparently think that reliability refers primarily to precision. BC2.26 Because attempts to explain what reliability was intended to mean in this context have proved unsuccessful, the Board sought a different term that would more clearly convey the intended meaning. The term faithful representation, the faithful depiction in financial reports of economic phenomena, was the result of that search. That term encompasses the main characteristics that the previous frameworks included as aspects of reliability.
But the term ‘faithful representation’ is not without its limitations either. A faithful representation might possibly be construed to mean that there is just one objective measure for 297
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something – perhaps as in physical science (for example, we might have a precise measure of the speed of light). But in accounting there are many judgements and estimates, which means there could be a number of ‘faithful representations’ of a particular transaction. Therefore, it is not really clear that replacing relevance with faithful representation solves many problems. What do you think?
Balancing relevance and representational faithfulness Ideally, financial information should be both relevant and representationally faithful. However, it is possible for information to be representationally faithful, but not very relevant, or the other way around. Such information would, in this case, not be deemed to be useful. Indeed, such information could lead readers of reports to make inappropriate decisions. As we have previously indicated, for information to be useful it needs to both be relevant and provide a faithful representation of what it purports to represent. Good decisions cannot be made on the basis of a faithful representation of irrelevant transactions or events. Nor can good decisions be made on the basis of unfaithful representations of relevant transactions and events. There is often a trade-off between relevance and representational faithfulness. For example, the earlier we can obtain information about the financial results of an entity, the more relevant the information will be in assessing that entity’s performance. However, to increase the representational faithfulness of the data we might prefer to use financial information that has been the subject of an independent audit (therefore, for example, reducing the likelihood of error). The resultant increase in representational faithfulness, or reliability, will mean that we will not receive the information for perhaps 10 weeks after the financial year end, at which point the information will not be quite as relevant because of its ‘age’. Therefore, there can, in practice, be a matter of balancing one against the other. However, if the data or information severely lacks one of the characteristics of relevance, or faithful representation, then that information should not be provided to financial statement readers. Considerations of costs and benefits Another consideration that needs to be addressed when deciding whether to disclose particular information is the potential costs of producing relevant and representationally faithful information, relative to the associated benefits. In relation to costs, paragraph 2.39 of the IASB Conceptual Framework states: Cost is a pervasive constraint on the information that can be provided by financial reporting. Reporting financial information imposes costs, and it is important that those costs are justified by the benefits of reporting that information.
In considering the associated benefits of financial reporting, paragraphs 2.42 and 2.43 of the IASB Conceptual Framework state: In applying the cost constraint, the Board assesses whether the benefits of reporting particular information are likely to justify the costs incurred to provide and use that information. When applying the cost constraint in developing a proposed Standard, the Board seeks information from providers of financial information, users, auditors, academics and others about the expected nature and quantity of the benefits and costs of that Standard. In most situations, assessments are based on a combination of quantitative and qualitative information. Because of the inherent subjectivity, different individuals’ assessments of the costs and benefits of reporting particular items of financial information will vary. Therefore, the Board seeks to consider costs and benefits in relation to financial reporting generally, and not just in relation to individual reporting entities. That does not mean that assessments of costs and benefits always justify the same reporting 298
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requirements for all entities. Differences may be appropriate because of different sizes of entities, different ways of raising capital (publicly or privately), different users’ needs or other factors.
Hence, while it can be a difficult exercise balancing the costs and benefits associated with particular disclosures, and related regulations, there is a general principle that the benefits derived from disclosing information should exceed the cost of providing it. This principle will be considered by the IASB when new accounting standards are being developed.
Enhancing qualitative characteristics As we indicated previously, apart from the two fundamental qualitative characteristics of relevance and faithful representation, there are also four ‘enhancing qualitative characteristics’. These enhancing qualitative characteristics are comparability, verifiability, timeliness and understandability, and each of these qualitative characteristics is assumed to enhance the usefulness of information that is both relevant and faithfully represented. As paragraph 2.4 of the IASB Conceptual Framework states: 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.
Comparability Various researchers have argued that a key role of a conceptual framework should be to produce consistent accounting standards that lead to comparable accounting information between different entities, as without such comparability it would be difficult for users to evaluate accounting information. In relation to the enhancing qualitative characteristic of ‘comparability’, to facilitate the comparison of the financial statements of different entities (and that of the financial statements of a single entity over time), methods of measurement and disclosure must be consistent, but should be changed if no longer relevant to an entity’s circumstances. This is an important issue – comparability is generally expected, but a quest for comparable information would not justify the continued use of a particular accounting method if a more relevant and representationally faithful depiction of an entity’s performance could be achieved by switching to another accounting method. Desirable characteristics such as comparability therefore imply that there are advantages in restricting the number of accounting methods that can be used by reporting entities. However, some researchers have argued that regulation that results in fewer accounting methods available for use by reporting entities leads potentially to reductions in the efficiency with which organisations operate (Watts and Zimmerman, 1986). For example, management might elect to use a particular accounting method because it believes that for its particular, and perhaps unique, circumstances that method best reflects the entity’s underlying financial performance (even though no other entity might use the accounting method in question). Restricting the use of such a method might result in a reduction in the efficiency with which external parties can monitor the performance of the entity, and this in itself has been assumed to lead to increased costs for the reporting entity (this ‘efficiency perspective’, which has been applied in Positive Accounting Theory, is explored in Chapter 8). If it is assumed, consistent with the efficiency perspective briefly mentioned here, that organisations adopt particular accounting methods because those methods best reflect the underlying economic performance of the entity, it is argued by some theorists that the regulation of financial accounting – particularly calls for uniformity in the use of all accounting methods (which enhances comparability) in a ‘one-size-fits-all’ approach to financial reporting practices – imposes unwarranted costs on reporting entities. For example, if a new accounting standard is released that bans the use of an accounting method by particular organisations, this will potentially lead to inefficiencies, as the resulting financial statements will no longer provide 299
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the best reflection of the performance of those organisations. Many theorists would argue that management is best able to select the most appropriate financial accounting methods in given circumstances and that government and/or others should not intervene by introducing a ‘one-size-fits-all’ accounting standard. Arguments for and against regulation are provided in Chapters 3 and 4 of this book. Obviously, the people in charge of developing conceptual frameworks that include comparability as a key qualitative characteristic must believe that the benefits of restricting the number of allowable methods outweigh the potential reductions in efficiency that some organisations may experience as a consequence of their managers not being free to select what they consider to be the most appropriate accounting method.
Verifiability Refers to the ability, through consensus among measurers, to ensure that information represents what it purports to represent, or that the chosen method of measurement has been used without error or bias.
Timeliness Having information available to decision-makers in time to be capable of influencing their decisions.
Understandability From an accounting perspective, and in accordance with the IASB Conceptual Framework, classifying, characterising and presenting information clearly and concisely makes it understandable. Considerations of understandability require judgements to be made about the proficiency of users of information.
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Verifiability Verifiability refers to the ability, through consensus among measurers, to ensure that information represents what it purports to represent, or that the chosen method of measurement has been used without error or bias. In relation to the enhancing qualitative characteristic of verifiability, paragraph 2.30 of the IASB Conceptual Framework states: Verifiability helps assure users that information faithfully represents the economic phenomena it purports to represent. Verifiability means that different knowledgeable and independent observers could reach consensus, although not necessarily complete agreement, that a particular depiction is a faithful representation.
Timeliness A third ‘enhancing’ qualitative characteristic is ‘timeliness’. The ‘timelier’ (or more up-to-date) that financial information is, the more useful it will be. As paragraph 2.33 of the IASB Conceptual Framework states: Timeliness means having information available to decision-makers in time to be capable of influencing their decisions. Generally, the older the information is the less useful it is. However, some information may continue to be timely long after the end of a reporting period because, for example, some users may need to identify and assess trends.
Understandability The fourth and final ‘enhancing’ qualitative characteristic is ‘understandability’, the view being that for information to be useful it needs to be understandable to the users. In the IASB Conceptual Framework, information is considered to be understandable if it is likely to be understood by users with some business and accounting knowledge (as discussed earlier). However, this does not mean that complex information that is relevant to economic decision making should be omitted from the financial statements just because it might not be understood by some users. Given that conceptual frameworks have been developed in large part to guide accounting standard setters in the setting of accounting rules, this qualitative characteristic of understandability is perhaps best seen as a requirement (or challenge) for standard-setters to ensure that the accounting standards they develop for dealing with complex areas produce accounting disclosures that are understandable (irrespective of the complexity of the underlying transactions or events). The qualitative characteristics of general purpose financial reporting are summarised in Figure 7.4. This figure demonstrates that the fundamental qualitative characteristics are the first characteristics that typically need to be considered. Once those characteristics have been established as potentially existing for particular information, then the relevance and/or faithful representation of financial information can be further enhanced by considering issues associated with comparability, verifiability, timeliness and understandability. Efforts to increase the comparability, verifiability, timeliness and understandability of the financial information can also effectively ‘feed back’ to improve the relevance and representational faithfulness of the information (as represented by the arrow from enhancing qualitative characteristics back to fundamental qualitative characteristics).
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FIGURE 7.4 An overview of the qualitative characteristics of useful financial information Predictive value Relevance Confirmatory value Fundamental qualitative characteristics Completeness If the information appears likely to satisfy the fundamental qualitative characteristics, then the enhancing qualitative characteristics are to be considered
Faithful representation
Neutrality Freedom from error
Comparability Verifiability
Enhancing qualitative characteristics Timeliness Understandability
It is interesting to note that the qualitative characteristics of useful financial information, as described above, are very similar to the qualitative characteristics that are identified within other reporting frameworks, which relate to other forms of reporting, such as reporting relating to various aspects of organisational social and environmental performance. For example, if we look at the reporting frameworks developed by the Global Reporting Initiative (see https://www.globalreporting.org), the International Sustainability Standards Board (https://www.ifrs.org/groups/international-sustainability-standards-board), the Task Force on Climate-Related Financial Disclosures (https://www.fsb-tcfd.org) and the Water Accounting Standards Board (see https://www.bom.gov.au/water/standards/wasb), then we will see almost identical qualitative characteristics identified. Therefore, the qualitative characteristics identified within the IASB Conceptual Framework appear to have some acceptance globally and in respect of different types of information. Arguably, for any information to be useful it should have these attributes. The IASB Conceptual Framework also notes that financial statements should be prepared using accrual accounting (see paragraph 1.17) as financial performance is best reflected by the application of accrual accounting, rather than information about cash payments and cash receipts. It is also noted (paragraph 3.9) that financial statements are normally prepared on the assumption that the entity is a going concern and will continue to operate for the foreseeable future. However, if there is an intention or need to enter liquidation or cease trading, the financial statements will need to be prepared on a different basis and the financial statements would need to be clear about the alternative basis used. The IASB Conceptual Framework notes also that these characteristics can be weighted differently in different circumstances and for different transactions or events – but without clear guidance there will obviously be a deal of subjectivity involved in seeking to provide useful financial information.
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REFLECTION QUESTION 7.1 The qualitative characteristics of all useful information Question Is there something unique about the qualitative characteristics that financial accounting information should possess relative to the qualitative characteristics that other types of useful information should possess? Solution Not really. Arguably, if we are making any form of decision (such as investing in an organisation, buying a new car or choosing a restaurant to dine at), we need information. Obviously, the more significant the decision, the more intent we should be on obtaining quality information and the more we might be
Reflection
prepared to pay for such information. Nevertheless, whatever decision we are making we would want relevant and reliable/ representationally faithful information, and ideally that information should allow us to compare between our available options; have some form of verifiability; be up to date (timely); and be given to us in a form that we can understand. Effectively, different reporting frameworks in existence – whether they include financial-, social- or environmental-related information – all tend to refer to the same expected qualitative characteristics that information should possess.
Can financial statements provide neutral and unbiased accounts of an entity’s performance and position? LO7.4
LO7.6
LO7.7
As we now know, the IASB Conceptual Framework prescribes that financial reporting provide a representationally faithful (complete, neutral and free from error) view of the performance and position of a reporting entity. Reflecting on such a prescription, Hines (1991, p. 314) states: … it appears that the ontological assumption underpinning the Conceptual Framework is that the relationship between financial accounting and economic reality is a unidirectional, reflecting or faithfully reproducing relationship: economic reality exists objectively, intersubjectively, concretely and independently of financial accounting practices; financial accounting reflects, mirrors, represents or measures the pre-existent reality.
The role of a well-functioning system of financial accounting has been compared by some researchers with that of cartography (map-making). That is, just as an area can be objectively ‘mapped’, some have argued that so can the financial position and performance of an organisation (Solomons, 1978). But, as we should understand, the practice of accounting is heavily based on professional judgement, explicitly tied to assessments of probabilities and measurement uncertainties. Clearly, there is a degree of subjectivity associated with such assessments. Cartography is not based on subjective assessments of probabilities.10 Although conceptual frameworks argue for attributes such as neutrality and representational faithfulness, is it valid or realistic to believe that financial accounting provides a neutral perspective of an entity’s performance? Chapter 4 looked at research that investigated the economic consequences of accounting regulations. It was explained that before an accounting standard-setting body releases new or amended reporting requirements, it attempts to consider the economic consequences that would follow from the decision to release an accounting standard. Even if a proposed financial accounting rule was considered the best way to account (however this is determined – which, of course, would be an issue provoking much debate about respective costs and benefits), if this proposed accounting rule would lead to significant costs being imposed on particular parties (for example, preparers) then plans to require the approach could be abandoned by the standard-setters. Once a profession starts considering the economic consequences of particular accounting standards 10
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If it was, we could imagine the carnage that might occur if a map of the ocean simply told a ship’s captain that it was probable that a reef was safe for crossing.
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it is difficult to perceive that the accounting standards, and therefore financial accounting practice, can really be considered objective or neutral. Tied to issues associated with economic implications, there is a body of literature (Positive Accounting Theory, which has already been briefly discussed and which is considered in Chapter 8) that suggests that those people responsible for preparing financial statements will be driven by self-interest to select accounting methods that lead to outcomes that provide favourable outcomes for their own personal wealth. That is, this literature predicts that managers and others involved in the accounting function will always put their self-interest ahead of that of others.11 If we accept this body of literature, we will perhaps dismiss notions of objectivity or neutrality as being unrealistic. Self-interest perspectives are often used to explain the phenomenon of ‘creative accounting’ – a situation where those responsible for the preparation of financial statements select accounting methods that provide the most desired outcomes from their own perspective (such as apparently occurred at Enron). Financial reporting standards and conceptual frameworks form the foundation of general purpose financial reporting. As noted in earlier chapters, financial reporting standards (accounting standards) and conceptual frameworks are developed through public consultation, which involves the release of exposure drafts and, subsequently, a review of the written submissions made by various interested parties, including both the preparers and the users of the financial information. Consequently, the process leading to finalised financial reporting standards and conceptual frameworks can be considered to be political. The political solutions and compromises impact on the financial information being presented and that information is, therefore, an outcome of a political process – a process where parties with particular attributes (power) may be able to have a relatively greater impact on financial reporting requirements than other parties (and in Chapter 4 we considered Capture Theory). This can be considered to have implications for the objectivity or neutrality of the financial information being disclosed. Hines (1989, p. 80) argues that many individuals not involved in the standard-setting process would be very surprised to find out just how political the development of accounting standards actually is. She states: an accounting outsider might find it remarkable that accounting knowledge should be articulated not only by professional accountants, but also by accounting information users – much like doctors and patients collaborating on the development of medical knowledge.
Hines is one author who wrote quite a deal of material on what she sees as the apparent ‘myth’ of accounting neutrality. Hines (1988) argues that parties involved in the practice and regulation of accounting impose their own judgements about what attributes of an entity’s performance should be emphasised (for example, profits or return on assets), and, also, what attributes of an entity’s operations (for example, expenditure on employee health and safety initiatives or carbon-related emissions) are not important enough to emphasise or highlight separately. The accountant can determine, under the ‘guise’ of objectivity, which attributes of an entity’s operations are important, and which can be used as a means of comparing the performance of different organisations. For example, we were informed in the United States’ SFAC No. 1 that reported earnings measures an enterprise’s performance during a period (paragraph 45), but clearly there are other perspectives of organisational performance (for example, that would take a more social or environmental, as opposed to financial, form).12 Hines (1991, p. 322) emphasises that in communicating reality accountants simultaneously construct reality:
One example that is often provided by proponents of Positive Accounting Theory is managers being given a bonus tied to the output of the accounting system, for example to profits. It would be argued in such a case that managers will have incentives to increase reported profits, rather than be objective. 12 And of course financial ‘performance’ is very much tied to the judgements about which particular accounting methods should be employed, over how many years an asset should be amortised and so forth. Further, because accounting rules can change over time, this in itself can lead to a change in reported profits and hence a change in apparent ‘performance’. 11
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If people take a definition or description of reality, for example, an organisational chart, or a budget, or a set of financial statements, to be reality, then they will act on the basis of it, and thereby perpetuate, and in so doing validate, that account of reality. Having acted on the basis of that definition of reality, and having thereby caused consequences to flow from that conception of reality, those same consequences will appear to social actors, in retrospect, to be proof that the definition of reality on which they based their actions was real … Decisions and actions based on that account predicate consequences, which, in retrospect, generally confirm the validity of the subsequent account. For example, say an investigator, or a newspaper report, suggested that a ‘healthy’ set of financial statements is not faithfully representational, and that a firm ‘really’ is in trouble. If this new definition of reality is accepted by, say, creditors, they may panic and precipitate the failure of the firm, or, through the court, they may petition for a liquidation. A new definition of reality, if accepted, will be ‘real in its consequences’, because people will act on the basis of it.
Until accountants determine that something is worthy of being recorded within the accounting system, the issue or item, in a sense, does not exist. There is no transparency, and as such there is no perceived accountability in relation to the item. This perspective is adopted by Handel (1982, p. 36), who states: Things may exist independently of our accounts, but they have no human existence until they become accountable. Things may not exist, but they may take on human significance by becoming accountable … Accounts define reality and at the same time they are that reality … The processes by which accounts are offered and accepted are the fundamental social process … Accounts do not more or less accurately describe things. Instead they establish what is accountable in the setting in which they occur. Whether they are accurate or inaccurate by some other standards, accounts define reality for a situation in the sense that people act on the basis of what is accountable in the situation of their action. The account provides a basis for action, a definition of what is real, and it is acted on so long as it remains accountable.13
Hence, we can see that there are a number of arguments that suggest that characteristics such as neutrality or representational faithfulness, while playing a part in the development of conceptual frameworks, do not, and perhaps may never be expected to, reflect the underlying characteristics of financial statements. As with much of the material presented in this book, whether we accept these arguments is a matter of personal opinion. As a concluding comment to challenge the belief in the objectivity or neutrality of accounting practice, reflect on the following statement of Baker and Bettner (1997, p. 293): Accounting’s capacity to create and control social reality translates into empowerment for those who use it. Such power resides in organizations and institutions, where it is used to instill values, sustain legitimizing myths, mask conflict and promote selfperpetuating social orders. Throughout society, the influence of accounting permeates fundamental issues concerning wealth distribution, social justice, political ideology and environmental degradation. Contrary to public opinion, accounting is not a static reflection of economic reality, but rather is a highly partisan activity.14
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As quoted in Hines (1991). The view that the practice of accounting provides the means of maintaining existing positions of power and wealth by a favoured ‘elite’ is further investigated in Chapter 13, which considers the works of a body of theorists who are labelled ‘critical theorists’.
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REFLECTION QUESTION 7.2 Accounts as a neutral depiction of an underlying reality Question Can financial reports provide a neutral account of an organisation’s financial performance? Also, if accountants do not ‘account’ for something, can that absence of accountability effectively cause something to be ‘invisible’? Solution The practice of financial reporting generally has perceived legitimacy because of the view typically held within the community that financial reports, and therefore financial accountants, provide an objective account of an underlying reality. Most people in the community do not know that financial reporting standards are developed by way of a political process, nor do they appreciate the amount of professional judgement involved when the accountant recognises assets, liabilities, income and expenses. Further, if we assume that many individuals – including managers and accountants – are driven, at least in part, by self-interest, then we would understand that some level of ‘creativity’ is often intentionally introduced into the financial accounting process (as it will also be introduced into the social and environmental accounting processes). Because of the amount of professional judgement involved in financial accounting, and because of other economicbased incentives, it would be almost impossible that independent teams of accountants would analyse the same set of organisational transactions and events to then produce identical measures of financial performance or financial position. With this in mind, any claims that financial reports are ‘neutral’ appears open to challenge.
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Turning our attention to the second part of this question, it is frequently argued that accountants can make things visible, or invisible. For example, if financial accountants separately record and present information about wages expense then this will direct attention to this specific expense and this might in turn generate initiatives to reduce the expense (which might lead to various social implications). By contrast, if wages expense was accumulated within a broader account, then increases may go unnoticed (perhaps any increase might be offset by decreases in other expenses). As a more important example, for many years accountants failed to report information about the carbon-related emissions of organisations. Further, because of the way we define assets and expenses (to be discussed in following sections of this chapter), contributions to climate change do not negatively impact ‘profits’ and therefore highly emitting organisations are able to report high profits – thereby likely leading to positive plaudits – at the same time that unrecognised (hidden) damage is being done to the planet. Had accountants developed a system that placed a cost of carbon-related emissions which was actually deducted from profits then perhaps efforts would have been made to reduce the ‘expense’ (to thereby lift reported profits) – but this was not the case. So, for hundreds of years the cost of climate change and environmental degradation was hidden, and therefore uncontrolled. We can only wonder how much better the planet might be if ‘accountants’ had been ‘accounting’ for climate change, thereby making it visible.
Definition and recognition of the elements of financial statements LO7.3
LO7.5
Having considered perspectives on the required qualitative characteristics of financial information, the next building block to consider is how the elements of financial reporting are defined and when they shall be recognised. The definitions provided within conceptual frameworks indicate the characteristics or attributes that are required before an item can be considered as belonging to a particular class of element (that is, before it can be considered to be an asset, liability, equity, income or expense). Recognition criteria, on the other hand, are employed to determine whether the item should actually be included within the financial statements (that is, whether a particular transaction or event should be recognised as affecting the financial accounts). Alternative approaches have been adopted in defining the elements of financial reporting. In the United States, 10 elements of financial reporting were identified in SFAC 3, and subsequently in SFAC 7.15 These elements were assets, liabilities, equity, investments,
15
Elements of financial reporting Pursuant to the IASB Conceptual Framework, the elements of financial reporting are assets, liabilities, income, expenses and equity.
SFAC 3 was superseded by SFAC 7. SFAC 3 related to business enterprises. SFAC 6 included non-business entities.
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distributions, comprehensive income, revenues, expenses, gains and losses. The IASB Conceptual Framework (which had formerly been the IASC Framework) identifies five elements, split into two broad groups. The first group comprises elements relating to financial position, the elements of assets, liabilities and equity. The second group includes elements relating to performance and comprises income and expenses. In the United Kingdom, the elements defined in the ASB’s 1999 framework were somewhere between the US framework and the IASB Framework, being assets, liabilities, ownership interest, gains, losses, contributions from owners and distributions to owners. The Australian conceptual framework, through SAC 4, identified five elements: assets, liabilities, equity, revenue and expenses. In the FASB conceptual framework, rather than simply having a single element entitled income (or gains as in the ASB’s framework), two elements were identified, revenues and gains, where revenues relate to the ‘ongoing major or central operations’ of the entity, while gains relate to ‘peripheral or incidental transactions’. Clearly, the FASB classification system required a judgement to be made about whether an item did or did not relate to the central operations of the entity. Such differentiation admits the possibility that managers might opportunistically manipulate whether items are treated as part of the ongoing operations of the entity or are treated as peripheral or incidental. Once the definition of the respective element of financial accounting has been satisfied in relation to a particular transaction or event, the next step is to determine when we should recognise that element in the financial accounting information system. According to the Appendix to the IASB Conceptual Framework: Recognition is the process of capturing for inclusion in the statement of financial position or the statements of financial performance an item that meets the definition of one of the elements of financial statements – an asset, liability, equity, income or expenses. Recognition involves depicting the item in one of those statements – either alone or in aggregation with other items – in words and by a monetary amount, and including that amount in one or more totals in that statement.
Whatever amount is shown in the statement of financial position (balance sheet) for a particular account, this amount is referred to as its ‘carrying amount’. In terms of the sequence of events, once we know what an ‘asset’ is in terms of the definition (as well as the other elements of financial accounting), and know when to recognise it, we will then need to determine the monetary amount that we should assign to it. That is, we will need to know how to ‘measure’ it. We will address measurement later in this chapter. Once we know how to define, recognise and measure an element of financial accounting, we then need to know what information we should disclose in respect of the item, and how that information shall be presented within the financial statements. When revisions were made to the IASB Conceptual Framework in 2018, there were some relatively significant changes made in relation to the definitions and the elements of financial statements. There was a removal of reference to ‘expected flow of economic benefits’ from the definition of assets and liabilities and there was a related removal of a probability criterion from the associated recognition criteria. The focus of the revised definitions – as we shall see below – is now on the existence of a ‘right’ (or obligation) that has the potential to produce (or require an entity to transfer) economic benefits. The implication of this is, for example, that a ‘right’ can meet the definition of an economic resource, and hence be an ‘asset’, even if the probability of it producing economic benefits is assessed as being lower than 50 per cent. As noted above, this is a significant departure from previous practice, which relied on establishing that the expected future flow of economic benefits was probable. That is, previously an asset and liability was to be recognised only if the related cash flow was deemed to be ‘probable’ and could be measured with reliability. 306
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Different approaches can be applied to determining profits (income less expenses) and this has direct implications for how we define the elements of financial accounting. Two such approaches are commonly referred to as the asset/liability approach and the revenue/expense approach. The asset/liability approach links profit to changes that have occurred in the assets and liabilities of the reporting entity, whereas the revenue/expense approach tends to rely on concepts such as the matching principle, which is very much focused on actual transactions and gives limited consideration to changes in the values of assets and liabilities. The IASB Conceptual Framework adopts the asset/liability approach. Therefore, within the Conceptual Framework, the task of defining the elements of financial statements must start with definitions of assets and liabilities, as the definitions of all the other elements flow from these definitions. This should become apparent as we consider each of the elements of financial accounting in what follows. In relation to the ‘asset and liability view’ of profit determination, the FASB and IASB (2005, pp. 7 and 8) stated: In both [FASB and IASB] frameworks, the definitions of the elements are consistent with an ‘asset and liability view’, in which income is a measure of the increase in the net resources of the enterprise during a period, defined primarily in terms of increases in assets and decreases in liabilities. That definition of income is grounded in a theory prevalent in economics: that an entity’s income can be objectively determined from the change in its wealth plus what it consumed during a period (Hicks, pp. 178–9, 1946). That view is carried out in definitions of liabilities, equity, and income that are based on the definition of assets, that is, that give ‘conceptual primacy’ to assets. That view is contrasted with a ‘revenue and expense view’, in which income is the difference between outputs from and inputs to the enterprise’s earning activities during a period, defined primarily in terms of revenues (appropriately recognized) and expenses (either appropriately matched to them or systematically and rationally allocated to reporting periods in a way that avoids distortion of income).
As we should know, the elements that appear within the balance sheet, and which relate to an organisation’s ‘financial position’, are assets, liabilities and equity. The elements that appear within the income statement, and which relate to an organisation’s ‘financial performance’, are income and expenses. These elements, and their role, are represented in Figure 7.5. We consider each of the five elements in turn, but notice, once again, as the discussion proceeds, how the definitions of expenses and income depend directly on the definitions given to assets and liabilities. FIGURE 7.5 The elements of financial accounting Assets Liabilities
The balance sheet which provides information about the financial position of an organisation at a point in time
Equity
Income
Expenses
The income statement which provides information about the financial performance of an organisation for a period of time
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Definition and recognition of assets According to the IASB Conceptual Framework, an asset is defined as: a present economic resource controlled by the entity as a result of past events.
The above definition of an asset refers to an economic resource. An ‘economic resource’ is defined in the IASB Conceptual Framework as: a right that has the potential to produce economic benefits.
Rights can take many forms, including rights to receive cash, rights to receive goods or services, or rights over physical objects, such as property, plant and equipment or inventories (where the right to use the property, plant, equipment or inventories might have been established as a result of buying or leasing the item). There are three separate components to the above definition of an ‘asset’ that we need to consider. All three related requirements must exist if we are to consider that a particular transaction satisfies the definition of an asset. From the above definition, these components are: 1 an asset is an economic resource (right) controlled by the entity 2 an asset exists as a result of past events 3 the right has the potential to produce economic benefits. Let us now consider each of these components separately.
Control Control From an accounting perspective, control relates to the capacity of a reporting entity to benefit from an asset and to deny or regulate the access of others to the benefit.
As indicated in the above definition of an asset, a resource must be ‘controlled’ before it can be considered to be an ‘asset’. Control relates to the capacity of a reporting entity to benefit from an asset and to deny or regulate the access of others to the benefit. The capacity to control would normally stem from legal rights. However, legal enforceability is not a prerequisite for establishing the existence of control. Hence, it is important to realise that control, and not legal ownership, is required before an asset can be shown within the body of an entity’s balance sheet (statement of financial position). Frequently, controlled assets are owned, but this is not always the case. Organisations frequently disclose leased assets as part of their total assets. In relation to control, the IASB Conceptual Framework states: Many assets, for example, receivables and property, are associated with legal rights, including the right of ownership. In determining the existence of an asset, the right of ownership is not essential; thus, for example, property held on a lease is an asset if the entity controls the benefits which are expected to flow from the property. Although the capacity of an entity to control benefits is usually the result of legal rights, an item may nonetheless satisfy the definition of an asset even when there is no legal control. For example, know-how obtained from a development activity may meet the definition of an asset when, by keeping that know-how secret, an entity controls the benefits that are expected to flow from it.
There are many ‘resources’ that generate economic benefits for an entity but that cannot be recorded for financial reporting purposes owing to the absence of control. A resource can be broadly defined as something that has value in the sense that it allows an organisation to undertake an activity so as to enable it to achieve a desired outcome. For example, the use of the road system generates economic benefits for an entity and would be considered to be a resource. However, because the entity does not control the roads, they do not constitute ‘assets’ of the entity. Similarly, particular waterways will provide economic benefits to entities and could be an important resource, but to the extent that such entities do not control the waterways, they are not assets of those entities. Similarly, while the operation of many organisational assets rely upon the air (which is therefore a ‘resource’), the air is not controlled, and therefore is not an asset as defined in the IASB Conceptual Framework. As the air is not an asset, any degradation 308
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caused to it (for example, through ongoing carbon emissions) will therefore not be treated as an ‘expense’. As we have noted, the definition and recognition of an expense is directly related to the definition and recognition of assets.
Past event The event that creates the ‘economic resource’ must have occurred. That is, in relation to ‘control’, it follows from the definition of an ‘asset’ that the relevant transaction generating ‘control’ must already have occurred. Conversely, economic resources that are not currently controlled are not recognised in the statement of financial position.
Potential to produce economic benefits The expected future economic benefits can be distinguished from the source of the benefit – a particular object or right. The definition refers to the economic benefit and not the source. Thus, whether an object or right is disclosed as an asset will be dependent upon the potential it has to generate economic benefits for the entity. In the absence of potential to generate economic benefits, the object or right should not be considered to be an asset. Rather, any related expenditure would constitute an expense. Cash is an asset owing to the economic benefits that can flow as a result of the purchasing power it generates. A machine is an asset to the extent that economic benefits are anticipated to flow from using it. That is, the asset is effectively the future economic benefits that will be generated, not the source of the economic benefits (such as the machine). These economic benefits could come from two broad sources – either from the asset’s use or from its sale. If the economic benefits are greater from its use by the reporting entity, then the asset would be expected to be retained, otherwise it would likely be sold. That is, the IASB Conceptual Framework does not require an item to have a value in exchange before it can be recognised as an asset. The economic benefits may result from its ongoing use (often referred to as ‘value-in-use’) within the organisation. This approach can be contrasted with the model of accounting proposed by Raymond Chambers: Continuously Contemporary Accounting (considered in Chapter 6). Under Chambers’ approach to accounting, if an asset does not have a current market value (value in exchange), it is to be excluded from the financial statements regardless of its value-in-use. As already noted, the previous definition of an asset and liability had required that the expected future flows of economic benefits be probable, which meant more likely than less likely. This is no longer the requirement. Recognition is now based upon there being a ‘potential’ for economic benefits to flow to the reporting entity. For that potential to exist, it does not need to be certain, or even likely, that the right will produce economic benefits. It is necessary only that the right already exists as a result of a past transaction or event and that, in at least one circumstance, it would produce economic benefits for the reporting entity. However, while there is no longer a requirement that the future economic benefits are judged to be ‘probable’, the assessed probability will nevertheless influence the measurement ultimately attributed to an asset (a resource with a higher likelihood of generating economic benefits would be expected to have a higher value in the ‘market’ compared to a similar asset with lower likelihood).
Assets acquired at no cost To satisfy the definition of an ‘asset’, it is not a prerequisite that the asset be acquired at a cost to the reporting entity. As the IASB Conceptual Framework notes (paragraph 4.18), although there is typically: a close association between incurring expenditure and acquiring assets, the two do not necessarily coincide. Hence, when an entity incurs expenditure, this may provide evidence that the entity has sought future economic benefits, but does not provide 309
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conclusive proof that the entity has obtained an asset. Similarly, the absence of related expenditure does not preclude an item from meeting the definition of an asset. Assets can include, for example, rights that a government has granted to the entity free of charge or that another party has donated to the entity.
Therefore, the key point here is that the presence or absence of expenditure is not a defining factor in determining the existence of an ‘asset’.
REFLECTION QUESTION 7.3 Applying the definition of assets A reporting entity has been involved with the following transactions and events: 1 The entity acquired some land at a cost of $1 million. However, after acquiring the land, it became known that the land was highly contaminated and was very unlikely to be usable or be able to be sold. 2 A satisfied long-term customer decided to give the organisation a delivery truck for free. The organisation expects to use the truck within the business. 3 The organisation has been given the right by the local government to use a nearby river to transport some of its products to nearby markets. Question Which of the above transactions and events would generate a resource that satisfies the IASB definition of an asset?
Reflection
Solution As we know, the definition of an asset has three key components. In relation to the land described above, while the organisation might control the land as a result of a past transaction or event, it appears that the land does not have the potential to generate economic benefits. Therefore, it does not seem to satisfy the definition of an asset. The delivery truck does appear to satisfy the definition of an asset. It is controlled as a result of a past event, and it does have the potential to generate economic benefits for the organisation. It does not directly matter that the truck was not acquired at a cost to the organisation. The right to use the nearby river is not an ‘asset’ of the organisation as the organisation does not have ‘control’ over the river – it just has access to it. The river would not appear in the financial statements of the organisation.
Recognition of an asset As already noted, in addition to defining an asset, we also need to consider when we should recognise the existence of an asset and therefore include it within the financial statements. The IASB Conceptual Framework provides general recognition criteria for all of the five elements of financial accounting (assets, liabilities, income, expenses and equity). Paragraph 5.6 states: Only items that meet the definition of an asset, a liability or equity are recognised in the statement of financial position. Similarly, only items that meet the definition of income and expenses are recognised in the statement(s) of financial performance. However, not all items that meet the definition of one of those elements are recognised.
Therefore, the first step in the recognition of a particular item in the financial statements (and therefore in our financial accounting system) is determining that the item meets the definition of an element of financial accounting – which is what we have just discussed. However, as the above paragraph indicates, further criteria (other than meeting the definition of an element of financial accounting) are required to be satisfied before an item shall be recognised for financial accounting purposes. When the IASB Conceptual Framework was revised and re-released in 2018, it specifically required that financial accountants must consider the fundamental qualitative characteristics of relevance and faithful representation (which were discussed earlier) when deciding if an item
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should be recognised within the financial statements. This was a change from the previous recognition criteria, which focused on assessing the probability of future economic benefits, as well as whether the item could be measured reliably. Specifically, the IASB Conceptual Framework now requires that an asset or liability be recognised – and therefore included within the balance sheet – only if it meets the respective definition and if recognition of that asset or liability and any resulting income, expenses or changes in equity provides users of financial statements with information that is useful, that is, with: 1 relevant information about the asset or liability, and about any resulting income, expenses or changes in equity 2 a faithful representation of the asset or liability and any resulting income expenses, or changes in equity. As we now know, relevance and faithful representation are the two fundamental qualitative characteristics that useful financial accounting information should possess. Information must both be relevant and provide a faithful representation of what it purports to represent, if it is to be useful. Therefore, it does seem logically consistent that the IASB Conceptual Framework now stipulates that decisions about recognising assets and liabilities in the balance sheet also require the financial accountant to make a judgement about whether the disclosure of the respective asset, or liability, will ultimately provide information that is relevant and representationally faithful, and therefore useful to the users of the financial statements. If this conclusion cannot be reached, then the information about the respective asset and liability should not be included (recognised) within the balance sheet. This will then have direct implications for the recognition of income and expenses. Because the accountant’s decision to recognise a particular transaction or event for financial statement purposes is directly linked to considerations of ‘relevance’ and ‘faithful representation’, much professional judgement is therefore required in terms of when, or if, to recognise an asset, liability, equity, income or expense. The IASB Conceptual Framework, however, provides some general guidance in relation to linking recognition to relevance and faithful representation, which we now consider.
Relevance In relation to the qualitative characteristic of relevance, the Conceptual Framework states (paragraph 5.12): Information about assets, liabilities, equity, income and expenses is relevant to users of financial statements. However, recognition of a particular asset or liability and any resulting income, expenses or changes in equity may not always provide relevant information. That may be the case if, for example: (a) it is uncertain whether an asset or liability exists, or (b) an asset or liability exists, but the probability of an inflow or outflow of economic benefits is low.
From the above, we can see that if there is sufficient uncertainty about whether a particular right exists – and remember that assets are considered to represent rights that have the potential to produce economic benefits – then an asset should not be recognised. As the IASB Conceptual Framework states (paragraph 4.13): For example, an entity and another party might dispute whether the entity has a right to receive an economic resource from that other party. Until that existence uncertainty is resolved – for example, by a court ruling – it is uncertain whether the entity has a right and, consequently, whether an asset exists.
Therefore, in recognising an asset, a judgement needs to be made about the extent of any possible ‘existence uncertainty’, which is defined in the IASB Conceptual Framework as 311
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‘uncertainty about whether an asset or liability exists’. For example, if an organisation has some farming land, but considerable doubt has been raised about whether it has proper legal title over that land, then it might be appropriate not to recognise the land within the financial statements until such time that there is clarity about who is permitted to occupy the land. In determining whether information is relevant to the users of financial statements, we can see from the quote provided above that there is also a requirement to consider the probability associated with any expected future inflow, or outflow, of economic benefits. In this regard, the IASB Conceptual Framework states (paragraph 5.17b): If there is only a low probability that the asset or liability will result in an inflow or outflow of economic benefits, users of financial statements might not regard the recognition of the asset and income, or the liability and expenses, as providing relevant information.
For example, an organisation might have an item of machinery that it no longer uses, and it is very unsure whether any other organisation would buy it. In this case, there might be deemed to be a low probability associated with inflows of economic benefits, and therefore information about the asset might not be relevant to financial statement users, and should not be disclosed within the balance sheet. Therefore, in considering whether the disclosure of information about an asset would be relevant, two factors for managers and their accountants to consider would include: 1 ‘existence uncertainty’ 2 the ‘probability associated with the expected inflow of economic benefits’. It is emphasised again that it is not a requirement that the future flow of economic benefits be probable, but if the potential to generate economic benefits is deemed to be very low, then it might not be relevant to users for them to have knowledge of the particular ‘right’ in question.
Faithful representation In relation to the other fundamental qualitative characteristic of faithful representation that requires consideration when determining whether to recognise an asset, or other element of financial accounting, the IASB Conceptual Framework states (paragraph 5.18): Recognition of a particular asset or liability is appropriate if it provides not only relevant information, but also a faithful representation of that asset or liability and of any resulting income, expenses or changes in equity. Whether a faithful representation can be provided may be affected by the level of measurement uncertainty associated with the asset or liability, or by other factors.
As we know, for an asset or liability to be recognised within the financial statements, it must be measured in monetary terms. We considered ‘measurement’ in depth within Chapter 6. Many of the measures attributed to assets are based upon estimates, meaning inherently that the amounts being attributed to some assets (and other elements of financial accounting) are often made with some level of uncertainty. As we have already indicated, some level of uncertainty is acceptable; however, if the different measures that could be attributed to an asset (or other element of financial accounting) are all considered to have a high level of measurement uncertainty, then the asset should not be recognised within the financial statements. Measurement uncertainty is defined in the Appendix to the IASB Conceptual Framework as: uncertainty that arises when monetary amounts in financial reports cannot be observed directly and must instead be estimated.
In relation to the issue of measurement uncertainty referred to in the above quote, the IASB Conceptual Framework stresses (paragraph 5.20) that in some cases, the level of uncertainty 312
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associated with estimating a measure of an asset or liability might be so high that it would be questionable whether the estimate would provide a sufficiently faithful representation of that asset or liability and of any resulting income, expenses or changes in equity. As an example of measurement uncertainty, an organisation might have some machinery that it no longer uses and it is very unsure about how much it could now sell the machinery for. This would be an instance of measurement uncertainty. If the level of measurement uncertainty is sufficiently high, then this might indicate that a faithful representation of the value of the machinery cannot be provided to the users of the financial statements, and the item should not be recognised within the balance sheet. Therefore, with the above discussion of relevance and faithful representation in mind, we now know that existence uncertainty, probability of expected inflows or outflows of economic benefits and measurement uncertainty are among the key factors to consider before an accountant should recognise an asset, liability, income, expense or equity item within the financial statements. Factors relating to existence uncertainty, probability and measurement uncertainty can require a great deal of professional judgement, and as such, different accountants might make different judgements in respect of whether particular items should be included within the financial statements. Any differences in judgements made by accountants would, in turn, ultimately result in different financial statements being prepared, with different profits being reported. The point being made here is that we require financial accountants to make judgements about such factors as: • the expected probabilities associated with expected flows of economic benefits • the level of uncertainty associated with the measurement of the expected future economic benefits • whether rights associated with the future economic benefits are clearly in existence. This, therefore, necessarily introduces a degree of professional judgement into the financial accounting process. Conceivably, different accountants will make different judgements. This means that if different accountants were to be provided with the same information, they may process the information differently and therefore, as we say above, produce different financial statements. Indeed, if different teams of accountants were given details of all of the transactions and events with which an organisation was involved throughout a particular reporting period, and each team was asked to separately prepare financial statements for that organisation, then it would be quite improbable that they would generate identical financial statements. The preparation of financial statements requires a great deal of professional judgement, and this has direct implications for what appears within the financial statements. If an asset is recognised within the financial statements at one point in time, it might need to be removed from the financial statements at a future time. For example, accountants might initially make a professional judgement that an item satisfies the criteria necessary to be recognised within the financial statements. However, at a subsequent point, additional information might come to light, or new conditions might arise, that create significant uncertainty about factors such as: • the expected probabilities associated with expected flows of economic benefits • the level of uncertainty associated with the measurement of the associated economic benefits. If the uncertainties become sufficiently high, then the asset should be removed from the balance sheet, and this would be referred to as ‘derecognition’ of the asset. Derecognition is defined in the IASB Conceptual Framework as ‘the removal of all or part of a recognised asset or liability from an entity’s statement of financial position’. So, in summarising this discussion, we know that for an item to be included within the balance sheet as an ‘asset’: • it must satisfy the definition of an asset (meaning it must be controlled by the entity as a result of a past transaction or event and it must have the potential to generate future economic benefits) • information about the asset must be capable of providing information that is considered as relevant and representationally faithful. 313
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We summarise the conditions necessary for the recognition of assets in Figure 7.6. It needs to be understood that all four of the initial steps identified in Figure 7.6 must be met before an asset is recognised. That is, if one of the requirements is missing, then the item should not be FIGURE 7.6 Conditions to be satisfied before an asset should be recognised for financial accounting purposes Is the item capable of generating future economic benefits that will flow to the entity?
NO
YES Does the organisation control the item as a result of some past events?
NO
YES Is information about the asset considered likely to be relevant to readers of financial statements (which requires accountants to consider factors such as potential existence uncertainty as well as probabilities associated with the expected inflows of economic benefits)?
NO
YES Is information about the asset considered likely to faithfully represent information about the expected future flows of economic benefits to be generated by the asset (which requires accountants to consider issues such as measurement uncertainty)? YES Item will appear as an asset in the balance sheet
Need to measure the amount to be assigned to the asset
Need to determine how information about the asset shall be presented to stakeholders
314
NO
Item will not appear in the balance sheet
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considered to be an asset, and therefore it should not appear within the balance sheet. It should also be emphasised that an asset does not have to have physical form. An asset might have no physical form, but still be recognised. These assets would be intangible assets, and would include such items as copyrights, goodwill, patents or brand names.
REFLECTION QUESTION 7.4 The decision to recognise an asset (or not) Sandy Bay Company acquired the rights to produce a certain product. Sandy Bay Company paid $2 750 000 for these production rights, which could be considered to be an intangible asset. The accountants of Sandy Bay Company initially recognised the asset in Sandy Bay Company’s balance sheet. However, the managers of Sandy Bay Company now have a high degree of uncertainty about whether there is any market for the related product when it is produced, and even if there are some sales, which they think probably will occur, they are very uncertain about the price that people would actually be prepared to pay to purchase the product. The managers, however, are confident that they do have the proper legal rights to produce the product. Question You are required to advise the managers of Sandy Bay Company about whether they should continue to recognise the production rights as an asset in their balance sheet. They also want to know the implications for the financial statements if a professional judgement is made that they should no longer recognise the asset. Solution As we know, the first thing to consider is the requirement within the IASB Conceptual Framework that only items that meet the definition of an asset, a liability or equity, are recognised in the balance sheet. If we consider the production rights, and the definition of an asset, then it would seem that the production rights do satisfy the definition of an asset. Specifically: • An asset is a resource controlled by the entity. The organisation does seem to be able to control the use of the production rights, so this condition is satisfied. • An asset exists as a result of past events. Sandy Bay Company has already acquired the production rights, so this condition is therefore satisfied. • An asset exists where the organisation has a right that has the potential to produce economic benefits for the entity. The expectation is that some products will be sold, and therefore economic benefits generated, so this condition appears to be met.
Reflection
Therefore, the production rights do seem to satisfy the definition of an asset. As we know, however, not all items that meet the definition of one of the elements of financial accounting are to be recognised within the financial statements. To recognise the asset, accountants then need to make the judgement that the disclosure of the asset will provide information that is both relevant and representationally faithful. Two factors to consider in determining whether the disclosure of information about an asset would be relevant to financial statement users are: 1 existence uncertainty 2 probability associated with the expected inflow of economic benefits. Sandy Bay Company seems to have a clear legal right to use the production rights, so there appears to be little or no existence uncertainty. Sandy Bay Company, however, has a high degree of uncertainty pertaining to the probability associated with the expected inflow of economic benefits. Therefore, the information about the production rights might not be very relevant and therefore useful to the users of the financial statements. In relation to the issue of faithful representation, one factor that we have already identified is measurement uncertainty. The higher the level of measurement uncertainty, the less able accountants are to provide a measurement that faithfully represents the value of the asset. In this case, there does seem to be significant uncertainty in relation to the monetary amounts that will be generated from the production rights. As a result of the high level of measurement uncertainty (which undermines the faithful representation of the asset, and therefore the usefulness of the information), and the uncertainties pertaining to the probability associated with the expected inflow of economic benefits (which undermines the relevance of information about an asset and therefore the usefulness of the information), it would appear inappropriate to recognise the production rights as an asset in the balance sheet of Sandy Bay Company. The asset should be removed from the balance sheet. This is referred to as ‘derecognition’. To remove the asset, an expense will be recognised, which decreases equity.
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Definition and recognition of liabilities Liabilities represent the financial claims against the organisation held by individuals, and organisations, other than by the owners of the organisation in their capacity as owners. Liabilities arise from activities such as borrowing funds, acquiring inventory on credit or incurring other expenses without yet paying for them. Within the IASB Conceptual Framework, a liability is defined as: a present obligation of the entity to transfer an economic resource as a result of past events.
The above definition of liability refers to an ‘obligation’. An ‘obligation’ is defined in the IASB Conceptual Framework as: a duty or responsibility that the entity has no practical ability to avoid.
An obligation would be expected to be satisfied at some time in the future. From the above definition of a liability we can see that – as with assets – there are three separate components to this definition, these being: 1 a liability represents a present obligation of the entity 2 it arises from past events 3 it creates an obligation to transfer economic resources away from the entity. Let us consider each of these three components separately.
Present obligation For a liability to be recognised and reported within the financial statements, the obligation must currently be in existence, and therefore not be contingent upon some future event. A liability exists when, at a given point in time, an organisation effectively has no reasonable alternative other than to settle the obligation at a future date. The present obligation must be to another entity or individual that is external to the organisation. The definition of a liability therefore requires the participation of two separate entities, these being the reporting entity and an outside entity to which the obligation is owed.
Past event The event that creates the obligation must have occurred. For example, if an organisation has placed an order for some inventory, but the inventory has not actually been placed in the control of the organisation, then an obligation to pay for the inventory would typically not be recognised.
Outflow from the entity of resources embodying economic benefits For a liability to be recognised, the organisation has an obligation to ultimately transfer something that has value. That is, it has a responsibility to give up something that constitutes ‘economic benefits’. This outflow of economic benefits does not have to be only in the form of cash. For example, if an organisation has an obligation to transfer some other asset, other than cash, in order to settle an obligation, then that obligation would still constitute a liability. The definition of a liability does not restrict ‘liabilities’ to situations where there is a legal obligation. Liabilities should also be recognised in certain situations where equity or usual business practice dictates that obligations to external parties currently exist. Hence, the liabilities that appear within an entity’s balance sheet might include obligations that are legally enforceable as well as obligations that are deemed to be equitable or constructive. When determining whether a liability exists, the intentions or actions of management need to be
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taken into account. That is, the actions or representations of the entity’s management or governing body, or changes in the economic environment, directly influence the reasonable expectations or actions of those outside the entity and, although they might have no legal entitlement, they might have other sanctions that leave the entity with no realistic alternative but to make certain future sacrifices of economic benefits. Such present obligations are sometimes called ‘equitable obligations’ or ‘constructive obligations’. An equitable obligation is governed by social or moral sanctions or custom rather than legal sanctions. A constructive obligation is created, inferred or construed from the facts in a particular situation rather than contracted by agreement with another entity or imposed by government. Determining whether an equitable or a constructive obligation exists, and therefore whether a liability should be recognised in the balance sheet (the statement of financial position), is often more difficult than identifying a legal obligation, and in most cases, judgement is required to determine if an equitable or a constructive obligation exists. One consideration is whether the entity has any realistic alternative to making the future sacrifice of economic benefits. If the situation implies that there is no discretion, then a liability would be recognised. In cases where the entity retains discretion to avoid making any future sacrifice of economic benefits, a liability does not exist and is not recognised. It follows that a decision of the entity’s management or governing body, of itself, is not sufficient for the recognition of a liability. Such a decision does not mark the inception of a present obligation since, in the absence of something more, the entity retains the ability to reverse the decision and thereby avoid the future sacrifice of economic benefits. For example, an entity’s management or governing body may resolve that the entity will offer to repair a defect it has recently discovered in one of its products, even though the nature of the defect is such that the purchasers of the product would not expect the entity to do so. Until the entity makes public that offer, or commits itself in some other way to making the repairs, there is no present obligation, constructive or otherwise, beyond that of satisfying the existing statutory and contractual rights of customers.
Recognition of liabilities Apart from satisfying the definition of a liability, the recognition of a liability, just as with assets, is linked to professional judgements about whether the information to be disclosed would be relevant to the readers of the financial statements, and whether the information to be disclosed would faithfully represent the underlying obligation.
Relevance As we have already learned from our discussion of assets, two important factors to consider when assessing relevance include: 1 existence uncertainty 2 assessments about the probabilities of an outflow of economic benefits. For a liability to be recognised in the financial statements, it needs to be reasonably apparent that an obligation to an external party exists. This will be based on available facts. If there is clearly little option for the reporting entity to avoid making a future transfer of economic benefits to another party, then the level of existence uncertainty might be considered to be low, and the recognition of a liability would, subject to other criteria, be expected. Conversely, if the level of existence uncertainty is high, then it might be inappropriate to recognise the liability in the financial statements. As an example of a situation where there might be a high level of existence uncertainty, we could consider an organisation that has been informed that it is being taken to court for some alleged wrongdoing. Before the court case is held, it might be very uncertain that a financial
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obligation exists, and therefore it might be inappropriate to recognise a liability. As the IASB Conceptual Framework notes (paragraph 4.35): In some cases, it is uncertain whether an obligation exists. For example, if another party is seeking compensation for an entity’s alleged act of wrongdoing, it might be uncertain whether the act occurred, whether the entity committed it or how the law applies. Until that existence uncertainty is resolved – for example, by a court ruling – it is uncertain whether the entity has an obligation to the party seeking compensation and, consequently, whether a liability exists.
In relation to considerations relating to the perceived probability of future outflows of economic benefits, the greater the uncertainties in terms of predicting the likelihood of future cash flows occurring, the less relevant would be the disclosure of information about a liability. For example, if an organisation has broken a particular law in terms of how it should be operating its business, but the managers are completely unable to determine the probability associated with whether they will have to pay a penalty, then no liability for the non-compliance should be recognised pursuant to the IASB Conceptual Framework.
Faithful representation As we also know, another factor to consider when determining whether to recognise an asset, or a liability, is measurement uncertainty. If there is a high level of uncertainty with regard to the amount of future cash outflows likely to occur in relation to a particular liability – meaning that a faithful representation of the liability is potentially not possible – then it might be inappropriate to recognise the liability in the financial statements. For example, and using the example provided in the above paragraph, if the organisation knows that it will be prosecuted for failure to comply with particular laws, but managers are unable to reasonably determine the magnitude of the future fine even within broad ranges of possible outcomes, then because of the high level of ‘measurement uncertainty’, no liability would be recognised. Therefore, various factors associated with both the ‘probability of an outflow of economic benefits’ and ‘measurement uncertainty’ require consideration when determining whether to recognise a liability (as they also do with the other elements of accounting). Since the recognition of liabilities relies upon professional judgements about the probability and measurability of expected future cash flows, this means that, as with the other elements of financial accounting, some managers and their accountants might utilise claims about potential difficulties, or uncertainties, associated with assessing probabilities and reliable measurements as an ‘excuse’ not to recognise liabilities. That is, they may be ‘creative’ in their assessment of whether a liability should be recognised and disclosed within the financial statements. Because professional judgement is involved, it can at times be difficult for other people to determine whether any failure to recognise liabilities is actually justified, or not. Within Australia, Ji and Deegan (2011) investigated instances where managers and their accountants might have opportunistically relied upon apparent difficulties in determining reliable measurements of liabilities as a justification for not recognising liabilities. Through an analysis of various sources of information, Ji and Deegan (2011) identified a number of significant and severely environmentally contaminated sites that were controlled by Australian companies, and for which the respective organisations were under a clear legal obligation to remove the contamination and remediate the land. In many cases, the expected obligations associated with cleaning and remediating the sites were tens or hundreds of millions of dollars.
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Once companies were identified as having significant legal obligations (liabilities) to clean and remediate contaminated sites, Ji and Deegan (2011) then reviewed the respective companies’ financial statements to see whether the liabilities were actually recognised within the balance sheet. Overwhelmingly, the authors found that the companies failed to recognise the liabilities in the balance sheet, with the companies noting that they did not recognise the liabilities mainly because they felt they were unable to determine a reliable measurement for the future payments. Ji and Deegan (2011) were of the opinion that the companies were potentially using the claims about ‘measurement uncertainty’ as an excuse not to recognise the liabilities, and the authors questioned the credibility of the claims and arguments that the companies could not reasonably calculate a fairly reliable measure of the costs associated with fixing up the contaminated land. There is a general belief that managers, when given a choice, would prefer not to disclose liabilities in the financial statements, as the greater the reported liabilities, the greater the perceived financial risk that is often associated with an organisation. There are also various contractual reasons why managers could prefer not to recognise liabilities, and we address these reasons in Chapter 8. The results of the analysis in Ji and Deegan (2011) were very similar to the results of research into Canadian and US mining companies reported some years earlier by Repetto (2004), thereby indicating that internationally some managers and their accountants potentially use issues associated with ‘measurement uncertainty’ and ‘low probabilities of outflows of economic benefits’ as factors to justify the non-recognition of liabilities. So, the point of this discussion is that we need to be careful when relying upon balance sheets as it is always possible that certain liabilities have been omitted that arguably should have been recognised. The authors referred to above believed that they had justification for questioning why certain liabilities were not being recognised within the financial statements. We summarise the conditions necessary for the recognition of liabilities in Figure 7.7.
REFLECTION QUESTION 7.5 Determining whether to recognise a liability The managers of an organisation have committed to the following future cash flows: • The managers have agreed to undertake a full overhaul of the organisation’s machinery in 12 months’ time at an expected cost of $2 500 000. • The organisation acquired some machinery at a cost of $3 000 000 and has committed to paying for the machinery in 12 months’ time. Question Which of the above transactions or events could be considered to be a liability pursuant to the IASB Conceptual Framework?
Reflection
Solution Because the overhaul of the machinery does not represent an obligation to another (external) party, this is not a liability. The commitment to pay for the machinery, however, satisfies the definition of a liability because it represents a present obligation to transfer economic resources to another organisation as a result of a past transaction or event. It would also appear to satisfy the requirements in relation to relevance and faithful representation because there is no apparent existence uncertainty and the probability of an outflow of economic benefits appears high and there is limited measurement uncertainty.
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FIGURE 7.7 Conditions to be satisfied before a liability should be recognised for financial accounting purposes Does the organisation have a present obligation to transfer economic benefits to an outside entity as a result of a past transaction or event?
NO
YES Is it true that the organisation has no practical ability to avoid the obligation?
NO
YES Is information about the liability considered likely to be relevant to readers of financial statements (which requires accountants to consider factors such as potential ‘existence uncertainty’ as well as ‘probabilities associated with the expected outflows of economic benefits’)?
NO
YES Is information about the liability considered likely to faithfully represent information about the expected future outflows of economic benefits to be generated by the liability (which requires accountants to consider issues such as ‘measurement uncertainty’)? YES Item shall appear as a liability in the balance sheet
Need to measure the amount to be assigned to the liability
Need to determine how information about the liability shall be presented to stakeholders
320
NO
Item does not appear in the balance sheet
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Definition and recognition of expenses The definition of expenses is dependent upon the definitions given to assets and liabilities. This reflects the view provided earlier that the IASB Conceptual Framework adopts an asset/ liability approach to determining income and expenses, and therefore profits. Within the IASB Conceptual Framework, expenses are defined (paragraph 4.69) as follows: Expenses are decreases in assets, or increases in liabilities, that result in decreases in equity, other than those relating to distributions to holders of equity claims.
There are therefore two essential characteristics of expenses, these being: 1 a decrease in assets, or an increase in liabilities 2 a resulting decrease in equity, other than as a result of distributions to owners.
What the above definition of expenses indicates is that unless we understand what assets and liabilities represent, we will not be able to understand what an ‘expense’ is. As we have already stressed, pursuant to the IASB Conceptual Framework the recognition of an expense is directly dependent upon the recognition of a change (decrease) in assets and/or a change (increase) in liabilities. We know that the definition of an asset relies upon the reporting entity having ‘control’ over the resource. If a resource is used up or damaged by an entity, but that entity does not control the resource – that is, it is not an ‘asset’ of the entity – then to the extent that no liabilities or fines are imposed, no expenses will be recorded by the entity. For example, if an entity pollutes the environment but incurs no related fines, no expense will be acknowledged because ‘the environment’ is not controlled by the entity. This issue is examined further later in this chapter. It is also addressed in Chapter 10. The point to be made here is that ‘profitable companies’ might nevertheless be creating significant and unrecognised social and environmental damage.
Definition and recognition of income As with expenses, the definition of income is dependent upon the definitions given to assets and liabilities. The Conceptual Framework (paragraph 4.68) defines income as: increases in assets, or decreases in liabilities, that result in increases in equity, other than those relating to contributions from holders of equity claims.
Income can therefore be considered to relate to transactions or events that cause an increase in the net assets of the reporting entity (net assets represent assets less liabilities), other than increases in net assets that arise as a result of owner contributions. The recognition of income is directly dependent upon the recognition of a change (increase) in assets and/or a change (decrease) in liabilities. As we can see from the definition provided above, to qualify as income or expenses, the changes in assets or liabilities must have the effect of changing equity. Equity changes because of either income or expenses, or through contributions from, or distributions to, owners. That is:
Equity end of period = E quity beginning of period + (Income − Expenses) + Contributions − Distributions Therefore, transactions such as the purchase of assets, or the issuance of debt, are not considered ‘income’ because they do not result in an increase in equity. Looking at the above formula, the acquisition of an asset is not income. For example, purchasing assets with cash simply involves substituting one asset for another and does not impact equity. Similarly, borrowing cash leads to an increase in assets (cash), and an increase in liabilities, with no direct effect on equity. The Conceptual Framework does not include ‘profit’ (or ‘loss’) as one of the elements of financial accounting. As we know, the five elements are assets, liabilities, income, expenses and equity. Profit is simply the difference between income and expenses, both of which are defined, and hence there is no need for separate recognition criteria for ‘profits’. Figure 7.8 summarises some of the rules pertaining to income and expense recognition. 321
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FIGURE 7.8 The recognition of income and expenses INCOME
EXPENSES
To satisfy the definition of income, has there been an increase in assets or a decrease in liabilities during the accounting period, other than those relating to contributions from equity participants?
To satisfy the definition of expenses, has there been a decrease in assets or an increase in liabilities, other than those relating to distribution to equity participants?
NO
YES
YES
YES Is the probability of the related inflow of economic benefits low?
Is the probability of the related outflow of economic benefits low?
NO
YES
NO
YES
NO
Is the measurement of the related inflow of economic benefits subject to high measurement uncertainty?
Is the measurement of the related outflow of economic benefits subject to high measurement uncertainty?
NO
YES
NO Recognised in income statement
Not recognised in income statement
REFLECTION QUESTION 7.6 Classifying a resource flow as an expense Taroona Ltd has just made the following payments: • $2 million in dividends paid to investors • $2 million in wages paid to employees. Question Are the above two payments ‘expenses’ as defined by the IASB Conceptual Framework? Solution As we know, there are two essential characteristics of expenses, these being: 1 a decrease in assets, or an increase in liabilities 2 a resulting decrease in equity, other than as a result of distributions to owners. Both of the above payments represent a decrease in assets (cash at bank). Therefore, they satisfy the first essential characteristic of a liability. However, the payment to investors
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represents a distribution of profits to owners, and therefore would not meet the second essential characteristic of an expense. By contrast, the payment to employees would be an expense which ultimately decreases profits. As we know, measures of financial performance, such as ‘profits’, are something that managers, and investors, typically want to have maximised. Therefore, while payments to owners (dividends) would ideally be high, payments to employees/ workers (wages) would typically be minimised to the extent possible. As critical thinkers, a point to consider here is that organisations require various factors of production (a factor of production is an economic term to describe the inputs used to produce goods and services in order to generate profits). For example, organisations require financial capital (perhaps as
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contributed by shareholders) and organisations also require labour capital (provided by employees). While it is an accepted part of how capitalist societies operate, it is nevertheless interesting to ponder why we have a system – and one that has existed for hundreds of years – that seeks to maximise the payments to one group of factor of production providers (investors), while at the same time trying to minimise the payments to a different group of factor of production providers (employees). That is, why do we have a system of accounting
that directly prioritises the interests of one group of resource providers over another group of resource providers given that both sources of capital (financial and labour) are necessary to operate an organisation? This may appear somewhat of a rhetorical question, but hopefully it stimulates some thought about how financial accounting rules can influence how organisations deal with some stakeholders relative to others. We further consider issues such as this in Chapter 13 when we address critical theories of accounting.
Definition of equity Paragraph 4.63 of the Conceptual Framework defines equity as: the residual interest in the assets of the entity after deducting all its liabilities.
That is:
Equity = Assets − Liabilities The residual interest is a claim or right to the net assets of the reporting entity held by the owners of an organisation. As a residual interest, equity ranks after liabilities in terms of a claim against the assets of a reporting entity. Consistent with the definitions of income and expenses, the definition of equity is directly a function of the definitions of assets and liabilities. Given that equity represents a residual interest in the assets of an entity, the amount disclosed as equity will correspond with the difference between the amounts assigned to assets and liabilities. As such, the criteria for the recognition of assets and liabilities, in turn, directly govern the recognition of equity. Therefore, there is no need for a separate recognition criterion for equity. For a summary of the definitions of the elements of financial accounting, see Figure 7.9. Again, note how the definition of income, expenses and equity is directly related to the definition of assets and liabilities. FIGURE 7.9 Summary of the elements of financial accounting Element
Definition
Reported within
Asset
A present economic resource controlled by the entity as a result of past events
The balance sheet (also known as the statement of financial position)
Liability
A present obligation of the entity to transfer an economic resource as a result of past events
The balance sheet
Equity
The residual interest in the assets of the entity after deducting all of its liabilities
The balance sheet
Income
Increases in assets, or decreases of liabilities, that result in increases in equity, other than those relating to contributions from holders of equity claims
The income statement (also known as the statement of profit or loss)
Expense
Decreases in assets, or increases in liabilities, that result in decreases in equity, other than those relating to distributions to holders of equity claims
The income statement
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Why do I need to know about the definitions and recognition criteria for the elements of financial accounting? Why
If we do not understand the definitions and recognition criteria, then we will not really understand what the reported financial performance and financial position of an organisation actually represents. For example, as a result of knowing the definitions of the elements of financial accounting, we know that certain aspects of organisational performance will not be reflected within reported profits. For instance, certain impacts on the environment will not be reflected within profits, perhaps because the negative impacts relate to resources that are not ‘controlled’ by the organisation, and which therefore are not recognised for financial reporting purposes.
LO7.3
LO7.5
We would therefore know that ‘profits’ is a somewhat incomplete measure of overall organisational ‘performance’. As another example, if we have knowledge of the definitions and recognition criteria of the elements of financial accounting, then we will also know that certain resources that are important to an organisation will not appear in the balance sheet if they are not ‘controlled’. We will also know that if there is significant doubt about the relevance, or faithful representation, of the information pertaining to an underlying item then it shall remain unrecognised from a financial reporting perspective.
Measurement principles
As we have already indicated, once we have decided that a liability or asset should be recognised within the financial statements, we then need to determine how to measure it. For financial reporting purposes, measurement refers to the process of determining the amounts to be included in the financial statements. Applying a measurement basis to an asset or a liability also creates a basis for measuring any related income or expense. Conceptual frameworks have tended to provide very limited prescription in relation to measurement issues. Assets and liabilities are often measured in a variety of ways depending upon the class of assets or liabilities being considered. Given the way income and expenses are defined, which relies upon measures attributed to assets and liabilities, this has direct implications for reported profits. For example, liabilities are frequently recorded at present value, face value or on some other basis, depending upon the type of liability in question. Assets are also measured in various ways – for example, pursuant to various financial reporting standards, inventory is to be measured at the lower of cost and net realisable value; some non-current assets, such as property, plant and equipment, can be measured at historical cost less accumulated depreciation or can also be measured at fair value; while other assets, such as financial assets, are to be measured at fair value. The multiplicity of measurement principles currently in use has resulted in accountants using what is often referred to as a ‘mixed attribute accounting model’. As we know, the IASB and the FASB were engaged for a number of years in joint efforts to develop a new conceptual framework. In relation to measurement, the FASB and IASB (2005, p. 12) stated: Measurement is one of the most underdeveloped areas of the two frameworks . . . Both frameworks (the IASB and FASB Frameworks) contain lists of measurement attributes used in practice. The lists are broadly consistent, comprising historical cost, current cost, gross or net realizable (settlement) value, current market value, and present value of expected future cash flows. Both frameworks indicate that use of different measurement attributes is expected to continue. However, neither provides guidance on how to choose between the listed measurement attributes or consider other theoretical possibilities. In other words, the frameworks lack fully developed measurement concepts . . . The long-standing unresolved controversy about which measurement attribute to adopt – particularly between historical-price and current-price measures – and the unresolved puzzle of unit of account are likely to make measurement one of the most challenging parts of this project. 324
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When the IASB then released its Discussion Paper – A Review of the Conceptual Framework for Financial Reporting, it stated (2013, p. 112): Consideration of the objective of financial reporting, and of the qualitative characteristics of useful financial information, has led the IASB to the following views about measurement: (a) the objective of measurement is to contribute to the faithful representation of relevant information about the resources of the entity, claims against the entity and changes in resources and claims, and about how efficiently and effectively the entity’s management and governing board have discharged their responsibilities to use the entity’s resources (b) a single measurement basis for all assets and liabilities may not provide the most relevant information for users of financial statements (c) when selecting the measurement to use for a particular item, the IASB should consider what information that measurement will produce in both the statement of financial position and the statement(s) of profit or loss and other comprehensive income (d) the selection of a measurement: (i) For a particular asset should depend on how that asset contributes to future cash flows; and For a particular liability should depend on how the entity will settle or (ii) fulfil that liability the number of different measurements used should be the smallest number (e) necessary to provide relevant information. Unnecessary measurement changes should be avoided, and necessary measurement changes should be explained (f) the benefits of a particular measurement to users of financial statements need to be sufficient to justify the cost.
The IASB Conceptual Framework, when it was revised and released in 2018, grouped existing measurement bases into two broad categories, these being: 1 historical cost 2 current value. Consistent with previous Exposure Drafts, the 2018 IASB Conceptual Framework and subsequent revisions did not stipulate one basis of measurement for all assets and liabilities. Instead, the Conceptual Framework notes that the selection should be based on which measurement basis provides the most ‘useful’ information to the readers of the financial statements. Paragraph 7.2 of the IASB Conceptual Framework states: Consideration of the qualitative characteristics of useful financial information and of the cost constraint is likely to result in the selection of different measurement bases for different assets, liabilities, income and expenses.
As we noted above, measurement bases can be broadly divided into either historical cost or current value. Current value measurement basis can be further classified into: • fair value • value in use (for assets), or fulfilment value (for liabilities) • current cost. Table 7.1 provides further information about these different measurement bases.
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TABLE 7.1 A description of different bases of measurement Measurement bases
Historical cost
Current value Fair value
Carrying amount determined by:
The cost of the transaction that gave rise to the asset or liability. Includes transaction costs.
Value in use/fulfilment value
The price that would be received to sell an asset, or paid to transfer a liability, in an orderly transaction betweenmarketparticipants at the measurement date.
Reflects entity-specific current expectations about the amount, timing and uncertainty of future cash flows. The present value of transaction costs are deducted.
It reflects market participants’ current expectations about the amount, timing and uncertainty of future cash flows. Transaction costs that would arise on disposal are not deducted
Value in use relates to the present value of the cash flows, or other economic benefits, that an entity expects to derive from the use of an asset and from its ultimate disposal. Fulfilment value is the present value of the cash, or other economic resources, that an entity expects to be obliged to transfer to satisfy a liability.
Current cost Reflects the current amount that would be paid to buy an equivalent asset, or received to take on an equivalent liability. Includes transaction costs.
Are transaction costs included?
Yes
No
No
Yes
The measurement is updated:
To recognise use/consumption of the asset
To reflect changes in measurementsinceprevious measurement date
To reflect changes in measurement since previous measurement date
To reflect changes in measurement since previous measurement date
Does measurement reflect entry or exit value?
Entry
Exit
Exit
Entry
As the above material indicates, the IASB Conceptual Framework does not stipulate that one basis of measurement should be used for all assets or for all liabilities. Therefore, in relation to assets, this means that some assets might be measured at cost, some assets might be measured at their present value and some assets might be measured at their fair value. Therefore, we can be left to question what the amount ultimately attributed to ‘total assets’ for a reporting entity actually equates to, given that it represents the addition of different types of assets that have been measured on different bases.
Why do I need to know about how assets and liabilities are measured for the purpose of general purpose financial reporting? Why
A number attributed to an asset or liability will make sense only if we know the basis on which that number has been determined. For example, the decisions we make in relation to the assets of an organisation might be very different if those assets are measured using historical cost or fair value. Also, the income and expenses to be recognised by an organisation
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are directly influenced by the way assets and liabilities are measured; therefore, some knowledge of the measurement bases being used allows a user of financial statements to better understand the context within which ‘profits’ have been calculated.
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Pros and cons associated with having a conceptual framework LO7.4
LO7.6
LO7.7
Some of the perceived advantages of having a conceptual framework for financial reporting include: 1 With a well-formulated conceptual framework, there is an expectation from various stakeholders, such as standard-setters, that information will be generated that is of more relevance to financial statements users, as well as being more representationally faithful. This in turn should flow through to create greater confidence within capital markets. 2 Developing a conceptual framework effectively forces accountants and standard-setters to think about what they are doing and why they are doing it. 3 Financial reporting standards should be more consistent and logical because they are developed from an orderly set of concepts. That is, the financial reporting standards will be developed on the basis of agreed principles. The view is that in the absence of a coherent theory, the development of financial reporting standards could be somewhat ad hoc. As the FASB and IASB (2005, p. 1) stated: To be principles-based, standards cannot be a collection of conventions but rather must be rooted in fundamental concepts. For standards on various issues to result in coherent financial accounting and reporting, the fundamental concepts need to constitute a framework that is sound, comprehensive, and internally consistent. 4 The standard-setters should be more accountable for their decisions because the thinking
behind specific requirements should be more explicit, as should any departures from the concepts that may be included in particular financial reporting standards. 5 The process of communication between the standard-setters and their constituents should be enhanced because the conceptual underpinnings of proposed financial reporting standards will be more apparent when the standard-setters seek public comment on them. Preparers and auditors will have a better understanding of why they are reporting/auditing. There is also a perspective that having a conceptual framework should alleviate some of the political pressure that might otherwise be exerted when financial reporting standards are being developed – the conceptual framework could, in a sense, provide a defence against political attack. 6 The development of financial reporting standards should be more economical because the concepts developed will guide the standard-setters in their decision making. 7 Where accounting concepts cover a particular issue, there might be a reduced need for developing additional financial reporting standards. Having considered some possible advantages of conceptual frameworks we can now consider some possible disadvantages or criticisms of conceptual frameworks. These include: 1 the IASB Conceptual Framework adopts a very restricted view of accountability 2 detailed conceptual frameworks stifle future reporting innovation 3 financial performance as depicted within the IASB Conceptual Framework provides a potentially distorted view of an organisation’s ‘performance’ 4 the Conceptual Framework simply reflects existing accounting practice 5 conceptual frameworks are used as a means of legitimising accounting standard setters and the accounting profession. We now consider each of these criticisms separately.
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A restricted view of accountability As we know, according to the IASB Conceptual Framework, the primary audience of general purpose financial reports is deemed to be existing and potential investors, lenders and other creditors. An individual’s view of an organisation’s responsibilities directly impacts their perceptions of organisational accountability. Those responsible for developing the IASB Conceptual Framework appear to take a restricted view of the accountabilities of business, given the restricted nature of the ‘primary audience’ of financial statements. By contrast, The Corporate Report (issued in 1975 by the Accounting Standards Steering Committee of the Institute of Chartered Accountants in England and Wales) provides what appears to be a much broader view of who should be perceived as a ‘user’ of financial statements. The Corporate Report considered the ‘public’ as a key audience of corporate financial reports. In this regard, the report states (paragraph 25): The public’s right to information arises not from a direct financial or human relationship with the reporting entity but from the general role played in our society by economic entities. Such organisations, which exist with the general consent of the community, are afforded special legal and operational privileges, they compete for resources of manpower, materials and energy and they make use of community owned assets such as roads and harbours.
The view taken within The Corporate Report was that as larger organisations within society create a variety of economic, social and environmental impacts, this means that they have an accountability for their financial performance and financial position to a broad group of stakeholders beyond investors, lenders and creditors. That is, this alternative view is that organisations have an accountability to stakeholders beyond those stakeholders with an existing, or potential, financial stake in the organisation.
REFLECTION QUESTION 7.7 Reflection Accountability as embraced within the IASB Conceptual Framework Question • to whom an organisation is accountable (that is, who are
What is ‘accountability’ and does the IASB Conceptual Framework embrace a limited perspective of accountability in relation to the users and objectives of general purpose financial reporting? Solution In Chapter 2 of this book, we provided the following definition of accountability (from Gray, Adams and Owen (2014, p. 50): ‘The duty to provide an account or reckoning of those actions for which one is held responsible.’ We also provided other definitions of accountability that are consistent with the above definition. As we explained in Chapter 2, an exploration of organisational accountability requires consideration of:
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the stakeholders?)
• for what aspects of performance the organisation is accountable
• how that organisation’s accountability is best demonstrated to the identified stakeholders. Because the IASB embraces a perspective that 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’, then this would represent a narrow view of corporate accountability which does not directly consider the interests of other stakeholders within society who do not have a direct financial interest in the organisation.
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Stifle future reporting innovation Some researchers have argued that developing extensive guidance, such as large-scale conceptual frameworks in a ‘one-size-fits-all’ manner, tends to stifle needed innovation. In this respect, Ball (2016, p. 556) states: Competition among alternative economic systems, including financial reporting systems, is conducive to healthy innovation…. In my view, adopting uniform worldwide standards invites risky centralization and reduced innovation.
Ball (2016, p. 557) also suggests that the existence of a conceptual framework for financial reporting could tend to counter needed changes as environments and societies change: A conceptual framework is a Hayekian (1988) conceit, a delusion, and a snare. It is a conceit because the world is complex and untidy, and not organized by a small set of ideas like a conceptual framework… Does (say) the worldwide automobile industry need a centralized planning document to design and make vehicles that buyers of different types find useful? Do law, medicine, engineering, and other professions (begging the question of whether accounting still can be described as a profession) have universal conceptual frameworks? A conceptual framework in accounting also has proven to be a delusion, despite attempts over at least half a century to prove otherwise…. A conceptual framework can prove to be a snare, because it can incent the planner that adopts – and becomes deeply committed to it – to ignore evidence of its unintentional consequences. No planner’s framework is fool proof. None can anticipate all the future events it will be required to address, and as a consequence solutions that would seem optimal under the circumstances can be blocked due to their inconsistency with the framework.
It is an interesting argument that the introduction of rules and regulations then stifles innovation. As Deegan and Shelly (2014) note, this is an argument that many business organisations and industry bodies often raise in opposition to the potential introduction of new laws and regulations.
A potentially distorted view of an organisation’s ‘performance’ A central role of financial accounting is to calculate the ‘profit’ or ‘loss’ of an organisation (as well as identifying items of ‘other comprehensive income’). As we are aware from media reports, profits and losses often appear to be used as an indicator of the ‘success’ or ‘failure’ of an organisation. However, there are many gains, and costs, that relate to an organisation’s activities that do not appear within financial statements and are not incorporated in the measurement we refer to as profits, or total comprehensive income. The increases in the financial value of many assets do not appear in the financial statements. As we learned in Chapter 6, accounting standards provide organisations with a choice between using cost or fair value to measure their property, plant and equipment. If the cost model is used, then any gains in fair value will not be recognised and therefore the gains in fair value will not be included within other comprehensive income. Further, most internally developed intangible assets are prohibited from being recognised within general purpose financial reports, despite the value they might create for an organisation. There is also a general prohibition on the revaluation of acquired intangible assets (unless an ‘active market’ exists for them, and this is uncommon for intangible assets). Therefore, the gains in the value of intangible assets will also be ignored within financial accounting.
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However, while gains, such as those mentioned above, might be of relevance to many users of financial statements, arguably of more concern to many people is the manner in which financial accounting treats the social and environmental impacts created by organisations. Generally speaking, financial accounting ignores most of the social and environmental impacts caused by organisations, despite the potential severity of some of these impacts. As we have noted a number of times, from a financial accounting perspective, expenses are defined as: decreases in assets, or increases in liabilities, that result in decreases in equity, other than those relating to distributions to holders of equity claims.
To understand the meaning of ‘expenses’, we need to understand the meanings of ‘assets’ and ‘liabilities’. From a financial accounting perspective, we know that assets are defined as: a present economic resource controlled by the entity as a result of past events.
The establishment of ‘control’ is therefore central to the recognition of an asset. If a resource is not controlled (for example, air, oceans and waterways, and an organisation’s workforce are not controlled), then that resource is excluded from asset recognition, and therefore will not appear within the balance sheet. If the resource is not recognised as an asset, then any decrease in value, or damage or harm done to that resource, will not be recognised as an expense of the organisation. That is, any diminution in the non-controlled resource’s value or quality, such as pollution’s adverse effect on air quality, will not be recognised as an expense of the organisation. Let us consider some examples of some negative social and environmental impacts an organisation’s activities might create, but which (unfortunately) will be ignored by financial accounting practices. In recent years, many companies in the clothing industry have been criticised for acquiring their products from factories in developing countries where the work environment is unhealthy and unsafe for workers. In developing countries like Bangladesh, thousands of people involved in manufacturing clothing for international companies have died as a result of building collapses and factory fires, which in turn have been blamed on poor health and safety policies being utilised within the factories. It is generally believed that large multinational companies buy their products from developing countries because they can obtain reasonable quality products at very low prices. These low prices mean the cost of sales of the multinational companies is low, and reported profits are higher than might otherwise be the case (thereby increasing the potential distributions to shareholders). But how does the death and injury of many workers associated with their production impact profits? The answer is that the death and injury of workers does not impact reported profits. As we know, our simple accounting equation is:
Assets = Liabilities + Equity Because the dead and injured workers are not assets from a financial accounting perspective (they are not controlled), then reported assets will not be decreased. Consequently, to balance our accounting equation – which is the cornerstone of financial accounting – equity also cannot be decreased, otherwise our accounting equation will not balance, and to financial accountants this would clearly not make sense (but, of course, how we, as financial accountants, could ignore such costs associated with the death and injury of workers might not make sense to non-accountants). Organisations often decide to reduce their expenses by replacing people within their workforce with some form of modern automated technology. This tends to increase accounting profits, because the related machinery and technology are cheaper to run than the salaries and wages that might otherwise have been paid to the employees and machines can be run for longer hours. But how are the ‘social costs’ relating to the sacked workers accounted for? Simply stated, these social costs are also ignored by financial accounting. These ignored social costs include 330
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the hardship created for employees and their families, particularly for those employees who are unable to find new jobs. Obviously, such costs are extremely difficult to measure, but it is nevertheless the case that they are completely overlooked by financial accounting. The news media often seem to praise the efforts of corporate managers who reduce wages expense. However, the news media typically does this without having any regard for the hardship that such sackings or redundancies might create for the employees and their families. For example, newspaper reports often discuss ‘cost cutting drives’ by organisations to increase their ‘profitability’ and such reports often discuss how retrenching staff has helped an organisation to ‘slash its expenses’ – but should we really say that ‘expenses’ are slashed when so many people will potentially become unemployed (see Figure 7.10)? This is an instance where expenses, as defined by financial accounting, will indeed fall, but unrecorded ‘social costs’ will climb. FIGURE 7.10 When companies retrench large numbers of their workforce and replace them with mechanised processes, this often reduces reported expenses and improves profits, but the reported profits fail to reflect the social costs that result from the termination of many people’s employment
Source: AAP Image/Joe Castro
A fixation on financial expenses, and profits, tends to motivate managerial actions that are not always in the interests of all members of society, and this reinforces the claim that we have made many times throughout this book that accounting is a practice that impacts many people throughout society, thereby making accounting a ‘social practice’. Positive improvement in financial accounting profits often is given more priority than the impacts on workers and their families. Perhaps it would be better if the news media had an interest in broader aspects of organisational performance, other than just ‘profits’. This would be consistent with a more ‘caring’ society. Extending this theme, businesses that generate their income through gambling-related activities – such as casinos – often report very high profits. However, for problem gamblers (those who can be defined as people who have difficulty limiting the amount of money and time they spend gambling and whose gambling activities create adverse consequences for themselves, 331
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others and/or the community), the ‘services’ supplied by casinos can create much hardship and loss. How are the social problems created for the many problem gamblers recognised by casinos within their financial accounting systems? (See Reflection question 7.8.) The answer is that they are not recognised as, again, given the way we define assets and expenses, such costs, which create various social impacts, simply do not fit into the definition of ‘expenses’ within the system of financial accounting we use.
REFLECTION QUESTION 7.8 Recognising the social costs of gambling Gambling is a source of enjoyment for some people, but it is a source of misery for others. Gambling is known to have destroyed the lives of many people, who are often referred to as problem gamblers, as well as badly impacting the family and friends of these problem gamblers. Questions 1 Why are the social costs of gambling not recognised as an expense in the financial accounts of casinos? 2 Where do these costs appear? 3 Is a profitable casino a ‘good’ organisation? Solutions 1 The social costs of gambling can be immense. However, these costs do not appear as an expense of a casino because there is no decrease in the value of any ‘asset’ controlled by the organisation, and there is no increase in any ‘liabilities’ of the organisation. The failure to account for such costs is also consistent with the entity principle, which is a key convention of financial accounting. The entity principle effectively requires that an organisation be treated as an entity that is separate to its owners and the communities in which it operates. 2 These social costs of gambling do not appear in the financial statements of casinos. However, indirectly,
Reflection
these costs impact the financial performance of other entities. For example, organisations that provide services to problem gamblers, and organisations that find housing for those people who become homeless, have their services used by problem gamblers, and this creates expenses for them. Government support, in terms of various social services, is also affected by problem gambling. Therefore, while the ‘services’ provided by casinos, and which impact problem gamblers, cause social problems that are not recognised in the financial accounts of the casinos, the gambling services create expenses for many other organisations that have to care for the affected problem gamblers. That is, the services provided by casinos generate various externalities that are imposed on various stakeholders within the community. 3 This is a matter of opinion. Some people believe that if an organisation is operating in accordance with the law and generates profits, then it is a good organisation. However, for those people who are opposed to gambling, or who see the devastation caused by problem gambling, then no casino – whether it is profitable or not – can be seen as a good organisation.
As another example, if an entity pollutes the ocean water in its local environs, thereby killing all local sea creatures and coastal vegetation, there will be no direct impact on reported profits, unless fines or other related cash flows are incurred. No externalities – which can be defined as impacts that an entity has on parties external to an organisation, where such external parties did not agree or take part in the action causing, or the decisions leading to, the cost or benefit – will be recognised, and the reported assets and profits of the organisation will not be affected. The performance of such an organisation could, depending upon the financial transactions undertaken, be portrayed as being very successful if profit is our focus. In this regard, the view of Gray and Bebbington (1992, p. 6) is: there is something profoundly wrong about a system of measurement (such as financial accounting), a system that makes things visible and which guides corporate and national decisions that can signal success in the midst of desecration and destruction.
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As a last example, what about all those plastic water bottles that wash up on our beaches and cause so many environmental problems (see Figure 7.11)? Do the financial profits of those companies selling the bottled drinking water reflect the social and environmental costs that the ongoing, inappropriate disposal of their products creates? Again, the answer is ‘No’. FIGURE 7.11 When the organisations that sell bottled water report their financial results, such results fail to reflect the costs often generated by the impacts their products have on the environment
Source: Shutterstock.com/Shemyakina Tatiana
We could give many more such examples. The point being made is that the operations of organisations create many externalities, yet these externalities typically go unrecognised within our financial accounts because of the way we define the elements of financial accounting. Nevertheless, stakeholders such as the news media continue to focus on profits, seeming to commend profitable companies and to condemn loss-making companies for being ‘failures’. While the above discussion has focused on social and environmental costs, financial accounting also tends to ignore the social and environmental ‘benefits’ that might be created by an organisation. If an organisation spends resources to support local community initiatives (for example, supporting educational initiatives, finding accommodation for homeless people or caring for lost animals), such expenditure is typically treated as an expense (with an adverse impact on profits), even though the expenditure generates important social and/or environmental benefits. Because the expenditures on these initiatives are treated as expenses, this can tend to discourage managers from undertaking such initiatives, which might otherwise create some positive social and environmental impacts and be good for the reputation of the organisation. Therefore, we perhaps should question our approaches to profit measurement – as espoused within the IASB Conceptual Framework – that make certain income and expenses visible but disregard many others, and which potentially signal great success (high profits) at the same time as many adverse social and environmental impacts are being created. Many people believe that it is the obsession of managers, investors, media commentators and other stakeholders with maximising profits that has contributed greatly to the many social and environmental
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problems confronting the world. Perhaps if we did not apply financial accounting rules in the way we do, and if capital markets did not emphasise financial measures, then the planet would be in better shape. What do you think? Can we realistically argue that financial accounting is somewhat complicit in creating many of the social and environmental problems we regularly hear about? For a more comprehensive view of an organisation’s performance, financial measures such as profitability should be supplemented with other types of performance-based information, perhaps tied to the social and environmental performance of the entity – something we specifically focus upon in Chapter 10.
Why do I need to understand that measures of financial performance, such as ‘profits’, typically ignore social and environmental impacts? Why
Corporate profits are often projected – for example, in the financial media – as some form of comprehensive measure of ‘organisational performance’. Highly profitable companies are often projected as very successful organisations that are adding great value to the societies in which they operate (for example, organisations are often lauded for generating ‘record profits’ or profits in excess of earnings predictions). While profitable companies might be contributing greatly to society, we need to understand that many of the social and environmental impacts caused by an organisation – which might be significant – are not recognised within financial statements because of the way we define the elements of financial accounting. Of course, in the longer run the profits of socially and environmentally irresponsible organisations might fall because of potentially declining community support (to the extent that the community cares about organisational
social and environmental performance), but we need to be aware that various types of negative externalities generated by organisations are ignored by the financial reporting systems of the organisation. Knowing that measures of financial performance are arguably not comprehensive measures of organisation performance or ‘success’, we then need to understand that an analysis of an organisation’s ‘performance’ should also incorporate a review of the organisation’s social and environmental performance. Larger organisations typically produce some form of sustainability report/corporate social responsibility report that we can review, and then it will be a matter for us to balance all the information about the organisation’s social, environmental and social performance before concluding about the ‘overall performance’ of an organisation. We consider sustainability reporting in depth in Chapter 10.
Simply a reflection of existing accounting practice Another suggested criticism of conceptual frameworks for financial reporting is that they simply represent a codification of existing practice (Hines, 1989), putting in place a series of documents that describe existing practice rather than prescribing an ‘ideal’ or logically derived approach to accounting. If the Conceptual Framework is considered to represent a codification of generally accepted accounting practices (GAAPs), can such principles logically be used as a rationale for selecting between alternative accounting methods? Perhaps not. In this regard, it is interesting to see how the recent revisions to the IASB Conceptual Framework addressed the issue of ‘measurement’. Many researchers and practitioners were of the view that, for example, the measurement of assets should be based upon one approach, such as fair value, rather than there being a variety of measurement approaches used for different types of assets (thereby causing the aggregate of ‘total assets’ to be somewhat problematic in meaning). However, if only one approach to asset measurement had been prescribed, this would have represented a significant change to financial reporting practices. As we know, when the IASB Conceptual Framework was amended, it suggested that it is appropriate for different measurement approaches to be used for different types of assets – a suggestion that was consistent with current practice and which therefore did not require any form of significant change. To have prescribed one approach to 334
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measurement would have potentially created ‘political problems’ for the IASB because many managers in different organisations might have been openly critical of such a significant change in accounting practice. Hines (1989, p. 79) argues that accounting regulations, as generated by the accounting regulators, are heavily impacted by political considerations and this tends to negatively affect the objectivity embraced by accounting standard-setters. As a related example of how proposed significant changes to existing accounting practice will ultimately not be accepted, we can consider some of the events leading to the development of the US Conceptual Framework Project. As discussed at the start of this chapter, in 1961 and 1962, the Accounting Research Division of the AICPA commissioned studies by Moonitz, and by Sprouse and Moonitz. These researchers proposed that accounting measurement systems be changed from historical cost to a system based on current values. However, before the release of the Sprouse and Moonitz study, the Accounting Principles Board of the AICPA stated in relation to this study and another Moonitz study that ‘while these studies are a valuable contribution to accounting principles, they are too radically different from generally accepted principles for acceptance at this time’ (Statement by the Accounting Principles Board, AICPA, April, in Sprouse and Moonitz, 1962). In 1963, the Accounting Principles Board (APB) commissioned Paul Grady to prepare yet another framework of accounting. It was published in 1965 and formed the basis of APB Statement No. 4, Basic Concepts and Accounting Principles Underlying the Financial Statements of Business Enterprises. In effect, APB Statement No. 4 reflected the GAAP of the time. Some years later in the United States, Miller and Reading (1986, p. 64) noted that: The mere discovery of a problem is not sufficient to assure that the FASB will undertake its solution … There must be a suitably high likelihood that the Board can resolve the issues in a manner that will be acceptable to the constituency – without some prior sense of the likelihood that the Board members will be able to reach a consensus, it is generally not advisable to undertake a formal project.
The above argument suggests that conceptual frameworks and accounting standards are often based primarily on the dominant accounting approaches in use at the time and that the development of accounting regulation is a political process, with unpopular accounting approaches failing to be approved, despite their potential merit.
A device to legitimise accounting standard setters and the accounting profession It has also been argued that conceptual frameworks have an important objective from the perspective of the accounting standard-setters which does not involve benefits to financial statement users. Hines (1989) argues that conceptual framework projects have been initiated at times when professions were under threat – that they are ‘a strategic manoeuvre for providing legitimacy to standard-setting boards during periods of competition or threatened government intervention’ (1989, p. 89). This was also noted by Solomons (1983. p. 115), who suggests that ‘an explicitly theoretical foundation is an indispensible defence against political interference’. It has been argued that conceptual frameworks ‘boost’ the accounting profession’s public standing (Dopuch and Sunder, 1980, p. 17). As Hines (1989, p. 74) suggests: One of the main obstacles against which accountants have continually had to struggle in the professionalism quest has been the threat of an apparent absence of a formal body of accounting knowledge, and that creating the perception of possessing such knowledge has been an important part of creating and reproducing their social identity as a profession … Viewing these attempts (at establishing conceptual frameworks) as claims to accounting knowledge, which are used as a political resource in reducing 335
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the threat of government intervention and competing with other groups, in order to maintain and increase professionalism and social mobility seems to explain these projects better than viewing them from a technical/functional perspective.
It is argued that conceptual frameworks provide a means of increasing the ability of a profession to self-regulate, thereby counteracting the possibility that government intervention will occur. Hines (1991, p. 328) states: Conceptual Frameworks presume, legitimise and reproduce the assumption of an objective world and as such they play a part in constituting the social world … Conceptual Frameworks provide social legitimacy to the accounting profession. Since the objectivity assumption is the central premise of our society … a fundamental form of social power accrues to those who are able to trade on the objectivity assumption. Legitimacy is achieved by tapping into this central proposition because accounts generated around this proposition are perceived as ‘normal’. It is perhaps not surprising or anomalous then that Conceptual Framework projects continue to be undertaken which rely on information qualities such as ‘representational faithfulness’, ‘neutrality’, ‘reliability’, etc., which presume a concrete, objective world, even though past Conceptual Frameworks have not succeeded in generating Accounting Standards which achieve these qualities. The very talk, predicated on the assumption of an objective world to which accountants have privileged access via their ‘measurement expertise’, serves to construct a perceived legitimacy for the profession’s power and autonomy.
In supporting her case, Hines referred to the work undertaken in Canada. The Canadian Institute of Chartered Accountants (CICA) had done very little throughout the 1980s in relation to its conceptual framework project. It had begun the development of a framework in about 1980, a period Hines claimed was ‘a time of pressures for reform and criticisms of accounting standard-setting in Canada’ (1989, p. 88). However, interest ‘waned’ until another Canadian professional accounting body, the Certified General Accountants Association, through its Accounting Standards Authority of Canada, began developing a conceptual framework in 1987. This was deemed to represent a threat to CICA, ‘who were motivated into action’. Solomons (1983) also provides an argument that conceptual frameworks are a defence against political interference by other interest groups. If we accept Hines’ argument, we would perhaps reject the notion that the accounting profession was attempting to uncover any truths or ideals, and, rather, we would consider that the development of conceptual frameworks was a political action to ensure the survival of the profession. Reflecting on the role of conceptual frameworks in assisting a professional accounting body to survive, Horngren (1981, p. 87) notes: The useful life of the FASB is not going to rest on issues of technical competence. The pivotal issue will be the ability of the board to resolve conflicts among the various constituencies in a manner perceived to be acceptable to the ultimate constituent, the 800-pound gorilla in the form of the federal government, particularly the SEC (of course, the federal gorilla is also subject to pressure from its constituents). The ability will be manifested in the FASB’s decisions, appointments and conceptual framework. So, the conceptual framework is desirable if the survival of the FASB is considered to be desirable. That is, the framework is likely to help provide power to the board. After all, the board has no coercive power. Instead, the board must really rely on power by persuasion.
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More recently, the global financial crisis (GFC) of 2007–09 generated a great deal of discussion about the potential deficiencies in financial accounting practices used in many countries, particularly within the United States. Indeed, many articles appeared in the news media suggesting that financial accountants were somehow, at least partially, responsible for the GFC – something we discussed within Chapter 4. Arguably, this provided greater impetus for the accounting profession to look like it was being active in improving the practice of financial reporting that was being criticised, and revised frameworks were released in 2010 and 2018 (however, it should be acknowledged that efforts to develop a revised conceptual framework did commence before the GFC).
STUDY TOOLS CHAPTER SUMMARY This chapter has considered the development of conceptual frameworks. Conceptual frameworks are made up of a number of building blocks that cover issues of central importance to the financial reporting process. From a technical or functional perspective, it has been argued by accounting standard-setters that the development of a conceptual framework will lead to improvements in financial reporting practices, which will in turn lead to financial statements that are deemed more useful for the economic decisions made by the financial statements users. With a well-formulated conceptual framework there is an expectation that information will be generated that is of more relevance to financial statements users, as well as being more representationally faithful. The use of a logically derived conceptual framework will also then lead to the development of accounting standards that are consistent with each other. Further, there is a view that conceptual frameworks will allow constituents to understand more fully how and why particular accounting standards require specific approaches to be adopted, and will provide preparers with guidance when no specific accounting standards exist. In considering the success of conceptual frameworks, there are numerous authors who suggest that the frameworks have been a failure and have questioned whether such work is ‘value adding’ (Dopuch and Sunder, 1980). Issues, such as those relating to measurement, have been suggested as stumbling blocks for the ongoing development of conceptual frameworks. The progress, or in some cases the lack of it, emphasises the political nature of the accounting standard-setting process and shows that where constituents do not support particular approaches the standard-setters will quite often abandon particular endeavours. While we can question the technical accomplishments of conceptual frameworks, some authors have suggested that technical advances were not the goal of the standard-setters. Rather, some authors have suggested that conceptual frameworks are actually established to bolster the ongoing existence and position of accountants in society. As Hines (1989, p. 79) states: Since professional powers, professional prestige and financial rewards are legitimised in society by being assumed to be founded on a formal body of knowledge unique to the profession, the possibility of the loss of this mystique poses a threat to the successful advancement or social reproduction of the profession. The phenomenon of the proliferation of conceptual framework projects in the UK, USA, Canada and Australia is better understood as a response to such a threat than in the functional/ technical terms in which the Conceptual Frameworks have been articulated and discussed.
Whether we accept that conceptual frameworks are developed to improve the practice of accounting, or by contrast, that such frameworks are primarily created to assist those within the accounting profession, is obviously a matter of personal opinion. Having read this chapter, you should be better informed to make a judgement.
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ANSWER TO OPENING QUESTION At the beginning of the chapter, we asked the following question. As a result of reading this chapter, you should be able to provide an informed answer to this question – ours is shown below. Module 1
Questions / Critically evaluate the following statement: high-quality financial reporting practices necessarily Answers require a well-designed conceptual framework for financial reporting. As this chapter has indicated, there are various views about the functions that should be performed by a conceptual framework for financial reporting. There are also various controversies surrounding what should be included within a conceptual framework. For example, should a conceptual framework link the objective of general purpose financial reporting to both ‘decision usefulness’ and ‘stewardship’; should it stipulate particular measurements principles or should it take a broader perspective of ‘accountability’? Generally speaking, there is acceptance that a well-designed conceptual framework is beneficial to financial reporting with the view that we need to agree about key conceptual issues (for example, about the meaning of general purpose financial reporting, the identification of the ‘reporting entity’, the objective of general purpose financial reporting, the qualitative characteristics that useful financial information should possess, the definition and recognition of the elements of financial reporting, the role of measurement and so forth) before we are able to then produce specific guidance or rules (standards) about how to account for particular types of transactions and events. Other arguments in favour of having a well-designed conceptual framework include that it leads to more relevant and representationally faithful information being available for users of reports; it encourages critical thinking; reporting becomes more cohesive and consistent; standardsetters become more accountable for their thinking; the development of financial reporting standards should be more economical and efficient because certain fundamental issues do not need to be revisited; and, if the guidance in the conceptual framework is clear, then it should reduce the need for some specific requirements to be developed in relation to particular types of transactions and events. In terms of some arguments against, or concerns about, conceptual frameworks, it has been argued that they can be subject to political interference and used as devices to legitimise the accounting profession and accounting standard-setters. There have been arguments that conceptual frameworks tend to focus more on ‘decision usefulness’ rather than ‘stewardship’ and there have also been concerns that frameworks such as the IASB Conceptual Framework have a very narrow view of accountability relative to other documents, such as The Corporate Report (UK), which embraced a much broader view of accountability that factored in the information rights of a much broader group of stakeholders. There is also a concern that conceptual frameworks stifle reporting innovation. There have also been concerns that because of the way standard-setters have defined the elements of financial accounting, many adverse social and environmental costs go unrecognised, meaning that organisations that are supported because of their ‘profits’ might also be the same organisations creating significant social and environmental damage. Conceptual frameworks of financial reporting are expected to evolve as community expectations change with respect to the reporting obligations that organisations should embrace.
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What is a conceptual framework for financial reporting? LO7.1 Do you think we need conceptual frameworks? Explain your answer. LO7.1 LO7.4 What force of law does the IASB Conceptual Framework have? LO7.1 Why might the IASB Conceptual Framework be considered a normative theory of accounting? How does this differ from a positive theory of accounting? LO7.1 What is the difference between a financial reporting standard and a conceptual framework for financial reporting? LO7.1 Why did Australia adopt the IASB Conceptual Framework effective from 2005? LO7.2
Normative theories of accounting: the case of conceptual framework projects CHAPTER 7
7.7
Would Hines argue that financial statement readers or the accounting profession will gain more from the establishment of a conceptual framework? LO7.7 7.8 What advantages or benefits have been advanced by standard-setters to support the development of conceptual framework projects? Do you agree that in practice such benefits will be achieved? LO7.1 LO7.4 7.9 Conceptual framework projects identify a number of qualitative criteria that financial information should possess if it is to be useful for economic decision making. One such attribute is representational faithfulness, which is linked to completeness, neutrality and freedom from error. Do you believe that financial information can, in reality, be neutral and representationally faithful? Explain your answer. LO7.3 7.10 The IASB Conceptual Framework states that financial reports should be representationally faithful and provide useful information that is neutral and free from bias. But given that accounting standards and conceptual frameworks are developed by way of a process that seeks written submissions from various constituents, do you think that these ‘negotiated rules’ can ultimately generate representationally faithful information? Discuss. LO7.3 LO7.6 7.11 Income and expenses can be determined by way of either the asset/liability approach or the revenue/expense approach. Explain the difference between these two approaches and identify which approach has been adopted in the IASB Conceptual Framework. LO7.3 7.12 Why don’t we need recognition criteria for ‘equity’? LO7.3 7.13 The two main qualitative characteristics that financial information should possess have been identified as relevance and representational faithfulness. Is one more important than the other or are they equally important? LO7.3 7.14 What does ‘accountability’ mean? LO7.7 7.15 Explain the linkage between accountability and corporate reporting. LO7.7 7.16 What aspects of corporate performance do you believe that a business organisation should be accountable for? Does your view differ from the IASB as enunciated within the IASB Conceptual Framework for Financial Reporting? LO7.6 LO7.7 7.17 What are some possible objectives of general purpose financial reporting? Which objective appears to have been embraced within the IASB Conceptual Framework? LO7.3 7.18 Do you think that the objective of general purpose financial reporting as embraced within the IASB Conceptual Framework is appropriate? Why? LO7.3 7.19 Which groups within society are likely to benefit from the development of a conceptual framework of accounting? LO7.7 7.20 Would you consider that conceptual frameworks have been successful in achieving their stated objectives? Why, or why not? LO7.4 LO7.6 LO7.7 7.21 Conceptual frameworks have yet to provide prescription in relation to measurement issues. Why do you think this is the case? LO7.2 LO7.3 7.22 Discuss and evaluate the following statement: A conceptual framework provides an accounting standard-setter with a defence against claims that an accounting standard advances particular economic interests, or that it will generate particular economic consequences. LO7.7
7.23 Hines (1989, p. 89) argues that conceptual frameworks are ‘a strategic manoeuvre for providing legitimacy to standard-setting boards during periods of competition or threatened government intervention’. Explain the basis of her argument and consider whether the history of the development of conceptual frameworks supports her position. LO7.2 LO7.7 7.24 The Corporate Report (UK) referred to the ‘public’s right to information’. How does this differ from the perspectives adopted in other conceptual framework projects? LO7.3 7.25 According to the IASB Conceptual Framework, what level of proficiency in accounting are financial statement readers expected to possess? Do you agree with this position? LO7.3 7.26 Hines (1991) claims that in communicating reality, accountants simultaneously create reality. What does she mean? LO7.6 7.27 This chapter discussed how accounting standard-setters typically find it difficult to get support for newly developed requirements if those requirements represent major changes to existing practice. Why do you think this is the case? Do you think the potential lack of support would influence the strategies adopted by accounting standard-setters? LO7.2 LO7.5 339
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7.28 Do you think the IASB should have identified one measurement approach for assets? Why? LO7.3
LO7.5
7.29 Dividends paid to providers of financial capital are not treated as expenses, but payments made to the providers of labour capital are treated as expenses. Comment on the rationale for this difference, and whether – from a broader ethical perspective – it is ‘ethical’. LO7.3 LO7.7 7.30 If two different teams of accountants were given details of all of the transactions and events with which an organisation was involved throughout a particular accounting period, and each team was asked to separately prepare financial statements for that organisation, then it is highly unlikely that they would generate identical financial statements. Why is this the case? What implications does this have for the expectation that financial statements should be representationally faithful? LO7.1 LO7.3 7.31 If an organisation received an interest-free loan from a related party with no set repayment date, then should that ‘loan’ be disclosed as debt or equity pursuant to the IASB Conceptual Framework. Does it really matter? LO7.3 7.32 Kingston Beach Ltd considers that its most valuable assets are its employees, yet it has to leave them off the balance sheet. Explain this situation. LO7.3 7.33 Big Bad Casino Ltd is known to have many problem gamblers regularly visiting its casino. Many of these gamblers have lost all their money and suffered significant trauma. This in turn has caused many problems for family members as well as requiring the help of various community-based agencies. Applying the definitions and recognition criteria for the elements of financial accounting, as included within the IASB Conceptual Framework, how would these various ‘social costs’ directly impact the profits of Big Bad Casino? LO7.3 LO7.4 LO7.7 7.34 The IASB Conceptual Framework states that the primary users of general purpose financial reports are existing and potential investors, lenders and other creditors. Do you think that identifying this group of users will have implications for the measurement basis that is ultimately chosen by the IASB? For example, would historical cost or fair value be more relevant to the primary users that have been identified? LO7.3 LO7.7 7.35 Within the IASB Conceptual Framework , the following objective of general purpose financial reporting has been determined: 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.
Given the above definition, would general purpose financial reports be of relevance to people who are trying to assess the social and environmental performance of an organisation? LO7.1 LO7.3 7.36 Financial reports can embrace a ‘decision usefulness’ and/or a ‘stewardship’ function. Explain what these two terms mean and explain also which of these two functions the IASB appears to have accepted as being the objective of general purpose financial reporting. LO7.3 LO7.5 7.37 Do you agree with a ‘one-size-fits-all’ approach to international financial accounting – that is, that all countries should adopt the same accounting standards and conceptual framework? Explain your answer. LO7.1 LO7.3 LO7.4 7.38 The IASB Conceptual Framework states that the fundamental qualitative characteristics of useful information are relevance and representational faithfulness. Must both of these qualitative characteristics be satisfied before particular information is included within a financial report? Explain your answer. LO7.3 LO7.5 7.39 What is the role of the enhancing qualitative characteristics? LO7.3 7.40 Are the qualitative characteristics of useful financial information as espoused within the IASB Conceptual Framework also applicable to other types of information or reporting? Explain your answer. LO7.3 LO7.7 7.41 Critically evaluate the following statement: The IASB Conceptual Framework’s definitions of the elements of financial accounting have ongoing negative implications for climate change. LO7.3 LO7.4 LO7.7
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7.42 Critically evaluate the following statement by Ball (2016, p. 557): A conceptual framework can prove to be a snare, because it can incent the planner that adopts – and becomes deeply committed to it – to ignore evidence of its unintentional consequences. No planner’s framework is foolproof. None can anticipate all the future events it will be required to address, and as a consequence, solutions that would seem optimal under the circumstances can be blocked due to their inconsistency with the framework. LO7.1 LO7.3 LO7.7
7.43 The FASB and IASB (2005, p. 12) state: The long-standing unresolved controversy about which measurement attribute to adopt – particularly between historical-price and current-price measures – and the unresolved puzzle of unit of account are likely to make measurement one of the most challenging parts of this project. Provide an explanation of why measurement was perceived as one of the most ‘challenging’ components in the development of the conceptual framework. LO7.2 LO7.3 LO7.6
7.44 In recent years, a new accounting standard on leasing was released (IFRS 16 Leases). It removed the classification of leases that had been used for decades and which divided leases into operating and financial leases. The new standard requires leases that were formerly known as operating leases (and were kept off balance sheets) to be recognised for balance sheet purposes (both an asset and a liability will be recognised). This means that leases with a term of say 18 months will now appear on a balance sheet, as will leases with a life of 30 years. Is this new approach consistent, or inconsistent with the definitions of assets and liabilities included within the IASB Conceptual Framework? LO7.3 7.45 Hines (1991, p. 328) made the following statement: Conceptual Frameworks presume, legitimise and reproduce the assumptions of an objective world and as such they play a part in constituting the social world … Conceptual Frameworks provide social legitimacy to the accounting profession. Since the objectivity assumption is the central premise of our society … a fundamental form of social power accrues to those who are able to trade on the objectivity assumption. Legitimacy is achieved by tapping into this central proposition because accounts generated around this proposition are perceived as ‘normal’. It is perhaps not surprising or anomalous then that Conceptual Framework projects continue to be undertaken which rely on information qualities such as ‘representational faithfulness’, ‘neutrality’, ‘reliability’, etc., which presume a concrete, objective world, even though past Conceptual Frameworks have not succeeded in generating Accounting Standards which achieve these qualities. The very talk, predicated on the assumption of an objective world to which accountants have privileged access via their ‘measurement expertise’, serves to construct a perceived legitimacy for the profession’s power and autonomy.
Explain and evaluate Hines’ statement.
LO7.2
LO7.4
LO7.7
REFERENCES Accounting Standards Board (UK) (2007), Stewardship/ Accountability as an Objective of Financial Reporting: A comment on the IASB/FASB Conceptual Framework Project, London: ASB. Accounting Standards Steering Committee (1975), The Corporate Report, London: Institute of Chartered Accountants in England and Wales. American Institute of Certified Public Accountants (1953), Accounting Terminology Bulletin No. 1, New York: AICPA. American Institute of Certified Public Accountants (1973), Report of Study Group on Objectives of Financial Statements, The Trueblood Report, New York: AICPA. Australian Accounting Research Foundation (1990), Statement of Accounting Concepts SAC 1, Definition of the Reporting Entity, https://www.aasb.gov.au/admin/file/ content102/c3/SAC1_8-90_2001V.pdf Baker, C. & Bettner, M. (1997), ‘Interpretive and critical research in accounting: a commentary on its absence from mainstream accounting research’, Critical Perspectives on Accounting, 8(1), pp. 293–310.
Ball, R. (2016), ‘IFRS – 10 years later’, Accounting and Business Research, 46(5), pp. 545–71. Chambers, R. J. (1966), Accounting, Evaluation and Economic Behavior, Englewood Cliffs, NJ: Prentice Hall. Coombes, R. J. & Martin, C. (1982), The Definition and Recognition of Revenue under Historical Cost Accounting, Accounting Theory Monograph 3, Melbourne: Australian Accounting Research Foundation. Deegan, C. & Shelly, M. (2014), ‘Corporate social responsibilities: alternative perspectives about the need to regulate’, Journal of Business Ethics, 121(4), pp. 499–527. Dopuch, N. & Sunder, S. (1980), ‘FASB’s statements on objectives and elements of financial accounting: a review’, The Accounting Review, 55(1), pp. 1–21. Edwards, E. O. & Bell, P. W. (1961), The Theory and Measurement of Business Income, Berkeley: University of California Press. Financial Accounting Standards Board (n.d.), ‘The Conceptual Framework’, https://www.fasb.org/Page/ PageContent?pageId=/the-conceptual-framework/theconceptual-framework.html
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Financial Accounting Standards Board (1974), ‘Discussion memorandum’, https://egrove.olemiss.edu/aicpa_sop/656 Financial Accounting Standards Board (2006), Preliminary Views – Conceptual Framework for Financial Reporting: Objective of Financial Reporting and Qualitative Characteristics of Decision-Useful Financial Reporting Information, Norwalk, CT: FASB. Financial Accounting Standards Board (2008), Project Update: Conceptual Framework – Phase B: Elements and Recognition, Norwalk, CT: FASB. Financial Accounting Standards Board (2010), Project Update: Conceptual Framework – Measurement, 28 July, http:// www.fasb.org/project/cf_phase-c.shtml#background Financial Accounting Standards Board and International Accounting Standards Board (2005), Revisiting the Concepts: A New Conceptual Framework Project, Norwalk, CT: FASB. Grady, P. (1965), An Inventory of Generally Accepted Accounting Principles for Business Enterprises, Accounting Research Study No. 7, New York: AICPA. Gray, R., Adams, C. & Owen, D. (2014), Accountability, Social Responsibility and Sustainability: Accounting for Society and the Environment, London: Prentice Hall. Gray, R. & Bebbington, J. (1992), Can the grey men go green?, Discussion paper, The University of Dundee: Centre for Social and Environmental Accounting Research. Handel, W. (1982), Ethnomethodology: How People Make Sense, Hemel Hempstead: Prentice Hall. Hendriksen, E. (1970), Accounting Theory, Homewood, IL: Richard D. Irwin. Hines, R. (1988), ‘Financial accounting: in communicating reality, we construct reality’, Accounting, Organizations and Society, 13(3), pp. 251–62. Hines, R. (1989), ‘Financial accounting knowledge, conceptual framework projects and the social construction of the accounting profession’, Accounting, Auditing and Accountability Journal, 2(2), pp. 72–92. Hines, R. (1991), ‘The FASB’s conceptual framework, financial accounting and the maintenance of the social world’, Accounting, Organizations and Society, 16(4), pp. 313–51. © Elsevier Horngren, C. T. (1981), ‘Uses and limitations of a conceptual framework’, Journal of Accountancy, 151(4), pp. 86–95. International Accounting Standards Board (2006), Preliminary Views on an Improved Conceptual Framework for Financial Reporting: The Objective of Financial Reporting and Qualitative Characteristics of Decision-Useful Financial Reporting Information. London: International Accounting Standards Committee Foundation, July. International Accounting Standards Board (2008), Exposure Draft of an Improved Conceptual Framework for Financial Reporting, London: IASB. International Accounting Standards Board (2010), Exposure Draft of Conceptual Framework for Financial Reporting: The Reporting Entity, London: International Accounting Standards Committee Foundation. International Accounting Standards Board (2013), Conceptual Framework: Draft Discussion Paper: Elements – Definition of Elements, London: IASB.
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International Accounting Standards Board (2018), Basis for Conclusions on Conceptual Framework for Financial Reporting, https://www.masb.org.my/pdf. php?pdf=2018ConceptualFramework_BC.pdf&file_ path=pdf_file International Accounting Standards Board (2022), Conceptual Framework for Financial Reporting, http:// www.ifrs.org/issued-standards/list-of-standards/ conceptual-framework International Accounting Standards Committee (1989), Framework for the Preparation and Presentation of Financial Statements, London: IASC. Ji, S. & Deegan, C. (2011), ‘Accounting for contaminated sites: how transparent are Australian companies?’, Australian Accounting Review, 21(2), pp. 131–53. Miller, P. B. W. (1990), ‘The conceptual framework as reformation and counterreformation’, Accounting Horizons (June), pp. 23–32. Miller, P. B. W. & Reading, R. (1986), The FASB: The People, the Process, and the Politics, Homewood, IL: Irwin. Moonitz, M. (1961), The Basic Postulates of Accounting, Accounting Research Study No. 1, New York: AICPA. Nussbaumer, N. (1992), ‘Does the FASB’s conceptual framework help solve real accounting issues?’, Journal of Accounting Education, 10(1), pp. 235–42. Peasnell, K. V. (1982), ‘The function of a conceptual framework for corporate financial reporting’, Accounting and Business Research, 12(4), pp. 243–57. Pelger, C. (2016), ‘Practices of standard-setting: an analysis of the IASB’s and FASB’s process of identifying the objective of financial reporting’, Accounting, Organizations and Society, 50(3), pp. 51–73. Repetto, R. (2004), Silence Is Golden, Leaden, and Copper: Disclosure of Material Environmental Information in the Hard Rock Mining Industry, New Haven, CT: Yale School of Forestry & Environmental Studies. Solomons, D. (1978), ‘The politicization of accounting’, Journal of Accountancy, 146(5), pp. 65–72. Solomons, D. (1983), ‘The political implications of accounting and accounting standard setting’, Accounting and Business Research, 13(56), pp. 107–18. Solomons, D. (1986), ‘The FASB’s conceptual framework: an evaluation’, Journal of Accountancy, 161(6), pp. 114–24. Sprouse, R. & Moonitz, M. (1962), A Tentative Set of Broad Accounting Principles for Business Enterprises, Accounting Research Study No. 3, New York: American Institute of Certified Public Accountants. Stamp, E. (1980), Corporate Reporting: Its Future Evolution, Toronto: Canadian Institute of Chartered Accountants. Staunton, J. (1984), ‘Why a conceptual framework of accounting?’, Accounting Forum, 7(2), pp. 85–90. Sterling, R. R. (1985), ‘An essay on recognition’, University of Sydney Accounting Research Centre. Watts, R. L. & Zimmerman, J. L. (1986), Positive Accounting Theory, Englewood Cliffs, NJ: Prentice Hall. Whittington, G. (2008), ‘What the “old guys” can tell us: Edwards and Bell’s the theory and measurement of business income’, The Irish Accounting Review, 15(1), pp. 73–84.
CHAPTER
8
POSITIVE ACCOUNTING THEORY LEARNING OBJECTIVES On completing this chapter, readers should: LO8.1
understand how a positive theory differs from a normative theory
LO8.2
understand the origins of Positive Accounting Theory (PAT)
LO8.3
understand that PAT uses insights from Agency Theory, and why Agency Theory is of relevance to financial accounting practices
LO8.4
understand the central assumptions of PAT
LO8.5
understand the meaning and nature of agency costs
LO8.6
understand why an organisation can be referred to as a ‘nexus of contracts’
LO8.7
understand the perceived role of accounting in minimising both the agency costs and the related transaction costs of an organisation
LO8.8
understand that accounting policy choices made by management will likely be influenced by both efficiency considerations as well as opportunistic motivations
LO8.9
understand the meaning of, and reasons for, the existence of ‘creative accounting’
LO8.10 understand the meaning of ‘political costs’ and how accounting can be used to reduce the costs associated with various political processes LO8.11 understand the role of management compensation schemes and debt covenants in reducing potential conflicts (agency costs) within an organisation LO8.12 understand how particular accountingbased agreements with parties such as debtholders and managers can provide incentives for managers to manipulate accounting numbers LO8.13 understand what constitutes ‘conservative accounting procedures’ and why conservative accounting procedures provide efficient mechanisms for minimising the contracting costs within an organisation LO8.14 understand the relevance of PAT to debates about how assets and liabilities should be measured LO8.15 understand the meaning of ‘earnings management’ LO8.16 understand some criticisms of PAT.
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OPENING QUESTION A financial reporting standard was released in 2016 that relates to leasing. At the Module 1 international level, this is IFRS 16 Leases. Relative to the former accounting standard relating to leasing (which, at the international level, was IAS 17 Leases), IFRS 16 had the Questions / Answers general effect of increasing reported assets that are referred to as ‘right-of-use assets’ and increasing reported liabilities – that is, lease liabilities. IFRS 16 also had the impact of changing expense recognition by effectively increasing the related lease costs in the earlier years of the lease relative to the former accounting standard that was in place. Would this change in rules relating to how a transaction and event should be accounted for in financial terms – in this case, how to account for a leasing transaction – realistically be likely to have any impact on the cash flows of an organisation, and therefore upon the value of the organisation? What would be the reasoning for your belief that this change in accounting rules will, or will not, potentially change an organisation’s value?
Introduction Previous chapters of this book have considered numerous issues as they relate to financial accounting, including theories to explain the needs and demand for financial accounting regulations (see Chapters 3 and 4), as well as explanations for international differences in financial accounting (see Chapter 5). Normative theories of accounting have also been considered – specifically, theories that prescribe how to undertake financial accounting in times of changing prices and changing market conditions (see Chapter 6), and the conceptual framework for financial reporting that provides prescription about how elements of financial accounting should be defined and measured, when they should be recognised, what qualitative characteristics useful financial information should possess and how that financial accounting information shall be presented (see Chapter 7). This chapter changes focus and considers a theory that seeks to explain why managers within organisations elect to adopt particular accounting methods in preference to others. That is, it does not consider theories (normative theories) that tell us how financial accounting should be undertaken. Quite often in financial accounting we will have a choice between alternative financial accounting methods to account for a particular transaction or event – that is, even with the many accounting standards (or ‘financial reporting standards’ as they are also called) that exist there still remains a degree of flexibility in how to account for specific transactions or events. The theory discussed in this chapter – Positive Accounting Theory – provides a particular perspective about why managers, when confronted with a choice between alternative financial accounting methods, would elect to adopt or support particular accounting methods in preference to others. Positive Accounting Theory relies in large part on assumptions from the economics literature and, in particular, on the assumptions derived from a theory known as Agency Theory. For example, Positive Accounting Theory assumes that ‘markets’ are efficient and that all individual action is driven by self-interest – assumptions that are fundamental to many economic theories. As with most theories of accounting, there are supporters of the theory and there are detractors. The chapter concludes with a review of some criticisms of Positive Accounting Theory.
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LO8.1
LO8.2
LO8.3
LO8.8
CHAPTER 8
Positive Accounting Theory defined
As indicated in Chapter 1, a positive theory is a theory that seeks to explain and predict particular phenomena. According to Watts (1995, p. 334), the use of the term positive research was popularised in economics by Friedman (1953) and was used to distinguish research that sought to explain and predict (which is labelled positive research) from research that aimed to provide prescription (as explained in previous chapters, prescriptive research is often labelled normative research). Positive Accounting Theory, the topic discussed in this chapter and the theory popularised by Watts and Zimmerman, is one of several positive theories of accounting.1 As indicated in Chapter 1, this text uses lower-case when referring to the general class of theories that attempt to explain and predict accounting practice (that is, ‘positive theories of accounting’), and uses upper-case when referring to Watts and Zimmerman’s particular theory of accounting, Positive Accounting Theory. Hence, while it might be confusing, we must remember that Watts and Zimmerman’s Positive Accounting Theory is an example of one particular ‘positive theory’ of accounting. This confusion might not have arisen had Watts and Zimmerman elected to adopt an alternative name (or ‘trademark’) for their particular theory. According to Watts and Zimmerman (1990, p. 148): We adopted the label ‘positive’ from economics where it was used to distinguish research aimed at explanation and prediction from research whose objective was prescription. Given the connotation already attached to the term in economics we thought it would be useful in distinguishing accounting research aimed at understanding accounting from research directed at generating prescriptions … The phrase ‘positive’ created a trademark and like all trademarks it conveys information. ‘Coke’, ‘Kodak’, ‘Levi’s’ convey information.
As Watts and Zimmerman (1986, p. 7) state, Positive Accounting Theory (hereafter referred to as PAT): … is concerned with explaining accounting practice. It is designed to explain and predict which firms will and which firms will not use a particular method … but it says nothing as to which method a firm should use.
Positive theories can be contrasted with normative theories. Chapters 6 and 7 considered different normative theories of accounting. Normative theories prescribe how a particular practice should be undertaken and this prescription might be a significant departure from existing practice. A normative theory is generated as a result of the particular theorist applying some norm, standard or objective against which actual practice should strive to achieve. For example, under Chambers’ normative theory of accounting, which he labelled Continuously Contemporary Accounting and which we considered in Chapter 6, all assets should – according to his prescriptions – be measured at net market value; according to Chambers, such information is more useful for informed decision making than information based on historical costs, which he believed could be misleading. Chambers made a judgement about the role of accounting (to provide information about an entity’s capacity to adapt to changing circumstances) and, as a result of this judgement, he prescribed a particular accounting practice that organisations should follow. Returning to PAT, this chapter reveals that PAT focuses on the relationships between the various individuals involved in providing resources to an organisation and how financial
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Legitimacy Theory, Institutional Theory and Stakeholder Theory, all covered in Chapter 9, are other examples of positive theories. For example, Legitimacy Theory predicts that in certain circumstances organisations will use positive or favourable disclosures in an effort to gain, maintain or restore the legitimacy of an organisation. These other positive theories are not grounded in classical economic theory, whereas Positive Accounting Theory is. Agency Theory, which we discuss shortly, is also a positive theory.
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Agency relationship Involving the delegation of decision making from the principal to an agent.
Principal The principal delegates work to another person, known as the agent, who performs the work. For example, an owner of a business (the principal) might delegate work to an agent.
Agent An individual (or organisation) appointed to act on behalf of another party (the principal).
Agency cost Costs incurred by owners because of asymmetric information, or conflicts of interest, between principals (owners) and agents (managers). There are three commonly cited agency costs: monitoring costs, bonding costs and residual costs.
Bonding cost Bonding costs are typically thought of as costs that are borne by the agent. Bonding occurs when the agent gives a guarantee to undertake, or not to undertake, certain activities.
Monitoring cost Costs incurred in monitoring the performance of others. In PAT and Agency Theory they refer to costs incurred when principals attempt to monitor the actions of agents.
Residual cost As PAT assumes that not all opportunistic actions of agents can be controlled by contractual arrangements, there will always be some residual costs associated with appointing an agent. These occur despite the potential use of various bonding and monitoring mechanisms.
accounting can be used to assist in the efficient functioning of these relationships. Examples are the relationships between the owners (as suppliers of equity capital) and the managers (as suppliers of managerial labour), or between the managers and the organisation’s debt providers (that is, the creditors). Many relationships involve the delegation of decision making from one party (the principal) to another party (the agent) – this is referred to as an agency relationship. When decision-making authority is delegated, this can lead to some loss of efficiency and consequent costs. For example, if the owner (principal) delegates decision-making authority to a manager (agent) it is possible that the manager might not work as hard as would the owner, given that the manager might not share directly in the results (for example, the ‘profits’) of the organisation. Any potential loss of profits brought about by the manager underperforming is considered to be a cost that results from the decision-making delegation within this agency relationship – an agency cost. The agency costs that arise as a result of delegating decisionmaking authority from the owner (the equity holders) to the manager are referred to in PAT as agency costs of equity. PAT, as developed by Watts and Zimmerman and subsequently by others, is based upon the central economics-based assumption that all individuals’ actions are driven by self-interest and that individuals will always act in an opportunistic manner to the extent that the actions will increase their own wealth. Notions of loyalty, morality, cooperation and the like are not incorporated in the theory (as they are not incorporated in many other accounting or economic theories). Given an assumption that self-interest drives all individual actions (which in many people’s mind is an overly simplistic and pessimistic assumption), PAT predicts that organisations will seek to put in place mechanisms that align the interests of the managers of the organisation (the agents) with the interests of the owners of the organisation (the principals). As discussed later in the chapter, some of these methods of aligning interests will be based on the output of the financial accounting system (such as providing the manager with a share of the organisation’s profits). Where such financial accounting-based ‘alignment mechanisms’ are in place, there will be a need for financial statements to be produced. Managers are predicted to ‘bond’ themselves to prepare these financial statements.2 This is costly, and in PAT would be referred to as a ‘bonding cost’. If we assume that managers (agents) will be responsible for preparing the financial statements, then PAT also would predict that there would be a demand for those statements to be audited or monitored, otherwise agents would, given self-interest (a maintained assumption of PAT), try to overstate profits, thereby increasing their absolute share of profits. In PAT, the cost of undertaking an audit is referred to as a ‘monitoring cost’. To address the agency problems that arise within an organisation when owners/principals delegate decision making to an agent, there may be various bonding and monitoring costs incurred. If it was assumed, contrary to the assumptions of PAT, that individuals always worked for the benefit of their employers, there would not be a demand for such activities, other than perhaps to review the efficiency with which the manager was operating the business. As PAT assumes that not all opportunistic actions of agents can be controlled by monitoring or bondingtype contractual arrangements or otherwise, there will always be some residual costs associated with appointing an agent to work on behalf of the principal. Having provided this introductory overview of PAT, we now turn to the origins and development of PAT. The issue of how financial accounting can be used to reduce conflicts within the organisation (for example, potential conflicts between owners and managers, or between managers and debtholders) is returned to later in the chapter. The following discussion shows that PAT developed out of the economics literature and was heavily reliant on assumptions about the efficiency of markets (from the Efficient Markets Hypothesis), on research that considered
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From the PAT perspective, bonding occurs when the agent gives a guarantee to undertake, or not to undertake, certain activities.
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the reactions of capital markets to accounting information (which was developed from models such as the Capital Assets Pricing Model, which we consider in greater depth in Chapter 11), and on the role of contractual arrangements in minimising conflicts within an organisation (from Agency Theory). All these theories share similar ontological and epistemological assumptions.
The origins and development of Positive Accounting Theory LO8.2
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Positive research in accounting started coming to prominence around the mid-1960s and appeared to become the dominant research paradigm within financial accounting in the 1970s and 1980s. Prior to this time, the dominant type of accounting research was normative (or prescriptive) accounting research – research that sought to provide prescription based on the theorists’ perspective of the underlying objective of accounting. High-profile normative researchers of this time included Sterling, Edwards, Bell and Chambers, and the focus of much of the research was how to undertake financial accounting in times of rising prices.3 Typical questions being asked and answered at the time by the normative researchers included whether to recognise changes in the fair value of assets if no transaction occurs, and what measurement basis to use when preparing financial statements (historical cost, market value, deprival value, etc.). Such normative research did not rely on examining existing practice – that is, it did not tend to be empirical. Watts (1995, p. 299) provides an insight into the trends in accounting research that occurred from the 1950s to the 1970s. As evidence of the trends, and relying on the works of Dyckman and Zeff (1984), he documents the number of publications accepted by two dominant academic accounting journals, The Accounting Review and the Journal of Accounting Research.4 He states: The introduction of positive research into accounting in the mid-1960s represented a paradigm shift. Prior to that time, the most common type of paper published in the leading English language academic journal of the time (The Accounting Review) was normative (like the works of Edwards and Bell, Chambers and Sterling). In the period 1956–1963, 365 of Accounting Review articles were of this type. These papers use assumptions about phenomena and objectives to deduce their prescriptions. They do not use systematic evidence and/or advance hypotheses for formal testing. Only 3% of the articles published in Accounting Review in 1956–1963 were empirical and most were not designed to test hypotheses. Virtually none of the papers in this time period were attempts to explain current accounting using mathematical modelling or less formal techniques. Today, almost all papers in Accounting Review are in the positive tradition and the same is true of most other leading academic journals (all of which started in 1963 or later).5
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The work of these theorists was considered in Chapter 6. As indicated in Chapter 6 as well as in Chapter 1, researchers such as Sterling, Chambers and many others were particularly critical of positive research, and particularly of Positive Accounting Theory. Among their many criticisms was the criticism that PAT, while attempting to explain and predict accountants’ behaviour, provided no prescription about what methods accountants should adopt to provide useful information to the readers of accounting reports. By relying on only two journals it could easily be argued, given that there are many other accounting journals, that the data may not be representative of all accounting research being undertaken. Further, evidence would indicate that the editors of these journals developed an extremely favourable disposition towards positive research, a disposition not necessarily shared by editors of other journals. Nevertheless, there was certainly a significant movement towards positive accounting research in the 1960s and 1970s and this research continues to be published in large numbers in many journals, particularly the so-called ‘leading’ North American journals such as Journal of Accounting Research, The Accounting Review, Journal of Accounting and Economics and Contemporary Accounting Research. As we might imagine, there are many researchers who do not favour the positive research paradigm, and hence would challenge Watts’ view that journals that publish positive research are ‘leading’ academic journals.
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In reflecting on what caused the shift in paradigm from normative to positive research, Watts (1995, p. 299) argues that: The paradigm shift is associated with changes in US business schools in the late 1950s and early 1960s. Reports on business education commissioned by the Ford Foundation and the Carnegie Corporation of New York were catalysts for those changes … Hypothesis forming and testing were viewed as essential for good research.6 Hypothesis A proposition typically derived from theory which can be tested for causality or association using empirical data.
The quote refers to the ‘essential’ nature of ‘hypothesis forming and testing’. This in itself represents a biased view about what constitutes ‘good research’.7 A hypothesis would be formed to test a prediction, for example, a prediction that under specific conditions accountants would select a particular method of accounting – this type of issue is something that fascinates researchers working within a PAT framework. The reason that normative researchers, on the other hand, would not form and test hypotheses is that such researchers would not be as concerned with, or interested in, explaining or predicting what is (which could be tested empirically); rather, they are more concerned with what should be. Hence, normative researchers do not necessarily develop any predictive hypotheses, but this in itself should not be used to dismiss their work as not being ‘good research’. Such rejection represents an inherent philosophical bias. Nevertheless, there was a view from opponents of normative research that, in failing to provide ‘falsifiable’ predictions (or hypotheses), normative researchers failed to meet the requirements necessary to advance knowledge. As indicated in Chapter 1, there is a subset of the research community known as the falsificationists (the leader of which was considered to be Karl Popper). They consider that knowledge develops through trial and error and that ‘sound research’ should generate propositions or hypotheses that are of a form that allows them to be rejected if evidence supporting the propositions or hypotheses is not available (that is, the hypothesis should be falsifiable). If falsifiable hypotheses are not generated from the theory, then falsificationists would believe that the theory is deficient. It was also argued that around the mid-1960s and throughout the 1970s computing facilities improved markedly, such that it became increasingly practical to undertake large-scale statistical analysis – an approach used within the positive research paradigm. As Watts and Zimmerman (1986, p. 339) state: Computers and large machine-readable data bases (CRSP and Compustat) became available in the 1960s. And, partially in response to the lowered cost of empirical work, finance and economic positive theories became available for accounting researchers’ use. This led to the development of positive accounting research and to researchers trained in the methodology of positive theory.8
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As indicated in Chapter 1, a paradigm can be described as an approach to knowledge advancement that adopts particular theoretical assumptions, research goals and research methods (Kuhn, 1962). As explained in Chapter 1, a hypothesis can be defined as a proposition typically derived from theory which can be tested for causality or association using empirical data. For example, a hypothesis might be: managers that are rewarded by way of accounting-based management bonus schemes are more likely to favour income increasing accounting methods than are managers that are not rewarded by such schemes. Chapter 13 (which considers the views of the critical theorists) provides alternative views about why positive accounting flourished in the 1970s and 1980s. These theorists (for example, Mouck, 1992, and Tinker, Lehman and Neimark, 1991) believe that many accounting researchers provide research results and perspectives that aim to legitimise and maintain particular political ideologies. As an example, in the late 1970s and in the 1980s, there were moves by particular governments around the world towards deregulation. This was particularly the case in the United States and the United Kingdom. Around this time, researchers working within the Positive Accounting Theory framework, and researchers who embraced the Efficient Markets Hypothesis and Agency Theory, came to prominence. The researchers typically took an anti-regulation stance, a stance that matched the views of the government of the time. Coincidentally, perhaps, the critical theorists show that such research, which supported calls for deregulation, tended to attract considerable governmentsourced research funding, thereby providing further resources for the theory’s development.
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As we discussed in Chapter 1, different researchers will embrace different ontological and epistemological assumptions, and this will influence the research they do and the theories they choose to apply. Ontological assumptions are those assumptions we make in relation to how we ‘see the world’ and whether we believe that we all individually attribute the same meanings to particular phenomena. Epistemological assumptions relate to how or whether we determine that certain things are ‘true’ or not, and whether data collected can have a generalised meaning beyond the point of data capture or must be considered relative to its context. Epistemological assumptions are typically linked to ontological assumptions. Researchers who apply theories such as PAT, or Agency Theory, embrace the view that all people are driven by ‘self-interest’ and that there is an ‘objective reality’ in which all people see and interpret things the same way. This means that such researchers are comfortable in gathering large amounts of data from different organisations and then making generalised predictions that apply to managers across various settings. This can be contrasted with other researchers who might believe that individual human behaviour is influenced by factors such as culture, education, religion, professional memberships, gender and so forth and that larger-scale generalisation is inappropriate. As we also explained within Chapter 1, positivist researchers would have an ontological assumption that the world is objective and external to the researcher and that all observers would see that ‘world’ similarly. By contrast, phenomenologists, for example, believe that the world is socially constructed and will be seen and interpreted differently by different social actors. They would also, in contrast to positivists, believe that researchers and research subjects themselves are affected by the process of research. Non-positivists would also tend not to generalise results from one research setting to another, as proponents of positive theories do. As Chua (2019, p. 6) states: Within positivism, reality is assumed to be objective and external to the researcher. Human beings are not theorized as sentient beings who individually and collectively bring reality into existence. Instead, by and large, they are theorized as principals and agents intent upon individualized maximization of utility within societies seen as stable collectives. Truth then is gained by theories that are ‘confirmed’/ supported/not falsified when confronted and tested against observational/empirical data (Popper 1959; 1963). Further, because the aim of a hypothetico-deductive science is the derivation of generalizable, invariant ‘laws’/relationships that enable prediction and control, quantitative, large-sample research methods are preferred. Field studies are often quietly ignored as ‘anecdotal’ and thus cannot be relied on as ‘rigorous’ evidence. By contrast, interpretive and critical research traditions do not share these assumptions. Interpretivism, for example, focuses on explaining how social reality emerges. Meaningful reality is seen as subjectively created with meanings becoming ‘objectified’/stabilized/institutionalized through human interaction (see Berger and Luckmann 1966; Schutz 1967). And, critical research does not assume the stability of societies but asks instead how such stability is achieved through relations of power and ‘truth regimes.’ Foucault (1977, 131), for instance, writes that ‘truth is a thing of this world: it is produced only by virtue of multiple forms of constraint. And it induces regular effects of power.’ Further, the distinction between ‘description’ and ‘prescription,’ like the distinction between fact and values is seen as highly problematic. It is argued that the choice of a ‘positive’ science is itself a normative and value-based position. Positivism, interpretivism, and critique, thus represent fundamentally different approaches to the study of accounting.
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Chua (2019, p. 9) also argues: Positivism is closely allied with the use of quantitative research methods, and these appear to offer standardized research methods that could be used by ‘anyone’ trained in statistics/mathematics. Further, statistics and mathematics, as ways of characterizing and understanding the world, did not change or decay when research was conducted in different places and times.
Watts considers that a paper that was crucial to the acceptance of the positive research paradigm was one by Ball and Brown (1968); it is one of the most highly cited papers in the accounting literature. According to Watts (1995, p. 303), the publication of this paper in the Journal of Accounting Research caused widespread interest in accounting-related capital markets research (research that seeks to explain and predict share price reaction to the public release of accounting information) and led to ever-increasing numbers of papers being published in the area (this paper will be considered shortly). Reflecting on the subsequent shift in publications towards positive research, Watts (1995, p. 303) states: Empirical papers as a proportion of papers published in Journal of Accounting Research rose from 13 per cent in 1967 to 31 per cent in 1968 and to 60 per cent by 1972. Normative papers in Journal of Accounting Research fell from 24 per cent in 1967 to seven per cent in 1968 and by 1972 to zero. The Accounting Review (which is another leading journal) followed suit and stopped publishing normative papers. The empirical papers in the capital markets area were in the positivist tradition. The normativists challenged the evidence and its interpretation, but did not supply their own counter-evidence. They did not have the training nor likely the desire to compete in this dimension.
Why do I need to know about the assumptions that particular groups of researchers make as part of their research? Why
As we explained in Chapter 1, all research applies various assumptions. Whether we accept these assumptions will be influenced by our own views about how we think the world operates. If particular theories embrace central assumptions that we do not accept, then we will tend to reject the theories.
As noted above, a central assumption of PAT is that everybody is driven by self-interest linked to maximising individual wealth. If we reject such an assumption, as many people do, then we would reject the theory.
REFLECTION QUESTION 8.1 Central assumptions of PAT Question What assumptions would PAT researchers make with regard to how they ‘see the world’ and whether the way they view the world is shared by others? Further, would they believe that they are able to uncover some underlying truth that can then be applied to different contexts?
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Solution Reflection PAT researchers would tend to believe that there is an ‘objective reality out there’ that we all see in the same way – that we all have a ‘shared reality’. They also tend to rely upon simplifying assumptions that everybody is motivated in the same way. As such, they believe their research can uncover universal truths that have generalised application in all settings. PAT researchers have a quest for knowledge that has application across different settings.
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Role of the Efficient Markets Hypothesis One development from the 1960s that was crucial to the development of PAT was the work of theorists such as Fama, particularly work that related to the development of the Efficient Markets Hypothesis (EMH). The EMH is based on the assumption that capital markets react in an efficient and unbiased manner to publicly available information.9 The perspective taken is that security prices, such as share prices, reflect the information content of publicly available information and this information is not restricted to accounting disclosures. The capital market is considered to be highly competitive, and as a result newly released public information is expected to be quickly impounded into share prices. As Watts and Zimmerman (1986, p. 6) state:
Efficient Markets Hypothesis (EMH) EMH is based on the assumption that capital markets react in an efficient and unbiased manner to publicly available information.
Underlying the EMH is competition for information. Competition drives investors and financial analysts to obtain information about the firm from many sources outside the firm’s accounting reports and even outside the firm itself. For example, analysts obtain weekly production data on automobile firms and interview management. Analysts also interview competitors about a corporation’s sales and creditors about the corporation’s credit standing.
If accounting results are released by an organisation, and these results were already anticipated by the capital market (perhaps as a result of interim announcements), the expectation is that the price of the security will not react to the release of the accounting results. Consistent with traditional finance theory, the price of a security is believed to be determined on the basis of beliefs about the present value of future cash flows pertaining to that security and when these beliefs change (as a result of particular ‘new’ information becoming available) the expectation is that the security’s price will also change.10 Because share prices are expected to reflect information from various sources (as the information relates to predicting future cash flows), there was a view that management cannot manipulate share prices by changing accounting methods in an opportunistic manner. If the change in accounting method does not signal a change in cash flows, then early proponents of the EMH would argue that the capital market will not react. Further, because there are many sources of data used by the capital market, if managers make less than truthful disclosures, which are not corroborated or contradict other available information, then, assuming that the market is efficient, the market will question the integrity of the managers. Consequently, the market will tend to pay less attention to subsequent accounting disclosures made by such managers. Watts and Zimmerman (1986), and subsequent PAT researchers, rely on this perspective to argue against the need for extensive accounting regulation. Because accounting information is only one source of information, because markets are assumed to be efficient in evaluating information and because of the existence of other potentially non-corroboratory evidence, there is believed
Research that subsequently tested the EMH predominantly adopted the assumption of semi-strong form market efficiency. Under the assumption of semi-strong form efficiency – an assumption still adopted by many capital markets researchers today – the market price of an organisation’s securities reflects all publicly available information. According to Watts and Zimmerman (1986, p. 19), the available evidence was generally consistent with the semi-strong form of EMH. Two other forms of market efficiency (with less empirical support) have also been advanced. A weak form of market efficiency assumes that existing security prices simply reflect information about past prices and trading volumes. The strong form of market efficiency assumes that security prices reflect all information known to anyone at that point in time (including information that is not publicly available). Capital markets research (and the EMH) is considered more fully in Chapter 11. 10 In studies that investigate the reaction of the capital market to earnings announcements, it is generally assumed that accounting earnings are highly correlated with cash flows, hence new information about accounting earnings is deemed to indicate new information about cash flows. 9
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to be limited benefit in imposing accounting regulation.11 As we know, however (see Chapters 3 and 4), there are many counterarguments supporting the regulation of financial reporting.
Share price reactions to unexpected earnings announcements
Abnormal returns In capital markets research, abnormal returns are the realised (actual) rate of return, less the expected rate of return (as calculated by reference to a market model).
Researchers such as Ball and Brown (1968) and Beaver (1968) sought to investigate empirically stock-market reactions to financial accounting earnings (profit) announcements. Using monthly information about earnings announcements in The Wall Street Journal and information about share returns, Ball and Brown investigated whether unexpected changes in accounting earnings lead to abnormal returns on an organisation’s securities. Relying on the EMH, Ball and Brown proposed that, if the earnings announcements were useful to the capital market (there was new or unexpected information in the announcement), share prices would adjust to reflect the new information. As they stated (1968, p. 159): If security prices do in fact adjust rapidly to new information as it becomes available, then changes in security prices will reflect the flow of information to the market. An observed revision of stock prices associated with the release of the income report would thus provide evidence that the information reflected in income numbers is useful.
Hence Ball and Brown needed to determine whether the earnings announcement contained any information that was unexpected and therefore potentially ‘useful’. Using statistical modelling, they calculated an estimate of what the expected earnings of the entity were in the absence of the earnings announcement. They also needed a model to estimate what the market return from holding the entity’s securities would have been in the absence of the new information. That is, they needed to be able to determine what normal returns would have been on the securities so that they could then determine whether any abnormal returns arose (which would have been assumed to relate to the information disclosure). In determining what normal returns would have been had there been no unexpected information in the earnings announcement, reliance is placed on the market model that is derived from the Capital Asset Pricing Model (CAPM).12 These models are more fully discussed in Chapter 11. Briefly, on the basis of past information, the CAPM provides an indication of the expected rate of return on securities by applying a linear model.13 The expected return on a particular company’s shares is calculated by considering the risk-free rate of return (for example, the return from holding government bonds), plus a risk/return component that is based on how the returns on the particular security have fluctuated historically relative to the movements in the overall (diversified) share market. The difference between the expected return and the actual return constitutes the abnormal return. The results of the Ball and Brown study were generally supportive of the view that, if earnings (or profit) announcements provided unexpected information, the capital market would react to the information, the reaction taking the form of abnormal returns on the entity’s securities. By indicating that earnings (or profit) announcements (mainly based on historical cost accounting as fair values were not really used at the time) were impacting on share prices, Ball and Brown provided evidence that they considered was consistent with a view that historical
As indicated in Chapter 4, advocates of a ‘free-market’ approach to regulation (that is, people who adopt an anti-regulation stance) typically use arguments that various markets (such as capital markets and managerial labour markets) are efficient and will penalise managers who fail to provide information that efficiently reflects the performance of their organisation. Hence, markets will ‘encourage’ full disclosure and there is therefore perceived to be no need for regulatory requirements or intervention. 12 Share returns would generally be calculated by taking into account the change in price of the security during the period, as well as any dividends received during the period. 13 The development of the CAPM is generally credited to the works of Sharpe (1964) and Lintner (1965). 11
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cost information was useful to the market.14 This was in direct conflict with various normative theorists (such as Chambers) who had argued that historical cost information is rather useless and misleading.15 The capital market apparently thought otherwise (if we accept that the change in share price reflected the usefulness of the accounting information).16 In this respect, Watts and Zimmerman (1986, p. 161) state: Some critics charge that, because earnings are calculated using several different methods of valuation (e.g. historical cost, current cost, and market value), the earnings numbers are meaningless and stock prices based on those numbers do not discriminate between efficient and less efficient firms. Given the EMH, evidence is inconsistent with this criticism. Positive stock price changes are associated with positive unexpected earnings (based upon historical costs) and negative stock prices with negative unexpected earnings. Therefore, since the stock price is an unbiased estimate of value, earnings changes are measures of value changes.
Throughout the 1970s and subsequent years, many other studies were published that documented the relationship between accounting earnings and security returns (and a number of these are considered in Chapter 11). However, while generally supportive of the EMH, the literature was unable to explain why particular accounting methods might have been selected in the first place. That is, the research provided no hypotheses to predict and explain accounting choices by managers – rather, the existing research simply considered the market’s reaction to the ultimate disclosures. PAT was to address this void.
REFLECTION QUESTION 8.2 Share price reactions to profit announcements Question If an organisation discloses information about its profits, and the profit amount was expected, then would we expect share prices to change? Solution If we accept the results of research undertaken by Ball and Brown, then the market reacts to unexpected information.
Reflection
All publicly available information is already assumed to be impounded in/reflected in current share prices. Therefore, if information is released which simply confirms existing information, then there is unlikely to be a change in share price.
Much research has followed Ball and Brown (1968). For example, subsequent research has shown that the relationship between the information content in earnings announcements and changes in share prices tends to be more significant for small companies. That is, in general, larger companies’ earnings announcements have relatively less information content (for example). This is consistent with the EMH and is explained by the fact that larger companies tend to have more information being circulated about them, as well as attracting more attention from such parties as security analysts. Hence, on average, earnings announcements for larger companies tend to be more anticipated, and already impounded in the share price prior to the earnings announcement. 15 Ball and Brown’s results were also considered to be important because they emphasise that financial accounting numbers were not the sole (or predominant) source of information about an organisation. This was in contrast to the views held by many normative theorists who considered that financial accounting data were the sole, or at least the most important, source of information about an organisation, hence their concerns about getting the accounting numbers ‘right’. 16 What should also be appreciated is that research such as that undertaken by Ball and Brown and subsequent researchers actually represents a joint test of the EMH as well as the procedures used to estimate expected returns and normal returns. That is, failure to generate significant results (or indeed, success in generating significant results) may be due to misspecification problems in the calculation of expected earnings and normal returns, rather than problems with the hypothesis itself. 14
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Use of Agency Theory to help explain and predict managerial choice of accounting policies Much of the research based on the EMH assumed that there were zero contracting and information costs, as well as assuming that the capital market could efficiently ‘undo’ the implications of management selecting different accounting methods.17 For example, if an entity elected to switch its inventory cost-flow assumptions and this led to an increase in reported profits, and if the capital market was informed of this change in accounting method, perhaps through appropriate notes to the financial statements, then the capital market is assumed to be able to ‘see through’ or adjust for this change, and, to the extent that there are no apparent cashflow implications (for example, through changing taxes), there would be no share price reaction. Hence, if the particular accounting method had no direct taxation implications, and assuming that markets were efficient and able to understand the effects of using alternative accounting methods, there was an inability to explain why one method of accounting was selected by management in preference to another. As Watts and Zimmerman (1990, p. 132) state: An important reason that the information perspective (e.g. Ball and Brown, 1968) failed to generate hypotheses explaining and predicting accounting choice is that in the finance theory underlying the empirical studies, accounting choice per se could not affect firm value. Information is assumed to be costless and there are no transaction costs in the CAPM frameworks. Hence if accounting methods do not affect taxes, then they are not assumed to affect firm value. In that situation there is no basis for predicting and explaining accounting choice. Accounting is irrelevant.
Yet, evidence indicated that corporate managers expended considerable resources lobbying regulators in regard to particular accounting methods that could potentially be included within accounting standards. Managers were also known to switch accounting methods from time to time. To such individuals (managers), the choice of accounting method apparently did matter. Further, there was evidence (for example, Kaplan and Roll, 1972) that organisations within an entire industry often elected to switch accounting methods at a particular time. But, at that point in time, accounting researchers were unable to provide an explanation for this behaviour – so what would we expect to happen when a discipline is exposed to observations that cannot be explained by existing theory? The answer would be that some innovative researchers would search for a theory to explain the observations and thereby make sense of an otherwise puzzling aspect of the world they inhabited (which, as we explained in Chapter 1, is a role of theory – that is, to make sense of a puzzling world). Dropping the assumptions of zero contracting costs, as was assumed under the EMH and CAPM paradigms, led to the acceptance that the choice of accounting methods had the potential to influence the cash flows of an organisation, and hence to affect organisation value. A key to explaining managers’ choice of particular accounting methods came from Agency Theory. Hence, to understand PAT, which is the focus of this chapter, we also need to understand some of the insights from Agency Theory. Agency Theory provides the necessary explanation for why the selection of particular accounting methods might matter, and hence was an important facet in the development of PAT. Agency Theory focuses on the relationships between principals 17
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As shown later in the chapter, however, subsequent arguments were developed to support a contrary view that a change in accounting method may have cash-flow consequences (and therefore, consequences for share prices). For example, the new accounting method may be considered to provide information more efficiently about the performance of the organisation, and hence may enable the organisation to attract more funds at lower cost (perhaps because investors consider the available information to be more relevant or reliable). Further, and as shown shortly, many contractual arrangements with associated cash flows (for example, there might be an agreement that the manager gets paid a percentage of profits) are tied to accounting numbers and hence changing those numbers can ultimately change cash flows (and hence, organisational value if we believe that the value of an organisation’s securities represent expectations about the net present value of the future expected cash flows of the organisation).
Positive Accounting Theory
and agents (for example, the relationship between shareholders and corporate managers), a relationship which, due to various information asymmetries, creates much uncertainty. In most agency relationships, there will be an element of information asymmetry – that is, the principal will not have the same knowledge as the agent about the actions being undertaken by the agent – and this is a key cause of the ‘agency problem’. The greater the difficulty or costs associated with monitoring what the agent is doing, the greater the potential agency costs. The agency problem can occur in a multitude of contexts whenever one party is employed by another party to make decisions on their behalf and where that agent has no, or limited, stake in the related outcomes of the decisions. Unlike some of the earlier theories used within accounting, Agency Theory accepted that transaction costs and information costs exist. Agency Theory, which addresses the agency costs discussed above, came to prominence in the 1970s and, to this day, informs branches of research in areas of accounting, finance, law, political science, economics and management. One of the earlier, and now most highly cited references to Agency Theory as applied within the accounting literature, is Jensen and Meckling (1976). Agency Theory focuses on the ‘agency relationship’ (depicted in Figure 8.1) and, in particular, on solving the problems (‘agency problems’) that occur within this relationship.
CHAPTER 8
Information asymmetry A situation where one party in a transaction has access to certain (superior) information that is not available to the other party to the transaction. This is potentially harmful, as one party could take advantage of the other party’s lack of knowledge.
FIGURE 8.1 The agency relationship Delegation of authority
Principal
Agency costs arise due to conflicts of interest
Agent
Decis ion making/taking action
According to Jensen and Meckling (1976, p. 308), the agency relation is a contract or agreement: under which one or more persons (the principal(s)) engage another person (the agent) to perform some service on their behalf which involves delegating some decisionmaking authority to the agent.18
In a corporation, the principals would be the shareholders and the agents would be the managers. The shareholders will want the managers to manage the company in a way that maximises shareholder value, and therefore the shareholders’ wealth. Conversely, given the assumption of self-interest, the managers will want to run the company in a way that maximises their own wealth, even if it has negative implications for the value of the company. As noted above, a maintained assumption within Agency Theory, particularly as it is employed within the accounting and economics literatures, is that all individuals act in their own self-interest with that self-interest typically linked to maximising their own financial wealth. This means that managers pursuing their own self-interest might not always act in the best interests of principals and it is the divergence between the principals’ and agents’ interests that creates what is referred to as the ‘agency problem’. That is, the ‘agency problem’ arises when principals appoint agents to make decisions on their behalf, but those agents fail to consider the best interests of the principals, thereby imposing losses or costs on the principal. 18
This contract does not have to be a written contract. That is, it may simply constitute implicit terms about how the principal expects the manager to behave.
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Relying on the traditional economics literature (including accepting the assumption that all individuals are driven by a desire to maximise their own wealth), Jensen and Meckling considered the relationships and conflicts between agents and principals and how efficient markets and various contractual mechanisms can be put in place to assist in minimising the cost to the organisation of these potential conflicts. Because principals and agents are all assumed to act in their own self-interest in quests towards maximising their own welfare (with welfare being assumed to be maximised as total wealth increases), there is no reason why we should believe that one person, for example the agent, will voluntarily act in another person’s, for example the principal’s, best interests. The agency problem becomes the problem of determining what can be done to induce an agent to act in a manner that is also consistent with maximising the principal’s welfare. A central premise of Agency Theory is that if appropriate incentives/contractual arrangements are put in place for the agent, and if the principal incurs costs to monitor the agent, then agency costs can be reduced. For example, if the agent is paid a share of profits, and income statements are prepared, which allows monitoring of ‘profits’, then this might encourage managers to take actions to maximise profits, which is also in the interests of the owners/principals. Further, if the manager agrees to bond themselves to prepare financial reports that will be subject to an independent audit, then this can further align the interests of the managers and the agents. However, monitoring and bonding costs will only be incurred to the point where the costs of these initiatives bring about an equivalent reduction in agency costs. As a result, some divergences are always assumed to remain, and we refer to these as ‘residual losses’. Within Agency Theory, a well-functioning organisation is considered to be one that minimises its agency costs (those costs inherent in the principal–agent relationship). As indicated above, if there is no mechanism to make an agent pay for actions that are undertaken and which adversely impact on the owners (principals), that agent (or manager) will, it is assumed, have an incentive to consume many perquisites, as well as to use confidential information for personal gain at the expense of the principals (the owners). As Lambert (2001) states: Agency theory models are constructed based on the philosophy that it is important to examine incentive problems and their ‘resolution’ in an economic setting in which the potential incentive problem actually exists. Typical reasons for conflicts of interest include (i) effort aversion by the agent, (ii) the agent can divert resources for his private consumption or use, (iii) differential time horizons, e.g., the agent is less concerned about the future period effects of his current period actions because he does not expect to be with the firm or the agent is concerned about how his actions will affect others’ assessments of his skill, which will affect compensation in the future, or (iv) differential risk aversion on the part of the agent.
It is assumed within Agency Theory that principals will assume that the agent (like the principal, and, indeed, all individuals) will be driven by self-interest, and therefore the principals will anticipate that the manager, unless restricted from doing otherwise, will undertake selfserving activities that could be detrimental to the economic welfare of the principals. In the absence of any contractual mechanisms to restrict the agents’ potentially opportunistic behaviour, the principal will pay the agent a lower salary in anticipation of the opportunistic actions.19 This lower salary will compensate the owners/principals for the adverse actions that the managers are considered likely to undertake (this is referred to as price protection).20 Hence, the perspective is that it is the agents who, on average, pay for the principals’ expectations of Or, if shares are being sold in a company, the shareholders will, in the absence of contractual constraints on the manager, pay a lower price for shares in the organisation. 20 Generally speaking, price protection refers to the situation in which a party accepts a higher (lower) risk in return for being paid a higher (lower) rate of return. That is, there is an expectation that higher risks are acceptable in return for being paid a higher price in compensation for accepting that higher risk. Therefore, if an organisation does not offer safeguards to debtholders, then some people may still be prepared to lend funds to the organisation, but they will expect to be paid a higher rate of interest. 19
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their opportunistic behaviour. The agents are therefore assumed to have an incentive to enter into contractual arrangements that appear to be able to reduce their ability to undertake actions (opportunistic actions) detrimental to the interests of the principals. Consistent with this, Watts and Zimmerman (1986, p. 184) state: This (perspective) provides the prime insight in the Jensen and Meckling analysis: the agent, not the principal, has the incentive to contract for monitoring. The outside shareholders do not care if monitoring (often involving accounting and auditing) is conducted. Competition in the capital markets leads to price protection and ensures that outside investors earn a normal return. Owner-managers (the agents) have the incentive to offer guarantees to limit their consumption of perks, for owner-managers receive all the gains … With competition and rational expectations, owner-managers who have incentives to take value reducing actions (opportunistic actions) such as over-consuming perks, shirking, or stealing when they sell outside shares, bear the costs of those dysfunctional actions. Hence, they have incentives to contract to limit those actions and to have their actions monitored. The incentive is reduced (but not eliminated) by price protection in managerial labour markets.21
That is, if it is assumed that managers would prefer higher salaries, there will be an incentive for them to agree to enter into contractual arrangements that minimise/restrict their ability to undertake activities that might be detrimental to the interests of the owners (many of these contractual arrangements will be tied to accounting numbers). The managers (agents) will have incentives to provide information to demonstrate that they are not acting in a manner detrimental to the owners (principals).22 In reflecting on why many accounting researchers embraced Agency Theory as part of their research, Lambert (2001, p. 4) states: The primary feature of agency theory that has made it attractive to accounting researchers is that it allows us to explicitly incorporate conflicts of interest, incentive problems, and mechanisms for controlling incentive problems into our models. This is important because much of the motivation for accounting and auditing has to do with the control of incentive problems [which perhaps can be contrasted with perspectives which assume that the role of accounting is to provide decision-useful information to external stakeholders – consider our discussion with Chapter 7]. For example, the reason we insist on having an ‘independent’ auditor is that we do not believe we can trust managers to issue truthful reports on their own. Similarly, much of the motivation for focusing on objective and verifiable information and for conservatism in financial reporting lies with incentive problems. At the most fundamental level, agency theory is used in accounting research to address two questions: (i) how do features of information, accounting, and compensation systems affect (reduce or make worse) incentive problems and (ii) how does the existence of incentive problems affect the design and structure of information, accounting, and compensation systems? In this context, reference is made to the owner-manager to imply that the manager might have some ownership in the organisation but does not own the entire organisation. This quote also reflects the beliefs that Positive Accounting Theorists have about the efficiency of markets, such as capital markets or labour markets. It is assumed that such markets can efficiently adjust required rates of return to anticipated levels of risk, such as the risks associated with managers being opportunistic. 22 These arguments about managers’ opportunistic behaviour are ‘on average’ arguments. Principals would not know with certainty whether specific agents will adopt particular opportunistic strategies that are detrimental to the principals’ economic welfare. Rather, the principals who believe that everybody is motivated by their own self-interest will assume, on average, that the agent will adopt such strategies, and the principal will price protect accordingly. Hence, agents who do not commit to restrict the available set of actions will be penalised (in the form of lower salary) even though they individually may not ultimately elect to undertake actions detrimental to the principal. 21
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The perspective of the organisation as a ‘nexus of contracts’ In the Agency Theory literature, the organisation itself is considered to be a nexus of contracts and these contracts are put in place with the intention of ensuring that all parties, acting in their own self-interest, are at the same time motivated towards maximising the value of the organisation. The view of the organisation as a nexus of contracts – a view that is still accepted by many researchers today – is consistent with Smith and Watts’ (1983, p. 3) definition of a corporation. They define the corporation as: … a set of contracts among various parties who have a claim to a common output. These parties include stockholders, bondholders, managers, employees, suppliers and customers. The bounds of the corporation are defined by the set of rights under the contracts. The corporation has an indefinite life and the set of contracts which comprise the corporation evolves over time.
Agency Theory does not assume that individuals will ever act other than in self-interest, and the key to a well-functioning organisation is to put in place mechanisms (contracts) that ensure that actions that benefit the individual also benefit the organisation.23 That is, that once efficient contracts are developed, the interests of owners and managers are all aligned. The organisation will have many contracts negotiated with various individuals and parties and these contracts will aim to reduce the many conflicts of interests and related uncertainties that might otherwise arise (that is, the organisation will be a nexus of contracts, and financial accounting methods constitute an integral part of this set of contracts). Apart from internal mechanisms (for example, compensation contracts with managers that pay managers a bonus tied to accounting profits), there will be other market-wide mechanisms that are also assumed to constrain the opportunistic actions of the managers. That is, apart from the effects of various contractual arrangements within the organisation, the literature of the 1970s also proposed that various markets, such as the market for corporate control and the market for managers, provided incentives for managers to work in the interests of the owners (Fama, 1980).24 That is, while many organisation-based contracts are important to controlling agency costs, these mechanisms are also complemented by outside market forces. As Bushman and Smith (2001, p. 238) state: Corporate control mechanisms are the means by which managers are disciplined to act in the investors’ interest. Control mechanisms include both internal mechanisms, such as managerial incentive plans, director monitoring, and the internal labor market, and external mechanisms, such as outside shareholder or debtholder monitoring, the market for corporate control, competition in the product market, the external managerial labor market, and securities laws that protect outside investors against expropriation by corporate insiders.
As indicated above, Agency Theory provides an explanation for the existence of the organisation. The establishment of the organisation (firm) is seen as an alternative and As shown later in this chapter, one way to align the interests of the manager with those of the owners of the organisation might be for the manager to be given a share of profits in the organisation. Hence, the manager would be motivated to increase profits (to increase their own wealth) and such self-interested activity will also provide benefits to the owners, who, all things being equal, will benefit from higher accounting earnings. 24 See Chapter 4 for an overview of the implications for managers that flow from an efficiently functioning ‘market for managers’ and ‘market for corporate takeovers’. Chapter 4 shows that an assumption about efficiency in these markets provides a justification for some people to argue against regulating accounting disclosures. Agency Theorists (and PAT Theorists) also consider that efficiently operating ‘markets for managers’ and ‘markets for corporate takeovers’ act to reduce potential agency costs (but none of these bonding, monitoring or market mechanisms will be fully efficient at reducing agency costs, hence there will always be some ‘residual loss’ associated with appointing an agent to make decisions on behalf of the principal).
23
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efficient way to produce or supply goods and services relative to individuals dealing with ‘the market’ by way of a series of separate transactions.25 As Emanuel, Wong and Wong (2003, p. 151) state: The firm is an alternative to the market when the costs of using the market become excessive. When a firm replaces the market, authority substitutes for the price mechanism in determining how decisions are made … Accounting, together with employment contracts, compensation arrangements, debt contracts and the board of directors including its audit and compensation committees comprise a package of structures that have evolved to govern the firm. These institutional devices become the firm’s efficient contracting technology. As accounting is part of that contracting technology, the accounting controls and systems and board structures that evolve and get implemented are efficient and the accounting methods that are used in calculating the numbers in the contractual arrangements are, likewise, efficient.
In explaining the existence of organisations (firms) from an Agency Theory perspective, reliance is often placed on the early work of Ronald Coase. Emanuel, Wong and Wong (2003, p. 152) state: Coase (1937) suggests that the firm is an alternative form of organisation for managing the very same transactions [that otherwise could be made with market participants]. For example, a firm could make its raw materials as opposed to acquiring them through the market. Coase indicates that firms exist because there are costs of using the pricing mechanism. Examples of these costs are the costs of discovering what the relevant prices are, the costs of determining quality, and the costs of negotiating and concluding a separate contract for each exchange transaction. Further, there are costs associated with drawing up a long-term contract because, due to uncertainty (i.e., where knowledge of future possible states of the world and all involved relationships are incomplete) and bounded rationality (i.e., the limitations of humans to make economic decisions because of their limited ability to receive, store, retrieve, and process information), complete contracting is not feasible (Williamson, 1975, 1985, 1988, 1996). Coase suggests that economies of scale in long-term contracting are what cause activity to be organised in firms … The Coasian and Williamson analysis suggests that firms exist because they are contracting-cost-efficient. Economic Darwinism ensures that competition will weed out inefficient structures and illdesigned organisations. Over the long-term, the institutional structure that survives is the firm’s efficient contracting technology. As accounting is part of that contracting technology, the accounting controls and systems that the firm uses and the accounting methods that are used to reduce conflicts of interests between parties to the firm and that align with the firm’s value-increasing activities are, likewise, efficient. In respect of the accounting methods, Watts and Zimmerman (1990, p. 134) describe these procedures as efficient accounting choices because they ‘are the result of a similar economic equilibrium’.
25
For example, if we want a new car, we can either buy it from an organisation that specialises in making cars (and which has developed efficient contracting mechanisms between the various providers of the factors of production) or we can individually negotiate via ‘the market’ with suppliers of tyres, seats, engines, windscreens, radios, frames, mechanics and so forth. It is accepted that it is more efficient, because of contracting efficiencies inherent within an organisation, to acquire the car from an organisation specialising in car production rather than to coordinate the production of the car ourselves.
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Organisations, therefore, exist because they are an efficient way to coordinate the activities of various agents. As explained, each of the agents employed within an organisation is assumed to act in their own ‘self-interest’. Principals will be aware of this self-interest. Unless agents can show that they are working in the interests of the principals, the principals will pay the agents lower rewards for their work in anticipation of the agent taking actions that are costly to the principal. Knowing this, agents are predicted to have an incentive to provide information to show they are working for the benefit of the owners (principals) so as to receive higher payments. This prediction (from Agency Theory), combined with the view that markets are efficient, has been traditionally used by researchers as a basis for arguments against the regulation of accounting. Managers (agents) are deemed, even in the absence of regulation, to have incentives to provide information that best reflects the underlying performance of the entity. Failure to do so will have negative implications for their reputation and hence will negatively impact on the total amount of income they can receive from within the organisation, or elsewhere. Referring to the work of Fama, Watts and Zimmerman (1986, p. 192) argue: Fama (1980) suggests that information on managers’ opportunistic value-reducing behavior eventually becomes known and affects their reputation. As a consequence, if managers consume a large quantity of perks (e.g., shirks), it eventually becomes known, and they acquire a reputation. Such managers are expected to over-consume perks in the future, and their future compensation is reduced. Hence, even if managers’ compensation is not adjusted in the period in which they over-consume, they still bear a cost for that over-consumption – the present value of the reductions in their future compensation. This effect is mitigated if the manager is close to retirement and does not have any deferred compensation (i.e., compensation paid after retirement).
As already noted, the divergence in interests between the agent and the principal result in ‘agency costs’, and the agency costs are typically classified into three categories, which we have briefly mentioned, with these being monitoring costs, agency costs and residual loss, as represented in Figure 8.2. Monitoring costs are the costs borne by principals to gather information about what the agent is doing. They would include costs of preparing financial statements, auditing the financial statements, and having a board of directors to oversee the activities of managers or providing stock options to managers. The bonding costs are deemed to be borne by the agent in order to build trust with the principal and involve the costs associated with the agent contractually committing to limit their own decision-making powers. These costs are typically considered to be harder to measure than the monitoring costs. As already noted, the costs associated with monitoring the agents’ performance, and the bonding costs incurred by the agent, will only be incurred to the point where the benefits of the contractual mechanisms exceed or equal the related reductions in agency costs. Not all agency costs can be addressed and, as such, there will always be a residual loss associated with appointing an agent. FIGURE 8.2 The components of total agency costs Agency costs
360
=
Monitoring costs
+
Bonding costs
+
Residual loss
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Why do I need to know about Agency Theory? The insights from Agency Theory are used in many other theories, including some theories of accounting. Therefore, to understand some accounting theories, we need to understand Agency Theory. Also, many current-day corporate governance guidelines and many corporations law requirements are based upon insights from Agency Theory, particularly insights about
how the separation of ownership and management Why (and therefore the appointment of ‘agents’) creates various potential conflicts of interests that need to be controlled. Therefore, much of the ‘business world’ is ordered around Agency Theory perspectives. Hence, we should know about it.
REFLECTION QUESTION 8.3 The existence of a ‘residual loss’ Question Within Agency Theory, agency costs are considered to include monitoring costs, bonding costs and a residual loss. Why would Agency Theory always assume that there is a ‘residual loss’? Solution Mechanisms will only ever be put in place to the extent that the benefits from putting in place a mechanism (policy or
Reflection
practice) at least match the costs of putting it in place. It gets to the point that the declining benefits do not match the costs and at that point, additional mechanisms will not be introduced. This means that not all costs can be eliminated – there will be residual losses.
REFLECTION QUESTION 8.4 The self-fulfilling prophecy Question If students are taught that all people’s actions can be predicted on the basis of an assumption that everybody puts self-interest first, might this likely influence how students subsequently behave in the workplace? Solution This is a simplifying assumption made within many economic theories. However, common-sense tells us that not everybody will behave as predicted. Nevertheless, one concern raised by many people is that if we teach students these theories, which tell them that the best predictions of human actions are based upon an assumption that people are self-interested, then when they go to work and need to make decisions they might believe
Reflection
that ‘if everybody else does it then so should I’. Learning these theories might also potentially desensitise students to the need to be moral, loyal, cooperative and so forth. We return to this concern later in this chapter when we consider the criticisms of PAT, but at this stage you should reflect on whether you think teaching students that this is the way people are assumed to act will in turn impact upon how they behave. If we accept that ‘sustainable development’ is a key goal that we need to urgently embrace – and sustainable development requires us to think about how our current activities are affecting current and future generations – then it is far from clear how embedding ‘self-interest’ in the minds of students is really that helpful. Arguably, the planet is in the trouble it is in because of a focus on self-interest.
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The emergence of Positive Accounting Theory By the mid to late 1970s, theory had therefore been developed that proposed that markets were efficient and that contractual arrangements were used as a basis for controlling the efforts of self-interested agents. The existence of organisations (firms) was also explained on the basis of the organisations’ efficiency in terms of reducing total transaction costs that arise as a result of agency relationships. This research provided the necessary impetus for the development of PAT. PAT emphasised the role of accounting in reducing the agency costs of an organisation (including the conflicts that exist between owners and managers). It also emphasised that efficiently written contracts, with many being tied to the output of the financial accounting system, were a crucial component of an efficient corporate governance structure. One of the first papers to document how considerations of contracting costs,26 as well as considerations of the political process, impacted on the choice of accounting methods was Watts (1977), which did not attract much attention. However, in the subsequent year, Watts and Zimmerman (1978a) published a paper that has become accepted as the key paper in the development and acceptance of PAT. Much research undertaken today that seeks to explain accounting policy choice still references Watts and Zimmerman (1978a). Their paper attempted to explain the lobbying positions taken by US corporate managers in relation to the Financial Accounting Standards Board’s (FASB’s) 1974 discussion memorandum on general price level adjustments (GPLAs). According to Watts and Zimmerman (1978a, p. 113): In this paper, we assume that individuals act to maximise their own utility. In doing so they are resourceful and innovative. The obvious implication of this assumption is that management lobbies on accounting standards based on its own self-interest.27
As indicated in Chapter 6, general price level accounting, through the use of a general price index, makes adjustments to historical cost profits to take into account the effects of changing prices. In times of inflation this typically has the effect of decreasing income as well as increasing assets. Watts and Zimmerman considered how particular organisational attributes might affect whether the managers of an organisation supported, or opposed, a particular accounting requirement. Among the factors considered, one was the possibility that managers were paid bonuses tied to reported profits (which they referred to as the management compensation hypothesis), and another was the possibility that the organisation was subject to high levels of political scrutiny (which they referred to as the political cost hypothesis). In relation to the issue of political scrutiny and the associated costs, Watts and Zimmerman (1978a, p. 115) state: To counter potential government intrusions, corporations employ a number of devices, such as social responsibility campaigns in the media, government lobbying and selection of accounting procedures to minimise reported earnings. By avoiding the attention that ‘high’ profits draw because of the public’s association of high reported profits and monopoly rents, management can reduce the likelihood of adverse political actions and, thereby, reduce its expected costs (including the legal costs the firm would incur opposing the political actions). Included in political costs are the costs labour
Contracting costs are costs that arise as a result of ‘contracting’ or formulating an agreement with another party (for example, a manager) wherein one party provides a particular service for a particular payment. The contracting costs include: the costs of finding the other party to the contract; negotiating the agreement; costs associated with monitoring that the agreement has been carried out in the manner expected; possible renegotiation costs; and so on. 27 Watts and Zimmerman, like many other economists, ignored non-financial aspects of an individual’s utility function and simply assumed that an individual’s utility, or wellbeing, is maximised when their wealth is maximised. Perhaps non-financial aspects of an individual’s utility function were ignored because such aspects were considered too difficult to model. 26
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unions impose through increased demands generated by large reported profits. The magnitude of the political costs is highly dependent on firm size.
Watts and Zimmerman’s (1978a) results did not provide support for the management compensation hypothesis.28 This was probably due to the fact that the discussion memorandum required GPLA disclosures to be provided as a supplement to the financial statements and did not require the financial statements themselves to be altered (and the bonus plans were expected to be tied to the numbers presented in the financial statements). However, significant findings were presented in relation to the political cost hypothesis.29 More specifically, larger organisations (who were deemed to be subject to higher political scrutiny) tended to support the discussion memorandum – an approach which would indicate (in times of rising prices) that the profits of the organisation, adjusted for the effects of inflation, were lower than were otherwise reported.30 The view of Watts and Zimmerman was that, by presenting lower adjusted profits, these organisations (firms) would attract less political attention and hence there would be less likelihood that parties would attempt to transfer wealth away from the organisation (perhaps in the form of calls for increased taxes, for less tariff protection, for higher wages and so on). In concluding their paper, Watts and Zimmerman (1978a, p. 131) state: The single most important factor explaining managerial voting behavior on General Price Level Accounting is firm size (after controlling for the direction of change in earnings). The larger firms, ceteris paribus, are more likely to favour GPLA if earnings decline. This finding is consistent with our government intervention argument since the larger firms are more likely to be subjected to government interference and, hence, have more to lose than smaller organisations.
Following the work of Watts and Zimmerman (1978a), research in the area of PAT flourished. Much of this research sought to address some of the limitations inherent in Watts and Zimmerman’s work. For example, subsequent research acknowledged that reported profits are affected by many different accounting choices (rather than just the one choice, such as the choice to use GPLA), some of which may be income increasing, while others are income decreasing (thereby potentially offsetting each other). For example, Zmijewski and Hagerman (1981) undertook research in an endeavour to predict managements’ choice in relation to four accounting methods choices, those relating to how to account for depreciation, stock (or inventory), investment tax credits and past pension costs. In 1990 Watts and Zimmerman published an article in The Accounting Review that considered 10 years of development of PAT (entitled ‘Positive Accounting Theory: a ten year perspective’). They identified three key hypotheses that had become frequently used in the PAT literature to explain and predict whether an organisation would support or oppose a particular accounting Specifically, the prediction provided within Watts and Zimmerman (1978a, p. 116) in relation to management compensation plans was that ‘a change in accounting standards which increase the firm’s reported earnings would, ceteris paribus, lead to greater incentive income. But this would reduce the firm’s cashflows and share prices would fall. As long as per manager present value of the after tax incentive income is greater than the decline in each manager’s share portfolio, we expect management to favour such an accounting change’. 29 Political costs are costs that particular groups external to the organisation may be able to impose on the organisation as a result of particular political actions. The costs could include increased taxes, increased wage claims or product boycotts. 30 The prediction provided by Watts and Zimmerman (1978a, p. 118) in relation to political costs was ‘that managers have greater incentives to choose accounting standards which report lower earnings (thereby increasing cash flows, firm value and their welfare) due to tax, political, and regulatory considerations than to choose accounting standards which report higher earnings and, thereby, increase their incentive compensation. However, this prediction is conditional upon the firm being regulated or subject to political pressure. In small (i.e., lower political costs) unregulated firms, we would expect that managers do have incentives to select accounting standards which report higher earnings, if the expected gain in incentive compensation is greater than the forgone expected tax consequences. Finally, we expect managers to also consider the accounting standard’s impact on the firm’s bookkeeping costs (and hence their own welfare)’.
28
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method. These hypotheses can be called the ‘management compensation hypothesis’ (or ‘bonus plan hypothesis’), the ‘debt hypothesis’ (or ‘debt/equity hypothesis’) and the ‘political cost hypothesis’. Watts and Zimmerman (1990, p. 138) explain these hypotheses as follows: .
The bonus plan hypothesis is that managers of firms with bonus plans [tied to reported income] are more likely to use accounting methods that increase current period reported income. Such selection will presumably increase the present value of bonuses if the compensation committee of the board of directors does not adjust for the method chosen. The choice studies to date find results generally consistent with the bonus plan hypothesis.
Hence, all things being equal, this hypothesis predicts that, if a manager is rewarded in terms of a measure of performance such as accounting profits, that manager will prefer accounting methods that have a greater impact on increasing profits to the extent that this leads to an increase in his or her bonus. In relation to the second hypothesis, this being the ‘debt hypothesis’, they state (1990, p. 139): The debt/equity hypothesis predicts [that] the higher the firm’s debt/equity ratio, the more likely managers use accounting methods that increase income. The higher the debt/equity ratio, the closer (i.e. tighter) the firm is to the constraints in the debt covenants. The tighter the covenant constraint, the greater [is] the probability of a covenant violation and of incurring costs from technical default. Managers exercising discretion by choosing income increasing accounting methods relax debt constraints and reduce the costs of technical default.31 Debt covenants Undertakings provided by a borrower as part of a contract associated with a loan, and these undertakings (covenants) either specifically restrict the borrower from taking particular actions or specifically require the borrower to take particular actions.
Technical default In relation to debt agreements, a technical default occurs when one party, the borrower, breaches a particular requirement (covenant) that has been negotiated with the lender.
In this chapter there are a number of instances when reference is made to debt covenants, such as in the above quote. Debt covenants can be considered as undertakings provided by a borrower as part of a contract associated with a loan, and these undertakings (covenants) either specifically restrict the borrower from taking particular actions or specifically require the borrower to take particular actions. The debt covenants protect the interests of debtholders, but also mean that the safety provided to debtholders will lead to the organisation being able to attract debt at a lower cost (for example, at a lower interest rate) because of the lower risk to debtholders. The debt covenants will restrict the ability of the owners/managers to: engage in paying excessive dividends to owners; dilute the claims of debtholders; substitute higher risk assets in place of lower risk assets; and, underinvest. These strategies are explained later in this chapter. Non-compliance with a debt covenant is often referred to as a technical default. All things being equal, if an organisation has entered into agreements with lenders, and these agreements involve accounting-based debt covenants (such as stipulating a maximum allowable debt/equity or debt/asset constraint), managers have an incentive to adopt accounting methods that relax the potential impacts of the constraints (such as adopting accounting methods that increase reported income and assets). This suggests that the use of ‘conservative’ accounting policies – something that we discuss more fully later in this chapter – will decrease after the debt contracts are negotiated (Kim, 2020). In relation to the third hypothesis of their study, the ‘political costs hypothesis’, Watts and Zimmerman state (1990, p. 139): 31
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As indicated here, Watts and Zimmerman made the assumption that ‘the higher the debt/equity ratio, the closer (i.e. tighter) the firm is to the constraints in the debt covenants’. This assumes that all organisations have entered into debt agreements that have covenants restricting the amount of total debt relative to the amount of total assets or total equity. While this assumption might have been reasonable back in the 1970s and 1980s, when most large companies had entered into such arrangements, Mather and Peirson (2006) provide evidence that, while the majority of large companies do still agree to debt covenants being used as part of the process of raising debt, less than half of the recently negotiated covenants restrict total liabilities to a proportion of either total assets or equity. Hence the predictive power of the hypotheses may not be as great as it once was. Nevertheless, it provides a useful prediction for companies known to have leverage constraints.
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The political cost hypothesis predicts [that] large firms rather than small firms are more likely to use accounting choices that reduce reported profits. Size is a proxy variable for political attention. Underlying this hypothesis is the assumption that it is costly for individuals to become informed about whether accounting profits really represent monopoly profits and to ‘contract’ with others in the political process to enact laws and regulations that enhance their welfare. Thus, rational individuals are less than fully informed. The political process is no different from the market process in that respect. Given the cost of information and monitoring, managers have incentive to exercise discretion over accounting profits and the parties in the political process settle for a rational amount of ex post opportunism.
Hence, all things being equal, if managers consider that they are under a deal of political scrutiny, this could motivate them to adopt accounting methods that reduce reported profits. Reducing reported profits could decrease the possibility that people will argue that the organisation is exploiting other parties by applying business practices that generate excessive profits for the benefit of owners while at the same time providing limited returns to other parties involved in the transactions, such as employees. As an indication of how reported profits can be used as a means to criticise companies for charging consumers too much for their products, and how the profits can also be used to justify a call for government action against a company, we can consider a newspaper article that appeared in The Age newspaper entitled ‘Profit attacked as obscene’ (Aston, 2017). In the article it is reported: Skyrocketing profits for insurers have been branded ‘obscene’ by sections of the health industry, coming just months after health funds secured another government-approved increase in premiums well above inflation. Health funds made post-tax profits of $1.3 billion in the year to April 1, an annual rise of 18 per cent. Groups representing doctors, surgeons and device makers went on the attack on Wednesday. Australian Medical Association president Michael Gannon said the figures made it ‘time for some serious questions’ about the system. ‘Australians are openly questioning the value of private health insurance, complaining about the out-of-pocket costs, increasing number of conditions, caveats, carve-outs and proliferation of junk policies,’ he said. ‘It’s absolutely obscene when you see the profits they’re making and the effect they’re having on health,’ said the Australian Society of Ophthalmologists society’s president, Michael Steiner.
Reporting profits, particularly high profits, might be welcomed by many stakeholders, including investors. However, consistent with our discussion above, high reported profits can also be used by some members of society as a basis, or ‘excuse’, for justifying calls for a reduction in the prices of an organisation’s goods or services. As another example, an article in the Daily Telegraph newspaper, entitled ‘Rip off the origin of profits’ (Benns, 2017), made reference to the ‘whopping profits’ produced by the large Australian national energy distributor Origin Energy. In the opinion of a member of The Australia Institute (a think tank that researches a range of economic, social and environmental issues), the profits were generated at the expense of ‘longsuffering consumers’, who were described as being ‘ripped off’ by the organisation. The argument in the article was that the organisation only needed to generate a ‘reasonable return’ and not the ‘massive profit’ that it reported. The large profit was used in the article as the basis for arguing that the company should reduce the energy charges imposed on customers to a level that enables the organisation to generate a lower but ‘reasonable level’ of profit. Such media articles are very common, and many different stakeholders often refer to profits to justify calls for greater contributions by companies to community-based initiatives, higher 365
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payments to employees, reductions in product or service prices, and so forth. Particularly for larger organisations, ‘profit’ is a very ‘political’ number. Researchers using the three hypotheses (the management bonus hypothesis, the debt/equity hypothesis and the political cost hypothesis), and there have been many such researchers, often adopted the perspective that managers (or agents) will act opportunistically when selecting particular accounting methods (for example, managers will select particular accounting methods because the choice will lead to an increase in profit and therefore to an increase in their bonus). Watts and Zimmerman’s study (1978a) was mainly grounded in the opportunistic perspective. However, a deal of the subsequent PAT research also adopted an efficiency perspective. This perspective proposes that managers will elect to use a particular accounting method because the method most efficiently provides a record of how the organisation performed. For example, the manager might have selected a particular depreciation method not because it would have led to an increase in their bonus (the opportunistic perspective), but because the method most correctly reflected the use of the underlying asset. The following discussion considers the opportunistic and efficiency perspectives of PAT. In practice, it is often difficult to determine whether opportunistic or efficiency considerations drove the managers’ choice of a particular accounting method, and this has been one limitation of much of this research.
REFLECTION QUESTION 8.5 The focus of PAT researchers
Reflection
Question Why do advocates of PAT seek to generate generalisable insights about how and/or why managers select particular accounting methods in preference to other methods? Solution They do this because they see this as the role of accounting theory – to describe and predict the selection of accounting
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methods. Because they believe in an ‘objective reality’ in which we all see the same things in the same way, and all react similarly to various events, then they believe it is possible to generate results that have application beyond their particular study.
Opportunistic and efficiency perspectives
As noted above, research that applies PAT typically adopts either an efficiency perspective or an opportunistic perspective. Within the efficiency perspective, researchers explain how various contracting mechanisms can be put in place to minimise the agency costs of the organisation – that is, the costs associated with assigning decision-making authority from the principal (for example, the owner) to the agent (for example, the manager). The efficiency perspective is often referred to as an ex ante perspective – ex ante meaning ‘before the fact’ – as it considers what mechanisms are put in place up front, with the objective of minimising future agency and contracting costs. For example, many organisations throughout the world voluntarily prepared publicly available financial statements before there was any regulatory requirement to do so. These financial statements were also frequently subjected to an audit, even when there also was no regulatory requirement to do so (Morris, 1984).32 Researchers such as Jensen and Meckling (1976) argue that the practice of providing audited financial statements leads to real cost savings as it enables organisations to attract funds at a lower cost. As a result of the audit, external parties have more reliable information about the resources and obligations of the organisation,
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Benston (1969) provides evidence that all the companies listed on the New York Stock Exchange in 1926 published balance sheets when there was no direct requirement to do so. Further, 82 per cent were audited by a CPA when there was also no direct statutory requirement to do so.
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which therefore enables the organisation to attract funds at a lower cost than would otherwise be possible, thereby increasing the value of the organisation. Within this efficiency (ex ante) perspective of PAT it is also argued that the accounting practices adopted by organisations are often explained on the basis that such methods best reflect the underlying financial performance of the entity. Different organisational characteristics are used to explain why different organisations adopt different accounting methods. For example, the selection of a particular asset depreciation rule from among alternative approaches is explained on the basis that it best reflects the underlying use of the asset. Organisations that have different patterns of use in relation to an asset will be predicted to adopt different depreciation or amortisation policies. That is, organisations will differ in the nature of their business, and these differences will in turn lead to differences in the accounting methods (as well as other policies) being adopted. By providing measures of performance that best reflect the underlying performance of the organisation, as well as providing an efficient basis for monitoring the performance of managers, it is argued that investors and other parties will not need to gather as much additional information from other sources. This will consequently lead to cost savings. As an illustration of research that adopts an efficiency perspective, Whittred (1987) sought to explain why organisations voluntarily prepared publicly available consolidated financial statements in a period when there was no regulation that required them to do so. Consolidated financial statements are financial statements that combine the accounts of a parent entity with those of its subsidiaries. Whittred found that when companies borrowed funds, security for debt often took the form of guarantees provided by other entities within the group of organisations. Consolidated financial statements were described as being a more efficient means of presenting information about the group’s ability to borrow and repay debts than providing lenders with separate financial statements for each entity in the group.33 If it is assumed, consistent with the efficiency perspective, that organisations adopt particular accounting methods because the methods best reflect the underlying economic performance of the entity and/or provide the best basis for assessing and monitoring the performance of management (thereby reducing the risks of investors and therefore decreasing the organisation’s cost of capital), it is argued by PAT theorists that the regulation of financial accounting can impose unwarranted costs on reporting entities. For example, if a new accounting standard is released that bans an accounting method being used by particular organisations, this will lead to inefficiencies, as the resulting financial statements might no longer provide the best basis for monitoring the performance of the managers of the organisation. Many PAT theorists would argue that management is best able to select the appropriate accounting methods in given circumstances, and government should not intervene in the process.34 These results were also supported by Mian and Smith (1990). Using US data, they found that the inclusion of financial subsidiaries in consolidated financial statements prior to Financial Accounting Standard 94 (which required the subsidiaries to be included within consolidated statements) was directly related to whether guarantees of debt were in existence between members of the group of companies. As Watts (1995, p. 332) indicates, the fact that two independent studies (Mian and Smith, 1990; Whittred, 1987) in different time periods and in different countries found the same results provides a stronger case that the efficiency perspective appears to explain this type of accounting choice. 34 In this regard, we can consider IAS 38 Intangible Assets (which in Australia is equivalent to AASB 138 Intangible Assets). This accounting standard requires all research expenditure to be expensed as incurred regardless of whether the expenditure is considered likely to lead to future economic benefits (IAS 38 does, however, allow development expenditure to be carried forward subject to certain stringent requirements). The requirement that all research be expensed as incurred is highly conservative and does not allow financial report readers to differentiate between entities that have undertaken valuable research (in terms of generating future economic benefits) and those entities that have pursued failed research projects. For financial accounting purposes, all research expenditure (good and bad) is to be treated the same. Arguably, this does not enhance the ‘efficiency’ of general purpose financial reports in terms of enabling an assessment of the past and future economic performance of respective reporting entities. However, that said, requiring that all research be expensed as incurred does restrict the ability of managers to opportunistically select whether or not to capitalise the research expenses and this restriction on managers’ ability to potentially be opportunistic could be favourably viewed by debtholders. 33
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The opportunistic perspective of PAT, on the other hand, takes as given the negotiated contractual arrangements of the organisation (some of which are discussed later in the chapter) and seeks to explain and predict certain opportunistic behaviours that will subsequently occur. Initially, the particular contractual arrangements might have been negotiated because they were considered to be most efficient in aligning the interests of the various individuals within the organisation, thereby providing cost savings for the organisation. However, it is not possible or efficient to write complete contracts that provide guidance on all accounting methods to be used in all circumstances – hence there will always be some scope for managers to be opportunistic. The opportunistic perspective is often referred to as an ex post perspective – ex post meaning after the fact – because it considers opportunistic actions that could be undertaken once various contractual arrangements have been put in place. For example, in an endeavour to minimise agency costs (an efficiency perspective), a contractual arrangement might be negotiated that provides the managers with a bonus based on the profits generated by the entity. Once it is in place, the manager could elect to adopt particular accounting methods that increase accounting profits and therefore the size of the bonus (an opportunistic perspective). Actions taken to opportunistically manipulate accounting profits are often referred to as ‘earnings management’ strategies, and these strategies involve ‘deliberate intervention in the reporting process to bias earnings away from the level which would be reported given a perfectly “neutral” application of generally accepted accounting principles’ (Wilson and Wang, 2010, p. 448). Managers might elect to adopt a particular asset depreciation method that increases income (for example, electing to depreciate an asset over a longer useful life), even though it might not reflect the actual use of the asset. It is assumed within PAT that managers will opportunistically select particular accounting methods whenever they believe that this will lead to an increase in their personal wealth. PAT also assumes that principals would predict a manager to be opportunistic. With this in mind, principals often stipulate the accounting methods to be used for particular purposes. For example, a bonus-plan agreement may stipulate that a particular depreciation or amortisation method, such as straight-line amortisation, shall be adopted to calculate profit for the determination of the bonus. However, as noted previously, it is assumed to be too costly to stipulate in advance all accounting rules to be used in all circumstances. Hence PAT proposes that there will always be scope for agents opportunistically to select particular accounting methods in preference to others. Across time, there have been many reported cases of organisations that have been found to have overstated their reported earnings and assets. The extent of the opportunistic accounting activities often only becomes evident following corporate failure, at which time the extent of the asset overstatement will be highlighted. The following discussion addresses the various contractual arrangements that may exist between owners and managers, and between debtholders and managers, particularly those contractual arrangements based on the output of the accounting system. Again, these contractual arrangements are initially assumed to be put in place to reduce the agency costs of the organisation (the efficiency perspective). However, it is assumed by Positive Accounting Theorists that once the arrangements are in place, parties will, if they can, adopt manipulative strategies to generate the greatest economic benefits to themselves (the opportunistic perspective). The following material also considers the political process and how organisations might use accounting to minimise the costs of potential political scrutiny. While some researchers tend to use either the efficiency perspective or the opportunistic perspective of PAT to explain particular accounting choices, it should be noted that in reality it is often difficult to conclude firmly that an accounting choice was driven solely by an efficiency or an opportunistic motivation. As Fields, Lys and Vincent (2001) state: Unconstrained accounting choice is likely to impose costs on financial statement users because preparers are likely to have incentives to convey self-serving information. For example, managers may choose accounting methods in self-interested attempts to 368
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increase the stock [share] price prior to the expiration of stock options they hold. On the other hand, the same accounting choices may be motivated by managers’ objective assessment that the current stock price is undervalued (relative to their private information). In practice, it is difficult to distinguish between the two situations, but it is the presence of such mixed motives that makes the study of accounting choice interesting.
Why do I need to understand that accounting policy choice might be driven by either efficiency-related, or opportunistic-related, motivations? Why
Managers make many accounting policy choices which can have a significant impact on reported financial performance and financial position. Before we rely on financial reports released by a particular team of managers, it would be useful to determine whether the managers selected those accounting policies that most efficiently represented the organisation’s financial performance and position (in which case we would be relatively confident to rely upon them) or whether they
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opportunistically selected particular accounting methods so as to generate a preferred set of financial statements (in which case we should be reluctant to rely upon the reported numbers). In practice, it will be difficult to determine what drove managers to select particular accounting methods (efficiency or opportunism), but if researchers can provide ways to detect what motivated managers, then this would generally be considered useful to users of financial statements.
Owner-manager contracting
If the manager owned the organisation, then that manager would bear the costs associated with their own perquisite consumption. Perquisite consumption could include consumption of the organisation’s resources for private purposes (for example, the manager may acquire an overly expensive company car, acquire overly luxurious offices or stay in overly expensive hotel accommodation) or the excessive generation and use of idle time. As the percentage ownership held by the manager decreases, that manager begins to bear less of the cost of their own perquisite consumption. The costs begin to be absorbed by the owners of the organisation. As noted previously, PAT adopts as a central assumption that all action by individuals is driven by self-interest, and that the major interest of individuals is to maximise their own wealth. Such an assumption is often referred to as the ‘rational economic person’ assumption. If all individuals are assumed to act in their own self-interest, then owners would expect the managers (their agents) to undertake activities that may not always be in the interest of the owners (the principals). Further, because of their position within the organisation, the managers will have access to information not available to the principals (as noted earlier, a problem that is frequently referred to as ‘information asymmetry’), and this may further increase managers’ ability to undertake actions beneficial to themselves at the expense of the owners. The costs of the divergent behaviour that arises as a result of the agency relationship are, as indicated previously, referred to as agency costs (Jensen and Meckling, 1976). It is assumed in PAT that the principals hold expectations that their agents will undertake activities that may be disadvantageous to the value of the organisation and to the interests of the principals, and the principals will price this into the amounts they are prepared to pay the manager. That is, in the absence of controls to reduce the ability of the manager to act opportunistically, the principals expect such actions and, as a result, will pay the manager a lower salary. In other words, the principals will price protect. This lower salary compensates the principals for the expected opportunistic behaviour of the agents. The manager will therefore bear some of the costs of the potential opportunistic behaviours (the agency costs) which they may, or may not, undertake. If it is expected that managers would derive greater satisfaction from additional salary than from
Perquisite consumption A perquisite is something of value which is a right, privilege or benefit received as a result of holding a particular position, title or job. Perquisite consumption is often used to refer to a situation where managers give themselves more ‘luxury’ items than would seem reasonable from the principal’s point of view.
Price protect An individual or organisation ‘price protects’ when it requires a higher rate of return to compensate it for a higher risk investment (or vice versa).
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the perquisites that they are predicted to consume, then managers might be better off if they are able to commit themselves contractually not to consume perquisites – that is, if they commit or bond themselves contractually to reducing their set of available actions (some of which would not be beneficial to owners). Of course, the owners of the organisation would need to ensure that any contractual commitments agreed to can be monitored for compliance before agreeing to increase the amounts paid to the managers. In a market where individuals are perfectly informed, it could be assumed that managers would ultimately bear the costs associated with the bonding and monitoring mechanisms (Jensen and Meckling, 1976). However, markets are typically not perfectly informed. Managers may be rewarded on a fixed basis (that is, a set salary independent of performance), on the basis of the results achieved, or on a combination of the two. If the manager was rewarded purely on a fixed basis, then, assuming self-interest, that manager would not want to take great risks as they would not share in any potential gains. If managers are paid a fixed salary, then there would also be limited incentives for the manager to adopt strategies that increase the value of the organisation (unlike equity owners, whose share of the organisation may increase in value). Like debtholders, managers with a fixed claim would want to protect their fixed income stream. Apart from rejecting risky projects, which may be beneficial to those with equity in the organisation, the manager with a fixed income stream may also be reluctant to take on optimal levels of debt, as the claims of the debtholders would compete with the manager’s own fixed income claim. Assuming that self-interest drives the actions of the managers, it may be necessary to put in place remuneration schemes that reward the managers in a way that is, at least in part, tied to the performance of the organisation. This will be in the interest of the manager, as that manager will potentially receive greater rewards and will not have to bear the costs of the perceived opportunistic behaviours (which may not have been undertaken anyway). If the performance of the organisation improves, the rewards paid to the manager correspondingly increase. Bonus schemes tied to the performance of the organisation will be put in place to align the interests of the owners and the managers. If the organisation performs well, both parties will benefit.
Bonus schemes generally It is common for managers to be rewarded in terms of: • the profits of the organisation (sometimes after adjustments to exclude some expenses, such as interest and taxes), or on the basis of the profits generated by particular sub-units, or divisions, of an organisation, and/or • on the basis of the sales of the organisation, or sales generated by a component of the organisation, and/or • on the basis of some measure pertaining to return on assets. That is, it is common to find that managers’ remuneration is based on the output of the financial accounting system (hence, depending upon the terms of the bonus scheme, a change in profits might directly affect a manager’s personal wealth). It is also common for managers to be rewarded in terms of the market price of the company’s shares. This might be through holding an equity interest in the organisation or perhaps by receiving a cash bonus explicitly tied to movements in the market value of the organisation’s securities.
Accounting-based bonus plans Given that the amounts paid to the manager may be directly tied to financial accounting numbers (such as profits/sales/assets), any changes in the accounting methods being used by the organisation will affect the bonuses paid (unless the bonuses have been explicitly tied to the accounting numbers that would be derived from the use of the accounting methods in place when the bonus schemes were originally negotiated – this is sometimes referred to as using ‘frozen
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GAAP’, where GAAP is the abbreviation of generally accepted accounting principles).35 Such a change may occur as a result of a new accounting standard being issued. For example, IAS 138 Intangible Assets (released in Australia in 2004 as AASB 138) permits some development (but not research) expenditure to be capitalised as an intangible asset in certain circumstances. Consider the consequences if a new rule was issued that required all research and development expenditure to be written off. With such a change, profits for some organisations that previously capitalised development expenditure could decline, and the bonuses paid to managers may also change. If it is accepted, consistent with classical finance theory, that the value of the organisation is a function of the future cash flows of the organisation (which is a maintained assumption of PAT), then the value of the organisation may change (perhaps because less expenditure will be incurred in relation to development). Hence, once we consider the contractual arrangements within an organisation, Positive Accounting Theorists would argue that we can start to appreciate that a change in accounting method can lead to a change in cash flows, and hence a change in the value of the organisation (because, as has already been emphasised, the value of an organisation is considered to relate directly to expectations about the present value of the organisation’s future cash flows). This perspective is contrary to the views of early proponents of the EMH, who argued that changes in accounting methods would not impact on share prices unless they had direct implications for expenses such as taxation. As a case in point, we can speculate on how the adoption of IAS 38 Intangible Assets (or, within Australia, AASB 138) in some countries (among other things, this standard requires that all research expenditure must be expensed as incurred) impacted the research and development activities of various organisations. For example, subject to certain requirements, Australian, New Zealand, French and Scandinavian listed companies could, prior to 2005, capitalise research expenditure. With the adoption of International Financial Reporting Standards (IFRS) from 2005, this was no longer permitted and all research expenditure must be expensed as incurred (subject to certain requirements, development expenditure can be capitalised). As a result, there might be some expectation that the accounting standard affected the amount of research being conducted by some organisations in those countries. With specific reference to the ‘bonus hypothesis’, there could be an expectation that if a manager is being paid a bonus tied to accounting profits, and given the ‘harsh’ treatment required in relation to research expenditure (‘harsh’ because it has to be written off as incurred), the existence of a management bonus may motivate managers to reduce the level of research expenditure, thereby increasing the size of their bonus. Such a strategy of reducing research expenditure might be even greater the closer the manager is to retirement – the reason for this being that the time lag between the research expenditure and the subsequent economic benefits might be longer than the period until the manager retires (we return to this ‘horizon problem’ shortly). Through the related impacts on cash flows, such a change in research activity in turn can be expected to impact on the value of the reporting entities’ equity (share price). This example demonstrates how a change in an accounting standard can have real implications for an organisation’s share price. Of course, it is possible that the bonus may be based on the ‘old’ accounting rules in place at the time the remuneration contract was negotiated (perhaps through a clause in the management compensation contract) such that a change in generally accepted accounting principles will not impact on the bonus, but this will not always be the case. Contracts that rely on financial accounting numbers often rely on ‘floating’ (or ‘rolling’) generally accepted accounting principles. This would suggest that should an accounting rule change, and should it affect an item used within a contract negotiated by the organisation, the value of the organisation (through changes in related cash flows) might consequently change. PAT would suggest that if a change 35
Where an accounting-based contractual arrangement is to be calculated according to the accounting rules in place at reporting date (and these rules may change as new accounting standards are issued), then such agreements are considered to be relying on ‘rolling GAAP’ (also called ‘floating GAAP’).
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in accounting policy had no impact on the cash flows of the organisation, then an organisation would be indifferent to the change. In explaining the use of accounting-based bonus schemes, Emanuel, Wong and Wong (2003, p. 155) state: Accounting earnings are often used to calculate the manager’s payoff (Smith and Watts, 1982; Healy, 1985; Sloan, 1993) because it is a more efficient measure of the manager’s performance than other measures such as stock prices and realised cash flows. There are two reasons for this. First, stock prices are influenced more by market factors that are outside the control of management and, hence, are less effective in isolating that part of performance that results from the manager’s actions (Sloan, 1993). Secondly, realised cash flows do not take into account the manager’s actions at the time those actions are put in place to increase the value of the firm. Hence, realised cash flows do not provide a timely measure of the effect of the manager’s actions on firm performance, especially when performance is measured over short intervals (Dechow, 1994). Further, accounting earnings possess a variety of desirable characteristics that other performance measures do not have, including objectivity, reliability, verifiability and conservatism (Watts and Zimmerman, 1986, pp. 205–207). Since accounting earnings are efficient in measuring firm performance, they play an important role in determining the reward and punishment of performance. We observe the existence of earnings-based bonus plans that provide an efficient means of aligning the manager’s and shareholders’ interests so that the manager does not participate in activities that are opportunistic, because such actions detract from firm value maximisation. To the extent that earnings are a good measure of future cash flows and all things else are constant, higher earnings lead to higher firm value and more compensation to the manager. Besides compensation, accounting performance measures affect other rewards and punishments of the firm’s employees, such as continued employment and promotion (Blackwell et al., 1994).
Incentives to manipulate accounting numbers In considering the costs of implementing incentive schemes based on accounting output, there is a possibility that rewarding managers on the basis of accounting profits may induce them to manipulate the related accounting numbers to improve their apparent performance and, importantly, their related rewards (the opportunistic perspective). That is, accounting profits may not always provide an unbiased measure of organisational performance or value. In a very highly cited paper, Healy (1985) provides an illustration of when managers may choose to manipulate accounting numbers opportunistically due to the presence of accounting-based bonus schemes. He found that when schemes existed that rewarded managers after a prespecified level of earnings had been reached, the managers would adopt financial accounting methods consistent with maximising that bonus. In situations where the profits were not expected to reach the minimum level required by the bonus plan, the managers appeared to adopt strategies that further reduced profit in that period (frequently referred to as ‘taking a bath’) but would lead to higher profit in subsequent periods – periods when the profits may be above the required threshold for the bonus to be paid. As an example, the manager may write off an asset in one period, when a bonus was not going to be earned anyway, such that there would be nothing further to depreciate in future periods when profit-related bonuses may be paid.36 However, if managers take this strategy too far, then they might place future job tenure at risk. 36
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Holthausen, Larcker and Sloan (1995) used private data on organisations’ compensation plans also to investigate managers’ behaviour in the presence of management compensation plans. Their results confirmed those of Healy (1985), except that they did not find any evidence to support the view that management will ‘take a bath’ when earnings are below the lower pre-set bound.
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Investment strategies that maximise the present value of the organisation’s resources will not necessarily produce uniform periodic cash flows or accounting profits. It is possible that some strategies may generate minimal accounting returns in early years, yet still represent the best alternatives available to the organisation. Rewarding managers on the basis of accounting profits may discourage them from adopting such strategies. That is, it may encourage management to adopt a short-term, as opposed to a long-term, focus. This will be exacerbated if the manager is approaching retirement, given that managers approaching retirement age are expected to avoid making investments that create longer-term value for the organisation, but which have a negative impact on their own short-term wealth – this is referred to as the ‘horizon problem’. When an ‘horizon problem’ is considered to exist, managers will be less likely to invest in research and development or socially responsible activities which will generate reputational and business benefits in the longer run. Lewellen, Loderer and Martin (1987) showed that US managers approaching retirement were less likely to undertake research and development expenditure if their rewards were based on accounting-based performance measures such as profits. This was explained on the basis that all research and development had to be written off (expensed) as incurred, pursuant to US accounting standards, and hence undertaking research and development would lead directly to a reduction in profits. Although the research and development expenditure would be expected to lead to benefits in subsequent years, the retiring managers might not have been there to share in the gains. That is, the employment horizon of the manager is short relative to the ‘horizon’ relating to the continuation of the organisation (which might be assumed to be indefinite). As noted, this difference in ‘horizons’ is often referred to as an ‘horizon problem’. Hence, the selfinterested manager who was rewarded on the basis of accounting profits was predicted not to undertake research and development in the periods close to the point of retirement because they would not share in any associated gains. This may, of course, have been detrimental to the ongoing operations (and value) of the business. In such a case, it would have been advisable from an efficiency perspective for an organisation that incurred research and development expenditure to take retiring managers off a profit-share bonus scheme or, alternatively, to calculate ‘profits’ for the purpose of the plan after adjusting for research and development expenditures. Alternatively, managers approaching retirement could have been rewarded in terms of market-based schemes that are tied to the long-term performance of the organisation. For example, perhaps the manager of a company involved in research and development, and who is expected to retire in the near future, should be allocated options to buy shares in the company (share options) that cannot be exercised for, say, three or four years after they retire. In that way, the manager would be encouraged to put in place projects that would be successful after they leave the organisation. There has been some interesting research about how to mitigate the ‘horizon problem’. While a deal of research provides evidence that the design of efficient incentive contracts with managers, and proper board monitoring, can mitigate the horizon problem, it is still unclear why some senior managers, such as some but not all chief executive officers (CEOs), are more prone to the horizon problem than others. In this regard, Abernathy, Jiang and Kuang (2019) draw from the psychological and identity economics literatures to test whether CEOs that ‘identify more’ with an organisation are less likely to reduce research and development expenditure, or CSR commitments, when approaching retirement. ‘Organisational identification’(OI) reflects the specific ways in which individuals define themselves in terms of their membership of a particular organisation. It is expected that individuals with higher OI achieve higher satisfaction by protecting and enhancing the future projects of their organisation even if that means a loss of personal wealth. Specifically, Abernathy, Jiang and Kuang’s (2019) hypothesis is that OI mitigates the CEO horizon problem. Their measure of OI was linked to whether the CEO was a founder of the organisation, the length of time working within the organisation and the extent of ownership they had in the organisation. Abernathy, Jiang and Kuang’s results were consistent 373
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with their hypothesis. The implications of this 2019 study are that organisations should consider strategies to cultivate CEOs’ OI. They also argue that OI reduces agency costs, even in the absence of efficient contracting or other control mechanisms. Research has also indicated that removing the CEO from being the Chair of the Board of Directors when that CEO is close to retirement can also mitigate the effects of the horizon problem (Krause and Semadeni, 2014).
REFLECTION QUESTION 8.6 Understanding aspects of managerial bonus plans by applying PAT An organisation has a bonus plan that rewards the general manager by providing her with a bonus equal to 5 per cent of reported profits. Questions
1 Using the efficiency perspective of PAT, briefly explain why the bonus plan was put in place. 2 Using the opportunistic perspective of PAT, briefly explain whether the general manager could be motivated to try to inflate reported profits. Solutions 1 PAT would suggest that the bonus plan was put in place to encourage the general manager – through an economic incentive – to work hard to maximise the profits of the organisation, and therefore also maximise the economic interests of the owners of the organisation. Higher profits are assumed to be in the interests of the owners/principals. The bonus plan would be seen as a
Reflection
mechanism to efficiently align the (self) interests of the owners and the managers.
2 Once the bonus plan is in place, to the extent that the general manager can ‘get away with it’, it would be assumed that she will opportunistically attempt to manipulate the reported profits in order to generate the greatest economic benefit for herself. However, as we have also learned above, while these are the general predictions that flow from PAT (using the simplifying assumption that everybody is self-interested), evidence shows – perhaps somewhat logically – that not everybody will abandon morality, loyalty and so forth in their quest for personal wealth. As Abernathy, Jiang and Kuang (2019) show, ‘organisation identification’ seems to mitigate this (assumed) ‘selfish’ quest for personal wealth. Other research that we will discuss later in this chapter also appears to indicate that factors such as gender also influence the extent to which managers behave opportunistically.
Accounting-based bonus schemes that rely upon conservative accounting practices
Conservative accounting methods Methods of financial accounting that tend to recognise losses when they appear probable but defer the recognition of gains until they are realised. Conservative accounting policies would measure assets at cost even when the net realisable value is above cost, but would recognise impairment losses as soon as the realisable value of an asset falls below cost.
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Conservative accounting policies are those methods that tend to delay the recognition of revenue, accelerate the recognition of expenses, and lead to lower asset and higher liability recognition. For example, measuring assets at cost (or recoverable amount if it is lower) would be considered as a conservative accounting method relative to measuring the assets at fair value. If assets are measured at the lower of cost or recoverable amount then this means that increases in fair value would not be recognised (keeping asset values lower), but if there is a decrease in value then a reduction in assets, and a consequent expense, would be recognised. By contrast, the use of fair values is more asymmetric with equal consideration given to both increases and decreases in fair value. The use of fair values also provides management with some discretion in determining fair values, particularly if the values are determined by use of a valuation model rather than on the basis of quoted prices in active markets. It has generally been argued in the literature that potential conflicts of interest between agents and principals are better managed when conservative accounting methods are used as it restricts the ability of the managers (agents) to opportunistically use income- and net assetincreasing accounting methods. As Iyengar and Zampelli (2010, p. 138) state: Accounting conservatism is critical to the alignment of the interests of managers and shareholders. Conservative accounting practices can afford firms an opportunity
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to use incentive pay effectively to increase firm value while lowering the probability of managerial opportunism. In its absence, the use of performance incentives in managerial and executive compensation contracts is fraught with the risks of managerial opportunism, aggressive accounting, the overstatement of the financial performance of firms, and the diminishment of the integrity and information content of financial reporting.
We return to the issue of conservative accounting policies later in this chapter when we consider and evaluate the implications for contracting parties of the efforts undertaken by the IASB and FASB to increase the use of fair value accounting.
Market-based bonus schemes Organisations involved in industries such as mining or high-technology research and development may have accounting earnings that fluctuate greatly. Successful strategies might be put in place that will not provide accounting earnings for a number of periods. In such industries, Positive Accounting Theorists may argue that it is more appropriate to reward the manager in terms of the market value of the organisations’ securities, which are assumed to be influenced by expectations about the net present value of expected future cash flows. This may be done either by basing a cash bonus on any increases in share prices or by providing the manager with shares or options to shares in the company. If the value of the company’s shares increases, both the manager and the owners will benefit (their interests will be aligned). It is very common for managers to hold an equity interest (shares or options to buy shares) in their employer. As already indicated, offering managers incentives that are tied to accounting profits might have the adverse effect of inducing them to undertake actions that are not in the interests of shareholders. This might particularly be the case in relation to expenditure on research and development. As already explained, within the United States all research and development is required to be expensed as incurred, and hence there is an immediate downward impact on profits when an organisation undertakes research and development.37 Apart from the initial impacts on profits, there is also evidence that capital markets frequently do not put a great amount of value on research and development expenditure because of the many uncertainties inherent in such expenditure (Kothari, Laguerre and Leone, 2002; Lev and Sougiannis, 1996) – that is, the market is considered to undervalue the benefits attributable to research and development. In relation to the personal motivations of chief executive officers (CEOs) in the United States, Cheng (2004, p. 307) states: CEOs consider the benefits and costs of R&D spending, and [consistent with the maintained assumption of self-interest] they invest in R&D only when the expected personal benefits dominate the personal costs. Their expected costs of R&D spending include the negative impact of R&D spending on short-term accounting and stock performance, since these measures affect CEO compensation and job security (Dechow and Skinner 2000; Murphy 1999). The negative impact of R&D spending on current accounting earnings is due to the fact that R&D spending is typically immediately expensed under US GAAP. Therefore, CEOs who want to boost current accounting earnings have incentives to reduce R&D spending (e.g., Baber et al., 1991; Dechow and Sloan, 1991). In addition, CEOs may consider R&D investments as less desirable than other investments in terms of the impact of the investments on short-term stock prices [because of the tendency of capital markets to undervalue R&D expenditures]. Relative 37
By contrast, IAS 38 Intangible Assets (and, within Australia, AASB 138) requires expenditure on research to be expensed as incurred, but does allow development expenditure to be capitalised to the extent that future economic benefits are deemed ‘probable’ and the cost can be measured reliably.
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to other investments, R&D projects are associated with higher information asymmetry between managers and shareholders (e.g., Clinch, 1991) and greater uncertainty of the future benefits (e.g., Chan et al., 2001; Kothari et al., 2002). As a result, current stock prices likely do not fully reflect the future benefits of R&D spending (Lev and Sougiannis, 1996). Therefore, CEOs concerned with short-term stock prices may reduce R&D spending to increase other investments with benefits more fully (or better) reflected in current stock prices.
These impacts are heightened as the manager approaches retirement. As Cheng (2004, p. 308) states: CEOs are concerned with short-term accounting and stock performance, and these concerns generate incentives for CEOs to reduce R&D spending. Such incentives become stronger when CEOs approach retirement or face earnings shortfalls (Baber et al. 1991; Dechow and Sloan 1991). As the CEO approaches retirement, it is less likely for the CEO to benefit from current R&D investments. Meanwhile, the CEO’s career concern diminishes, and the CEO becomes more short-term oriented (Gibbons and Murphy 1992) due to weakened concern about the discipline from the managerial labor markets. Likewise, when facing deteriorating economic performance, the CEO is more concerned with the expected personal costs of R&D spending, since poor performance may trigger such results as job termination and corporate takeover, which may disentitle the CEO to the future of current R&D spending. Thus, CEOs have incentives to reduce R&D spending in order to reverse a poor performance, especially if an expected shortfall is small and thus more easily reversed.
Given that there would conceivably be incentives for senior management to reduce spending on research and development (particularly if managers are offered bonuses tied to accounting profit), it is perhaps predictable that additional contractual agreements might be put in place to reduce this motivation to reduce research and development. One approach would be to have those people who are responsible for determining senior management salaries (often done by way of a compensation committee that is established within the organisation and on which nonmanagerial directors often serve) specifically adjust the salaries in such a way that the salary is directly tied to research and development activity. As Cheng (2004, p. 308) states: When CEO incentives to reduce R&D spending become stronger, compensation committees may adjust CEO compensation arrangements to mitigate such incentives. This adjustment should affect CEOs’ consideration of the expected personal benefits and expected personal costs of R&D spending in favour of R&D expenditures. One possible adjustment is to establish a greater positive association between changes in R&D spending and changes in CEO compensation. Such a greater association makes increasing R&D spending more beneficial to the CEO, and reducing R&D spending more costly to the CEO.
The results of Cheng (2004) indicate that compensation committees do often establish a link between changes in research and development spending and changes in CEOs’ total compensation. Further, the compensation being offered to the retiring managers is often by way of the provision of share options. Granting share options increases the longer-term focus of the managers, thereby further motivating them to embrace optimal levels of research and development activity.38 38
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As a particular example of the use of share options, Cheng (2004, p. 321) refers to the options provided to the CEO of a large US corporation. According to Cheng, ‘the CEO of the company was scheduled to retire on April 1, 2000 at age 64. The compensation committee approved to grant 1,500,000 stock options to the CEO in 1997 in order to provide a stock option-based incentive to continue his contributions to the improvement of the share price through and beyond retirement, and half the options would not become exercisable until the CEO became 66’.
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In considering the use of share options, and as with accounting-based bonus schemes, there are also problems associated with the manager being rewarded in ways that are influenced by share price movements. First, the share price will be affected not only by factors controlled by the manager but also by outside, market-wide factors. That is, share prices may provide a ‘noisy’ measure of management performance – ‘noisy’ in the sense that they are affected not only by the actions of management but also largely by general market movements over which the manager has no control. Further, only the senior managers would be likely to have a significant effect on the cash flows of the organisation and hence the value of the organisation’s securities. Therefore, market-related incentives may be appropriate only for senior management. Offering shares to lower-level management may be demotivational, as their own individual actions would have little likelihood (relative to senior management) of impacting on share prices and therefore their personal wealth. Consistent with this, it is more common for senior managers than other employees to hold shares in their employer. However, if managers hold share options, then this has also been argued to potentially influence whether they engage in opportunistic earnings management (as is the case if managers are offered accounting-based management bonuses). In this regard, Bartov and Mohanram (2004) reviewed a sample of 1218 US companies that had senior executives who exercised large holdings of employee share options. Their results showed that if senior managers were potentially aware of deteriorating profitability, then such managers would be more likely to adopt income increasing accounting methods in an effort to increase share prices and therefore the value of their share options. They would then exercise their share options, thereby acquiring the shares, and fairly quickly thereafter they would sell the shares before reported profits ultimately declined and the value of the shares fell. In other related research, Aboody and Kasnik (2000) provided evidence that if managers appeared to know that share options were soon to be granted to them as part of their remuneration package then they would disclose ‘bad news’ early so as to reduce share prices and therefore the likely future exercise price of the share options. This would mean that when they ultimately exercise the granted options, thereby buying the underlying shares, they would pay less and therefore make greater financial gain. Reflecting the way executives often share in the performance of an organisation, in a newspaper article in The Age entitled ‘Carrot tempts CEO to stick around’ (Lewis and Melin, 2021), reference is made to the remuneration being paid to the CEO of JPMorgan Chase & Co, Jamie Dimon. Apart from a base salary and some profit sharing (which would be a short-term incentive), the CEO was also awarded some longer-term incentives in the form of 1.5 million share appreciation rights, which are similar to share options and will increase in value in future years as the share price of the organisation increases. According to the article: If JPMorgan’s share price grows by 50 percent, the options will net Dimon $US112 million before taxes. If it doubles, they’ll yield around $224 million. Conversely, if it falls below the current share price level once Dimon is able to exercise the options, they will be worthless.
According to the article, the board provided the appreciation rights to the CEO to motivate him to keep doing his job well. The options are not able to be exercised for at least five years from the date of issue, and he must hold any net shares gained from the award until mid-2031. The article stated: For the next five years the board can take away as many as half of his options if the bank’s performance is ‘unsatisfactory for a sustained period of time’, if the bank’s annual profit excluding certain items turns negative, or if the bank’s business units don’t meet certain financial thresholds.
It would be expected that rewarding the executives in the manner outlined should align the interests of the executives (agents) with those of the shareholders (principals), a view consistent with Agency Theory and PAT. It would be expected that such schemes would be restricted to 377
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senior managers, as they have the greatest ability to affect share prices. However, there has been considerable criticism from shareholders in recent years of the size of executive share option schemes. From the perspective of PAT, this might indicate that shareholders believe that the size of some such schemes potentially dilutes the value of shareholders’ existing shares (through the issue of new shares at a substantial discount to future market values) by so much that the agency benefits of the share options are outweighed by the cost to existing shareholders. In general, it is argued that the likelihood of accounting-based or market-based performance measures or reward schemes being put in place will, in part, be driven by considerations of the relative ‘noise’ of market-based versus accounting-based performance measures. The relative reliance on accounting-based or market-based measures may potentially be determined on the basis of the relative sensitivity of either measure to general market (largely uncontrollable) factors. Sloan (1993) indicates that CEO salary and bonus compensation appears to be relatively more aligned with financial accounting earnings in those organisations where: • share returns are relatively more sensitive to general market movements (relatively noisy) • accounting earnings have a high association with the firm-specific movement in the organisation’s share values • accounting earnings have a less positive (more negative) association with market-wide movements in equity values. While the above arguments have discussed how or why managers might work in the interests of owners if they are offered rewards that are tied to the value of the shares of the organisation, there is also an argument that if managers are provided with an equity interest in the organisation this will have other positive impacts in terms of encouraging the managers to increase the level of disclosure. Without an equity interest in the organisation, managers might be motivated to withhold information from shareholders and other interested stakeholders. As Nagar, Nanda and Wysocki (2003, p. 284) state: Managers avoid disclosing private information because such disclosure reduces their private control benefits. For instance, a lack of information disclosure limits the ability of capital and labour markets to effectively monitor and discipline managers (Shleifer and Vishny, 1989). The disclosure agency problem can thus be regarded as a fundamental agency problem underlying other agency problems. Practitioners also echo the view that managers exhibit an inherent tendency to withhold information from investors, even in the ‘high disclosure’ environment of US capital markets. A panellist at the recent STERN Stewart Executive Roundtable states, ‘all things equal, the managers of most companies would rather not disclose things if they don’t have to. They don’t want you to see exactly what they’re doing; to see the little bets they are taking’ (Stern Stewart, 2001, p. 37).
In relation to the concern that managers might be motivated to restrict disclosure, Nagar, Nanda and Wysocki (2003) suggest that providing managers with equity interests (for example, shares or share options) in the organisation will act to reduce the ‘non-disclosure tendency’. Specifically, they state (p. 284): Stock [share] price-based incentives elicit both good news and bad news disclosures from managers. Managers have incentives to release good news and bad news because it boosts stock price. On the other hand, the potential negative investor interpretation of silence (Verecchia, 1983; Milgrom, 1981), and litigation costs (which reduce the value of the managers’ ownership interest) are incentives to release bad news. Therefore, we argue that managerial stock price-based incentives, both as periodic compensation and aggregate shareholdings, help align long-run managerial and investor disclosure preferences and mitigate disclosure agency problems … Our basic premise is that stock 378
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price-based incentives are contractual mechanisms that align managerial disclosure preferences with those of shareholders.
The results of Nagar, Nanda and Wysocki’s study are consistent with their expectations. Their results show that offering managers equity-based incentives increases the managers’ propensity to disclose information. Specifically, they found that company disclosures, measured by both the frequency of earnings forecasts and analysts’ ratings of the companies’ disclosures, increase as the proportion of CEO compensation tied to the share prices and the value of CEO shareholdings increase. In considering the use of share-based versus accounting-based bonus schemes, accountingbased rewards have the advantage that the accounting results may be based on subunit or divisional performance, but one would need to ensure that individuals do not focus on their division at the expense of the organisation as a whole. PAT assumes that if a manager is rewarded on the basis of financial accounting numbers (for example, on the basis of a share of profits) then the manager will have an incentive to manipulate the accounting numbers. Given such an assumption, the value of audited financial statements becomes apparent. Rewarding managers in terms of accounting numbers (a strategy aimed at aligning the interests of owners and managers) may not be appropriate if management was solely responsible for compiling those numbers. The auditor will act to arbitrate on the reasonableness of the accounting methods adopted. However, it must be remembered that there will always be scope for opportunism. The above arguments concentrate on how management’s rewards will be directly affected by the particular financial accounting methods chosen. Management might also be rewarded in other indirect ways as a result of electing to use particular accounting methods. For example, DeAngelo (1988) provided evidence that when individuals face a contest for their positions as managers of an organisation they will, prior to the contest, adopt accounting methods that lead to an increase in reported profits (and the increased reported earnings could not be associated with any apparent increase in cash flows), thereby bolstering their case for re-election. DeAngelo also showed that, where the existing managers were unsuccessful in retaining their positions within the organisation, the newly appointed managers were inclined to recognise many expenses as soon as they took office (that is, ‘take a bath’), in a bid to highlight the poor ‘state of affairs’ they had inherited. Such strategies would be consistent with the opportunistic perspective applied within PAT. The view that incoming CEOs may ‘take a bath’ was also confirmed by Wells (2002). Using Australian data, Wells (p. 191) states: There is support for the view that incoming CEOs take an ‘earnings bath’ in the year of the CEO change … Tests of earnings management yield evidence of income decreasing earnings management in the year of the CEO change, with the strongest results for CEO changes categorised as ‘non-routine’. In this setting, the incoming CEO is typically not associated with past decisions, implicit criticism of which may be embodied in downwards earnings management. Moreover, the outgoing CEO is unable to constrain such behaviour. This highlights an important corporate governance issue, namely the effect of the CEO succession process in constraining the opportunities for incoming management to undertake earnings management in the period subsequent to the CEO change.39
Wilson and Wang (2010) also provided some interesting insights into when we might expect the appointment of senior corporate executives to lead to some form of earnings management. As they state (p. 452): Of particular interest in this study is the effect of senior managerial changes concurrent with CEO change. Specifically, we investigate the effect of concurrent changes in CEO 39
Information reported on Crikey.com, in article entitled ‘ANZ boss joins the “clear the decks’ club”’(Mayne, 2007), also provides evidence of how newly appointed chief executive officers of 13 large Australian listed companies, including ANZ Bank, made significant asset write-downs in the initial stages of their appointment.
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and board chairperson, and CEO and chief financial officer (CFO). At the heart of our conjectures in this regard is the assertion that a CEO’s ability to effect a downward bias in first period earnings is enhanced where the CEOs incentives are aligned with those of other parties whose complicity is required (the chairperson and the CFO). Where the CEO’s goals conflict with those of the CFO and/or chairperson, there is a lesser chance that attempts by the CEO to influence reported earnings will be effective.
In discussing the results of their research, Wilson and Wang (2010, p. 475) state: The paper has documented evidence that the relationship between earnings management and CEO changeover is conditioned by the presence of other senior management appointments concurrent with that of a new CEO. Specifically, we find that concurrent CEO and Chair appointments are associated with significant incomedecreasing earnings management in the year of appointment. Conversely, CEO changes unaccompanied by other senior management changes, or accompanied only by a change in CFO are not significantly associated with discretionary accruals. We find no evidence of significant earnings management in the period immediately following managerial appointments.
Therefore, from the above evidence, before we can predict whether incoming CEOs are likely to opportunistically manage earnings, we perhaps need to consider whether other senior managers have been appointed at the same time. Whatever the case, we are again being confronted with research-based evidence that accounting numbers are not always objectively determined, and this has implications for the effectiveness of accounting numbers for monitoring and controlling the behaviour of managers. The results of such research also have implications for the governance of the organisation – with the above evidence in mind, perhaps some form of specific monitoring has to be implemented following changes in senior management in an endeavour to ensure that opportunistic earnings management has not been employed. Apart from using particular incentive schemes to motivate employees to work in the interests of owners in the current period, particular remuneration plans can also be used to retain key employees. For example, offering managers share options that cannot be exercised for a number of years, and that would be forfeited on departure from the organisation, can not only act to motivate them to increase the organisation’s value but can also act as an incentive for them to remain with the organisation (Deegan, 1997). As Balsam and Miharjo (2007, p. 96) state: Equity compensation, or more precisely, forfeitable equity compensation, can reduce voluntary executive turnover by imposing a cost on the executive, which a prospective employer may not be willing to reimburse … The vast majority of publicly traded corporations provide equity compensation, usually stock options, to their executives in an effort to retain them and motivate them to act in the shareholders’ interests. Equity compensation provides a direct link between executive compensation and shareholder wealth and consequently aligns the interests of a firm’s executives with those of its shareholders.
Balsam and Miharjo provide evidence that offering executives share options that cannot be exercised for a number of periods does have the effect of retaining strongly performing executives. By contrast, they provide little incentive for poorly performing managers to stay with an organisation, as poor performance will translate to lower share prices and hence may make the options worthless, thereby eliminating any retention effects. Having considered the contractual relationship between managers (agents) and owners (principals), and how accounting can be used as a means of reducing the costs associated with potential conflict, we can now consider the relationship between debtholders and managers. 380
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It will be seen that financial accounting can be used to restrict the implications of this conflict and thereby enable an organisation to attract funds at a lower cost than might otherwise be possible. LO8.7
LO8.8
LO8.11
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LO8.13
Debt contracting
When a party lends funds to another organisation, the recipient of the funds may undertake activities that reduce or even eliminate the probability that the funds will be repaid. These costs that relate to the divergent behaviour of the borrower are referred to in PAT as the agency costs of debt and, under PAT, lenders will anticipate divergent behaviour. For example, the recipient of the funds may pay excessive dividends, leaving few assets in the organisation to service the debt. Alternatively, the organisation may take on additional and perhaps excessive levels of debt (referred to as claim dilution). The new debtholders would then compete with the original debtholder for repayment – that is, their respective claims will be diluted. Further, the organisation that has borrowed the funds may also invest in very high-risk projects (often referred to as ‘asset substitution’). This strategy would also not be beneficial to the debtholders (who can also be referred to as ‘creditors’). The debtholders have a fixed claim (that is, they are receiving a set rate of interest) and hence, if the project generates high profits, they will receive no greater return, unlike the owners, who will share in the increased value of the organisation. If the project fails, which is more likely with a risky project, the debtholders may receive nothing. The debtholders therefore do not share in any ‘upside’ (the profits) but suffer the consequences of any significant losses (the ‘downside’). Another problem that might negatively affect the interests of debtholders is ‘underinvestment’. Underinvestment occurs when owners/manager of an organisation elect not to undertake projects that would generate positive net present values. Underinvestment is thought more likely to occur when an organisation is approaching insolvency. For example, assume that a company’s total debts exceed its total assets by $100 million (meaning equity is negative $100 million). If a project arises that might generate a positive net present value of $25 million then owner/ managers might dismiss such a project because all the gains would go to the debtholders. Therefore, from the above material we can see that there are at least four general strategies that owners/managers might adopt that can disadvantage debtholders, these being (Smith and Warner, 1979): 1 payment of excessive dividends 2 claim dilution 3 asset substitution 4 underinvestment. In the absence of safeguards that protect the interests of debtholders, the holders of debt will assume that management will take actions, such as those described above, that might not always be in the debtholders’ interest, and, as a result, it is assumed that they will require the organisation to pay higher costs of interest to compensate the debtholders for the high-risk exposure (Smith and Warner, 1979). That is, the debtholders will ‘price protect’ (just as the principals did when they were dealing with the agents – something we discussed previously). If the organisation/managers agrees not to pay excessive dividends, not to take on high levels of debt or to underinvest, and not to invest in projects of an excessively risky nature, it is assumed that this will reduce the risks of lenders and, as a result, the organisation will be able to attract debt capital at a lower cost than would otherwise be possible. To the extent that the benefits of lower interest costs exceed the costs that may be associated with restricting how management can use the available funds, management will elect to sign agreements that restrict their subsequent actions. Again, signing such an agreement that includes restrictive debt covenants would be an efficient strategy from the organisation’s perspective as it will be likely to lead to a reduction in its cost of attracting funds.
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Many of the above agreements are linked to financial accounting numbers such as profits, assets, liabilities and total equity. For example, a debt covenant might stipulate that the ratio of total debts to total assets shall not exceed, say, 60 per cent, or that profits shall be at least five times total interest expense. If these negotiated covenants are breached, which we often refer to as ‘technical default’, then the consequences might, depending upon the terms of the agreement, include: • transferring the control of the operations or assets of the organisation to the lender • requirement for immediate repayment of the loan • renegotiation of the loan terms • adjustments to interest rates being charged to the borrower.
The use of conservative accounting methods to reduce agency costs of debt Apart from explicitly agreeing not to undertake certain actions (such as taking on excessive levels of debts or agreeing not to invest in particularly risky ventures), management might also agree to adopt particular accounting methods if such adoption leads to a reduction in the cost of attracting debt capital. For example, Zhang (2008) argues that managers might agree to adopt conservative accounting methods because they believe that this might reduce the perceived risks faced by the lender. As we have already mentioned in our discussion of management compensation schemes, conservative accounting methods bias the organisation towards more readily recognising losses than gains, consistent with the traditional ‘doctrine of conservatism’. Conservative accounting practices would also restrict the organisation from undertaking numerous (or perhaps, any) asset revaluations. The effect of conservative accounting methods is that both profits and net assets (and therefore equity) would tend to be understated (that is, they provide ‘conservative measures’ of financial position and financial performance) relative to organisations that do not adopt conservative accounting methods. As an example of a conservative accounting policy, we can consider an organisation that uses the ‘cost model’ rather than the ‘revaluation model’ to account for non-current assets. Under the cost model, which would be considered to be a ‘conservative accounting policy’, where a non-current asset is worth more than its carrying amount, then no accounting adjustment is made; however, if it is worth less than its carrying amount (with carrying amount being cost less accumulated impairment costs and accumulated depreciation), then an impairment loss must be recognised. This conservative treatment means that measures such as net assets tend to be understated relative to other accounting methods that could have been employed. This description of conservative accounting practices is consistent with Watts (2003), who describes them as ‘asymmetrical verification requirements for gains and losses that lead to persistent understatement of net asset values’. The use of conservative accounting procedures within an organisation means that debt covenants restricting the amount of debt relative to assets (or debt to equity), or the amount of times profits must cover interest (known as an ‘interest coverage’ clause), will tend to be more restrictive or binding compared to those organisations that do not adopt conservative accounting methods. As Zhang (2008) argues, the more binding covenants will provide an earlier warning of default risk and will thereby reduce the risk exposure of the lending party (for example, a bank). The reason for this is that, because management will have less ability to circumvent restrictive covenants (for example, by undertaking asset revaluations), such covenants will create a technical default of a loan agreement earlier than if management has the scope to loosen the restrictions, perhaps through undertaking an asset revaluation. The earlier the lender can take action to safeguard its funds, the lower the risk of the lender. Zhang (2008) reports that borrowers who adopt conservative accounting methods attract funds at lower rates of interest (a benefit to the borrower). This is consistent with Ahmed et al. (2002), who also found that adopting conservative accounting methods leads to a reduction in the cost of attracting capital. According to Zhang (2008), borrowers that adopt conservative 382
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accounting methods are also more likely to violate debt contracts and to violate them sooner (and the early default signal creates lower risk for lenders, which explains why they are prepared to lend the money at a lower cost). Another interesting finding (DeFond, Lim and Zang, 2016) is that organisations that adopt relatively conservative accounting methods are generally charged lower audit fees (lower audit-firm risk), receive fewer adverse going concern opinions from auditors and tend to have their auditors resign less regularly.
Evidence of the use of accounting-based debt covenants Historical evidence on Australian public debt contracts is provided by Whittred and Zimmer (1986), who found that for public debt contracts written between 1962 and 1985:40 … with few exceptions, trust deeds for public debt place restrictions on the amount of both total and secured liabilities that may exist. The constraints were most commonly defined relative to total tangible assets; less often relative to shareholders’ funds. The most frequently observed constraints were those limiting total and secured liabilities to some fraction of total tangible assets (p. 22).41
While Whittred and Zimmer provided information about public debt issues, Cotter (1998) provided evidence of private debt contracts negotiated between Australian listed companies and banks between 1993 and 1995. Her findings reveal that (p. 187): Leverage covenants are frequently used in bank loan contracts, with leverage most frequently measured as the ratio of total liabilities to total tangible assets. In addition, prior charges covenants that restrict the amount of secured debt owed to other lenders are typically included in the term loan agreements of larger firms, and are defined as a percentage of total tangible assets.42
Hence, it is clear that for a number of years both private and public debt contracts within Australia have included restrictive covenants that are directly linked to accounting numbers. Where covenants restrict the total level of debt that may be issued, as was found by both Whittred and Zimmer (1986) and Cotter (1998), this is assumed to lead to a reduction in the risk to existing debtholders. It is further assumed to translate to lower interest rates being charged by the ‘protected’ debtholders. Where the covenants (or debt contract clauses) in a debt contract are breached, and depending on the terms of the debt contract, the debtholder could have the right to demand immediate repayment or the right to seize particular assets over which it has security. Alternatively, the debtholder could agree to renegotiate the terms of the contract and not enforce the conditions of the breach, but, as indicated below, renegotiation would typically be available only in the case of private debt agreements, given that the negotiation for privately raised debt would involve a limited number of parties.
When we note that something is a ‘public issue’ it means that the particular security (such as a debenture, an unsecured note or a convertible note) was made available for the public to invest in (with the terms of the issue typically provided within a publicly available prospectus document). Investors in a public debt issue would have a trustee who is to act in the interests of all the public investors. By contrast, a private debt issue involves an agreement between a limited number of parties (perhaps just one party, such as a bank) to provide debt capital to an organisation. 41 It is common in debt contracts that the measure of assets to be used excludes intangible assets. In part, this is due to the concern that if an organisation becomes financially distressed then many of its intangible assets (such as brand names, patents and goodwill) may have little market value. 42 Cotter (1998) notes that in the 1990s banks became the major source of corporate debt. This can be contrasted with the earlier period reviewed by Whittred and Zimmer (1986). In the early 1980s Australian corporations placed relatively greater reliance on raising debt through public funding, rather than privately dealing with institutions such as banks. 40
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In relation to debt restrictions incurred within debt contracts, Cotter (1998) found that the definition of assets commonly used within debt agreements allowed for assets to be revalued. However, for the purposes of the debt restriction, some banks restricted the frequency of revaluations to once every two or three years, while others tended to exclude revaluations undertaken by directors of the company. These restrictions lessened the ability of companies to loosen debt constraints by revaluing assets, thereby providing greater security to debtholders. Cotter (1998) also found that apart from debt-to-assets constraints, interest coverage and current ratio clauses were frequently used in debt agreements. These clauses typically required that the ratio of net profit, with interest and tax added back, to interest expense be at least a minimum number of times. In the Cotter study, the number of times that interest had to be covered ranged from one and a half to four times. The current ratio clauses reviewed by Cotter required that current assets had to be between one and two times the size of current liabilities, depending on the size and industry of the borrowing organisation. Mather and Peirson (2006) also undertook an analysis of Australian public and private debt issues made between 1991 and 2001. They reported that, relative to the earlier samples used by Whittred and Zimmer, public debt issues showed a ‘significant reduction in the use of debt to asset constraints such as covenants restricting the total liabilities/total tangible assets, or total secured liabilities to total tangible assets, with only 28 per cent of the sample of recent contracts including these covenants’ (p. 292). However, Mather and Peirson provide evidence that, while there is a reduction in the use of covenants that restrict the amount of total liabilities relative to assets, there appears to be a greater variety of covenants being used relative to earlier years. Among the other covenants they found in debt contracts were requirements stipulating required minimum interest coverage, minimum dividend coverage, minimum current ratio and required minimum net worth. Again, if these minimum accounting-based requirements are not met, the borrower is considered to be in technical default of the debt agreement and the lenders may take action to retrieve their funds. As already discussed, the purpose of the various debt covenants is to provide lenders with regular and timely indicators of the possibility of a borrower defaulting on repayment of its debts. A violation of a debt covenant signals an increase in the likelihood of default. However, it needs to be appreciated that the covenant measures are simply indicators of the chances that an organisation will not repay borrowed funds, and an organisation being in technical default of a covenant is not a perfect indicator that it would not have repaid the borrowed funds. When debt contracts are written, and where they use accounting numbers, the contract can rely on either the financial accounting rules in place when the contracts were signed (as we indicated earlier, this is often called ‘frozen GAAP’) or the accounting rules in place at each year’s reporting date (referred to as ‘rolling GAAP’ or ‘floating GAAP’). Mather and Peirson found that, in all the public debt contracts other than one, rolling (or floating) GAAP was to be used to calculate the specific ratios used within the contracts. The use of rolling GAAP increases the risk to borrowers in the sense that, if a new accounting standard is released by the IASB (and thereafter by the AASB) that changes the treatment of particular assets, liabilities, expenses or income, this has the potential to cause an organisation to be in technical default of a loan agreement. For example, a new accounting standard might be released that requires a previously recognised asset to be fully expensed in the statement of comprehensive income, which could have obvious implications for debt to asset constraints or interest coverage requirements. This in itself could motivate an organisation to actively lobby accounting standard-setters against a particular draft accounting standard. As Mather and Peirson (2006, p. 294) state: The use of rolling GAAP in Australia means that new (or revisions to) accounting standards might cause breaches of covenants not anticipated at the time of contract negotiation.
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The use of rolling GAAP can also increase the risks of lenders (debtholders) because if a new accounting standard is released that gives the company the option to use accounting methods that are not conservative (for example, the new rules might give an option for an organisation to revalue certain assets to fair value) then managers might use the new flexibility to opportunistically reduce the likelihood that debt covenants will become binding. When comparing the use of covenants in public and private debt issues, Mather and Peirson (2006) found that the mean number of accounting-based covenants used in the sample of public debt contracts is smaller (mean of 1.5) than the mean number of covenants (mean of 3.5) found in the sample of private debt contracts. That is, there were more restrictions placed on privately negotiated debt agreements. Similarly, where debt covenants restricted total liabilities to total tangible assets, Mather and Peirson found that ‘the limits imposed in public debt contracts (a mean total liabilities/total tangible assets of 82.2 per cent) appear to be less restrictive than those in private debt contracts (mean limit of 75.2 per cent)’. The fact that private debt contracts are more restrictive than public debt contracts can be explained from an efficiency perspective. Where a covenant is violated, an organisation is in technical default of the debt contract. If an organisation is in technical default, it often has the option to try to negotiate with the debtholders to come up with a compromise that does not involve immediate repayment of the debt. However, it is very difficult to come up with a negotiated outcome in a public debt issue as there are so many diverse parties involved, some of which might not even be able to be contacted, making it difficult, or nearly impossible, to have a successful renegotiation. Hence, we would expect to find less restrictive covenants in public debt contracts relative to private debt contracts.43 As Mather and Peirson (p. 305) state: In comparison to our sample of recent public debt contracts, private debt contracts contain a greater number, variety and, collectively, more restrictive set of financial covenants. We also document differences in accounting rules associated with financial covenants used in these contracts. Tailoring of the definition of liabilities and earnings in private debt contracts make them more restrictive compared with the definitions in public debt contracts. Our findings support theory that suggests that covenantrestrictive and renegotiation-flexible contracts are more suited to borrowers contracting with financial intermediaries in private debt markets than in public debt markets that are characterized by diverse and numerous investors.
In research that investigated the impact of changing accounting standards on borrowing practices, Cohen et al. (2019) investigated how a change in accounting standards influenced the level of borrowings by organisations that had negotiated debt covenants in place. Specifically, they explored the release by the US Financial Accounting Standards Board (FASB) of SFAS 160 Noncontrolling Interests in Consolidated Financial Statements. Basically, SFAS 160 reclassified ‘minority interests’ on the balance sheet from being part of liabilities to being part of shareholders’ equity. This meant that covenants relying on debt (such as debt to asset constraints) would be loosened. As a result, organisations that were close to violating debt covenants were able to increase their borrowings without breaching the debt covenant. What was also of interest was that most of the increased borrowing occurred within organisations that were otherwise deemed to be ‘financially healthy’. The fact that organisations increased their borrowings following the change in accounting standard (which loosened the effect of the debt covenants) suggests that the covenants restricted the level of borrowing prior to any covenant violation. The finding that financially healthy organisations increased their borrowing following the release of the accounting standard led the authors to suggest that debt covenants may have been too tight and 43
As Mather and Peirson (2006) point out, a trustee would typically be appointed to look after the interests of individual investors in a public debt issue. However, individual investors would still be required to approve any course of action ensuing from a technical breach of a debt covenant.
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were restricting efficient levels of borrowing. The findings also suggested that while many of the contractual agreements in place did have the option to enforce frozen GAAP, lenders chose not to exercise that option. In discussing their findings, Cohen et al. (2019, p. 135 state): Our study makes several important contributions. First, following the call of Graham and Leary (2011), we show that debt covenants can restrict leverage before they are violated. Although the literature has provided compelling evidence that debt covenants restrict borrowing after they are violated (Roberts and Sufi, 2009), we show that covenants affect financing choices of financially healthy firms even before they are violated. Second, we provide evidence that once the covenant constraints are relaxed, firms make justifiable investment choices with the additional capital. Our findings support the incomplete contract theory proposition that covenants are set too tightly (Christensen et al. 2016). Third, consistent with the vast positive accounting theory literature (Watts and Zimmerman 1990), we show that even accounting changes that appear cosmetic have real implications that can affect leverage. Finally, to the best of our knowledge, our study is the first to illuminate the use of the option to freeze GAAP, which is included in many debt contracts. We find no evidence that lenders exercised their option to freeze GAAP after SFAS 160, despite its impact on their lending position. In addition, we find no evidence that the added leverage for borrowers was detrimental to lenders. Thus, our findings imply that lenders were not adversely affected by SFAS 160. Collectively, we find that incomplete contracts may suppress leverage to suboptimal levels for Constrained firms. Relaxing debt covenants allows such firms to increase their leverage with no obvious detrimental effect on their lenders.
Incentives to manipulate accounting numbers in the presence of debt contracts As with management compensation contracts, PAT assumes that the existence of debt contracts (which are initially put in place as a mechanism to reduce the agency costs of debt and can be explained from an efficiency perspective) provides management with a subsequent (ex post) incentive to manipulate accounting numbers, with the incentive to manipulate the numbers increasing as the accounting-based constraint approaches violation. As Watts (1995, p. 323) states: Early studies of debt contract-motivated choice test whether firms with higher leverage (gearing) are more likely to use earnings-increasing accounting methods to avoid default (leverage hypothesis). The underlying assumptions are that the higher the firm’s leverage the less [is the] slack in debt covenants and the more likely the firm is to have changed accounting methods to have avoided default. This change is usually interpreted as opportunistic since technical default generates wealth transfers to creditors but it could also be efficient to the extent that it avoids real default and the deadweight loss associated with bankruptcy.
For example, if the organisation contractually agreed that the debt to total tangible assets ratio should be kept below a certain figure, then if that figure was likely to be exceeded (causing a technical default of the loan agreement), management may have an incentive either to inflate assets or deflate liabilities. This is consistent with the results reported in Christie (1990) and Watts and Zimmerman (1990). To the extent that such an action was not objective, management would obviously be acting opportunistically and not to the benefit of individuals holding debt claims against the organisation. Debt agreements typically require financial statements to be audited.
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Other research to consider how management might manipulate accounting numbers in the presence of debt agreements includes that undertaken by DeFond and Jiambalvo (1994) and Sweeney (1994). Both of these studies investigated the behaviour of managers of organisations known to have defaulted on accounting-related debt covenants. DeFond and Jiambalvo (1994) provided evidence that the managers manipulated accounting accruals in the years before and the year after violation of the agreement. Similarly, Sweeney (1994) found that as an organisation approaches violation of a debt agreement, managers have a greater propensity to adopt incomeincreasing strategies relative to organisations that are not approaching technical default of accounting-based debt covenants. The income-increasing accounting strategies included changing key assumptions when calculating pension liabilities and adopting first-in-first-out cost-flow assumptions for inventory. Sweeney (1994) also showed that managers with an incentive to manipulate accounting earnings might also strategically determine when they will first adopt a new accounting requirement. When new accounting standards are issued, there is typically a transition period (which could be a number of years) in which organisations can voluntarily opt to implement a new accounting requirement. After the transitional period the use of the new requirement becomes mandatory. Sweeney showed that organisations that defaulted on their debt agreements tended to adopt income-increasing requirements early, and deferred the adoption of accounting methods that would lead to a reduction in reported earnings. Research by Dhaliwal (1982) and Holthausen (1990) has also shown that organisations with high leverage ratios (debt to equity), and which are thereby assumed to be approaching the violation of debt agreements, tend to oppose the introduction of accounting methods that have the potential to introduce high variability in reported earnings. This is because the high variability might increase the possibility of defaulting on accounting-based debt agreements in particular years. Debt contracts occasionally restrict the accounting techniques that may be used by the organisation, hence requiring adjustments to published accounting numbers. For example, and as stated above, Cotter (1998) showed that bank loan contracts sometimes did not allow the component related to asset revaluations to be included in the definition of ‘assets’ for the purpose of calculating ratios, such as ‘debt to assets’ restrictions. These revaluations were, however, permitted for external reporting purposes. Therefore, loan agreements sometimes require the revaluation component (or other accounting adjustments that are allowed by accounting standards) to be removed from the published accounting numbers prior to the calculation of any restrictive covenants included within the debt contract. Within accounting, management usually has available a number of alternative ways to account for particular items. Hence, management has at its disposal numerous ways to minimise the effects of existing accounting-based restrictions. Therefore, it may appear optimal for debtholders to stipulate in advance all accounting methods that management must use. However, and as noted previously, it would be too costly, and for practical purposes impossible, to write ‘complete’ contracts up front. As a consequence, management will always have some discretionary ability, which may enable it to loosen the effects of debtholder-negotiated restrictions. The role of external auditors (if appointed) would be to arbitrate on the reasonableness of the accounting methods chosen. Apart from debt covenants (such as debt-to-asset constraints or minimum interest coverage requirements), which may or may not be breached, another contractual mechanism is something known as ‘performance pricing’. Referring to US data, Beatty and Weber (2003, p. 120) state: Performance pricing is a feature in bank debt contracts that explicitly makes the interest rate charged on a bank loan a function of the borrower’s current creditworthiness. Asquith, Beatty and Webber (2002) document that performance-pricing features typically measure the borrower’s creditworthiness using financial ratios such as debt to earnings before interest, taxes, depreciation and amortisation (EBITDA), leverage and interest coverage. That is, the interest rate charged in the contract does not remain fixed 387
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over the length of the loan, but varies inversely with changes in measures of financial performance. Compared to covenants under which accounting information affects loan rates only when the borrower violates a single threshold, performance pricing creates a more continuous and direct link between accounting information and interest rates. Thus, performance pricing likely gives managers additional incentives to make incomeincreasing accounting method changes.
Beatty and Weber (2003) explore whether the existence of accounting-based performance pricing increases borrowers’ tendencies to adopt income-increasing accounting method changes. Beatty and Weber also note that debt contracts often prohibit borrowers from using voluntary accounting method changes to affect contract calculations. Hence, they expect that borrowers who change their accounting methods are more likely to make income-increasing changes if their debt contracts allow the changes to affect contract calculations. It has previously been argued that borrowers would typically agree to various contractual restrictions (including restrictions on the accounting methods they are permitted to use) in an effort to reduce the interest costs and other borrowing costs that they are required to pay. However, Beatty and Weber (2003) also suggest that some borrowers might actually agree to pay higher costs of interest in return for being allowed greater flexibility in choosing accounting methods. That is, if we accept that restrictions placed on borrowers (which have the effect of reducing the ability of the borrower to transfer wealth away from the lenders and thereby potentially reduce the agency costs of debt) lead to a reduction in cost, then conversely we could speculate that in some circumstances some managers might be prepared to pay for increased flexibility – that is, there could be a value in having the ability to select alternative accounting measures. Beattie and Weber found that 75 borrowers, from their sample of 125 borrowing corporations, had at least one contract that allowed voluntary accounting method changes to affect contract calculations. Predictably, they found that organisations with contracts that allowed voluntary changes in the accounting methods used were more likely to adopt income-increasing accounting methods than organisations that had debt contracts that did not allow debt covenants to be calculated using new accounting methods. Further, they found that the likelihood that such organisations would adopt income-increasing methods increased as the cost of technical violation of debt contracts increased. In relation to the existence of accounting-based performance pricing, their results show that borrowers that change their accounting methods are more likely to make income-increasing accounting changes if their debt contracts include accounting-based performance pricing. Having discussed how managers might have incentives to adopt income-increasing accounting methods, we can now briefly consider the role of independent auditors. In relation to auditors, and following discussion so far in this chapter, there would arguably be a particular demand for financial statement auditing (that is, monitoring by external parties) when: • management is rewarded on the basis of numbers generated by the accounting system (therefore giving managers an incentive to increase accounting numbers to increase personal financial rewards) • the organisation has borrowed funds, and accounting-based covenants are in place to protect the investments of the debtholders. Consistent with this, it could also be argued that, as the managers’ share of equity in the business decreases, and as the proportion of debt to total assets increases, there will be a corresponding increase in the demand for auditing. In this respect, Ettredge, Simon, Smith and Stone (1994) show that organisations that voluntarily elect to have interim financial statements audited tend to have greater leverage and lower management shareholding in the organisation. The next section considers how expectations about the political process can also impact on a manager’s choice of accounting methods. 388
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Why do I need to know that the existence of accounting-based debt covenants will potentially influence managers’ choice of accounting methods? Why
To make appropriate decisions, readers of financial statements need both relevant and representationally faithful information. As such, it is useful to know about some factors that could undermine representational faithfulness. We have learned that the existence of accounting-based debt covenants does have the potential to motivate managers to favour accounting policies or choices that either inflate assets and/ or increase profits, particularly if those covenants are close to
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being in ‘technical default’. Therefore, if we think that an organisation has high levels of debt relative to its assets then we should, perhaps, exercise some caution when reading the organisation’s financial reports. We should also be particularly interested in the apparent expertise of the auditors to identify unacceptable instances of opportunistic accounting method selection. As students of accounting, we should know the factors that are likely to influence accounting policy selection.
Political costs
We have already indicated that financial accounting numbers are important with respect to debt contracting and management compensation contracting. Financial accounting also plays a key role in the political process. As indicated previously, organisations (particularly large ones) are sometimes under scrutiny by various groups, for example, by government, employee groups, consumer groups, environmental lobby groups and so on. The size of an organisation, which is often determined by using accounting numbers such as total assets, sales or profits, is often used as an indication of market power and this in itself can attract the attention of regulatory bodies such as the Australian Competition and Consumer Commission (ACCC), the Competition Commission in the United Kingdom or the Federal Trade Commission in the United States. Government and interest groups may publicly promote the view that a particular organisation (typically large) is generating excessive profits and not paying its ‘fair share’ to other segments of the community (the wages it is paying are too low, its product prices are too high, its financial commitment to environmental and community initiatives is too low, its tax payments are too low and so on). Watts and Zimmerman (1978b, 1986) highlight the highly publicised claims about US oil companies made by consumers, unions and government within the United States in the late 1970s that oil companies were making excessive profits and were in effect exploiting the nation. Such claims may have led to the imposition of additional taxes in the form of ‘excess profits’ taxes. In a more recent example, in 2022 the British Government imposed an additional ‘windfall profits tax’ on oil and gas companies because of the high profits they were reporting, in part driven by the war in Ukraine (for example, the London-based energy company, Shell, reported its highest ever quarterly profit around the time of the taxation announcement). The high profits of the oil and gas companies had attracted a great deal of negative news media attention, particularly because they were being reported at a time when local cost of living surged, partly due to rising energy prices being charged by the companies. Consistent with the early work of Watts and Zimmerman (1978b), it has been argued that to reduce the possibility of adverse political attention and the associated costs of this attention (the costs associated with increased taxes, increased wage claims or product boycotts), politically sensitive organisations (typically large organisations) will adopt accounting methods that lead to a reduction in reported profits.44 However, the view that lower reported profits will lead to lower political scrutiny (and ultimately to lower wealth transfers away from the organisation) assumes that parties involved in the political process are unable or not prepared to ‘unravel’ the 44
Difficulties with using organisational size to proxy for political costs, including the likelihood that it can proxy for many other effects, such as industry membership, are discussed in Ball and Foster (1982).
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implications of the managers’ various accounting choices. That is, managers can somehow fool those involved in the political process by simply adopting one method of accounting (income decreasing) in preference to another. In this regard, Fields, Lys and Vincent (2001, p. 260) state: In order for earnings management to be successful the perceived frictions must exist and at least some users of accounting information must be unable or unwilling to unravel completely the effects of the earnings management … Political cost-based motivations implicitly assume that users of accounting information (e.g, trade unions or government agencies) may be unable to undo completely the effects of earnings management.
Political costs Costs that groups external to an organisation might be able to impose on the organisation as a result of political actions. For example, if an organisation reports high profits then these profits might be used as an excuse by trade unions, lobby groups or government to justify efforts to transfer wealth away from the organisation.
But why would it be the case that external parties can potentially be ‘fooled’ by management as a result of management’s choices of alternative accounting methods when elsewhere it has been assumed (consistent with the EMH) that individuals within other markets, such as the capital market, can efficiently unravel management’s choice of accounting methods? Simply stated, it is assumed by researchers, such as PAT researchers, that ‘political markets’ are less efficient than capital markets and this leads to opportunities for wealth transfers through lobbying and other political actions. In relation to political costs, and from an economic perspective, there is a view that in political markets there is limited expected ‘pay-off’ that can result from the actions of individuals (Downs, 1957). For example, if an individual seeks to know the real reasons why government elected to adopt a particular action from among many possible actions, the gathering of such information would be costly. Yet that individual’s vote would have very little likelihood of affecting the existence of the government. Hence, individuals will elect to remain rationally uninformed. However, should particular interest groups form, then such information costs can be shared and the ability to investigate government actions can increase. A similar perspective is taken with groups other than government, for example representatives of labour unions, consumer bodies and so on. Officials of these bodies represent a diverse group of people, with the individual constituents again having limited incentive to be fully informed about the activities of the office-bearers. Because PAT assumes that all actions by all individuals (including officials of interest groups, politicians and so on) are driven by self-interest, representatives of interest groups are predicted to adopt strategies that maximise their own welfare in the knowledge that their constituents will have limited motivation to be fully informed about their activities. With the above arguments in mind, consider the actions of politicians. Because politicians know that highly profitable companies could be unpopular with a large number of their constituency, the politicians could ‘win’ votes by taking action against such companies. However, Watts and Zimmerman (1979) argue that politicians will claim that the actions they have taken were in the ‘public interest’, as obviously they need to disguise the fact that such actions best served the politicians’ own interests. Watts and Zimmerman (p. 283) state: In recent years economists have questioned whether the public interest assumption is consistent with observed phenomena. They have proposed an alternative assumption – that individuals involved in the political process act in their own self-interest (the self-interest assumption). This assumption yields implications which are more consistent with observed phenomena than those based on the public interest assumption.45 45
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Chapter 4 of this book considered different theories of regulation. One theory, public interest theory, suggests that regulators are not driven by self-interest but, rather, elect to put in place regulations that are in the best interests of society. By contrast, economic interest group theories of regulation assume that everybody, including regulators, is motivated by their own self-interest and hence regulators put in place regulations that best serve themselves rather than society generally. This latter theory ties in best with the assumptions embodied within PAT.
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To justify their actions, politicians may simply rely on the reported profits of companies to provide an excuse for their actions, knowing that individual constituents are unlikely to face the cost of investigating the politicians’ motives, or the cost of investigating how the corporation’s profits were determined (that is, whether the profit resulted because a particular accounting method was used in a less than objective manner). To reduce the excuses of politicians, potentially politically sensitive organisations are predicted to anticipate politicians’ actions and therefore managements of politically vulnerable organisations have an incentive to reduce their reported profits. As Watts and Zimmerman (1979, p. 281) state: Government commissions often use the contents of financial statements in the regulatory process (rate setting, anti-trust, etc.). Further, Congress often bases legislative actions on these statements. This, in turn, provides management with incentives to select accounting procedures which either reduce the costs they bear or increase the benefits they receive as a result of the actions of government regulators and legislators.
Interestingly, when the media report a company’s profitability they seldom give any attention to the accounting methods used to calculate the profit. In a sense, profit is held out as some form of objective measure of organisational performance (much like governments might rely on profits to support a particular action). Media reports of high corporate profitability can potentially trigger political costs for an organisation. As discussed, representatives of interest groups or political parties might use profits as a justification for particular actions. In this respect, an article appeared in the Hobart Mercury in 2013 (entitled ‘Tax on big four hits brick wall’) in which the Australian Greens political party used the size of bank assets (measured in accounting terms) to be the basis for levying additional taxes on banks. In part, the article stated: The Greens want a levy of 0.2 per cent on all bank assets above $100 billion in return for Federal Government guarantees, which the independent Parliamentary Budget Office has costed as raising $11 billion over the next four years. ‘At a time when there’s pressures on the budget, and the government is looking around for ways of raising revenue, especially in light of the failed mining tax, who can afford to pay it the most?’ Australian Greens’ Mr Bandt said yesterday. ‘If we don’t stand up to the big banks and the big miners, then the Labor Party is going to come after the rest of us, like they have with single parents, and like they are threatening with the forthcoming budget.’
From the above extract we can see how an accounting number – total assets – had been used as the basis of levying the additional tax. While the proposal was rejected by the government, it does show how accounting numbers are used in political debates. In the same article, the banks responded by noting how such a proposed tax would impact many people, including retirees and ‘working Australian’. Such a response would be aimed at trying to dampen any future calls for additional taxes: The Australian Bankers’ Association warned that if the Greens policy was adopted it would effectively amount to a tax on Australian’s retirement savings. The association’s chief executive Steven Munchenberg said the majority of bank profits were paid through dividends to mum and dad shareholders and superannuation funds. ‘Taxing banks’ profits reduces those returns for working Australians saving for their retirement through superannuation accounts and to retirees who are increasingly dependent upon positive business profit growth,’ he said.
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It is very common for corporate profits to be used by governments, consumer groups, employee unions and other stakeholders as justification for actions to be taken against organisations. For example, in a Sydney Morning Herald article entitled ‘CBA cuts 1000 staff on record profit day’ (2002) reference was made to the high profits of the Commonwealth Bank and questions were raised about how the bank could retrench so many employees when it generated such high profits. The high profits coupled with the loss of jobs for employees were reported as potentially ‘double-daring’ the government to introduce legislation to reduce the socially irresponsible behaviour of the banks. The union leader quoted in the article accused the organisation of acting with ‘incredible arrogance’. In a sense, the reported accounting profits could be used as an excuse to push for greater regulation of bank lending practices and to call for banks to pay higher wages and reduce the level of job redundancies. If reported profits were not so high, there might be less chance that demands for increased regulation or a reduction in job redundancies would be made. As Watts and Zimmerman (1978b, p. 115) state: By avoiding the attention that high profits draw because of monopoly rents, management can reduce the likelihood of adverse political actions and, thereby, reduce its expected costs (including the legal costs the firm would incur opposing the political actions). Included in political costs are the costs labour unions impose through increased demands generated by large reported profits.
As a further example of how reported profits can be used in a political debate, in an article in The Australian newspaper entitled ‘Deadlock in engineers’ salary discussions’ (Stapleton, 2008) reference was made to a dispute between Qantas and both its engineers and the union representing the engineers. Within the article, the company’s record profits were used by union officials to justify the claim that Qantas was not paying enough in salaries. Again, consistent with the political cost hypothesis of PAT, it could be argued that had the company not reported such high profits such calls for increased salaries might not have been as strongly made. Numerous studies have considered how particular accounting methods can be used in an endeavour to decrease political costs. As well as the work of Watts and Zimmerman, research has been undertaken by Jones (1991), who, in a US study, considered the behaviour of 23 domestic companies from five industries that were the subject of government import-related investigations over the period from 1980 to 1985. These investigations by the International Trade Commission sought to determine whether the companies were under threat from foreign competition. Where such a threat is deemed to be unfair, the government can grant relief by devices such as tariff protection. In making its decision, the government relied on a number of factors, including economic measures such as profits and sales. The results of the study show that in the year of the investigations the sample companies selected accounting strategies that led to a decrease in reported profits. Such behaviour was not evidenced in the year before or the year after the government investigation (perhaps indicating that politicians are fairly ‘shortsighted’ when undertaking investigations). In a UK study, Sutton (1988) found that politically sensitive companies were more likely to lobby in favour of current cost accounting.46 In a New Zealand study, Wong (1988) investigated the practice of New Zealand companies between 1977 and 1981 and found that those that adopted current cost accounting (which had the effect of reducing reported profits) had higher
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While a number of studies considered in this chapter investigate the choice between alternative accounting methods, it should be noted that in recent years there has been an increased focus on studying the manipulation of accounting accruals. Relative to investigating the selection of particular accounting methods (for example, the use of straight-line depreciation versus reducing-balance depreciation), the study of the accruals is more difficult and requires the use of modelling techniques to identify discretionary accruals (those controlled by management) and non-discretionary accruals (Jones, 1991). The use of accruals can also be explained from either an efficiency or an opportunistic perspective (Guay, Kothari and Watts, 1996).
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effective tax rates and larger market concentration ratios than other companies. Effective tax rates and market concentration rates were both used as a measure of political sensitivity. Authors such as Ness and Mirza (1991) have argued that particular voluntary social disclosures in an organisation’s annual report can be explained as an effort to reduce the political costs of the disclosing entities. Ness and Mirza studied the environmental disclosure practices of a number of UK companies. They considered that companies in the oil industry had developed particularly poor reputations for their environmental practices and that this reputation could be used by various interest groups to transfer wealth away from the organisation (and presumably away from the managers). Such wealth transfers might be generated if certain groups lobbied government to impose particular taxes (perhaps related to their environmental performance) or if particular employee groups took action to insist that the companies put in place strategies to improve their environmental performance and reputation. Ness and Mirza argued that if organisations voluntarily provide environmental disclosures (typically of a positive or self-laudatory nature) this may lead to a reduction in future wealth transfers away from the organisation. They found, consistent with their expectations, that oil companies provided greater environmental disclosures within their annual reports than did companies operating in other industries. The authors believe that this was because oil companies had more potentially adverse wealth transfers at stake. Before concluding the discussion on political costs it is useful to consider a headline that appeared in The Age on 4 February 2006 (p. 5): ‘Shell cops heat as $31bn profit leaves many cold’. During 2005 and 2006 fuel prices had reached record levels worldwide. The high prices meant that many people had difficulty finding the money for such basic requirements as heating. Arguably, a time when high fuel costs were adversely affecting so many people was not the most politically favourable time for Shell to post record profits. The following is an extract from the article: Oil giant Shell has come under attack from consumers, trade unions and green groups after announcing on Thursday the biggest profit by a British company. Shell made £1.5 million ($A3.5 million) an hour on the back of soaring oil prices. ‘It is high time the Government acted decisively and brought in a proper windfall tax,’ said Tony Woodley, general secretary of the Transport and General Workers Union. ‘At a stroke a windfall tax could strengthen the Financial Assistance Scheme and put some backbone into the Pension Protection Fund.’ Meanwhile, poverty activists argued that Shell’s profits came at the expense of one million more households falling into fuel poverty. The Road Haulage Association, representing British hauliers, also joined in the attack on Shell, urging the Government to ‘take a little more’ from the oil companies and use the cash to reduce fuel tax for road transport operators.
The Age article shows how accounting profits can be used to justify actions being taken against an organisation. If Shell’s profits had not been so high, such calls for action might not have been made. This is consistent with Watts and Zimmerman’s political cost hypothesis. To this point, we have seen that PAT indicates that the selection of particular accounting methods may impact on the cash flows associated with debt contracts, the cash flows associated with management compensation plans, and the political costs of the organisation, and these impacts can be used to explain why companies elect to use particular accounting methods in preference to others. PAT also indicates that the use of particular accounting methods may have opposing effects. For example, if a company was to adopt a policy that increased income (for example, it may capitalise an item, rather than expensing it as incurred), this may reduce the probability of violating a debt constraint; however, it may increase the political visibility of the company due to the higher profits. Managers are assumed to select the accounting methods that best balance the conflicting effects (and also that maximise their own wealth).
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REFLECTION QUESTION 8.7 Opportunistic use of accounting to attract government support Question Applying the ‘political cost hypothesis’, would you expect that if an organisation or industry is expecting to get some form of support from government (such as tax relief or tariffs imposed on foreign suppliers) then it will likely apply income-reducing accounting methods? Should politicians be aware of such incentives? Solution The ‘political cost hypothesis’ would suggest that politicians do use organisations’ reported profits as justifications for taking actions that impact those organisations. Politicians often need
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to justify their decisions to different stakeholder groups/ groups of voters. Therefore, on the basis of the research evidence we would expect that organisations will attempt to reduce their reported profits at the same time they are seeking tariff support. Politicians will then be able to point to the low profits if they are challenged to defend their decision to support the particular industry. Politicians should be aware of these incentives, but it is likely that many politicians do not understand that accounting numbers can be manipulated through the choice of accounting policies.
REFLECTION QUESTION 8.8 Opportunistic use of accounting to reduce political attention As noted above, the British Government imposed a windfall profits tax on British oil and gas companies in 2022. It was a time when the companies were reporting record profits and when energy prices had surged, creating various hardships within the community. Question Would oil companies in the United Kingdom have been likely to have adopted income-decreasing accounting methods in 2022? Further, would the government have been motivated by the ‘public interest’ when deciding to introduce the additional tax? Solution Applying the material in this chapter, PAT researchers would predict that a review of the financial statements of the oil
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and gas companies would reveal that income-decreasing accounting methods were applied in an endeavour to minimise the likelihood of adverse political intervention. Therefore, even though the reported profits were very high, they would likely have been even higher without the expected efforts that were undertaken to reduce profits. Whether managers did, or did not, adopt income decreasing methods in 2022 would be an issue that PAT researchers might explore. In terms of the government’s motivation for introducing the tax, PAT researchers believe that all people are driven by selfinterest. Therefore, it would likely be argued that the politicians introduced the additional taxes because they believed such an initiative would increase their chances of re-election.
Relevance of PAT-based research to efforts by the IASB and FASB to promote fair value accounting LO8.13
LO8.14
As we have already explained in this chapter, conservative accounting methods are those accounting methods that lead to relatively slower revenue recognition, faster expense recognition, higher liability recognition and lower asset recognition. Until recent decades, organisations tended to use accounting methods that applied conservative measures of profits, net assets and, therefore, equity. In particular, there was greater reliance on historical cost accounting, which is generally accepted as a conservative approach to accounting relative to other approaches to financial accounting, such as fair value accounting. Historical cost accounting numbers are less able to be manipulated by management and are more readily verified than information based on current values. Therefore, conservative accounting methods are considered to provide relatively
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greater efficiency from a contracting perspective. In relation to the use of conservative accounting methods, Kothari, Ramanna and Skinner (2010, p. 259) state: Conservatism has been embedded in accounting rules as they have evolved endogenously over hundreds of years, which suggests it is an economically efficient part of financial reporting. This is not surprising when one considers that agency problems among various corporate stakeholders, and particularly between management and other groups, are ubiquitous [meaning they are everywhere], and the agency relationships often provide management with incentives to overstate periodic performance measures.
As we would know from our studies of financial accounting, in more recent times there has been an increased propensity for both the IASB and FASB to release accounting standards that apply fair value as the basis of measuring various assets. This section will briefly investigate whether this movement towards fair values in accounting standards is efficient with respect to minimising the contracting costs of an organisation – an issue that has been focused upon in this chapter. As we would appreciate as a result of reading the material already provided in this chapter, managers, as suppliers of financial information, have greater knowledge about the organisation’s performance and future prospects (there is information asymmetry), as well as having incentives to manage earnings when such earnings management will provide favourable benefits to themselves (the opportunistic perspective of PAT). In Chapter 7 we learned that the two fundamental qualitative characteristics of useful financial information, according to the IASB Conceptual Framework for Financial Reporting (a normative framework of accounting), are relevance and representational faithfulness. While equity investors (owners) and debtholders will be interested in receiving information that is relevant for valuing the organisation (for example, fair values), they will also recognise that management has an incentive to opportunistically introduce bias to this information. From a contracting perspective, there will be a trade-off away from relevance in favour of verifiability (which is tied to ‘representational faithfulness’). Historical cost information tends to be more verifiable (and representationally faithful) than fair value, though its relevance in times of changing prices can be questioned. As indicated elsewhere in this chapter, conservative accounting methods are argued to contribute to efficient contracting (Watts, 2003). There is a belief among a number of researchers that it is more efficient for parties (for example, shareholders and debtholders) to monitor the activities of managers when those managers use conservative accounting methods to produce financial accounting information. Conservative accounting methods are typically more verifiable and subject to less possibility of manipulation. For example, debtholders are typically concerned about the possibility that they will not be repaid their invested funds. Because conservative accounting methods tend to defer profit recognition, such accounting methods reduce the likelihood that the organisation will pay excessive dividends, and this will act to allay some of the concerns of the debtholders. Further, because conservative accounting methods tend to reduce net assets and profits relative to other accounting methods, this means that accounting-based debt covenants will be activated earlier (that is, technical default will be triggered earlier), and this means that debtholders will be able to take earlier steps to safeguard their investments. The earlier the intervention of debtholders (or their representatives), the more likely that assets will still be available within the organisation to repay the debts. As Iyengar and Zampelli (2010, p. 122) state: One explanation for why firms might choose to implement conservative accounting practices lies in efficient contracting theory, i.e. conservative accounting can be used as part of a firm’s strategy to mitigate the conflicts that arise among the many claimants 395
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of a firm’s net assets. This is due to the fact that conservative accounting methods place constraints on the distribution of those net assets thereby limiting the scope for self-serving opportunistic behaviour. For example, Ahmed et al. (2002) look at the role of accounting conservatism in mitigating the conflict between bondholders and shareholders. Specifically, because conservative accounting lowers earnings and retained earnings, dividend policy is necessarily restricted, reducing the probability of excessive dividend payouts. Consequently, firms using more conservative accounting practices tend to incur lower costs of debt.
As reflected in the above quote, and as noted elsewhere in this chapter, because conservative accounting methods can reduce the possibility that management will undertake opportunistic earnings management, organisations that use conservative accounting methods might be able to attract debt and equity capital at a lower cost because of perceptions about lower risk. Applying this reasoning, authors such as Iyengar and Zampelli (2010), Khan and Watts (2009) and LaFond and Watts (2008), argue that the IASB and FASB should take note of the advantages inherent in conservative accounting procedures before finalising any judgements about accounting measurement. That is, while information about fair values will be useful to various financial stakeholders in terms of assisting them to make informed investment/resource allocation decisions (and fair value measurements would not be considered to constitute a conservative approach to measurement), more conservative accounting methods also provide benefits in terms of controlling potentially divergent behaviour of individuals involved in various contractual arrangements. Indeed, as Ivengar and Zampelli (2010, p. 139) state: Such attempts by the FASB [and IASB] to eliminate accounting conservatism from financial reporting [through greater reliance on fair values] may very well be misguided and in need of re-evaluation.
There is a clear trade-off between the advantages of having relevant information about current values and the contracting benefits that more conservative accounting benefits provide. From a contracting perspective, one advantage of conservative accounting methods is that they generally require a greater degree of verifiable information for revenue recognition (good news) than for expense recognition (bad news). That is, there is a bias towards understating the net assets of the reporting entity. This helps to guard against management’s tendency to overstate net assets and profits – actions that might, for example, be undertaken to opportunistically loosen the binding nature of debt covenants or to increase rewards paid by virtue of accountingbased management bonus schemes. Further, if there is a technical default of a debt covenant then debtholders’ ultimate action is to seize control of assets over which they have security. As such, debtholders will seek information about the probable values of assets upon liquidation. Upon liquidation, many intangible assets, such as goodwill and brand names, will have limited or no value. Therefore, from an efficient contracting perspective, there would be an argument that such assets should not be recognised for balance sheet (or statement of financial position) purposes, although this is a controversial proposal as it means that many assets that have traditionally been recognised should be expensed. As Kothari, Ramanna and Skinner (2010, p. 261) state: The use of the balance sheet by debtholders justifies the exclusion of economic resources that cannot be used to satisfy their claims against the entity. There has been a good deal of controversy about whether the balance sheet should include ‘assets’ related to various internally developed intangibles such as brandnames, customer satisfaction, intellectual capital of various forms, and so forth. These items typically fail conventional asset recognition criteria because there is no external transaction (the items being
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internally developed), or because the associated benefits are highly uncertain (for example, research and development expenditures), or because property rights over these items are not well developed, making legal claims uncertain. Proponents of the view that these types of intangibles should be capitalized argue that by failing to recognize these items, the balance sheet excludes assets that have significant economic value (e.g., Lev and Zarowin, 1999). However, management-supplied estimates of the value of such intangibles are difficult to verify, and for contracting and monitoring purposes, their inclusion is of limited use. In contracting, these exclusions are justifiable because it is unclear that these items could be used to satisfy creditors’ claims given uncertainty about both their future economic benefits and/or whether property rights are sufficiently well-defined as to establish legal rights over these items. Moreover, measurement of these items often relies on information and estimates provided by management, which are not verifiable and are subject to bias. Also, as discussed by Holthausen and Watts (2001, pp. 36, 37), to the extent that the value of these assets is dependent on the ongoing operations of the firm, these assets are not available to satisfy the claims of debtholders. This strengthens the view that internally developed intangible assets should not be included on the balance sheet.
Therefore, as we can see, Kothari, Ramanna and Skinner (2010) would be in favour of the strict rules in IAS 38 Intangible Assets that internally generated intangibles should not be recognised and that expenditures on research should be expensed as incurred. As they state (p. 260): Under current generally accepted accounting practices (GAAP), the anticipated cashflows from most internally developed intangibles are seen as being inherently too uncertain to justify recognition. Given the role of the balance sheet in efficient contracting, there is good reason for this convention.
The above view conflicts with the views of many managers from different organisations who were vocal in their opposition to the introduction of IAS 38 within Australia (in the form of AASB 138). They were particularly concerned that IAS 38 required many intangible assets to be removed from the balance sheet. If we agree with the views of Kothari, Ramanna and Skinner (2010), another potential reason why corporate managers opposed the introduction of the conservative accounting policies incorporated within IAS 38 was that such rules reduced their scope to use their own judgement to adjust asset values. While expenditure on research is required to be expensed as incurred by both the IASB and FASB, in the respective accounting standards issued by the IASB and FASB there is a difference in treatment of development expenditure: development expenditure typically follows research activities. Under the FASB accounting standard, development expenditure is to be expensed as incurred, a practice that would be considered as ‘conservative’. By contrast, the IASB allows, by virtue of IAS 38, that development expenditure can be capitalised rather than expensed. Therefore, the FASB rules for development expenditure would be considered to be more conservative than the treatment required by IASB rules. In this regard, Kothari, Ramanna and Skinner (2010, p. 262) state: Under U.S. (GAAP) (FASB ASC 730), research and development costs are expensed as incurred in spite of the fact that, on average, these expenditures have future economic benefits. This rule has survival value under an efficient contracting view because the alternative, i.e., possible capitalization, requires reliance on managerial judgments about the likelihood of future benefits that are difficult to verify. In contrast, under IFRS (IAS 38), research costs are expensed as incurred while development costs may be capitalized if commercial and technical feasibility have been established. This is a more
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subjective rule that relies on information that is usually only known to management. Because this leads to the potential for manipulation by management, the efficient contracting view implies a more conservative approach, such as that in ASC 730 for research and development, when there is a relatively large information asymmetry about asset value between management and outsiders.
Hence, advocates of efficient contracting would oppose the IASB’s decision to allow the capitalisation of development expenditure. Again, however, we should appreciate that the requirement to use rules that allow no discretion (often referred to as ‘blanket rules’), and that require the write-off of all expenditures incurred in relation to particular ‘assets’, will reduce the ability of the balance sheet to provide information about valuable resources controlled by the reporting entity. As explained in Chapter 6, the IASB released an accounting standard on fair value, IFRS 13 Fair Value Measurement, in May 2011. A near identical accounting standard also published by the FASB ‘Fair value’ is defined in IFRS 13 (IASB, 2022) as: the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.
If there is an active and liquid market in which assets are traded that are identical to the asset to be valued, then the fair value will be equivalent to the quoted price (market value) of the asset. This would be a fairly objectively determined number. However, the IASB and FASB recognise that there will be instances where assets, for which fair value measurements are required, do not have markets where identical assets are actively traded, so a directly comparable market value might not be available. In such instances, fair value can still be used for assets and the market price of a very similar asset or liability can be used or, where there is not an active market for the form of asset that is to be fair valued (so market values for an identical or similar asset cannot be observed), an alternative is to use an accepted valuation model to infer the fair value. In comparing fair value to historical cost, fair value is typically considered to be more relevant to the intended users of general purpose financial reports. However, it is a more subjective measurement basis if an active market does not exist for an item. If a valuation model is applied because there is not an active market, then many assumptions and professional judgements must be made by management as part of the valuation process, and this creates an opportunity for biased reporting to be introduced. Related to the above points, the IASB’s (and FASB’s) accounting standard on fair value measurement, IFRS 13, establishes a ‘fair value hierarchy’ in which the highest attainable level of inputs must be used to establish the fair value of an asset or liability. Levels 1 and 2 in the hierarchy can be referred to as mark-to-market situations, with the highest level, level 1, being described as (paragraph 76 of IFRS 13): Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the entity can access at the measurement date. (IASB, 2022)
Level 2 are directly observable inputs other than level 1 market prices (level 2 inputs could include market prices for similar assets or liabilities, or market prices for identical assets but that are observed in less active markets). As paragraph 81 states: Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. (IASB, 2022)
Level 3 inputs are mark-to-model situations where observable inputs are not available and risk-adjusted valuation models need to be used instead.
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It is particularly in regard to the level 3 ‘mark-to-model’ valuation methods that advocates of efficient contracting have concerns. In this regard, Kothari, Ramanna and Skinner (2010, p. 265) state: Given the efficient capital allocation objective for GAAP, it is useful to consider whether fair value is an appropriate measurement basis for balance sheet items generally. If reliably measured, it seems clear that measurement at fair value is superior to the use of the historic cost basis as a means of providing information about the potential economic values of assets, provided those assets are separable. Thus, a sufficient condition for the reliable measurement of these items is that they trade in liquid secondary markets, as is the case currently for investment securities. If such markets are unavailable, however, it is harder to envision fair value being viable, especially if the determination of fair value is largely a matter of managerial judgment.
While the above arguments relate to balance sheet items, similar concerns relate to revenue recognition. According to Kothari, Ramanna and Skinner (2010, p. 280): We acknowledge the advantage of using fair values in circumstances where these are based on observable prices in liquid secondary markets, but note that such markets do not exist for most assets. In the absence of verifiable market prices, fair values are determined by management judgment and the evidence on the opportunistic use of this judgment is germane. Accordingly, we caution against expanding fair-value measurement to areas such as intangibles, as standard setters have sometimes proposed. The principal role of the income statement is to measure performance for contracting, particularly that of management. Accordingly, the agency relationship between management and the firm’s owners is predicted to be paramount in determining criteria for revenue recognition. We view the ‘earned’ standard in extant revenue recognition rules as a reflection of concerns generated by this agency relationship (i.e., revenue is not recognized until effort is exerted), and the FASB’s proposals to abandon this standard for fair-value-based revenue recognition rules as inconsistent with economic demands and therefore ill advised.
In summarising their views on the potential of fair value measurement, Kothari, Ramanna and Skinner (2010, p. 266) state: We do not expect that the expanded use of fair values, which is an important feature of current standard setting agendas at the FASB and IASB, enhances the value of financial reporting under efficient contracting.
Therefore, as a result of reading this section of the chapter, we can understand some of the opposition that might be raised in the current debates around the increasing use of fair values. Of course, we must also realise that minimising contracting or transaction costs – which is the basis of the above objections to fair value measurement – is not the only purpose, or objective, of general purpose financial reporting. LO8.15
Earnings management
We can relate some of the above material from PAT (and Agency Theory) to what is commonly referred to as the ‘earnings management literature’. A great deal of our previous discussion did relate to earnings management. Where managers and their accountants adopt particular accounting policies, or make particular accounting-based decisions primarily to generate desired measures of profits/ earnings, then this is often referred to as earnings management. Earnings management can also occur through managers deciding to undertake, or not undertake, certain transactions primarily because of the way those transactions will influence reported profits. 399
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Earnings management can be done to influence the perceptions that some stakeholders might have about an organisation or to impact certain economic outcomes that are linked to financial accounting numbers (perhaps because certain accounting numbers are used within contractual arrangements). If the readers of financial reports are misled as a result of earnings management, then this could result in the inappropriate allocation of resources. According to Schipper (1989), earnings management occurs when managers use the flexibility inherent within accounting standards to manage an organisation’s reported accounting profits so as to influence some economic outcome to the organisation’s benefit. A broader definition of earnings management is provided by Walker (2013), who defines it as: The use of managerial discretion over accounting choices, earnings reporting choices, and real economic decisions to influence how underlying economic events are reflected in one or more measure of earnings.
Accrual-based earnings management Occurs when managers make, or defer, recognising various items of accrued income or accrued expenses (such as accruals for unpaid expenses) with the intention of generating a preferred financial result.
Real earnings management Occurs when management varies the time at which particular transactions are undertaken with the intention of influencing reported results.
One of the key factors that drives earnings management is the pressure on managers to report sound short-term financial performance (profits). As indicated above, earnings management can be, and often is, undertaken as a result of making (or deferring) various discretionary accruals of income or expenses (often referred to as ‘accrual-based earnings management’), or it can come about as a result of selectively undertaking actual transactions near the end of the financial year (sometimes referred to as ‘real earnings management’). The earlier research on earnings management tended to focus on accruals-based earnings management. Examples of accrual-based earnings management, also often referred to as ‘discretionary accounting choices’, would include choices of (and changes made to) depreciation rates and methods, inventory cost flow assumptions and measurement assumptions, bad and doubtful debt calculations, timing of revaluations of property, plant and equipment, and assumptions around revenue recognition. Researchers exploring earnings management attempt to determine what accruals would have been in the absence of earnings management (‘normal accruals’), and then compare them with actual accruals to determine what is often referred to as ‘discretionary accruals’. Examples of ‘real earnings management’, on the other hand, would include altering amounts of research and development, bringing forward sales perhaps by offering limited term pricing discounts, altering advertising expenditure, changing shipping schedules and the transfer of ‘control’ of goods to bring forward the recognition of revenue, altering maintenance schedules, and changing the timing of sale on non-current assets. Consistent with findings from PAT, research evidence shows that organisations close to breaching debt covenants tend to engage in greater earnings management compared to organisations that are not close to violation. Also, evidence suggests that organisations that use conservative accounting methods and do not have a history of earnings management are able to secure lower interest rates when borrowing funds (Pappas, Walsh and Xu, 2019). In relation to real earnings management (REM), Pappas, Walsh and Xu (2019, p. 398) report that their evidence suggests: Loan providers are likely to identify the borrower firms’ REM activities. They view these activities as detrimental to firm value and require higher interest rates, shorter maturities, the presence of collateral, and more intensive financial covenants to mitigate the increased information and default risks induced by REM…. A key implication of this study is that it alerts firms that REM can be detected and penalised by creditors. Firms using REM to boost current-period earnings should bear in mind the increase in their borrowing cost.
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In this regard, and according to Zang (2012), accrual-based earnings management and real earnings management can both be employed by an organisation depending upon the relative costs and benefits of each type of earnings management, with the costs of accrual-based earnings management increasing with the existence of stronger outside monitoring. In this regard, Anagnostopoulou and Tsekrekos (2017) provide evidence that in the presence of high levels of leverage/debt (or changes in debt), the trade-off between real earnings management and accrual-based earnings management turns into a ‘complementary effect’. This evidence is interpreted as an indication that very high leverage is typically accompanied by strong outside scrutiny, making it necessary for organisations to use real earnings management in combination with accrual-based earnings management to be able to achieve particular earnings targets. Such findings are deemed to provide evidence that an environment of increased monitoring and scrutiny supports a preference by managers for real earnings management as opposed to accrualbased earnings management. There has also been evidence to indicate that the introduction of additional government oversight and regulations (such as the introduction of the SarbanesOxley (SOX) Compliance Regulations in the United States) can act to reduce accruals-based earnings management but also lead to a corresponding increase in real earnings management (Hill, Korczak and Wang, 2019). Various organisation-based factors, including internal governance practices, have been found to impact the incidence and type of earnings management employed by managers. For example, it has been argued that the longer the expected remaining working life of senior managers, the less the likelihood that the managers will focus opportunistically on short-term performance. Conversely, the shorter the remaining expected work-life of a senior manager, the greater the likelihood of a manager making decisions that generate profits (and rewards to the manager) in the short term. According to Cheng, Lee and Shevlin (2016), senior managers below the level of CEO, and who are expected to have a longer remaining work-life which motivates them to care more about long-term value of the organisation, are expected less likely to support activities that sacrifice long-term positive net present value investments to meet short-term earnings targets. Conversely, CEOs would typically have fewer years left in their working life and would be relatively more in favour of earnings management that generates higher short-term performance measures. Further, Cheng, Lee and Shevlin (2016) also argue that the more influence that key subordinate executives have, the more effective is the internal governance, and the less likely that the company will engage in activities for the sake of impacting short-term profits. However, this ability to reduce the propensity of an organisation to engage in transactions aimed at increasing short-term profits will be reduced the greater the power and authority of the CEO within the organisation. Cheng, Lee and Shevlin (2016) also argue that organisations that are about to issue debt or equity will benefit more from beating earnings benchmarks or targets as this can increase the ultimate proceeds from debt/equity financing. Therefore, subordinate managers will have weaker incentives to constrain earnings management when an organisation is about to go to the capital market to raise debt or equity. The gender of directors has also been suggested as a factor that influences the practice of earnings management. Such suggestions are based upon a belief by some researchers that women are more likely to emphasise assisting others, whereas men are more competitive and focus on ‘making money’; that women are more ethical in the workplace and less likely to act immorally; and that women are more likely to report incidents of fraudulent behaviour (Kaplan, Pany, Samuels and Zhang, 2009). Evidence also suggests that women are less tolerant of opportunistic behaviour (Krishnan and Parsons, 2008). Drawing upon this research, Gull, Nekhili, Nagati and Chtooui (2018) explore the association between the presence of women on boards of directors and the magnitude of earnings management. They find evidence of a negative relationship between female executives who are CEOs or chief financial officers (CFOs) and earnings management. This is consistent with earlier findings 401
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from Arun, Almahrog and Aribi (2015), which shows that UK companies with a majority of female directors adopt more restrained earnings management practices. One issue that we should keep in mind from this research is that, unlike some of the assumptions made by many positive accounting researchers, it is not assumed that all people (male and female) act the same or have the same motivations. Such insights have direct implications for prescriptions about board membership. Research has also shown that managers will undertake earnings management to influence government investigations. This is consistent with our earlier discussion of ‘political costs’. Godsell, Welker and Zhang (2017) examine earnings management of EU organisations around the time of the EU undertaking anti-dumping trade investigations. Accounting data is collected as part of these investigations. ‘Dumping’ is deemed to occur when foreign exporters are selling goods into the EU at prices lower than the respective goods’ normal prices when sold in the exporting country market. If dumping is seen to occur, and if it is apparent that the domestic industry has suffered financial injury (perhaps reflected by lower reported profits), then actions can be taken against the organisation selling the goods into the EU, inclusive of additional taxes/ duties being imposed. Specifically, the EU compares accounting data prior to the initiation of the claim with accounting data in the year and, in some cases, the year after or before the investigation is started. Godsell, Welker and Zhang (2017) explain that EU organisations petitioning for trade remedies in anti-dumping investigations have incentives to engage in profit-decreasing earnings management in the year of, and year subsequent to, their application for trade relief. The results of their study support this view and are consistent with the view that the petitioning organisations manage earnings in a downward direction to enhance their apparent injury from overseas dumping of products into their country, and increase their probability of success in having action taken against the foreign organisation. However, the authors also find that organisations that are about to raise new debt or equity in the year of, and/or the year after the initiation of anti-dumping investigations, moderate the extent to which they embrace decreasing earnings management. In other related research, Liu, Subramanyam, Zhang and Shi (2018) investigated potential earnings management undertaken by organisations that have been placed on a ‘negative credit watch’. A credit watch occurs when ratings agencies (which provide ratings of various organisations’ credit-worthiness) place particular organisations (that are rated, and which are generally very large organisations) with uncertain changes in credit risk under a formal review process. The organisation is notified by the ratings agency and is placed ‘on watch’ when a downgrade is likely, but not certain. An organisation’s financial statements serve as the starting point for the financial analysis of a rated organisation. Liu et al. (2018) argue that issuers under negative credit watch have a strong incentive to manage earnings because downgrades in ratings have significant economic implications and because uncertainty in the watch resolution encourages managers to influence the outcome. Credit ratings impact the cost of borrowing, and as a result, organisations have a strong incentive to maintain their credit rating. Liu et al. (2018) found evidence of significant income-increasing accrual management by negative watch organisations during the watch period. Further, the income-increasing earnings management is significantly higher than in the respective pre- and post-credit watch periods. Further still, the results indicate that the earnings management during the negative watch favourably influences the outcome of the watch resolution, thereby suggesting that sophisticated users of accounting reports, such as ratings agencies, are actually influenced by opportunistic earnings management. That is, the impacts of the earnings management is not ‘unravelled’ even by such sophisticated users of accounting information. The presence of strong labour unions has also been found to influence the use of earnings management, with managers often trying to use methods to reduce reported income in an 402
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endeavour to reduce unions’ ability to justify calls for higher wages for their members. Further, Hamm, Jung and Lee (2018) also argue that organisations with strong labour unions will adopt accounting strategies that tend to reduce the volatility of reported profits. Employees (like debtholders) are deemed to perceive volatile earnings of their employer as a sign that the organisation is at higher risk of failure and therefore creates higher risk for them in terms of providing a place of ongoing secure employment. To compensate the employees for the higher risks associated with potentially losing their job, they will generally demand higher wages. The success of such demands is proposed to be linked to the strength of the labour union to which the employees belong. Consequently, Hamm et al. (2018) predict that managers dealing with a stronger labour union have a greater incentive to avoid reporting volatile earnings and they do this by using various accounting accruals in a way that effectively ‘smooths’ reported profits. The results of their study support the prediction. Another variable that has been found to influence earnings management is the quality of the auditor. In this regard, Alhadab and Clacher (2018) explored earnings management undertaken by organisations around the time of an initial public offering (IPO) and they investigate whether the quality of the auditor influences the propensity of an organisation to manage earnings (an IPO occurs when a company, which was formerly a private company, offers shares to the public and thereafter becomes a public company). They found that the presence of high-quality auditors (which simplistically they assign to ‘Big 4’ audit firms: PWC, Deloitte, KPMG and EY) constrains the use of discretionary accruals to manage earnings around the time of an IPO. However, the appointment of a Big 4 auditor did not constrain ‘real earnings management’ (as defined above), with this real earning management often being through manipulations of sales-based activities. Reflecting on their results, Alhadab and Clacher state (p. 450): The presence of a big-4 auditor from a regulatory standpoint would therefore be expected to curtail managerial manipulation, as a big-4 auditor will have the technology/experience to identify real earnings management. Moreover, because of the higher litigation risk faced by a big-4 auditor they will be more likely to qualify the audit report. Consequently, managers, while still incentivized to undertake earnings management, may be less likely to utilise all the potential levers at their disposal, as their ultimate goal is to have a successful IPO. The risk that the newly listed company is sanctioned in some way, for example through a qualified audit opinion is, therefore, likely to curtail the full extent of earnings management that firms undertake.
Most of the research undertaken in the earnings management literature, including that referred to above, has taken a very ‘economics-based approach’ and has relied upon statistical analysis using large amounts of data collected from different organisations sometimes dispersed across broad geographical locations. By contrast, there has been less in-depth analysis from behavioural, psychological, critical or other points of view. This means that we are potentially missing some important insights about what is driving managers’ choices. Many accounting researchers do nevertheless apply various insights from the behavioural and psychological literature to explain other aspects of accounting, as we discuss in Chapter 12. While relatively brief, this discussion of earnings management emphasises the point that accounting numbers, like profits, are used in a variety of ways and, as a result, managers often have incentives to opportunistically manipulate such numbers. This further highlights the fact that we need to have some healthy scepticism when reviewing an organisation’s financial reports.
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REFLECTION QUESTION 8.9 Implications associated with the timing of income and expense recognition The reported profits of an organisation will be impacted by various factors, including when particular transactions and events are recognised and how such transactions and events are measured. Question Why would managers, especially those who work within large organisations, care about the timing of when income or expenses are recognised? Solution Obviously, whether and how income and expenses are recognised will, in turn, affect profits. From an objective perspective, managers should be concerned that income is recognised when it has actually been earned and expenses are recognised when they have been incurred (and when there have been related changes in assets and/or liabilities). In terms of why managers might care about when profit is recognised, there are many reasons, including the following:
• The news media pay a lot of attention to the profits of larger organisations. Many stakeholders have an interest in these profits and, rightly or wrongly, interpret them as a key measure of the ‘success’ of an organisation. Therefore, because of the attention managers believe profit attracts, they might generally prefer to disclose higher profits. The higher profits might indicate that managers have been performing their duties well. However, as we have noted, high profits can be used by some stakeholders as an excuse to argue that the organisation is making excessive profits, and that it should decrease the prices it charges for its goods or services and/or increase the payments it makes to its employees. • It is common for managers to receive bonus payments that are linked to profits. For example, the managers might receive a fixed salary plus a bonus that comprises a specified percentage of profit. Because managers would prefer to receive a bonus now rather than later (the
Reflection
present value of a dollar received now is greater than the present value of a dollar received later), then managers who have been offered an accounting-based bonus will typically prefer that income (and profits) be recognised earlier than later and that expenses be deferred. However, if the managers believe they will not reach the target level of profits required for a bonus to be paid, they might prefer to defer the recognition of income until the following year, so as to help reach next year’s target and enable a bonus to be paid.
• Organisations that borrow funds often sign debt contracts that include clauses (debt covenants) that are linked to accounting numbers. As we know, managers agree to these contracts as they allow their organisation to attract debt funds at a lower cost because they safeguard lenders. For example, the debt contract might have a requirement that profits must be maintained at a certain level (for example, a specific multiple of total interest costs), thereby providing a margin of safety that the debtholders will receive the required interest payments or that a certain level of profit is earned before dividends can be paid to owners. If organisations are close to breaching these contractual requirements, then managers will potentially be motivated to recognise income as early as possible so as to ensure compliance with the restrictive covenants. We could give many more reasons as to why managers might care about when income and expenses are recognised, but the point to again be made is that profit is a number that attracts much attention and is used within many agreements that an organisation is party to. It is a measure of performance that is of interest to many stakeholders. Therefore, the timing of the recognition of income and expenses is an issue that managers do care about.
Accounting policy choice and ‘creative accounting’ LO8.9
Those people responsible for selecting between the different accounting techniques – which should be explained in the accounting policy notes that accompany financial statements – might select the accounting policies that they believe most effectively and efficiently report the performance of their organisation; in other words, they might approach their selection
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objectively. As paragraph 10 of IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors (IFRS Foundation, 2022) states: In the absence of an Accounting Standard that specifically applies to a transaction, other event or condition, management shall use its judgement in developing and applying an accounting policy that results in information that is: (a) relevant to the economic decision-making needs of users; and (b) reliable, in that the financial statements: (i) represents faithfully the financial position, financial performance and cash flows of the entity; (ii) reflects the economic substance of transactions, other events and conditions, and not merely the legal form; (iii) are neutral, that is, free from bias; (iv) are prudent; and (v) are complete in all material respects.
By contrast, it is also possible for such individuals to select the policies that best serve their own interests; in other words, they might approach their selection and application of accounting techniques ‘creatively’. The term ‘creative accounting’ is frequently used in the media. It refers to instances where those responsible for the preparation of financial statements select accounting methods that provide the result desired by the preparers. As we have already seen, PAT provides an explanation of why organisations might be creative – or opportunistic – with their financial accounting (perhaps to increase the rewards paid to managers, to loosen the effects of accountingbased debt covenants or to reduce potential political costs). Indeed, from our overview of PAT, we know that PAT researchers would expect managers to apply creative accounting whenever it is in their interests to do so. Further, from the material covered in this chapter, we have also learned that there are three general hypotheses, these being referred to as: 1 the debt hypothesis 2 the management bonus hypothesis 3 the political cost hypothesis. The debt hypothesis predicts that organisations close to breaching accounting-based debt covenants will select accounting methods that lead to an increase in profits and assets. The management bonus hypothesis predicts that managers on accounting-based bonus plans will select accounting methods that lead to an increase in profits. And the political cost hypothesis predicts that organisations subject to political scrutiny will adopt accounting methods that lead to a reduction in reported profits. With the range of accounting techniques available, account preparers can be creative, yet at the same time follow accounting standards. Although they might not be objective, it might be difficult for parties such as auditors, with an oversight function, to report that the account preparers are doing anything wrong. It is hoped, however, that the vast majority of individuals preparing financial statements place objectivity before self-interest – a hope that is perhaps in conflict with a central assumption of PAT. Griffiths, a British author, devoted an entire book to the issue of creative accounting within the United Kingdom. In Creative Accounting: How to Make Your Profits What You Want Them to Be, Griffiths (1987, p. 1) stated: Every company in the country is fiddling its profits. Every set of published accounts is based on books which have been gently cooked or completely roasted. The figures which are fed twice a year to the investing public have all been changed in order to protect the guilty. It is the biggest con trick since the Trojan horse. Any accountant worth his salt will confirm that this is no wild assertion. There is no argument over the extent and existence of this corporate contortionism, the only dispute might be over 405
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the way it is described. Such phrases as ‘cooking the books’, ‘fiddling the accounts’ and ‘corporate con trick’ may raise eyebrows where they cause people to infer that there is something illegal about this pastime. In fact this deception is all in perfectly good taste. It is totally legitimate. It is creative accounting.
This is a fairly extreme view of creative accounting, and not one necessarily shared by the author of this book. If the output of the accounting system lacks credibility, and assuming that such markets as the capital market are efficient, it would be unlikely that they would use the output of the accounting system in the design of contractual arrangements with such an organisation. However, evidence clearly indicates that the market does rely on the output of the accounting system. For example, the bond (debenture) trust deeds of large, listed companies, as well as negotiated lending agreements with banks, without any apparent exception, use the output of the accounting system to control and monitor the behaviour of corporate management. While we need to acknowledge that creative accounting does exist, it is reasonable to argue that, with the increased number of accounting standards being issued, the scope for being creative has decreased (to the extent that compliance with these accounting standards is being monitored and enforced). Whatever the actual incidence of creative accounting, to consider that all financial statements are developed on an objective basis would be naive. This chapter has discussed how the wealth of the organisation, or particular individuals, might be tied to the output of the accounting system. This can be through the existence of accounting-based debt contracts and accountingbased management compensation schemes, both of which are, according to PAT, initially devised to increase the efficient operations of the entity (the efficiency perspective). The existence of political costs, which might be influenced in part by such accounting numbers as ‘profits’, will also affect the value of an organisation. Adopting the opportunistic perspective of PAT, whenever individuals’ wealth is at stake, there is always the possibility that opportunistic actions might override the dictates of objectivity. Certainly, PAT assumes that considerations of selfinterest would drive the selection of accounting policies. Whatever the case, creativity might be employed, but hopefully not too often!
Why do I need to know about the concept of ‘creative accounting’? According to the IASB Conceptual Framework for Financial Reporting, general purpose financial reports should provide a representationally faithful portrayal of the transactions and events that have affected the assets and liabilities (and therefore, the equity) of a reporting entity. This means that the depiction of the transactions and events should ideally be complete, neutral and free from error. This in turn means the information is not biased and there are no material omissions of data. While this is an ideal, the reality is that this does not always occur. Because of private economics-based incentives, managers with the assistance of accountants will, from time
to time, manipulate reported financial information to Why provide an outcome that is beneficial to the organisation, its managers and also potentially the shareholders. They will often do this ‘creatively’ such that it might not be clear to others that the information has been manipulated through creative accounting. As readers of financial statements, it is important for us to know that creative accounting does occur, and to understand why it might occur and how it might occur. To believe that all financial reports are prepared objectively would be naive.
Some criticisms of Positive Accounting Theory LO8.16
There have been many criticisms of PAT and the theories from which it is derived, particularly Agency Theory. One widespread criticism of PAT is that it does not provide prescription and therefore does not provide a means of improving accounting practice. It is argued that simply 406
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explaining and predicting accounting practice, which is the aim of PAT, is not enough. Using a medical analogy, Sterling (1990, p. 130) states: PAT cannot rise above giving the same answers because it restricts itself to the descriptive questions. If it ever asked how to solve a problem or correct an error (both of which require going beyond a description to an evaluation of the situation), then it might go on to different questions and obtain different answers after the previous problem was solved. If we had restricted the medical question to the description of the smallpox virus, for example, precluding prescriptions to be vaccinated, we would need more and more descriptive studies as the virus population increased and mutations appeared. Luckily Edward Jenner was naughtily normative, which allowed him to discover how cowpox could be used as a vaccine so smallpox was eventually eliminated, which made room for different questions on the medical agenda.
Howieson (1996, p. 31) provides a view that, by failing to provide prescription, Positive Accounting Theorists may alienate themselves from practising accountants. As he states: … an unwillingness to tackle policy issues is arguably an abrogation of academics’ duty to serve the community which supports them. Among other activities, practitioners are concerned on a day-to-day basis with the question of which accounting policies they should choose. Traditionally, academics have acted as commentators and reformers on such normative issues. By concentrating on positive questions, they risk neglecting one of their important roles in the community.
A second criticism of PAT is that it is not value free, as it asserts. A review of the various research that has adopted PAT will reveal a general absence of prescription – that is, there is no guidance as to what people should do; rather, it explains or predicts what they will do. Positive Accounting Theorists normally justify this by saying that they do not want to impose their views on others, but would prefer to objectively provide information about the expected implications of particular actions and let people decide for themselves what they should do. (For example, they may provide evidence to support a prediction that organisations close to breaching accountingbased debt covenants will adopt accounting methods that increase the organisation’s reported profits and assets.) However, as a number of accounting academics have pointed out, selecting a theory to adopt for research (such as PAT) is based on a value judgement; what to research is based on a value judgement; and believing that all individual action is driven by self-interest, and that being ‘rational’ effectively means a rejection of morals, loyalty and the like, is a value judgement; and so on.47 Equally, whether one accepts that ‘stealing by the owner-manager is analogous to the owner-manager’s over-consumption of perks’, as Watts and Zimmerman (1986, p. 185) note, is a matter of personal opinion. Also, Watts and Zimmerman appear to have taken a normative position when they identify the objective of accounting research. According to them, ‘the objective of accounting theory is to explain and predict accounting practice’ (1986, p. 2). Clearly, there are many other views about what the role of accounting theory is, or should be. Hence, no research, whether conducted under PAT or otherwise, is ‘value free’. While Watts and Zimmerman did continue to argue for a number of years that PAT was value free, they did eventually concede (1990, p. 146) that: Positive theories are value laden. Tinker et al. (1982, p. 167) argue that all research is value laden and not socially neutral. Specifically, ‘Realism operating in the clothes of positive theory claims theoretical supremacy because it is born of fact, not values’
47
In Chapter 13 it is noted that some researchers argue that Positive Accounting Theorists adopt a conservative right-wing ideology in promoting the virtues of markets, the rights of shareholders (the capitalist class) and so on.
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(p. 172). We concede the importance of values in determining research: both the researcher’s and user’s preferences affect the process.
Another criticism of PAT is that since its general inception in the 1970s the issues being addressed have not shown great development. Since the early days of Watts and Zimmerman (1978b), there have been three key hypotheses, as discussed earlier and reiterated here: the debt hypothesis (which proposes that organisations close to breaching accounting-based debt covenants will select accounting methods that lead to an increase in profits and assets); the bonus hypothesis (which proposes that managers on accounting-based bonus schemes will select accounting methods that lead to an increase in profits); and the political cost hypothesis (which proposes that organisations subject to political scrutiny will adopt accounting methods that reduce reported income). A review of the recent PAT literature indicates that these hypotheses continue to be tested in different environments and in relation to different accounting policy issues, even more than 45 years since Watts and Zimmerman’s paper (1978b). In this respect, Sterling (1990, p. 130) posed the following question: What are the potential accomplishments [of PAT]? I forecast more of the same: twenty years from now we will have been inundated with research reports that managers and others tend to manipulate accounting numerals when it is to their advantage to do so.
In commenting on the perceived lack of development of PAT, Fields, Lys and Vincent (2001, p. 301) state: Fundamentally, we believe it is necessary to step back from the current research agenda, and to develop the ‘infrastructure’ surrounding the field. In a sense, the accounting choice field has been a victim of its own perceived success, and has outrun the development of theories, statistical techniques and research design that are necessary to support it. We therefore are calling for a return to work in these basic areas, before the field is able to advance further.
Also, much of the research within PAT considers individual accounting choices (for example, whether an entity will revalue a particular class of non-current assets), when in practice the organisation will have a vast number of accounting choices, many of which might have opposing effects on financial performance and position. That is, while researchers might be studying whether an entity elects to adopt an accounting method that increases income, at the same time the entity might also be adopting another (unresearched) accounting method that reduces income. Considering one accounting method choice from the portfolio of all the accounting choices being made within the organisation provides a very incomplete picture. In this regard, Fields, Lys and Vincent (2001, p. 288) state: Most of the work [in PAT] examines the choice of a particular accounting method within the context of the goals driving the accounting choice, whereas managers may make multiple accounting method choices to accomplish a specific goal. As a result, examining only one choice at a time may obscure the overall effect obtained through a portfolio of choices.
Fields, Lys and Vincent (p. 290) further state: In addition to the problem of addressing multiple accounting choices, generally as reflected in accruals, there is also the issue of multiple, and potentially conflicting, motivations for the accounting choices. Most of the work discussed focuses on a single motive for accounting choice decisions. For example, the compensation literature focuses on the question of whether managers use accounting discretion to maximize their compensation. Implicitly, the results suggest that managers’ actions come at 408
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the expense of shareholders. But if this is so, why do compensation contracts allow discretion? One plausible answer is that managers’ actions are not only anticipated, but also desirable from shareholders’ perspective. For example, the same accounting choices that maximize managers’ compensation may also decrease bond covenant violations or increase asset valuations. However, such motives are typically not included in the analysis. By focusing on one goal at a time, much of the literature misses the more interesting question of the interactions between and tradeoffs among goals. Moreover, it is not clear whether the conclusions are attributable to the specific motivation being analyzed; generally results consistent with one hypothesis are consistent with many. For example, what may appear to be an opportunistic choice of an earnings increasing accounting method choice (to benefit managers at the expense of other stakeholders in the firm), may be in fact a response to avoid a bond covenant violation (and thus benefits all other stakeholders at the expense of the creditors). Finally, with only few exceptions, research generally focuses on motives identified in the 1970s and 1980s. Typically the usual suspects are rounded up. However, we suspect that new insights may be gained by investigating additional motives. The problem of multiple conflicts can be viewed, in turn, as a special case of the familiar ‘correlated omitted variable’ problem in econometrics.
Another criticism is that the measurements or proxies being used within the literature are often far too simplistic. As Fields, Lys and Vincent (p. 272) state: Most work investigating the debt hypothesis in the 1980s used crude proxies such as the leverage ratio for the proximity of the firm to violation of its debt covenants. However, Lys (1984) documents that because leverage is determined endogenously, it is a poor proxy for default risk, unless there is a control for the risk of the underlying assets. On the other hand, Duke and Hunt (1990) determine that the debt to equity ratio is a good proxy for the closeness to some covenant violations, including retained earnings, net tangible assets and working capital, but not for other covenants. In the 1990s researchers began studying firms that actually violated covenants in order to avoid the use of proxies.
A further criticism is that PAT is scientifically flawed. It has been argued that as the hypotheses generated pursuant to PAT (the debt hypothesis, the bonus hypothesis and the political cost hypothesis) are frequently not supported (they are falsified), then scientifically PAT should be rejected. Christenson (1983, p. 18) states: We are told, for example, that ‘we can only expect a positive theory to hold on average’ [Watts and Zimmerman, 1978, p. 127, n. 37]. We are also advised ‘to remember that as in all empirical theories we are concerned with general trends’ [Watts and Zimmerman, 1978, pp. 288–9], where ‘general’ is used in the weak sense of ‘true or applicable in most instances but not all’ rather than in the strong sense of ‘relating to, concerned with, or applicable to every member of a class’ [American Heritage Dictionary, 1969, p. 548] … A law that admits exceptions has no significance, and knowledge of it is not of the slightest use. By arguing that their theories admit exceptions, Watts and Zimmerman condemn them as insignificant and useless.
As a study of people, however (accounting is a process undertaken by people and the accounting process itself cannot exist in the absence of accountants), it is hard to consider that any model or theory could ever fully explain human action. In fact, ability to do so would constitute a dehumanising action. Are there any theories of human activity or choice processes
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that always hold? In defence of the fact that PAT predictions do not always hold, Watts and Zimmerman (1990, p. 148) state: But accounting research using this methodology has produced useful predictions of how the world works. A methodology that yields useful results should not be abandoned purely because it may not predict all human behaviour. Do we discard something that works in some situations because it may not work in every circumstance?
Another criticism of PAT is that the positive researchers believe that they can generate laws and principles expected to operate in different situations, and that there is one underlying ‘truth’ that can be determined by an independent, impartial observer who is not influenced by individual perceptions, idiosyncrasies or biases (Tinker, Merino and Neimark, 1982, p. 167). That is, the apparent perspective is that reality exists objectively, and one observer’s view of that reality will be the same as all other people’s views. This is referred to as the ‘realist philosophy’. A number of researchers have challenged this philosophy (for example, Hines, 1988). They have argued that, in undertaking large-scale empirical research, positive researchers ignore many organisation-specific relationships and the information collected is only the information that the researchers consider relevant. A different person would possibly consider that other information is more relevant. Many researchers critical of the ‘realist perspective’ argue that more insights might be gained by undertaking in-depth case studies. Positive researchers would provide a counterargument, however, that case study research is very specific to a particular time and place and therefore cannot be generalised to a broader population. Such arguments about research methodology abound in the literature, with very little likelihood that researchers operating across different paradigms will ever agree on what constitutes valid research. As Watts and Zimmerman (1990, p. 149) concede when defending their research against numerous criticisms: To most researchers, debating methodology is a ‘no win’ situation because each side argues from a different paradigm with different rules and no common ground. Our reason for replying here is that some have mistaken our lack of response as tacit acceptance of the criticisms.
Another particularly important criticism of PAT relates to the fundamental assumption that all action is driven by a desire to maximise one’s wealth. To many researchers, such an assumption represents a far too negative and simplistic perspective of humankind. In this respect, Gray, Owen and Adams (1996, p. 75) state that PAT promotes ‘a morally bankrupt view of the world’. Given that everybody is deemed to act in their own self-interest, the perspective of self-interest has also been applied to the research efforts of academics. For example, Watts and Zimmerman (1990, p. 146) argue that: Researchers choose the topics to investigate, the methods to use, and the assumptions to make. Researchers’ preferences and expected payoffs (publications and citations) affect their choice of topic, methods, and assumptions.
Many academics would challenge this view and would argue that they undertake their research because of real personal interest in an issue. The way that PAT accounting theory portrays self-interested, wealth-maximising behaviour as ‘rational’ – indeed, reference is often made to the ‘rational economic person’ – also implies that moral action that cannot be directly associated with increasing wealth would be classified as ‘irrational’. This causes great concern among those who try to instil ‘ethics’ into educational programs. Many ‘ethicists’ reject such theoretical frameworks given that so-called ‘rationality’ encourages various vices, including viewing people with distrust, uncooperativeness, suspicion and so forth. Further, when PAT/Agency Theorists are confronted with situations where no agency costs or self-interested actions are apparent, then rather than accept that other influences 410
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are present (such as ethical considerations), the theorists will typically continue to consider that a related ‘rational incentive’ must be there somewhere, but they simply have not been able to identify it yet. It is questionable whether such a philosophy is in the interests of the broader community.48 The fact that individualistic and opportunistic actions are portrayed as ‘rational’, whereas cooperative and morally driven actions might be portrayed as ‘irrational’, could also potentially embed views in the minds of impressionable students that morally based behaviour is neither appropriate nor expected. This would then potentially influence the decisions they subsequently make as managers, thereby becoming a self-fulfilling prophecy – something we referred to earlier in this chapter. As Heath (2009, p. 517) states: No matter how strenuously agency theorists may insist that theirs is only a ‘positive’ theory of the firm, and thus entails no ‘value judgments,’ the fact remains that the basic approach has as its foundation a normative theory of practical rationality, one that categorizes certain forms of action as ‘rational’ and certain other forms as ‘irrational.’ The fact that morality (or cooperation) gets consistently categorized within such models as irrational, and opportunism (or defection) as rational, might easily lead more impressionable minds to the conclusion that they should learn to ignore moral constraints (Miller, 1999). This can have two pernicious consequences. First, in the interests of acting more ‘rationally,’ individuals may begin to plan their own behavior in accordance with the dictates of the instrumental model, and thus begin to act more opportunistically. Second, even if they do not change their own deliberative processes, they may begin to expect higher levels of opportunistic behavior from others, and therefore feel justified in engaging in ‘preemptive’ defection in order to protect themselves from the anticipated defection of others. Thus, Ronald Duska observes that the instrumental conception of rationality has the potential to become a ‘self-fulfilling prophecy.’ ‘If I think humans are always going to be selfish, and cannot help but be so, it becomes the height of foolishness to sacrifice myself, or to predict their behavior on any other than selfish grounds’ (Duska, 1992: 149, see also Argyris, 1973: 264–66). Yet the type of ‘I did it to him to prevent him from doing it to me’ reasoning that this generates provides another one of the classic techniques of neutralization used to excuse anti-social behavior (see Sykes & Matza, 1975: 668).
Reflecting the ‘self-fulfilling prophecy’, Heath (2009) makes reference to experiments in which certain ‘public goods’ games were played by both business students and students from other disciplines. Such experiments showed that business/economics students were significantly less likely to indicate that considerations of ‘fairness’ influenced their decision making, and they were also less likely to act cooperatively with others when making a decision. There has also been some belief that teaching Agency Theory to business students creates a corporate culture that ultimately leads to corporate scandals (Ghoshal, 2005). While the criticisms discussed above do, arguably, have some merit, Agency Theory and PAT continue to be used by many accounting researchers. Respected accounting research journals continue to publish PAT research (although the numbers appear to be declining). A number of the leading accounting research schools throughout the world continue to teach it. What must 48
It certainly is not consistent with any quest towards ecologically and socially sustainable development – an issue addressed in Chapter 10. To embrace sustainable development, which is defined as development that meets the needs of the present world without compromising the ability of future generations to meet their own needs (World Commission on Environment and Development, 1987), we need to consider the interests of future generations. If we accept and promote a view that self-interest drives all current actions, as PAT researchers and many other economics researchers do, such an assumption holds very little hope for any real quest towards sustainable development.
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be remembered is that all theories of accounting will have limitations. They are, of necessity, abstractions of the ‘real world’. Whether individually we prefer one theory of accounting in preference to another will be dependent upon our assumptions about many of the issues raised in this chapter.
Why do I need to know about the criticisms that are raised in relation to different accounting theories? Why
No theory will be without criticism. Criticisms might be based on concerns about the logic of the theory or because the predictions emanating from the theory do not match what we believe we see in the ‘real world’. Other criticisms might be based on the philosophical beliefs or assumptions that are embodied within, or central to, particular theories. For example, and as we have seen, numerous researchers reject PAT and Agency Theory because they believe that the theories adopt
inappropriate or ‘morally bankrupt’ assumptions about human behaviour. As critical thinkers we should always consider the criticisms that have been raised in relation to theories that we might potentially use to explain our world. In doing so, we should also consider the logic of the various criticisms and whether we agree with the philosophical position on which those criticisms are based.
STUDY TOOLS CHAPTER SUMMARY A positive theory seeks to explain and predict particular phenomena. This chapter considered Positive Accounting Theory (PAT), a theory that seeks to explain and predict managers’ choices of accounting methods. PAT focuses on relationships between various individuals within and outside an organisation and explains how financial accounting can be used to minimise the costly implications associated with each contracting party operating in his or her own self-interest. The economic perspective that all individual behaviour is motivated by self-interest is central to PAT, and PAT predicts that contractual arrangements will be put in place to align the interests of the various self-interested parties. Many of these contractual arrangements will use the output of the accounting system. PAT became a dominant research paradigm in the 1970s and 1980s and its development owed much to previous research work that had been undertaken, including work on the Efficient Markets Hypothesis (EMH) and Agency Theory. The EMH provided evidence that capital markets react to new information, but it provided little explanation for why managers might elect to use particular accounting methods in preference to others. PAT was developed to fill this void. Applying Agency Theory, PAT focused on relationships between principals and agents. PAT proposed that agents have incentives to enter various contracts. Organisations themselves were considered as a nexus of contracts between many self-interested individuals. The contractual arrangements are initially put in place for efficiency reasons, with well-developed contracts reducing the overall agency costs that could arise within the organisation. Further, agents are predicted to adopt those accounting methods that most efficiently reflect their own performance. Regulation is considered to introduce unnecessary costs and inefficiencies into the contractual arrangements, particularly as it often acts to reduce the methods of accounting that would otherwise be adopted. Early work within PAT relied on three central hypotheses: the bonus hypothesis, the debt hypothesis and the political cost hypothesis. The bonus hypothesis predicts that from an efficiency perspective many organisations will elect to provide their managers with bonuses tied to the 412
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performance of the organisation, with these bonuses often being directly related to accounting numbers (for example, management might be rewarded with a share of profits). Offering performance-based rewards will motivate the self-interested manager to work also in the best interests of the owners. However, under the opportunistic perspective, PAT predicts that once bonus schemes are in place, managers will, to the extent that they can get away with it, manipulate performance indicators such as profits to generate higher individual rewards. The debt hypothesis predicts that to reduce the cost of attracting debt capital, organisations will enter into contractual arrangements with lenders that reduce the likelihood that the managers can expropriate the wealth of the debtholders. Arranging such agreements prior to obtaining debt finance is deemed to be an efficient way to attract lower cost funds. However, once a debt contract is in place, the opportunistic perspective of PAT predicts that organisations, particularly those close to breaching debt covenants, will adopt accounting methods that act to minimise or loosen the effects of the debt constraint. The political cost hypothesis explores the relationships between an organisation and various outside parties who, although perhaps not having any direct contractual relationships, can nevertheless impose various types of wealth transfers away from the organisation. It is argued that high profits can attract adverse and costly attention to the organisation, and hence managers of politically vulnerable organisations look for ways to reduce the level of political scrutiny. One way is to adopt accounting methods that lead to a reduction in reported profits. Most tests of the political cost hypothesis use size of the organisation as a proxy for the existence of political scrutiny. A simplified diagrammatic representation of PAT is provided in Figure 8.3. The chapter also provided a number of criticisms of PAT. Included among the various criticisms was a challenge to the central PAT assumption that all individual action is driven by self-interest. Another major criticism was that PAT fails to provide prescriptions for practising accountants in terms of how they should account for various transactions or events. FIGURE 8.3 Diagrammatic summary of PAT Key assumptions from the economics literature
The Efficient Markets Hypothesis
Agency Theory, which focuses on the relationships between agents and principals
Contracting theory, which envisages an organisation as a ‘nexus of contracts’
Positive Accounting Theory
Efficient contracting perspective
Bonus plan hypothesis
Opportunistic perspective
Debt/equity hypothesis
Political cost hypothesis
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ANSWER TO OPENING QUESTION A financial reporting standard was released in 2016 that relates to leasing. At the international level, this is IFRS 16 Leases. Relative to the former accounting standard relating to leasing (which,Module 1 Questions / at the international level, was IAS 17 Leases), IFRS 16 had the general effect of increasing reported Answers assets that are referred to as ‘right-of-use assets’ and increasing reported liabilities – that is, lease liabilities. IFRS 16 also had the impact of changing expense recognition by effectively increasing the related lease costs in the earlier years of the lease relative to the former accounting standard that was in place. Would this change in rules relating to how a transaction and event should be accounted for in financial terms – in this case, how to account for a leasing transaction – realistically be likely to have any impact on the cash flows of an organisation, and therefore upon the value of the organisation? What would be the reasoning for your belief that this change in accounting rules will, or will not, potentially change an organisation’s value? Prior to the introduction of Agency Theory and PAT into the accounting literature, many researchers would probably have thought that if a new accounting method was introduced, and readers of financial statements were fully informed about the difference between the former rules and the new rules, then there should be no direct impact on organisational value. It is simply a change in how a transaction is to be recorded with no direct implications for cash flows. However, when researchers started showing how accounting methods and related accounting numbers are used in various contractual arrangements in an endeavour to reduce agency costs – for example, the use of accounting numbers in debt contracts and management remuneration plans – it became apparent how a change in accounting method, and therefore accounting numbers, can impact these contractual arrangements. Specifically, because of the financial accounting-based contracts (which almost all organisations have negotiated), any change in numbers used in these contracts could affect cash flows, and therefore the value of the organisation (these researchers accept that the value of the organisation is directly related to expected future cash flows). For example, if the new leasing standard brought more liabilities onto the balance sheet, then that could have implications for debt covenants that used measures of debt (for example, debt to asset constraints). Perhaps, as a result of a new accounting standard that brought more liabilities onto the balance sheet, the organisation then failed to comply with the debt covenant – a case of ‘technical default’. This could then trigger a requirement that the debt had to be repaid, renegotiated, interest rates increased and so forth, all of which has implications for cash flows and therefore the value of the firm. Because the new accounting standard will also tend to increase lease-related expenses in the early years of the lease, then payments to managers (who perhaps are awarded a percentage of profits in order to align their interests with principals) would change, and this also has implications for organisational value.
QUESTIONS 8.1 8.2
8.3 8.4 8.5
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What is the difference between a positive and normative theory of financial accounting, and is one better than the other? LO8.1 Early positive research investigated evidence of share price changes as a result of the disclosure of accounting information. However, such research did not explain why particular accounting methods were selected in the first place. How did Positive Accounting Theory fill this void? LO8.2 What does it mean to say that an organisation can be represented as a nexus of contracts? LO8.6 Explain the management bonus hypothesis and the debt hypothesis of Positive Accounting Theory. LO8.7 LO8.11 Explain why a decision made in London by members of the IASB and incorporated within an accounting standard could influence the business operating strategies employed by a manager in Melbourne, Australia? LO8.8
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8.6
8.7 8.8 8.9 8.10
8.11 8.12 8.13 8.14 8.15
8.16
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8.18 8.19
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If a manager is paid a percentage of profits, does this generate a motive to manipulate profits? Would this be anticipated by principals and, if so, how would principals react to this expectation? LO8.8 LO8.11 What is an agency relationship and what is an agency cost? How can agency costs be reduced? LO8.3 Explain the political cost hypothesis of Positive Accounting Theory. LO8.10 Why is accounting important in political processes? LO8.10 In recent years, both the IASB and FASB have required that certain assets be measured at fair value. In this regard, would researchers who embrace the view that accounting plays a vital role in reducing the contracting costs of an organisation favour the adoption of fair value in all situations? Carefully explain your answer. LO8.14 Explain the efficiency perspective and the opportunistic perspective of Positive Accounting Theory. Why is one considered to be ex post and the other ex ante? LO8.8 Why would offering managers only a fixed salary not be in the interests of the owners of an organisation? LO8.4 LO8.5 LO8.11 Would an increased reliance on fair value measurement of assets be efficient from a contracting perspective? LO8.13 LO8.14 What is ‘creative accounting’? Provide two scenarios in which you would expect it to occur. LO8.9 Would managers who have negotiated debt contracts with accounting-based covenants based around ‘rolling GAAP’ be relatively more likely to lobby an accounting standard-setter about a proposed accounting standard than would a manager from an organisation who has negotiated accounting-based debt covenants that use ‘frozen GAAP’? Why? LO8.8 Organisations typically have a number of contractual arrangements with debtholders, with many covenants written to incorporate accounting numbers. a Why would an organisation agree to enter into such agreements with debtholders? b On average, do debtholders gain from the existence of such agreements? LO8.3 LO8.11 Positive Accounting Theorists typically argue that managers can reduce political costs by simply adopting an accounting method that leads to a reduction in reported income. Does this imply anything about the perceived efficiency of those parties involved in the political process and, if so, what perception is held? LO8.10 Do you think the policy decisions made by members of the IASB would or should give consideration to the insights provided by PAT? Why? LO8.8 If a reporting entity has a choice of either expensing or capitalising an item of expenditure, and if the entity is subject to a high degree of political scrutiny, then what choice would be predicted by the political cost hypothesis of PAT? Explain your answer. LO8.10 If senior managers within a company were rewarded by way of accounting-based bonus plans then would they, or the owners/shareholders (or both), prefer the use of conservative accounting methods? Explain the reasoning for your answer. LO8.12 LO8.13 In this chapter we discussed how teaching students theories that assume that all individual action can be predicted by self-interest (often referred to as the ‘rational economic person’ assumption) might subsequently influence how they make decisions in their working life. In this regard, explain what might be meant by the ‘self-fulfilling prophecy’ comment on whether you think there are any major problems associated with teaching students theories that assume self-interest. LO8.16 What is ‘earnings management’, and what are ‘accruals-based earnings management’ and ‘real earnings management’? LO8.15 In most countries, companies that are listed on securities exchanges are required to make various disclosures about their liabilities. For example, they are required to make disclosures about the amount of debt outstanding and the dates on which loans outstanding need to be repaid. However, they are generally not required to make extensive disclosures about the contents of the various debt covenants they have negotiated with lenders. Arguably, to determine the risk of a company, and therefore to place a value on it, it would be important to know the amount of debt, the associated interest rates, repayment requirements and the events – included within the debt covenants – that could result in the organisation being required to immediately repay the outstanding debt. Investors and other interested stakeholders are often only informed of a breach of a debt covenant when it occurs. 415
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a Do you think that parties such as investors and analysts can properly determine the risk of investing in an organisation if they do not have information about the various debt covenants a company has agreed to? b Can ‘price protection’ properly function if potential investors are unaware of the existing debt covenants in a company’s lending agreements? c While debt covenants reduce the risk of the debtholders that negotiated the covenants, would they increase the risk borne by other creditors? d Would the theory provided within this chapter suggest that companies should publicly disclose information about existing debt covenants? Clearly explain your answer. LO8.8 LO8.11 8.24 Assume that Kahuna Company Ltd decides to undertake an upward revaluation of its non-current assets just prior to the end of the financial year, the effect being that the total assets of the company increases, as does the total shareholders’ equity. a Explain the decision of management to undertake an asset revaluation in terms of the debt hypothesis of PAT. b Explain the decision of management to undertake an asset revaluation in terms of the management compensation hypothesis of PAT. LO8.8 LO8.11 8.25 Mather and Peirson (2006) report that public debt contracts tend to have a lower average number of accounting-based debt covenants as well as less binding debt covenants. (For example, in relation to debt to assets constraints in both public and private debt agreements, the covenants in the public debt agreements were found to be ‘looser’, meaning that the ratio percentage is typically higher in the public debt contract.) Why would this be the case? LO8.11 8.26 Within annual reports, companies frequently disclose information about how their managers are rewarded in terms of the components of their management compensation plans. For example, within IAS 24 (and within AASB 124 in Australia) there is a requirement that information about the components of rewards paid to key management personnel be disclosed within a company’s annual report. Required: Select two large companies listed on a securities exchange and identify the components of their management remuneration plans. You are then required to explain how the respective components would be expected to align the interests of the managers with those of the owners, and to minimise the contracting costs of the organisation. LO8.11 8.27 Positive Accounting Theory assumes that all individual action is driven by self-interest, with the self-interest being tied to wealth maximisation. a Is this a useful and/or realistic assumption? b Adopting this assumption, why would politicians introduce particular regulations? c Why would researchers study particular issues? LO8.4 8.28 What are some of the criticisms of PAT? Do you agree with them? Why or why not? LO8.16 8.29 In an article that appeared in the Sydney Morning Herald and entitled ‘Both sides must end budget dishonesty’ (Gittins, 2013), the following comments were made in relation to the Australian Federal Treasurer, Wayne Swan: Credibility will be attained only if, unlike the past two or three budgets, this one involves no resort to creative accounting: no shifting of spending from the budget year back to the previous, almostended year, no use of Swan’s ‘fiscal bulldozer’ to push spending commitments off beyond the forward estimates where they can’t be seen, and no exploitation of loopholes in the definition of the underlying cash balance, including funding spending on the national broadband network off-budget.
The above sentiment was also reflected in an article that appeared in the Australian Financial Review, entitled ‘Swan in a budget bind’ (Winestock, 2013): Swan has resorted to the silliest fudges. He has, the Business Council of Australia says, made optimistic revenue assumptions, fiddled with minor programs and, above all else, he has shuffled spending and revenue forward and back between time periods to achieve cosmetic results.
Required: Explain whether the insights provided by PAT can also be used to explain government action, such as the above actions allegedly undertaken by Wayne Swan, who was Australian Treasurer in 2013. LO8.9 LO8.12 8.30 Traditionally, organisations have tended to choose accounting methods that applied conservative measures of profits, net assets, and therefore equity. From a contracting perspective, why do you think this might have been the case? LO8.13 416
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8.31 Positive Accounting Theory embraces a reasonably simplistic assumption that all individuals’ utility functions are maximised by actions that lead to a maximisation of their own wealth. Does such a simplistic assumption mean that the predictions generated by PAT are not really that useful? LO8.4 8.32 Zhang (2008) argues that if a borrower adopts conservative accounting methods this will reduce the risk exposure of the lender and will lead to a reduced interest cost for the borrower. What is the basis of this argument? LO8.13 8.33 If companies use conservative accounting methods, and they have accounting-based debt covenants, then do the conservative accounting methods provide greater protection to debtholders relative to a situation where conservative accounting methods were not used? Explain the reason for your answer. LO8.11 LO8.12 LO8.13 8.34 In this chapter we referred to a particular criticism of PAT, this being the fundamental assumption that all action is driven by a desire to maximise one’s wealth. In this respect, Gray, Owen and Adams (1996, p. 75) have the opinion that PAT promotes ‘a morally bankrupt view of the world’. Evaluate this opinion. LO8.4 8.35 Does ‘good research’ need to rely on the development and testing of hypotheses? LO8.1 LO8.4 8.36 The Australian bank, Babcock & Brown once had a market capitalisation of over $8.5 billion. It had 28 offices and employed over 1500 people. However, it then had a collapse in its share price which dramatically reduced its total market capitalisation (Gluyas, 2008). Babcock & Brown had negotiated an agreement – a debt covenant – with lenders that its market capitalisation would not fall below an agreed amount of $7.50 per share. However, the share price dipped well below this agreed amount, meaning that the lenders could demand repayment of the funds if they chose to invoke their right to do so. The organisation ultimately went into voluntary administration. From a PAT perspective, why would Babcock & Brown have agreed to this market capitalisation requirement rather than other types of covenants, such as a restriction on the organisation’s total liabilities to total tangible assets? Further, why would the bank have negotiated to have this market capitalisation agreement included within the debt agreement? LO8.7 LO8.11 8.37 In an Australian Financial Review article entitled ‘Foster’s: less goodwill, higher earnings’ (Hughes, 2005) it was reported that in 2005, when Australia adopted the accounting standards issued by the IASB (IFRS), there would be significant changes to the global brewer’s reported assets and reported liabilities. In particular, the new accounting standard on intangibles required that about $1.3 billion in intangible assets would be written off to retained earnings. Further, as a result of the removal of some internally intangible assets, certain amortisation charges would fall, with the result that profits would rise by about $30 million relative to what would have been reported under the old accounting standard. Adopting a PAT perspective, consider the following issues: a If a new accounting standard impacts on profits, should this impact on the value of the organisation, and if so, why? b Will the imposition of a particular accounting method have implications for the efficiency of the organisation? LO8.11 8.38 When IFRS 2 Share Based Payment was issued by the IASB it introduced rules that, among other things, changed how organisations are to account for the costs of share options issued to managers. Prior to the accounting standard being issued, reporting entities typically recognised no expenses in relation to the issue of share options to managers. Therefore, share options could be provided to managers (perhaps instead of cash-based bonuses) with little or no effect on profit. However, when IFRS 2 was issued, it required reporting entities to recognise an expense in relation to the share options offered to managers/employees. Specifically, organisations have to determine the fair value of the share options, and this is deemed to be the cost of the share options that are provided to employees. Applying PAT, answer the following questions: a From an efficiency perspective, why could the introduction of new rules on share option accounting be costly for an organisation? b Why could the introduction of the new rules on share option accounting be costly for a manager? c What would motivate the regulators to develop the new rules? LO8.7 LO8.11 417
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8.39 A new accounting standard relating to how to account for leased assets and associated liabilities – this being IFRS 16 Leases – was released by the IASB in 2016. This accounting standard took many years to develop. In an article that appeared in the Australian Financial Review some years before the accounting standard was issued, entitled ‘New accounting standards could trigger debt covenants’ (Cain, 2012), it was reported: A decade after the idea was proposed, it’s likely a new accounting standard will require businesses to recognise operating leases on balance sheets. Under existing accounting standards, operating leases are not recorded on balance sheets. Bringing these leases on balance sheet could trigger debt covenants for organisations with a large number of leased vehicles. This is because bringing operating leases on balance sheet could increase a business’s liabilities over and above levels agreed with lenders. The IASB received 786 responses in relation to the initial exposure draft – a huge amount – which indicates the significance of what they are proposing. As a result the IASB is reconsidering its exposure draft, which is very unusual.
The leasing accounting standard took many more years than most accounting standards to be developed. a Why do you think that the accounting standard on leasing took so many years to be developed before it was finally released? b Why could the new accounting standard trigger debt covenants (that is, create a technical default)? c Do you think that the likelihood that a new accounting standard would be released would have influenced the leases that companies were entering into in the years prior to the new accounting standard being released? d Do you think that debtholders would prefer that more leases be recognised and disclosed on the balance sheet, or be kept off balance sheet? LO8.11 LO8.12
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LaFond, R. & Watts, R. (2008), ‘The information role of conservative financial statements’, The Accounting Review, 83, pp. 447–78. Lambert, R. (2001), ‘Contracting theory and accounting’, Journal of Accounting and Economics, 32, pp. 3–87. Lev, B. & Sougiannis, T. (1996), ‘The capitalization, amortization, and value relevance of R&D’, Journal of Accounting and Economics, 21, pp. 107–38. Lev, B. & Zarowin, P. (1999), ‘The boundaries of financial reporting and how to extend them’, Journal of Accounting Research, 37, pp. 353–85. Lewellen, R. A., Loderer, C. & Martin, K. (1987), ‘Executive compensation and executive incentive problems’, Journal of Accounting and Economics, 9, pp. 287–310. Lewis, H. & Melin, A. (2021), ‘Carrot tempts CEO to stick around’, The Age, 24 July. Lintner, J. (1965), ‘The valuation of risk assets and the selection of risky investments in stock portfolios and capital budgets’, Review of Economics and Statistics, 47, pp. 13–37. Liu, A., Subramanyam, K., Zhang, J. & Shi, C. (2018), ‘Do firms manage earnings to influence credit ratings? Evidence from negative credit watch resolutions’, The Accounting Review, 93(3), pp. 267–98. Lys, T. (1984), ‘Mandated accounting changes and debt covenants: the case of oil and gas accounting’, Journal of Accounting and Economics, 9, pp. 39–66. Mather, P. & Peirson, G. (2006), ‘Financial covenants in the markets for public and private debt’, Accounting and Finance, 46, pp. 285–307. Mayne, S. (2007), ‘ANZ boss joins the “clear the decks’ club”’, 26 October, Crikey.com. Mian, S. L. & Smith, C. W. (1990), ‘Incentives for consolidated financial reporting’, Journal of Accounting and Economics, 12, pp. 141–71. Milgrom, P. (1981), ‘Good news and bad news: representation theorems and applications’, Bell Journal of Economics, 12, pp. 380–91. Morris, R. (1984), ‘Corporate disclosure in a substantially unregulated environment’, ABACUS (June), pp. 52–86. Mouck, T. (1992), ‘The rhetoric of science and the rhetoric of revolt in the story of positive accounting theory’, Accounting, Auditing and Accountability Journal, 5(4), pp. 35–56. Murphy, K. (1999), ‘Executive compensation’, in Handbook of Labor Economics, 3B, The Netherlands: North Holland, Amsterdam. Nagar, V., Nanda, D. & Wysocki, P. (2003), ‘Discretionary disclosure and stock-based incentives’, Journal of Accounting and Economics, 34, pp. 283–309. Ness, K. & Mirza, A. (1991), ‘Corporate social disclosure: a note on a test of agency theory’, British Accounting Review, 23, pp. 211–17. Pappas, K., Walsh, E. & Xu, A. (2019), ‘Real earnings management and loan contract terms’, British Accounting Review, 51(4), pp. 373–401. Schipper, K. (1989), ‘Commentary on earnings management’, Accounting Horizons, 3, pp. 91–102. Sharpe, W. F. (1964), ‘Capital asset prices: a review of market equilibrium under conditions of risk’, Journal of Finance, 19, pp. 425–42. Shleifer, A. & Vishny, R. (1989), ‘Management entrenchment: the case of manager-specific investments’, Journal of Accounting and Economics, 25, pp. 8–41. Sloan, R. G. (1993), ‘Accounting earnings and top executive compensation’, Journal of Accounting and Economics, 16, pp. 55–100.
Positive Accounting Theory
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UNREGULATED CORPORATE REPORTING DECISIONS: CONSIDERATIONS OF SYSTEMSORIENTED THEORIES LEARNING OBJECTIVES understand how organisational disclosures can be used as a means of establishing, maintaining, or repairing legitimacy
On completing this chapter, readers should: LO9.1
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understand how community or stakeholders’ perceptions can influence the disclosure policies of an organisation, and conversely, how organisational disclosures can influence community and stakeholder perceptions understand the fundamentals of Legitimacy Theory, Stakeholder Theory and Institutional Theory and appreciate that these theories have much in common with each other understand that the above theories are, in large part, derived from Political Economy Theory, and that Political Economy Theory can be considered as having two branches understand how Legitimacy Theory, Stakeholder Theory and Institutional Theory can be applied to help explain why an entity might elect to make voluntary disclosures, particularly voluntary social and environmental disclosures understand what we mean by ‘organisational legitimacy’ and how organisational disclosures within such places as annual reports, sustainability reports and corporate websites can be used as a strategy to maintain, or restore, the legitimacy of an organisation understand that the legitimacy attributed to an organisation can change across time and
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understand how, pursuant to Stakeholder Theory, the respective power and information demands of particular stakeholder groups can influence organisational disclosure policies understand that Stakeholder Theory can be considered as having an ethical branch, and a managerial branch understand that the disclosure of information by managers can be used as a means of managing, or manipulating, powerful stakeholder groups understand the view that a successful organisation is one that can balance or manage the demands (sometimes conflicting), including information demands, of different stakeholder groups understand that institutional pressures exist that cause organisations to take on organisational forms and practices that are considered ‘legitimate’ understand that due to institutional pressures there can be a ‘decoupling’ between the way an organisation appears to be operating and how it is actually operating be aware of some of the limitations of the theories discussed in this chapter.
Unregulated corporate reporting decisions: considerations of systems-oriented theories CHAPTER 9
OPENING QUESTION Before reading this chapter, please consider how you would answer the following question. We will return to this question at the end of the chapter, where we suggest an answer. In May 2020, and as part of an exploration project targeting iron ore, the large global mining company Rio Tinto destroyed two important and very sacred rock shelters at Juukan Gorge in the Pilbara Region of Western Australia. These sites revealed evidence of continual human habitation dating back at least 46 000 years and were of great cultural significance to local Indigenous communities and to communities generally. Following news of the destruction – and there was much news media coverage of the destruction – there was great public outrage. Would you expect the company to react to such negative news media publicity, and if so, what would be the likely nature and objective of any reaction?
Introduction Chapter 8 discussed a number of theoretical arguments that have been developed to explain why corporate managers might elect to voluntarily provide particular information to parties outside the organisation. Central to such explanations were arguments that certain financial disclosures would enable an organisation to attract capital at a lower cost, as well as enabling an organisation to reduce various contracting and agency costs. Within the research literature discussed within Chapter 8, financial statements were perceived as a vehicle to align the interests of managers (agents) with owners (principals), and managers with debtholders. These arguments were grounded within Positive Accounting Theory (PAT). This chapter considers some alternative theoretical perspectives that address the motivations perceived to be driving voluntary disclosures; specifically, we consider Legitimacy Theory, Stakeholder Theory and Institutional Theory. These theories are often used to explain managers’ motivations to make non-financial disclosures (for example, to provide information about the social and environmental implications of various corporate activities), although they have also been used to explain voluntary financial disclosures. As is stressed throughout this book, and particularly in Chapter 1, theories are abstractions of reality that are developed to help us make sense of the world, and hence particular theories cannot be expected to provide a full account or description of particular behaviour. Hence, it is sometimes useful to consider the perspectives provided by alternative theories. Different researchers might study the same phenomenon but elect to adopt alternative theoretical perspectives. The choice of one theoretical perspective in preference to others will, at least in part, be due to particular value judgements made by the authors involved. As O’Leary (1985, p. 88) states: Theorists’ own values or ideological predispositions may be among the factors that determine which side of the argument they will adopt in respect of disputable connections of a theory with evidence.
Legitimacy Theory, Stakeholder Theory and Institutional Theory – the focus of this chapter – are three theoretical perspectives that have been adopted by many researchers in recent years. These theories are sometimes referred to as ‘systems-oriented theories’. In accordance with Gray, Owen and Adams (1996, p. 45): … a systems-oriented view of the organisation and society … permits us to focus on the role of information and disclosure in the relationship(s) between organisations, the State, individuals and groups.
Systems-oriented theories Also referred to as open systems theories, these are theories that perceive of an organisation as being part of a broader social system in which the organisation is influenced by, as well as influences, the society in which it operates.
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Systems-oriented theories have also been referred to as ‘open-systems theories’. Commenting on the use of open-systems theorising, Suchman (1995, p. 571) states: Open-system theories have reconceptualised organisational boundaries as porous and problematic … Many dynamics in the organisational environment stem not from technological or material imperatives, but rather, from cultural norms, symbols, beliefs and rituals. Corporate disclosure policies are considered to represent one important means by which management can influence external perceptions about their organisation.
In explaining why organisations should be viewed as part of a broader social system, Gray, Adams and Owen (2014, p. 18) state: Business is a complex system, comprising many components and operating within and interacting with a complex array of social and natural systems. Neither is business just part of some system which we might describe as ‘economic’. Business, accounting, finance, marketing all also interact with systems which we might call ‘social’, ‘political’ and ‘ethical’ and so on. More substantially, business, accounting, finance, and marketing systems are directly related to interactions within and between organisational systems and between those organisational systems and individuals, groups, communities, societies, nations and non-human elements of the planetary natural environment. Conventional economic analysis – and conventional accounting and finance in particular – too often ignore these interactions.
Within a systems-based perspective, the entity is therefore assumed to be influenced by, and in turn to have an influence upon, the society in which it operates. The actions and reactions of organisations can make more sense when viewed in the context (for example, in the context of the respective institutional environment) within which the actions take place. This is simplistically represented in Figure 9.1. Within Legitimacy Theory, Stakeholder Theory and Institutional Theory, accounting disclosure policies are considered to constitute a strategy to influence the organisation’s relationships with the other parties with which it interacts. In recent times, Stakeholder Theory, FIGURE 9.1 The organisation viewed as part of a wider social system Interest groups Employees Investors Industry bodies THE ORGANISATION
The public
Consumers
Suppliers Media Government
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Unregulated corporate reporting decisions: considerations of systems-oriented theories CHAPTER 9
Legitimacy Theory and Institutional Theory have all been applied to explain why organisations make certain social responsibility disclosures.1 However, these theories could also be applied to explain why companies adopt particular financial accounting techniques. To the extent that these theories provide explanations for, and predictions of, particular managerial decisions, such as decisions to disclose information, they can also be considered to be positive theories (as opposed to normative – or prescriptive – theories, which as we know are theories used to prescribe what activities should be undertaken). LO9.1
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Political Economy Theory
According to Gray, Adams and Owen (2014), Legitimacy Theory, Stakeholder Theory and Institutional Theory are all derived from a broader theory which has been called Political Economy Theory. The ‘political economy’ itself has been defined by Gray, Owen and Adams (1996, p. 47) as ‘the social, political and economic framework within which human life takes place’. The perspective embraced is that society, politics and economics are inseparable, and economic issues cannot meaningfully be investigated in the absence of considerations about the political, social and institutional framework in which the economic activity takes place. It is argued that by considering the political economy, a researcher is better able to consider broader (societal, political and economic) issues that impact how an organisation operates and what information it elects to disclose. According to Guthrie and Parker (1990, p. 166): The political economy perspective perceives accounting reports as social, political, and economic documents. They serve as a tool for constructing, sustaining, and legitimising economic and political arrangements, institutions, and ideological themes which contribute to the corporation’s private interests. Disclosures have the capacity to transmit social, political, and economic meanings for a pluralistic set of report recipients.
Guthrie and Parker (1990, p. 166) further state that corporate reports should not be considered as neutral, unbiased (or representationally faithful) documents – as frameworks, such as the IASB Conceptual Framework for Financial Reporting (IASB Conceptual Framework; covered in Chapter 7) would have us believe – but, rather, corporate reports are ‘a product of the interchange between the corporation and its environment and attempt to mediate and accommodate a variety of sectional interests’. Proponents of political economy theories would argue that there are a multitude of political and social forces at play that render any claims that reports released by management are ‘representationally faithful’ as unrealistic. Political Economy Theory has been divided (perhaps somewhat simplistically, but nevertheless usefully) into two broad streams, which Gray, Adams and Owen (2014, p. 79) have labelled ‘classical’ and ‘bourgeois’ political economy. Classical Political Economy Theory is related to the works of philosophers such as Karl Marx, and explicitly places ‘sectional (class) interests, structural conflict, inequity, and the role of the State at the heart of the analysis’ (Gray, Owen and Adams, 2010, p. 20). This can be contrasted with ‘bourgeois’ Political Economy Theory which, according to Gray, Kouhy and Lavers (1995, p. 53), largely ignores these elements and, as a result, is content to perceive the world as essentially pluralistic.2 1
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Classical Political Economy Theory A theory which explicitly places sectional (class) interests, structural conflict, inequity, and the role of the State at the heart of the analysis.
Social responsibility disclosures are considered more fully in Chapter 10. However, at this stage they can be defined as disclosures that provide information about the interaction of an organisation with its physical and social environment, inclusive of community involvement, the natural environment, human resources, energy and product safety (Gray, Adams and Owen, 2014). A pluralistic perspective assumes (typically, implicitly) that many classes of stakeholders have the power to influence various decisions by corporations, government and other entities. Within this perspective, accounting is not considered to be put in place to favour specific interests (sometimes referred to as ‘elites’). By using ‘society’ as the topic of focus rather than subgroups within society, theories such as Legitimacy Theory, which is typically derived from the bourgeois branch of Political Economy Theory, ignore ‘struggles and inequities within society’ (Puxty, 1991).
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In contrast to the ‘bourgeois’ branch of Political Economy Theory, Classical Political Economy Theory tends to perceive accounting reports and disclosures as a means of maintaining the favoured position (for example, the wealth and power) of those stakeholders who control scarce resources (capital), and as a means of undermining the position of those without scarce capital. It focuses on the structural conflicts within society.3 According to Cooper and Sherer (1984), the study of accounting should recognise power and conflict in society, and consequently should focus on the effects of accounting reports on the distribution of income, wealth and power in society. This is consistent with Lowe and Tinker (1977), who argue that accounting research is often based upon a pluralist conception of society (which, as mentioned earlier, assumes that no one group within society dominates all others). According to Lowe and Tinker, this pluralistic view assumes (incorrectly, they argue) that power is widely diffused, and that society is composed of many individuals whose preferences are to predominate in social choices, and with no individual able consistently to influence that society (or the accounting function therein). Researchers such as Lowe and Tinker (1977) and Cooper and Sherer (1984) oppose such a view and provide a counter-perspective that the pluralist view ignores a great deal of evidence that suggests that the majority of people in society are controlled by a small but ‘well-defined elite’ – an elite that uses accounting (as well as other mechanisms) as a means of maintaining their position of privilege and dominance. The works of authors who take this view are further considered in a discussion on critical accounting perspectives in Chapter 13. Such researchers tend to be extremely critical of current accounting and reporting techniques. According to Gray, Adams and Owen (2014), and as briefly noted above, bourgeois political economy, on the other hand, does not explicitly consider structural conflicts and class struggles; rather, it ‘tends to be concerned with interactions between groups in an essentially pluralistic world (for example, the negotiation between a company and an environmental pressure group, or between a local authority and the State)’. It is this branch of Political Economy Theory from which Legitimacy Theory and Stakeholder Theory typically derive. Neither theory, as generally applied, questions or studies the various class structures (and possible struggles) within society.4 However, Institutional Theory can be applied within either a classical or a bourgeois conception of political economy. We now turn our attention to Legitimacy Theory. A discussion of Stakeholder Theory and Institutional Theory then follows.
Why do I need to know about ‘systems-oriented views’ of organisations, or about theoretical perspectives that view organisations as operating within various social, political and economic frameworks? These perspectives are useful because they reinforce the view that what organisations might do (and disclose) within one social, political or economic environment might be very different to what they might do elsewhere. A systems-oriented view also encourages us to consider how an organisation is impacted by, and how it creates impacts upon, other organisations and stakeholders with which it interacts. When applied to accounting, a systems-oriented view encourages us to consider
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how accounting reports are used to shape the opinions and actions of various stakeholder groups and how accounting reports can be used as a means to provide advantage to some groups to the potential detriment of others. In our working life we need to understand that many factors influence what strategies we adopt – including our accounting choices – and what outcomes will result from particular actions. The theories we explore in this chapter assist this understanding.
For example, in considering the practice of social responsibility reporting, classical political economists would typically argue that the growth of social and environmental disclosure by companies since the late 1980s can be seen as an attempt to act as if in response to social and environmental groups (NGOs) while actually attempting to wrest the initiative and control of the environment agenda from these groups in order to permit capital to carry on doing what it does best – making money from capital (Gray, Owen and Adams, 1996, p. 47). Positive Accounting Theory, the focus of Chapter 8, also does not consider issues associated with inequities within society or the role of accounting in sustaining these inequities.
Unregulated corporate reporting decisions: considerations of systems-oriented theories CHAPTER 9
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Legitimacy Theory
Legitimacy Theory, as typically applied within the social and environmental accounting literature, adopts a central assumption that the maintenance of successful organisational operations requires managers to ensure that their organisation appears to be operating in conformance with community expectations, and therefore is attributed the status of being ‘legitimate’. Within Legitimacy Theory, which we already know embraces a systems-oriented view, organisations are perceived as being part of a broader social system and are not considered to have any inherent right to resources. Rather, a right to resources must be ‘earned’ (Mathews, 1997) and it is ‘legitimate organisations’ that are able to sustain their ongoing access (or ‘rights’) to needed resources. Within Legitimacy Theory, the expectations of the community are not considered to be fixed, but change over time, thereby requiring managers to be responsive to the ethical (or moral) environment in which they operate. Lindblom (1993) distinguishes between legitimacy, which is considered to be a status or condition, and legitimation, which she considers to be the process that leads to an organisation being adjudged legitimate. According to Lindblom (p. 2), legitimacy is:
Legitimacy Theory A theory that proposes that organisations need to operate within the bounds and norms of their respective societies. Compliance with societal norms and expectations is assigned the status of ‘legitimacy’. If ‘legitimacy’ is not apparent, then managers will embrace the process of legitimation.
… a condition or status which exists when an entity’s value system is congruent with the value system of the larger social system of which the entity is a part. When a disparity, actual or potential, exists between the two value systems, there is a threat to the entity’s legitimacy.
Legitimacy is a relative concept; it is relative to the social system in which the entity operates and is time and place specific. As Suchman (1995, p. 574) states: Legitimacy is a generalised perception or assumption that the actions of an entity are desirable, proper, or appropriate within some socially constructed system of norms, values, beliefs, and definitions.
Within Legitimacy Theory, ‘legitimacy’ is often considered to be a ‘resource’ on which an organisation is dependent for survival (Dowling and Pfeffer, 1975; O’Donovan, 2002). It is something that is conferred upon the organisation by society, and it is something that is desired or sought by the organisation. However, unlike many other ‘resources’, it is a ‘resource’ that the organisation is considered to be able to affect or manipulate through various disclosure-related strategies (Woodward, Edwards and Birkin, 1996). Consistent with resource dependence theory (see Pfeffer and Salancik, 1978), proponents of Legitimacy Theory would suggest that whenever managers consider that the supply of the particular resource – legitimacy – is vital to organisational survival, they will pursue strategies to ensure the continued supply of that resource. As will be seen shortly, strategies aimed at gaining, maintaining or repairing legitimacy (often referred to as ‘legitimation strategies’) may include targeted disclosures, or perhaps controlling, or collaborating with, other parties that in themselves are perceived by society to be legitimate and therefore able to provide ‘legitimacy by association’ (Oliver, 1991; Deegan and Blomquist, 2006; Deegan, 2019). For an organisation seeking to be perceived as legitimate, it is not the actual conduct of the organisation that is important; it is what society collectively knows or perceives about the organisation’s conduct that shapes legitimacy. Information disclosure – and, therefore, ‘accounting’ – is vital to establishing corporate legitimacy. As Suchman (1995, p. 574) states: An organisation may diverge dramatically from societal norms yet retain legitimacy because the divergence goes unnoticed. Legitimacy is socially constructed in that it reflects a congruence between the behaviours of the legitimated entity and the shared (or assumed shared) beliefs of some social group; thus legitimacy is dependent on a collective audience, yet independent of particular observers.
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Consistent with the view that ‘legitimacy’ is based on perceptions, Nasi et al. (1997, p. 300) state: A corporation is legitimate when it is judged to be ‘just and worthy of support’ (Dowling and Pfeffer, 1975). Legitimacy therefore is not an abstract measure of the ‘rightness’ of the corporation but rather a measure of societal perceptions of the adequacy of corporate behaviour (Suchman, 1995). It is a measure of the attitude of society toward a corporation and its activities, and it is a matter of degree ranging from highly legitimate to highly illegitimate. It is also important to point out that legitimacy is a social construct based on cultural norms for corporate behaviour. Therefore, the demands placed on corporations change over time, and different communities often have different ideas about what constitutes legitimate corporate behaviour.
Legitimacy, public expectations and the social contract Social contract It is an implied contract representing the norms and expectations of the community in which an organisation operates.
Legitimacy as explained within Legitimacy Theory is often linked to the idea of a ‘social contract’ (Adler, Mansi and Pandey, 2018; Deegan, 2019; Patten, 1992) wherein the social contract represents the multitude of implicit and explicit expectations that society has about how an organisation should conduct its operations. The legitimacy of an organisation is considered likely to be challenged when an organisation does not comply with the terms of the ‘social contract’, and therefore with the expectations of the society in which it operates (creating what is referred to as a ‘legitimacy gap’). It can be argued that traditionally profit maximisation was perceived to be the optimal measure of corporate performance. Under this notion, an organisation’s profits were viewed as an all-inclusive measure of organisational legitimacy. However, public expectations have undergone significant change in recent decades. With heightened social expectations, successful business organisations need to be responsible and accountable for the human, environmental and other social consequences of their activities. That is, the ‘social contract’ has changed. Researchers applying Legitimacy Theory also typically assume (albeit, typically an unstated assumption) a dichotomous state for ‘legitimacy’. That is, there will either be compliance with community expectations (a legitimate organisation), or non-compliance (an illegitimate organisation). It is assumed within Legitimacy Theory that society allows the organisation to continue operations to the extent that it generally meets society’s expectations – that is, to the extent that it complies with the social contract. Legitimacy Theory emphasises that the organisation must appear to consider the rights of the public at large, not merely those of its investors. Failure to comply with societal expectations (that is, a failure to comply with the terms of the ‘social contract’) may lead to sanctions being imposed by society, for example in the form of legal restrictions imposed on an organisation’s operations, limited resources (for example, financial capital and talented labour) being provided and/or reduced demand for its products (sometimes through organised consumer boycotts). That is, consistent with Legitimacy Theory, organisations are not considered to have any inherent right to resources. Rather, the right to access resources must be earned. Legitimacy (from society’s perspective) and the right to operate go hand in hand. As Mathews (1993, p. 26) states: The social contract would exist between corporations (usually limited companies) and individual members of society. Society (as a collection of individuals) provides corporations with their legal standing and attributes and the authority to own and use natural resources and to hire employees. Organisations draw on community resources and output both goods and services and waste products to the general environment. The organisation has no inherent rights to these benefits, and in order to allow their existence, society would expect the benefits to exceed the costs to society.
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Organisations frequently refer to the ‘social contract’ when making various public disclosures, although they might instead use the term ‘social licence’, ‘social licence to operate’ or ‘community license to operate’, which effectively all mean the same thing as ‘social contract’. For example, in the 2021 Annual Report of the large global mining company, Rio Tinto, the organisation refers to a number of objectives it wants to achieve. It then makes the statement (p. 13) that: None of our other objectives described above would be possible without trust, meaningful relationships and mutually beneficial partnerships. This is our social licence to operate. It is judged by others and is essential for our long-term future.
BHP, the world’s largest mining company, also refers to the importance of complying with the ‘social licence to operate’ (or, social contract). In the BHP Annual Report 2021, the company specifically notes the importance of appointing Directors who can protect the organisation’s ‘social licence to operate’. Specifically, when discussing the skills, experience and attributes expected of BHP Directors, BHP (2021, p. 82) states: The Board will comprise Directors who have proven past performance and the level of business, executive and non-executive experience required to: • provide the breadth and depth of understanding necessary to effectively create long-term shareholder value • protect and promote the interest of BHP and its social licence to operate, and • ensure the talent, capability and culture of BHP to support the long-term delivery of the strategy.
Consistent with the view that failing to meet societal expectations – and therefore failure to meet the ‘social contract’, or as it is also called, ‘social licence to operate’ – will lead to potential sanctions being imposed upon the organisation (a point made previously), BHP (2021, p. 58) also states: The long-term viability of our business is closely connected to the wellbeing of the communities and environments where we have a presence. At any stage of the asset life cycle, our activities and operations may have or be seen to have significant adverse impacts on communities and environments. In these circumstances, we may fail to meet the evolving expectations of our stakeholders (including investors, governments, employees, suppliers, customers and community members) whose support is needed to realise our strategy and purpose. This could lead to loss of stakeholder support or regulatory approvals, increased taxes and regulation, enforcement action, litigation or class actions, or otherwise impact our social licence to operate and adversely affect our reputation, ability to attract and retain talent, operational continuity and financial performance.
The above quotes emphasise the point that organisations need to demonstrate they are complying with community expectations, and therefore with the social contract/social licence to operate, if they want to survive in the long run. This is an embodiment of systemsoriented thinking. The idea of a ‘social contract’ is not new and has been discussed long before corporations started referring to it. It was discussed by philosophers such as Thomas Hobbes (1588–1679), John Locke (1632–1704) and Jean-Jacques Rousseau (1712–78). Shocker and Sethi (1974, p. 67) provide a good overview of the concept of a social contract in stating: Any social institution – and business is no exception – operates in society via a social contract, expressed or implied, whereby its survival and growth are based on: 1 the delivery of some socially desirable ends to society in general, and 2 the distribution of economic, social, or political benefits to groups from which it derives its power. 429
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In a dynamic society, neither the sources of institutional power nor the needs for its services are permanent. Therefore, an institution must constantly meet the twin tests of legitimacy and relevance by demonstrating that society requires its services and that the groups benefiting from its rewards have society’s approval.
It is emphasised that the social contract is a theoretical construct, and hence an individual or manager cannot simply go and find a copy of the social contract ‘negotiated’ between an organisation and the society in which it operates. Different managers will have different perceptions about how society expects the organisation to behave across the various attributes of its activities (that is, they will have different perspectives of the contract) – and this in itself can explain, at least in part, why some managers will elect to do things differently from other managers. If a manager undertakes certain actions that are subsequently found to be unacceptable to the community (for example, sourcing clothing from supply chains suspected of harbouring modern slavery – an issue that has outraged many people within the community), Legitimacy Theorists would explain this in terms of managers misinterpreting the terms of the social contract and this misinterpretation may subsequently have an adverse impact on the organisation’s survival. Consider the implications for Nike, GAP and other clothing and footwear manufacturers when the news media ran campaigns about their association with various abusive and unsafe factories in developing countries. Such campaigns were costly for the organisations in terms of lost sales and the organisations typically responded by making public disclosures about what they were doing to ensure that factories that produce their products are treating workers properly. As a specific example of where things can go ‘wrong’, we can consider an article that appeared in the Sydney Morning Herald, entitled ‘Surf clothing label Rip Curl using “slave labour” to manufacture clothes in North Korea’ (McKenzie and Baker, 2016). Rip Curl is a global retailer of surfing-related clothing and accessories, and it is a company that has, for several decades, developed a reputation for being socially and environmentally responsible. Nevertheless, the article reported that: Iconic Australian surfwear giant Rip Curl has sold millions of dollars’ worth of clothes made in North Korea, where factory workers endure slave-like conditions. In a major embarrassment that raises serious questions about Rip Curl’s garment sourcing practices, a Fairfax Media investigation can reveal that workers at a the Taedonggang Clothing Factory near the North Korean capital Pyongyang were contracted to make some of Rip Curl’s 2015 winter range of clothing.
Rip Curl responded very quickly to the scandal and publicly noted that it had outsourced its production to a Chinese supplier who, without notifying Rip Curl, diverted production to an unauthorised subcontractor. Rip Curl responded by making various disclosures on its website, and in various Rip Curl reports, about what it has done to ensure that it will never again have its products produced in factories that treat workers poorly. Such disclosures are arguably aimed at restoring potentially lost legitimacy and to show that the organisation is attempting to comply with the ‘social contract’ negotiated with society wherein it is expected that workers across supply chains are provided with equitable, safe, and healthy working conditions. In Chapter 10 we explore the practice now being followed by many organisations, wherein they produce Modern Slavery Statements that provide information about how they assess the risks that ‘modern slavery’ exists within their supply chains and what the organisation is doing to address the risks. This trend in organisations producing Modern Slavery Statements is a result of evolving community expectations about proper, or ‘acceptable’, organisational conduct. That is, their existence is arguably a result of changes in the ‘social contract’ negotiated between organisations and the communities in which they operate. The social contract is considered to be made up of numerous terms (or clauses), some explicit and some implicit. Gray, Adams and Owen (2014, p. 52) suggest that legal requirements provide 430
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the explicit terms of the contract, while other non-legislated societal expectations embody the implicit terms of the contract. That is, there is an imperfect correlation between the law and societal norms (as reflected by the social contract), and, according to Dowling and Pfeffer (1975), there are three broad reasons for the difference. First, even though laws are reflective of societal norms and values, legal systems are slow to adapt to changes in the norms and values in society. Second, legal systems often strive for consistency, whereas societal norms and expectations can be contradictory. Third, it is suggested that, while society may not be accepting of certain behaviours, it may not be willing or structured enough to have those behavioural restrictions codified within law. It is in relation to the composition of the implicit terms of the ‘contract’ that managers’ perceptions can be expected to vary greatly. The idea of a ‘social contract’ was not new when used within the social and environmental accounting literature, and had commonly been used for decades in theories such as Institutional Theory, Political Economy Theory and variants of Stakeholder Theory. However, when used within these other theoretical contexts, researchers did not directly link compliance with the social contract to organisational legitimacy. It was within the social and environmental accounting literature that authors such as Gray, Mathews, Patten and Deegan directly linked organisational legitimacy to compliance with the social contract. Given the potential costs associated with conducting operations deemed to be outside the terms of the ‘social contract’, Dowling and Pfeffer (1975) state that organisations will take various actions to ensure that their operations are perceived to be legitimate. That is, they will adopt strategies (of which disclosure is a key component) to establish congruence between ‘the social values associated with or implied by their activities and the norms of acceptable behaviour in the larger social system of which they are a part’ (Dowling and Pfeffer, 1975, p. 122). Trying to ensure that a company is aware of changing community expectations and responds accordingly requires managers to have particular ‘skill sets’, something we highlighted earlier when we noted that Directors of BHP were expected to have the skills necessary to protect the organisation’s social licence to operate. This is also reflected in the following comments made in a newspaper article that appeared in The Age, entitled ‘Corporate coaches emerge to make some difference’ (Allen, 2006, p. 10): Former BHP Billiton chief executive John Prescott once told an audience of business people and business critics that winning a community licence to operate and the notion of legitimacy in public opinion were essential to business survival. ‘To maintain this legitimacy, and to ensure a positive environment in which to operate, requires skills and approaches which are as important as the financial, technical and marketing capabilities we in business have traditionally valued,’ he said.
Legitimacy and changing social expectations As community expectations change, organisations must also adapt and change. That is, if society’s expectations about performance change, an organisation will need to show that what it is doing is also changing (or perhaps it will need explicitly to communicate and justify why its operations have not changed). This is consistent with a statement made in the Commonwealth Bank of Australia 2021 Annual Report (p. 211), where it is stressed that a consideration of changing social expectations is a necessary component of risk management for an organisation: Strategic risk is the risk of material stakeholder value destruction or less than planned value creation. The Strategic Risk Management Framework of CBA considers the impact of the Group’s strategy of dynamically evolving material current and emerging risks arising from changes in areas such as: the competitive landscape, emerging technologies, macroeconomic conditions, the regulatory and political environment, and changes in social expectations
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In relation to the dynamics associated with changing community expectations, Lindblom (1993, p. 3) states: Legitimacy is dynamic in that the relevant publics continuously evaluate corporate output, methods, and goals against an ever-evolving expectation. The legitimacy gap will fluctuate without any changes in action on the part of the corporation. Indeed, as expectations of the relevant publics change the corporation must make changes or the legitimacy gap will grow as the level of conflict increases and the levels of positive and passive support decreases.
The term ‘legitimacy gap’, as used in the above quote, is a term that has been used by many researchers to describe the situation where there appears to be a lack of correspondence between how society believes an organisation should act and how it is perceived that the organisation has acted. In relation to how legitimacy gaps arise, Sethi (1978) describes two major sources of the gaps. First, societal expectations might change, and this will lead to a gap arising even though the organisation is operating in the same manner as it always has. As an example of this source of a legitimacy gap, Nasi et al. (1997, p. 301) state: For American tobacco companies in the 1970s, for example, the increasing awareness of the health consequences of smoking resulted in a significant and widening legitimacy gap (Miles and Cameron, 1982). The tobacco companies had not changed their activities, and their image was much the same as it had been, yet they suddenly faced a significantly different evaluation of their role in society; they faced a significant and widening legitimacy gap.
As already emphasised, community expectations are not static; rather, they change across time, thereby requiring the organisation to be responsive to current and future changes to the environment in which they operate. While organisations might change towards aligning with community expectations, if the momentum of their change is slower than the changing expectations of society, then legitimacy gaps will arise. Legitimacy itself can be threatened even when an organisation’s performance is not deviating from society’s expectations of appropriate performance. This might be because the organisation has failed to make disclosures that show it is complying with society’s expectations, which in themselves might be changing across time. That is, legitimacy is assumed to be influenced by disclosures of information, and therefore, by ‘accounting’, and not simply by (undisclosed) changes in corporate actions. According to Guthrie and Parker (1990, p. 166): The political economy perspective perceives accounting reports as social, political, and economic documents. They serve as a tool for constructing, sustaining, and legitimising economic and political arrangements, institutions, and ideological themes which contribute to the corporation’s private interests. Disclosures have the capacity to transmit social, political, and economic meanings for a pluralistic set of report recipients.
As noted above, if society’s expectations about performance change, then arguably an organisation will need to show by way of various corporate disclosures that what it is doing is also changing (or perhaps it will need explicitly to communicate and justify why its operations have not changed). The second major source of a legitimacy gap, according to Sethi (1977), occurs when previously unknown information becomes known about the organisation – perhaps through disclosure being made within the news media. In relation to this possibility, Nasi et al. (1997, p. 301) make an interesting reference to ‘organisational shadows’. They state: The potential body of information about the corporation that is unavailable to the public – the corporate shadow (Bowles, 1991) – stands as a constant potential threat to 432
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a corporation’s legitimacy. When part of the organisational shadow is revealed, either accidentally or through the activities of an activist group or a journalist, a legitimacy gap may be created.
In relation to the above source of a legitimacy gap, consider how society reacted to media revelations about certain sportswear companies’ use of factories in developing countries with unsafe or unethical labour practices (for example, Nike or Rip Curl), revelations about the pollution being caused by mining companies’ tailings dams in remote environments (for example, BHP Billiton’s operations in Papua New Guinea), or revelations about how the products of particular companies affect consumer health (for example, the reaction to the investigation into McDonald’s as told in the movie Supersize Me). All these revelations had significant cost implications for the companies involved, and to solve the legitimacy problems the organisations typically relied on various disclosure strategies. The notion of a legitimacy gap has been depicted diagrammatically by O’Donovan (2002) (see Figure 9.2). In explaining the diagram, O’Donovan states: The area marked X [in Figure 9.2] represents congruence between corporate activity and society’s expectations of the corporation and its activities, based on social values and norms. Areas Y and Z represent incongruence between a corporation’s actions and society’s perceptions of what these actions should be. These areas represent ‘illegitimacy’ or legitimacy gaps (Sethi, 1978). The aim of the corporation is to be legitimate, to ensure area X is as large as possible, thereby reducing the legitimacy gap. A number of legitimation tactics and disclosure approaches may be adopted to reduce the legitimacy gap.
Much of the research that has been undertaken within the social and environmental accounting literature, and which has embraced Legitimacy Theory, has typically addressed actions undertaken by organisations to regain their legitimacy after some form of legitimacythreatening event occurs. But as authors such as Suchman (1995) and O’Donovan (2002) indicate, legitimation strategies might be used to either gain, maintain or repair legitimacy. According to O’Donovan (2002, p. 349): Legitimation techniques/tactics chosen will differ depending upon whether the organisation is trying to gain or extend legitimacy, to maintain its current level of legitimacy, or to repair or to defend its lost or threatened legitimacy. FIGURE 9.2 Issues/events and corporate legitimacy Issues/Events
Y Society’s expectations and perceptions of a corporation’s activities
X
Y Corporation’s actions and activities
Source: G. O’Donovan (2002), ‘Environmental disclosures in the annual report: extending the applicability and predictive power of legitimacy theory’, Accounting, Auditing and Accountability Journal, 15(3).
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Phases of legitimation While researchers have proposed that legitimation tactics might differ depending on whether the entity is trying to gain, maintain or repair (defend) legitimacy, the theoretical development in this area remains weak. Although the literature provides some general commentary, there is a lack of guidance about the relative effectiveness of legitimation strategies with regard to either gaining, maintaining or regaining legitimacy. In terms of the general commentary provided within the literature, gaining legitimacy occurs when an organisation moves into a new area of operations in which it has no past reputation. In such a situation, the organisation suffers from the ‘liability of newness’ (Ashforth and Gibbs, 1990) and it needs to proactively engage in activities to win acceptance. This acceptance is won, in part, through various communication strategies. The task of maintaining legitimacy, which is undertaken once legitimacy has been established, is typically considered easier than gaining or repairing legitimacy (Ashforth and Gibbs, 1990; O’Donovan, 2002). According to Ashforth and Gibbs (1990, p. 183), legitimacy-maintenance activities would include maintaining activities that are consistent with community expectations and the provision of symbolic assurances that all is well. One of the ‘tricks’ in maintaining legitimacy is to be able to anticipate changing community perceptions. According to Suchman (1995, p. 594), strategies for maintaining legitimacy fall into two groups – forecasting future changes and protecting past accomplishments. In relation to monitoring or forecasting changing community perceptions, Suchman (1995, p. 595) states: Managers must guard against becoming so enamoured with their own legitimating myths that they lose sight of external developments that might bring those myths into question. With advanced warning, managers can engage in pre-emptive conformity, selection, or manipulation, keeping the organization and its environment in close alignment; without such warning, managers will find themselves constantly struggling to regain lost ground. In general, perceptual strategies involve monitoring the cultural environment and assimilating elements of that environment into organizational decision processes, usually by employing boundary-spanning personnel as bridges across which the organization can learn audience values, beliefs, and reaction.
In relation to protecting past (legitimacy-enhancing) accomplishments, Suchman (1995, p. 595) states: In addition to guarding against unforeseen challenges, organizations may seek to buttress the legitimacy they have already acquired. In particular, organizations can enhance their security by converting legitimacy from episodic to continual forms. To a large extent this boils down to (a) policing internal operations to prevent miscues, (b) curtailing highly visible legitimation efforts in favour of more subtle techniques, and (c) developing a defensive stockpile of supportive beliefs, attitudes and accounts.
In relation to maintaining legitimacy, the greater the extent to which the organisation trades on its level of legitimacy, the more crucial it will be for that organisation to ensure that it does not deviate from the high standards that it has established. Conversely, the less ‘legitimacy’ an existing organisation has to begin with, the less it needs to maintain. For example, compare an armaments manufacturer with, say, the Body Shop (an organisation that had developed a reputation for sound social and environmental practices). The products of armaments manufacturers are designed to kill, so such an organisation arguably has less to worry about in terms of its legitimacy than the Body Shop. The Body Shop had, for many years, traded on a reputation for caring about the environment, society and the welfare of animals. If an organisation within the supply chain of the Body Shop, and without the knowledge of the Body Shop, undertook activities that were
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somehow related to animal testing or with particular environmental damage, and these activities were discovered by the media, this could be extremely costly to the organisation. It has a lot of investment in legitimacy to lose. A similar comment could be made in relation to what happened to Rip Curl, as discussed earlier in this chapter. In considering repairing legitimacy, Suchman (1995, p. 597) suggests that related legitimation techniques tend to be reactive responses to often unforeseen crises. In many respects, repairing and gaining legitimacy are similar. As O’Donovan (2002, p. 350) states: Repairing legitimacy has been related to different levels of crisis management (Davidson, 1991; Elsbach and Sutton, 1992). The task of repairing legitimacy is, in some ways, similar to gaining legitimacy. If a crisis is evolving, proactive strategies may need to be adopted, as has been the case for the tobacco industry during the past two decades (Pava and Krausz. 1997). Generally, however, the main difference is that strategies for repairing legitimacy are reactive, usually to an unforseen and immediate crisis, whereas techniques to gain legitimacy are usually ex ante, proactive and not normally related to crisis.
In the discussion that follows, the strategies that can be used by corporate management in an effort to gain, maintain or regain legitimacy are considered. As already indicated, the theoretical development has not developed sufficiently to link specific legitimation techniques with efforts to either gain, maintain or regain legitimacy. Most of the proposed legitimation techniques appear to relate to regaining legitimacy in the light of particular crises – something that has been the focus of many researchers working within the social and environmental accounting area (and who embrace Legitimacy Theory). Nevertheless, all legitimation strategies rely on disclosure – hence, their relevance to accounting researchers. Dowling and Pfeffer (1975, p. 127) outline the means by which an organisation may, perhaps when confronted with legitimacy-threatening events, legitimate its activities: • The organisation can adapt its output, goals and methods of operation to conform to prevailing definitions of legitimacy. • The organisation can attempt, through communication, to alter the definition of social legitimacy so that it conforms to the organisation’s present practices, output and values. • The organisation can attempt, through communication, to become identified with symbols, values or institutions that have a strong base of legitimacy. Consistent with Dowling and Pfeffer’s strategy of ‘communication’, Lindblom (1993) proposes that an organisation can adopt a number of strategies where it perceives that its legitimacy is in question because its actions (or operations) are at variance with society’s expectations and values. Lindblom identifies four courses of action (there is some overlap with Dowling and Pfeffer) that an organisation can take, particularly when it needs to defend or repair legitimacy. The organisation can: 1 seek to educate and inform its ‘relevant publics’ about (actual) changes in the organisation’s performance and activities which bring the activities and performance more into line with society’s values and expectations 2 seek to change the perceptions that ‘relevant publics’ have of the organisation’s performance and activities – but not change the organisation’s actual behaviour (while using disclosures in corporate reports to indicate falsely that the performance and activities have changed) 3 seek to manipulate perception by deflecting attention from the issue of concern onto other related issues through an appeal to, for example, emotive symbols, thus seeking to demonstrate how the organisation has fulfilled social expectations in other areas of its activities 4 seek to change external expectations of its performance, possibly by demonstrating that specific societal expectations are unreasonable. 435
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While the above discussion relates to various legitimation tactics, one issue we can also consider is whether there might come a time in the life cycle of some organisations where their legitimacy has been so badly eroded that strategies to repair or defend legitimacy might ultimately be abandoned. Some organisations might have limited legitimacy to start with, such as the armaments manufacturer discussed previously. Such an organisation would not be expected to have widespread appeal and therefore disclosures might be limited to showing compliance with legal requirements. Other organisations might initially have legitimacy, but lose it across time. For example, we can consider the tobacco industry. In this regard, Tilling and Tilt (2010) undertook research in which they reviewed the disclosure policies of Rothmans Limited, an Australian producer of tobacco products, over the period from 1955 to 1999. According to the authors, this industry moved from being one of relatively high legitimacy (prior to scientific confirmation of the negative health effects of tobacco) to being one of relatively low legitimacy. While there is a general expectation that organisations would increase disclosures as part of a legitimation process and as legitimacy is threatened, they found that there came a time – which Tilling and Tilt referred to as the ‘loss phase’ – when it appeared that the company ceased making disclosures of a positive nature to defend or repair lost legitimacy. That is, there came a time when efforts to regain lost legitimacy are deemed ‘useless in the legitimation effort’ (de Villiers and van Staden, 2006, p. 767). According to Tilling and Tilt (2010, p. 75), organisations might be confronted with a choice: A firm that is in the loss phase, is then likely to either move to some form of disestablishment [in which it no longer tries to legitimise its existence], or begin to build its legitimacy once again, in a sense returning to the original legitimacy establishment phase.
In reflecting upon their results, Tilling and Tilt (2010, p. 71) state: The tobacco industry in general, and Rothmans specifically, had one major threat to its legitimacy: the smoking and health issue. Other than in 1964 it choose not to engage with this issue, instead focusing on community service and charitable works. This could appear to be an attempt to engage in Lindblom’s (1993) third strategy, trying to get the community to accept the company’s legitimacy, not in terms of the health issue, but instead highlighting the organisation’s engagement in good works, therefore trying to bolster its position as a legitimate organisation without having to engage in change. Ultimately this would appear to have failed, at least to the extent that the industry is now highly regulated, scrutinized and taxed, although it continues to survive. When there no longer seemed to be value in even trying to defend legitimacy, the analysis suggests the company ultimately gave up its charitable community involvement and reporting on it.
The tobacco industry is an interesting industry in the sense that unlike many other industries, it can survive, albeit probably at a reduced level of operations, even when the legitimacy of the industry has been eroded. In large part this is due to the addictive qualities of the product. However, the lower level of legitimacy in the broader (non-addicted) community arguably led to higher taxes being imposed on the products of the industry, higher salaries required to be paid to attract quality staff, and higher returns required to be paid to capital providers. The phases discussed above can be represented as shown in Figure 9.3. Not all organisations will enter all phases. As Figure 9.3 shows, and applying Legitimacy Theory, most organisations will initially seek to establish legitimacy, after which time they will reach the stage where they will
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FIGURE 9.3 Phases of the legitimation process Legitimacy establishment
Legitimacy maintenance
Loss phase
Defence of legitimacy should a legitimacy gap arise
Abandonment of legitimacy efforts Source: Adapted from Tilling and Tilt (2010).
try to maintain legitimacy. As legitimacy-threatening events arise, the organisation might then try to defend its legitimacy; however, it might reach a stage where legitimacy has effectively been lost. At that point, the organisation might choose to either seek to re-establish its legitimacy, or alternatively, elect to abandon efforts to maintain legitimacy. As already emphasised in this chapter, corporate disclosure would be used as a central part of the strategy to establish, maintain or repair lost legitimacy.
Use of accounting reports in legitimation strategies According to Lindblom (1993), and Dowling and Pfeffer (1975), the public disclosure of information in such places as annual reports or other publicly available reports (such as sustainability reports) can be used by an organisation to implement each of their suggested strategies. Certainly, this is a perspective that many researchers of social responsibility reporting have adopted, as discussed shortly. For example, an organisation might provide information to counter or offset negative news that is publicly available, or it might simply provide information to inform the interested parties about attributes of the organisation that were previously unknown. In addition, organisations might draw attention to their strengths – for example, environmental or community awards won or safety initiatives that have been implemented – while neglecting or downplaying information concerning negative implications of their activities, such as pollution or workplace accidents. In considering the various proposed legitimising techniques, we can see that the techniques might be ‘symbolic’ (and not actually reflect any real change in activities) or they might be ‘substantive’ (and reflect actual change in corporate activities). As Ashforth and Gibbs (1990) indicate, the use of substantive management techniques might ‘involve real, material change in organizational goals, structures, and processes or socially institutionalized practices’ (p. 178). By contrast, symbolic management techniques of legitimation involve the portrayal of corporate behaviour in a manner to ‘appear consistent with social values and expectations’, but the actual operating policies of the organisation may not change (Ashforth and Gibbs, 1990, p. 180). For example, companies may publish policies on various issues, including the environment, but not enforce or set in place mechanisms for the full adoption of such policies. Other techniques relating to symbolic management techniques include offering excuses for behaviour or apologies (Ashforth and Gibbs, 1990).
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According to Ashforth and Gibbs, it is not necessary for corporations to use either substantive or symbolic management techniques exclusively, and they may adopt a mix of substantive and/ or symbolic legitimating techniques which they apply with varying levels of intensity. As an example of the potential use of ‘legitimising symbols’, consider research reported by Deegan and Blomquist (2006). Deegan and Blomquist investigated the development of the Australian Minerals Industry Code for Environmental Management by the Mineral Council of Australia. Many Australian mining companies signed up to this code of conduct. The code had among its many requirements a reporting requirement that required signatories to the code to prepare and release a publicly available environmental report within two years of signing the code. Concerned about the quality of reporting being undertaken within the minerals industry, WWF-Australia (formerly known as the World Wide Fund for Nature) undertook a project in which it assessed the quality of the reports being released by the signatories of the code. WWF assessed the reports using particular reporting criteria that WWF had developed. WWF’s results were reported in a document it released entitled ‘Mining environmental reports: ore or overburden?’ In explaining how the establishment of the code and the subsequent involvement of WWF might have contributed to the legitimacy of the minerals industry, Deegan and Blomquist referred to the work of Richardson and Dowling (1986). Richardson and Dowling refer to ‘legitimating symbols’ and ‘procedural legitimation’, with the two being linked to one another. According to Richardson and Dowling (1986, p. 102): Procedural legitimation represents a process of negotiation through which the values of a community and their connotative link to particular social relations and artifacts is created and institutionalized, as legitimating symbols. In the process, both value standards and social structures are subject to change.
In discussing their results, Deegan and Blomquist (2006) state: The legitimating symbol in this case was the Australian Minerals Industry Code for Environmental Management. As Richardson and Dowling emphasise, legitimating symbols are open to ‘challenge and change’ and they can only sustain their existence through the support and affirmation of those parties that are perceived by the community as having high ‘value standards’ (a process of procedural legitimation involving a third party). WWF would arguably be perceived as having high ‘value standards’ and hence, their participation in the process would add to the legitimacy of the Code and increase the community perception that the Code had some form of ‘higher order reality’ that was independent of the creating body (the Mineral Council of Australia). Indeed, the comments made by the interviewees [from the Australian Minerals Council who were involved with the development of the Code] were consistent with the view that the WWF’s involvement assisted the social standing of the Code. By reviewing the reporting policies of Code signatories, the WWF was effectively treating the Code as a ‘value standard’ which it was ‘sanctioning’ (Giddens, 1976) – something that would appear to be beneficial to the industry. While data was not collected from non-signatories at the time, it is conceivable that WWF’s ‘sanctioning’ of the Code might have encouraged other organisations to subsequently become signatories. Certainly, the membership numbers increased subsequent to WWF’s involvement (though obviously many factors could have contributed to this increase).
Consistent with the positions taken both by Dowling and Pfeffer and by Lindblom, Hurst (1970) suggests that one of the major functions of accounting, and subsequently accounting reports, is to legitimate the existence of the corporation. Such views highlight the strategic nature of corporate reports.
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Why do I need to know about the insights that Legitimacy Theory provides? Managers of organisations often make disclosures voluntarily. This is very much the case when it comes to various social and environmental disclosures being made by organisations. By being aware of the insights provided by Legitimacy Theory, we are encouraged to consider the motivations that might be driving managers to make the particular disclosures that we are reading. Legitimacy Theory tells us that if disclosures are made at a time that follows a particular crisis or ‘negative
event’, then the disclosures might be motivated by a desire to maintain or regain legitimacy, rather than being motivated by a desire to demonstrate a sound level of accountability in respect of particular actions or outcomes. Legitimacy Theory encourages us to consider the context – in terms of both place and time – in which disclosures are made and to retain an element of scepticism about what managers are disclosing and why they are disclosing.
Corporate views on the importance of the social contract The view within Legitimacy Theory that organisations will be penalised if they do not operate in a manner consistent with community expectations (that is, in accordance with the social contract, or, as it is sometimes called, the ‘social licence to operate’) is a view being embraced publicly by corporate managers internationally. For example, in its 2021 Annual Report, the Commonwealth Bank (2021, p. 7) refers to its ‘Should We?’ Test, which it embeds in many decision-making processes. CBA states: We use the ‘Should We?’ Test in all our interactions and decisions. It is a simple way to ensure our actions meet community expectations.
Rio Tinto also emphasises the necessity to comply with community expectations and the ‘social licence’. As stated in the Rio Tinto Annual Report 2021 (p. 16): Delivering on our strategy depends on four objectives set out at the start of 2021: to be the best operator, to achieve impeccable environmental, social and governance (ESG) credentials, to excel in development, and to protect our social licence.
These statements illustrate that the notions embodied within Legitimacy Theory are reflective of the public positions being taken by corporate executives. Managers clearly believe that meeting the expectations of the community in which their organisations operate can protect or enhance profitability, while failure to do so can be detrimental to the organisations’ ongoing operations and survival.
REFLECTION QUESTION 9.1 The social contract Questions 1 Is it the role of managers to determine the contents of their organisations’ ‘social contract’? 2 How would managers determine the expectations embodied within the ‘social contract’? 3 Would all managers have the same perspective of a particular organisation’s social contract?
Solutions 1 As we know, the social contract, or social licence to operate, is a theoretical concept representing the views and expectations society has about how an organisation should conduct its operations. Organisations must act in conformity with the social contract, and ongoing changes thereto, otherwise they will encounter trouble surviving. It would seem very much the role of managers to consider and reflect upon the contents of the social contract, and to act accordingly.
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2 There could be various ways. Managers could arrange consultations with various stakeholder groups; they could regularly scan the news media for information about changing community expectations; or they could look at community-based surveys that different organisations regularly undertake to determine what concerns different elements of society.
3 Because the contents or terms of the social contract are not written down anywhere, but rather are subject to interpretation by managers, then it would be the case that different managers will interpret the contents of the ‘social contract’ differently. This in part explains why some managers will do things differently to other managers.
Empirical tests of Legitimacy Theory In recent years, Legitimacy Theory has been used by numerous accounting researchers who have elected to study social and environmental reporting practices. A number of papers have identified specific types of social responsibility disclosures that have appeared within annual reports and sustainability reports or on organisational websites. The researchers have attempted to explain these disclosures on the basis that they form part of the portfolio of strategies undertaken by accountants and their managers to bring legitimacy to, or maintain the legitimacy of, their respective organisations. A number of such papers are now considered. An early study that sought to link ‘legitimacy’ to corporate social disclosure policies was conducted by Hogner (1982). This longitudinal study examined corporate social reporting in the annual reports of the US Steel Corporation over a period of 80 years, beginning in 1901, the data being analysed for year-to-year variation. Hogner showed that the extent of social disclosures varied from year to year, and he speculated that the variation could represent a response to society’s changing expectations of corporate behaviour. Patten (1992) focused on the change in the extent of environmental disclosures made by North American oil companies, including Exxon Oil Company, both before and after the Exxon Valdez incident in Alaska in 1989, which was one of the largest oil spills in history and had a significant effect on many creatures and the environments in which they lived. He argued that if the Alaskan oil spill resulted in a threat to the legitimacy of the petroleum industry, and not just to Exxon, then Legitimacy Theory would suggest that companies operating within that industry would respond by increasing the amount of environmental disclosures in their annual reports. Patten’s results indicate that there were increased environmental disclosures by the petroleum companies for the post-1989 period, consistent with a legitimation perspective. This disclosure reaction took place across the industry, even though the incident was directly related to only one oil company. He stated (p. 475): … it appears that at least for environmental disclosures, threats to a firm’s legitimacy do entice the firm to include more social responsibility information in its annual report.
In an Australian study, Deegan and Rankin (1996) used Legitimacy Theory to try to explain systematic changes in corporate annual report environmental disclosure policies around the time of proven environmental prosecutions. The authors examined the environmental disclosure practices of a sample of Australian companies that were successfully prosecuted by environmental protection authorities (EPAs) for breaches of various environmental protection laws during the period 1990–93 (any prosecutions by these agencies were reported in the EPAs’ annual reports, which were publicly available). The annual reports of a final sample of 20 companies, prosecuted a total of 78 times, were reviewed to ascertain the extent of the environmental disclosures. These annual reports were matched by industry and size to the annual reports of a control group of 20 companies that had not been prosecuted. Of the 20 prosecuted companies, 18 provided environmental information in their annual report, but the disclosures were predominantly of a positive nature, providing ‘good news’ about the organisations’ performance, and the disclosures were of a qualitative nature. Only two 440
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organisations made any mention of the prosecutions. Deegan and Rankin found that prosecuted companies disclosed significantly more environmental information (of a favourable nature) in the year of prosecution than in any other year of the sample period. Consistent with the view that companies increase disclosure to offset any effects of EPA prosecutions, the EPA-prosecuted companies also disclosed more environmental information relative to non-prosecuted companies. The authors concluded that the public disclosure of proven environmental prosecutions had an impact on the disclosure policies of the companies involved.
REFLECTION QUESTION 9.2 Breaching the ‘social contract’ With the results of Patten (1992) and Deegan and Rankin (1996) in mind, consider an article that appeared on the Australian Broadcasting Corporation (ABC) website (and reported on ABC radio and television news) entitled ‘Report reveals Rio Tinto knew the significance of 46,000-year-old rock caves six years before it blasted them’ (Borschmann, 2020). The article noted that: Mining giant Rio Tinto was alerted six years ago that at least one of the caves it blasted in Western Australia’s Pilbara region last month was of ‘the highest archaeological significance in Australia’. The cave sites were among the oldest in Australia, with evidence of continuous human habitation going back 46,000 years. The destruction caused a great deal of anguish for traditional owners, led to several government inquiries, and culminated in the departure of several senior executives from the company. Questions In regard to this disaster, consider how Legitimacy Theory could be used to predict how companies in the industry might react to such publicity. Specifically:
1 Do you think that Rio Tinto would be deemed to have breached its ‘social contract’?
2 Do you think that Rio Tinto might use its annual report, sustainability report or disclosures in other media in an attempt to reinstate its legitimacy? 3 Do you think that the subsequent apologies and changes in corporate governance policies by the company, and the removal of various senior executives could act to help the company reinstate its legitimacy? Solutions 1 We would probably all agree that the most likely answer to this is ‘yes’. 2 The company did make many disclosures in the years following about how it was changing its governance policies to ensure something like this never happens again. 3 This is something that is not easily determined. Perhaps ongoing reviews of negative media articles, or periodic engagement with particular groups of stakeholders, might provide some insights into changing perceptions of the company. Certainly, we would expect that the strategies adopted by managers were, at least in part, aimed towards restoring lost legitimacy.
In another study that embraced Legitimacy Theory, Deegan and Gordon (1996) reviewed annual report environmental disclosures made by a sample of companies from 1980 to 1991. They investigated the objectivity of corporate environmental disclosure practices and trends in environmental disclosures over time. They also sought to determine if environmental disclosures were related to concerns held by environmental groups about particular industries’ environmental performance. The results derived by the Deegan and Gordon study indicated, among other findings, that during the period covered by the study: (1) increases in corporate environmental disclosures over time were positively associated with increases in the levels of environmental group membership; (2) corporate environmental disclosures were overwhelmingly self-laudatory; and (3) there was a positive correlation between the environmental sensitivity of the industry to which the corporation belonged and the level of corporate environmental disclosure.5 These results were deemed to be consistent with Legitimacy Theory.
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Environmental sensitivity was determined by use of a questionnaire sent to environmental lobby groups in which office-bearers were required to rate industries (on a 0 to 5 scale) on the basis of whether the industry had been made the focus of action as a result of its environmental performance/implications.
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Gray, Kouhy and Lavers (1995) performed a longitudinal review of UK corporate social and environmental disclosures for the period 1979–91. In discussing the trends in corporate environmental disclosure policies, they made use of Legitimacy Theory, with specific reference to the strategies suggested by Lindblom (1993) that were considered earlier in the chapter. After considering the extent and types of corporate disclosures, they stated (p. 65): The tone, orientation and focus of the environmental disclosures accord closely with Lindblom’s first, second and third legitimation strategies. A significant minority of companies found it necessary to ‘change their actual performance’ with respect to environmental interactions (Lindblom’s first strategy) and use corporate social reporting to inform their ‘relevant publics’ about this. Similarly, companies’ environmental disclosure has also been an attempt, first, to change perceptions of environmental performance – to alter perceptions of whether certain industries were ‘dirty’ and ‘irresponsible’ (Lindblom’s second strategy) and, second, as Lindblom notes, to distract attention from the central environmental issues (the third legitimation strategy). Increasingly, companies are being required to demonstrate satisfactory performance within the environmental domain. Corporate social reporting would appear to be one of the mechanisms by which the organisations satisfy (and manipulate) that requirement.
In relation to trends found in regard to health and safety disclosures, Gray, Kouhy and Lavers (p. 65) stated: We are persuaded that companies were increasingly under pressure from various ‘relevant publics’ to improve their performance in the area of health and safety and employed corporate social reporting to manage this ‘legitimacy gap’. That is, while the disclosure did not, as such, demonstrate improved health and safety records (lack of previous information makes such assessment impossible), it did paint a picture of increasing concern being given by companies to the matter of protecting and training their workforce. This disclosure then helped add to the image of a competent and concerned organisation which took its responsibilities in this field seriously. As such, health and safety disclosure appears to be a strong illustration of Lindblom’s second legitimation strategy – ‘changing perceptions’.
Applying Legitimacy Theory to financial (as opposed to social and environmental) disclosure practices, in a US study the choice of an accounting framework was deemed to be related to a desire to increase the legitimacy of an organisation. Carpenter and Feroz (1992) argued that the New York State’s (government) decision to adopt generally accepted accounting procedures (GAAP) (as opposed to a method of accounting based on cash flows rather than accruals) was ‘an attempt to regain legitimacy for the State’s financial management practices’ (p. 613). According to Carpenter and Feroz, New York State was in a financial crisis in 1975, with the result that many parties began to question the adequacy of the financial reporting practices of all the associated government units. To regain legitimacy, New York State elected to implement GAAP (which incorporates accrualsbased accounting). As Carpenter and Feroz (1992, pp. 635, 637) state: The state of New York needed a symbol of legitimacy to demonstrate to the public and the credit markets that the state’s finances were well managed. GAAP, as an institutionalized legitimated practice, serves this purpose … We argue that New York’s decision to adopt GAAP was an attempt to regain legitimacy for the state’s financial management practices. Challenges to the state’s financial management practices, led by the state comptroller, contributed to confusion and concern in the municipal securities market. The confusion resulted in a lowered credit rating. To restore the credit rating, a symbol of legitimacy in financial management practices was needed. 442
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It is debatable whether GAAP was the solution for the state’s financial management problem. Indeed, there is strong evidence that GAAP did not solve the state’s financial management problems. New York needed a symbol of legitimacy that could be easily recognised by the public. In the realm of financial reporting, ‘GAAP’ is the recognised symbol of legitimacy.
According to Carpenter and Feroz, few people would be likely to oppose a system that was ‘generally accepted’ – general acceptance provides an impression of legitimacy. As they state (p. 632): In discussing whether to use the term ‘GAAP’ instead of ‘accrual’ in promoting the accounting conversion efforts, panel members argued that no one could oppose a system that is generally accepted. The name implies that any other accounting principles are not accepted in the accounting profession. GAAP is also seemingly apolitical.
As emphasised in this chapter, Legitimacy Theory proposes a relationship between corporate disclosures (and other corporate strategies) and community expectations, the view being that management reacts to community concerns and makes the necessary changes. But we are left with a question: how does management determine community expectations? There is evidence that management might rely on sources such as the news media to determine community expectations. For example, Brown and Deegan (1998) investigated the relationship between the print media coverage given to various industries’ environmental impacts and the levels of annual report environmental disclosures made by a sample of companies within those industries. The basis of the argument was that the media can be particularly effective in driving the community’s concern about the environmental performance of particular organisations, and where such concern is raised, organisations will respond by increasing the extent of disclosure of environmental information within the annual report. Brown and Deegan used the extent of media coverage given to a particular issue as a measure (or proxy) for ‘community concern’. They made explicit reference to Media Agenda Setting Theory. In doing so, they were the first researchers to bring Media Agenda Setting Theory into the social and environmental accounting literature. The theory, which was developed in the journalism literatures, is now regularly cited within the accounting literature. Media Agenda Setting Theory proposes a relationship between the relative emphasis given by the media to various topics, and the degree of salience these topics have for the general public (Ader, 1995, p. 300).6 In terms of causality, increased media attention is believed to lead to increased community concern for a particular issue. The media are not seen as mirroring public priorities; rather, they are seen as shaping them.7 That is, Media Agenda Setting Theory posits that the media shapes public awareness, with the media agenda preceding public concern for particular issues (McCombs and Shaw, 1972). The view taken is that members of the public need the news media to tell them how important an issue within the ‘real world’ is, as, for many issues, individuals do not learn this from available real-world cues. Neuman (1990) identifies a distinction between ‘obtrusive’ and ‘unobtrusive’ issues. He notes, for example, that inflation is seen as a ‘classic example’ of an obtrusive issue because the public would become aware of it every time they went to the supermarket and they do not need the media to report the official statistics to realise that this issue affects their lives. Unobtrusive issues, on the other hand, would include foreign events (such as polluting activities undertaken at offshore locations, or workplace practices in remote overseas factories) that cannot be experienced or known by the public without the media functioning as a conduit (Neuman, 1990; Zucker, 1978). It is argued that the media’s agendasetting effect is most apparent in relation to unobtrusive events. Using a joint consideration of 6
7
For an explanation of media agenda setting theory, see Ader (1995), Blood (1981), Eyal, Winter and DeGeorge (1981), Mayer (1980), McCombs (1981), McCombs and Shaw (1972) and Zucker (1978). An extreme, but somewhat interesting, view of the media’s power of influence is provided by White (1973, p. 23). In relation to the United States, he states that ‘the power of the press in America is a primordial one. It sets the agenda of public discussion; and this sweeping political power is unrestrained by any law. It determines what people will talk and think about – an authority that in other nations is reserved for tyrants, priests, parties and mandarins’.
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Media Agenda Setting Theory and Legitimacy Theory, the arguments provided in Brown and Deegan (1998) can be summarised as: 1 Management use media such as the annual report or sustainability report as a tool to legitimise the ongoing operations of the organisation (from Legitimacy Theory). 2 Community concerns with the social or environmental performance of a specific organisation (or, indeed, any aspect of corporate performance) in an industry will also impact on the disclosure strategies of organisations across that industry. In a simple equation form we can represent this as:
Corporate Disclosures = fn (Community Concern) where ‘fn’ refers to ‘a positive function’ (or positive relationship). 3 The news media are able to influence community perceptions about issues such as the social
or environment impacts (from Media Agenda Setting Theory). In simple equation form we can represent this as:
Community Concern = fn (Media Attention) 4 If management responds to community concerns, and if it is accepted that community
concerns are influenced by news media attention given to particular social and environmental issues, then we should find a relationship between the extent of disclosure of social and environmental issues within their reports and the media attention given to those issues. That is, if we substitute the second equation above into the first equation then we will be left with:
Corporate Disclosure = fn (Media Attention) The results in Brown and Deegan (1998) indicate that, for the majority of the industries studied, higher levels of media attention to social and environmental issues (as determined by a review of a number of print media newspapers and journals) are significantly associated with higher levels of social and environmental disclosures. O’Donovan (1999) also considered the role of the news media in shaping community expectations, and how corporate management responds to potentially damaging media attention. O’Donovan provides the results of interviews with senior executives from three large Australian companies (Amcor Ltd, BHP Billiton Ltd and ICI Australia Ltd). The executives confirmed that, from their perspective, the media does shape community expectations, and that corporate disclosure is one way to correct ‘misperceptions held or presented by the media’. O’Donovan reproduced a number of statements made by the executives who were interviewed. These quotes included: If there was something that was given prominent press coverage, yes (news reports influence disclosure decisions). This year and last year we mentioned the ground water survey at Botany Bay as it attracted press coverage and was important to Sydney residents (Company C). … The environmental issues that are covered in the annual report really try to address matters of current concern as depicted in the media. Shareholders then get an understanding on where our company stands on issues such as recycling, forestry, chlorine and greenhouse gases (Company A).
In related research, Deegan, Rankin and Tobin (2002) investigate the social and environmental disclosures made within the annual reports of BHP – the world’s largest mining and resources company – between 1983 and 1997. The authors embrace the view that managers will use social and environmental disclosures as a means to counter negative community sentiment (legitimacy threats). As a proxy for community concern, the authors also used news media attention (printed newspapers) as a measure of community concern. The findings by Deegan, Rankin and Tobin 444
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(2002), which are supportive of Legitimacy Theory, show that those social and environmental issues (49 separate issues in total) that attracted the largest amount of media attention were also those issues with the greatest amount of corporate disclosures. AnimportantpointthatwasraisedinDeegan,RankinandTobin(2002),andwhichhasbeenspecifically referred to in many published papers since, is that legitimising disclosures are potentially very detrimental to the community, and indeed, to other inhabitants of the planet. From this perspective, the managers of organisations only provide (respond with) social and environmental disclosures if community/ stakeholder concerns are aroused, perhaps because of the news media, meaning that the disclosures have nothing directly to do with managerial perceptions or judgements about corporate responsibilities and associated accountabilities. Further, a managerial portrayal of organisational change through legitimating disclosures may act as an instrument (or ‘shield’) to effectively forestall any real and necessary change. Hence, consistent with the views of Puxty (1991), legitimising disclosures are assessed as being potentially quite harmful and not in the interests of society. If successful in legitimising an organisation’s operations, legitimising disclosures can also have the effect of reducing stakeholder pressure for the introduction of regulation that might alter or restrict an organisation’s activities, which again is potentially in the interests of the organisation, but not in the interests of the broader society. Within the context of companies that source their products from developing countries, Islam and Deegan (2010) undertook a review of the social and environmental disclosure practices of two leading multinational sportswear and clothing companies, Nike and Hennes and Mauritz. Islam and Deegan found a direct relationship between the extent of global news media coverage of a critical nature being given to particular social issues relating to the industry and the extent of social disclosure. In particular, they found that once the news media started running a campaign that exposed poor working conditions and the use of child labour in developing countries, it appeared that the multinational companies then responded by making various disclosures identifying initiatives that were being undertaken to ensure the companies did not source their products from factories that had abusive or unsafe working conditions or used child labour. Islam and Deegan found the evidence to be consistent with the view that the news media influenced the expectations of Western consumers (consistent with Media Agenda Setting Theory), thereby causing a legitimacy problem for the companies. The companies then responded to the legitimacy crisis by providing disclosures within their annual reports that particularly focused on the highlighted issue. Islam and Deegan showed that, prior to the time at which the news media started running stories about the labour conditions in developing countries (media attention to these issues appeared to begin in the early 1990s), there was a general absence of disclosures being made by the companies. This was despite the fact that evidence suggests that poor working conditions and the use of child labour existed in developing countries for many years prior to the newspapers beginning coverage of the issues. Islam and Deegan speculate that had the Western news media not run stories exposing the working conditions in developing countries – which created a legitimacy gap for the multinational companies – the multinational companies would not have embraced initiatives to improve working conditions, nor provided disclosures about the initiatives being undertaken in relation to working conditions. Further work by Deegan and Islam has also shown that non-government organisations (NGOs) including labour rights and environmental organisations often use the news media as a means of disseminating information about poor labour practices in developing countries (Deegan and Islam, 2014). Without the use of the media, consumers would generally not have knowledge of poor workplace practices. As they state (p. 397): Our results show that social and environmental NGOs strategically use the news media to effect changes in the operating and disclosure policies pertaining to corporate labour practices. More particularly, both the NGOs and the news media representatives stated that NGOs would be relatively powerless to create changes in corporate accountability without media coverage. 445
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Figure 9.4 provides a simple representation of the sequence of events as reflected by the evidence presented in Deegan and Islam (2014). The NGOs become concerned about poor practices and take news stories to the newspapers. The newspapers are generally sympathetic to such issues and run stories exposing the issues. Consistent with Media Agenda Setting Theory, this in turn influences community expectations and therefore the legitimacy of the focal organisations, which in turn reduces the demand for the organisation’s products. Faced with the losses associated with the legitimacy crisis, the organisation undertakes legitimation strategies of which disclosure is a key component. These disclosures hopefully, from management’s perspective, influence community concerns and help repair lost legitimacy and re-establishes community demand for the organisation’s goods and services.
FIGURE 9.4 Diagrammatic representation of the sequence of events as reported in Deegan and Islam (2014) Labour groups (NGOs) become concerned about workplace practices and take stories to news media
Media runs negative stories on alleged workplace abuses – issues that would otherwise be unobtrusive
The perceived legitimacy of the organisation influences the level of demand for the organisation’s products
Consumers’ perspectives of the products and legitimacy of the organisation are influenced by various factors, including news stories and corporate disclosures
The organisation undertakes legitimation tactics (e.g. one of the strategies identified by Lindblom [1993]), and makes public disclosures about the efforts with the aim of reducing the legitimacy gap Source: Adapted from Deegan, C. & Islam, M. A. (2014), ‘An exploration of NGO and media efforts to influence workplace practices and associated accountability within global supply chains’, British Accounting Review, 46(4), pp. 397–45.
In a study of how the social and environmental disclosure practices of a sample of gambling companies operating within Australia changed around the time of a number of government inquiries into the gambling industry, Loh, Deegan and Inglis (2015) reported that the organisations from the gambling industry appeared to utilise public disclosures in a manner consistent with an intent to legitimise their activities at a time when their activities had come under particular political scrutiny. The social and environmental disclosures made by the sample organisations appear to change as the political scrutiny focused upon the gambling industry changes. Specifically, the disclosures were consistent with a perspective that the companies use their disclosures for the purpose of legitimation rather than as a means of objectively providing an account of the social aspects, or impacts, of their operations. Further, even though community concern in relation to problem gambling appeared to heighten during the period of the investigation, the companies provided relatively little disclosure in relation to problem gambling when compared to disclosures relating to issues such as community involvement and human resources. That is, it appeared that the sample of companies were deflecting attention from problem gambling – the issue at the forefront of political attention – to other social and environmental issues.
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Research has also shown that managers elect to change the reporting frameworks they use if they believe the change will influence their legitimacy. Gaia, Leoni and Neri (2021) provide evidence that organisations that appear to have their legitimacy threatened will publicly embrace the practice of ‘integrated reporting’ (which we discuss in Chapter 10) as a means to regain lost legitimacy. To further restore legitimacy, the authors argue that managers will also note within their reports that they are specifically applying the Framework developed by the International Integrated Reporting Council (since the research was undertaken the International Sustainability Standards Board has taken responsibility for further developing the Framework). Specifically, it is reported that organisations with higher risks to their reputation and legitimacy (as reflected by a relatively higher amount of negative news media attention to their environmental, social and governance-related performance) will tend to provide greater disclosure with respect to the Framework. As Gaia, Leoni and Neri (2021, p. 3) state: Our findings suggest that IR adopters believe that the adoption of IR and the related disclosures is an effective response to poor corporate reputation. As the deterioration of a firm’s reputation may limit the ability of the firm to conduct its business in the eye of its stakeholders, the decision to adopt IR at a time of poor corporate reputation, suggests that the company is leveraging IR to seek legitimation … Our work identifies a new factor that appears to influence the decision to adopt the Framework and suggests that IR can be seen as a reputational or legitimising tool, rather than a genuine accountability instrument.
As research that has embraced Legitimacy Theory has developed across time, a number of organisational, cultural or institutional variables have been identified that might influence the extent to which managers will embrace legitimising disclosures. For example: • in relation to organisational context, the research indicates that the extent of ‘political connectiveness’ can impact the need to provide legitimising disclosures. For example, Muttakin, Mihret and Khan (2018) challenge the traditional pluralist view embraced within Legitimacy Theory and suggest a revamped Legitimacy Theory, which they refer to as a ‘neo-pluralist view of legitimacy theory’. Their results show that the greater the ‘political connectiveness’ (which reflects an organisation’s ‘closeness’ to government) of an organisation, the less the need for legitimising disclosures in the advent of a crisis (although this is shown to be moderated by the extent to which the organisation is export oriented, and therefore relies upon the support of stakeholders located elsewhere) • the extent of ‘press freedom’ within particular countries has been reported as impacting the propensity of managers to produce legitimising disclosures. Blanc et al. (2017) show that if press freedom is restricted, then the propensity of a major crisis (in their case, relating to corruption) to evoke a legitimising disclosure reaction is reduced • the level of ‘democracy’ within a country has been shown to impact the propensity of managers to use legitimising disclosures. De Villiers and Marques (2016) show that social performance information is more likely to be disclosed in those countries that are deemed to be more democratic. The authors also identify effects associated with the levels of investor protection in place as well as showing that the regulative nature of a country impacts the propensity of managers to employ legitimising disclosures • national commitments to the environment have also been shown to positively influence the propensity of managers to make legitimising environmental disclosures (Alrazi, de Villiers and Van Staden, 2016) • research continues to show that size positively influences the propensity to use legitimising disclosures. Adler, Mansi and Pandey (2017) provide further confirmation of this • the environmental or social rating attributed to an organisation also potentially impacts its propensity to employ legitimising disclosures. Adler, Mansi and Pandey (2018) show that 447
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how an organisation is rated in terms of its biodiversity-related risks positively influences the nature, and amount, of social and environmental disclosures • an organisation’s relative impact on biodiversity also appears to influence the disclosures being made. For example, Adler, Mansi and Pandey (2017) show that biodiversity is an issue that is becoming more important to mining companies, particularly those operating in areas of important environmental benefit, and therefore negative aspects associated with impacts upon biodiversity can, when publicly known, be expected to elicit a related disclosure reaction from mining companies • recent research is also indicating that researchers must consider the evolution in different media available for reporting. For example, the advent of different reporting media, including social media, will potentially change how managers use disclosures to legitimise the ongoing operations of an organisation. Bellucci and Manetti (2017) note that social media is particularly suitable for stakeholder engagement, and as a potential tool for legitimation • research has also shown that there are interrelationships between different media for disclosures, which affect the overall legitimising impact of each disclosure. Lupu and Sandu (2017) provide evidence that the nature of the interrelationships between corporate disclosures/communications will influence the effectiveness of the disclosures in achieving the legitimation-related goals of managers. Therefore, it does seem to be the case that legitimacy theorists need to carefully consider the context within which organisations operate when trying to explain, or predict, the disclosures particular managers might make.
Why do I need to know about some of the empirical results generated through the application of Legitimacy Theory? Legitimacy Theory is effectively a ‘positive theory’ as, given the way it is applied by many accounting researchers, it is used to explain and/or predict particular accounting/reporting behaviour undertaken by managers. The theory provides some useful insights but before we place faith in its predictive or explanatory ability, we need to see how it works to explain real-world events, and this is the benefit of being aware of various empirical studies.
These studies will tell us where the theory seems to work, and conversely where it does not seem to work, and this will be important to us if we are seeking to use Legitimacy Theory as a ‘tool’, or a ‘lens’ through which to make sense of particular accounting and reporting-related aspects of managerial behaviour.
REFLECTION QUESTION 9.3 Regulators’ knowledge of theory Question Should regulators be aware of the research findings generated through the application of Legitimacy Theory? Solution They certainly should be aware of the research findings generated from Legitimacy Theory. What the results show is that managers will make certain disclosures if they perceive that their organisation’s legitimacy is threatened. By contrast, if legitimacy is not threatened then there might be minimal disclosures. Such opportunistic disclosure-related behaviour therefore has nothing
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to do with demonstrating accountability. If community suspicions are not aroused, then managers might elect to make minimal disclosures. The upshot of this is that if regulators believe that particular stakeholders have a right to, or a need for, certain information about organisational performance then rather than leaving it to the managers to decide to disclose (perhaps when they decide the disclosures are necessary to support the legitimacy or reputation of the organisation), then the disclosures might need to be mandated through regulation.
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REFLECTION QUESTION 9.4 Legitimising actions, or demonstrating accountability? Question If the available evidence indicates that managers are disclosing particular items of information because community concerns have been aroused, then is this the same as managers demonstrating accountability for related aspects of performance? Solution No, it is not. It needs to be appreciated that if an organisation makes disclosures because of concerns about its legitimacy, then the disclosures are effectively being motivated by survival or profitability considerations rather than by a desire to demonstrate greater accountability. That is, there is much evidence to suggest that many organisational disclosures are a ‘legitimation device and not an accountability mechanism’ (Gray and Bebbington, 2000, p. 16). As Deegan, Rankin and Tobin (2002) state in relation to corporate social and environmental disclosure: Legitimising disclosures are linked to corporate survival. In jurisdictions such as Australia, where
there are limited regulatory requirements to provide social and environmental information, management appear to provide information when they are coerced into doing so. Conversely, where there is limited concern, there will be limited disclosures. The evidence in this paper, and elsewhere, suggests that higher levels of disclosure will only occur when community concerns are aroused, or alternatively, until such time that specific regulation is introduced to eliminate managements’ disclosure discretion. However, if corporate legitimising activities are successful then perhaps public pressure for government to introduce disclosure legislation will be low and managers will be able to retain control of their social and environmental reporting practices.
Legitimacy Theory favoured by some researchers as it provides a parsimonious explanation of an underlying phenomenon Theories, such as Legitimacy Theory, are embraced because they help us attribute meaning, or explanation, to phenomena that occur around us. For social and environmental accounting researchers, the phenomenon under investigation has often been the voluntary disclosure of social and environmental information. As simplified abstractions of a potentially confusing reality, theories allow us to make sense of our social experiences, thereby reducing confusion and instances of ambiguity (Llewelyn, 2003). Following on from the above discussion, Legitimacy Theory provides a relatively simple (parsimonious) explanation of what causes or motivates changes in social and environmental disclosure practices. We explained ‘parsimony’ in Chapter 1, wherein we noted that often the theory that is chosen is the one that provides the simplest, or most straightforward, explanation of a particular phenomenon. In explaining the idea of parsimony, we referred to ‘Occam’s razor’ in Chapter 1, which prescribes that if multiple theories are available which each satisfactorily explain something that is occurring then the theory making the fewer assumptions or having the fewest variables should be the one that is ultimately chosen. As has been demonstrated above, because Legitimacy Theory does not introduce many variables and makes various simplifying assumptions, it can be deemed to provide parsimonious explanations of various reporting decisions. For example: • organisational legitimacy – a simplifying theoretical construct in itself – is typically considered as a dichotomous variable with an organisation being assumed to be either legitimate, or illegitimate • legitimacy is assumed to be dependent upon compliance with community expectations • community expectations are rather ‘neatly’ assumed to be encapsulated within a ‘social contract’. The idea of a social contract, in turn, is made relatively easy to understand with Shocker and Sethi’s (1974) explanation of a social contract being commonly used by Legitimacy Theorists
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• the social contract represents the views of a broad cross-section of the community, and no one
group dominates others in determining what activities are acceptable, or otherwise. Therefore, considerations relating to sectional (class) interests, the role of the state, structural conflict and inequity are all typically ignored in favour of an underlying, and simplifying, assumption that the world is essentially pluralistic with various groups of stakeholders having a ‘voice’ in determining which actions and behaviours are acceptable • the occurrence of major social or environmental crises is assumed to represent breaches of the social contract, and therefore to create a ‘legitimacy gap’ that will be attended to by managers • managers will adopt legitimising strategies when a legitimacy gap arises, and a vital component of these strategies will incorporate the public disclosure of information • managers are simply assumed to be motivated by survival/profitability considerations rather than reasons tied to beliefs about responsibilities and accountabilities, and managerial motivations are typically assumed to be similar across different national, cultural, or institutional contexts. In large part, the reason that Legitimacy Theory provides a relatively parsimonious (or simple) explanation of reporting behaviour is because the way it has been applied/developed by researchers has tended to fixate on the strategic aspect of legitimacy. What effectively happened is that in the 1980s and 1990s, the ‘early Legitimacy Theorists’ in the social and environmental accounting area ‘borrowed’ various ‘parts’ that were needed to develop an explanation for, and predictions of, social and environmental disclosures from Institutional Theory – a theory we discuss later in this chapter – and particularly from the sociological branch of Institutional Theory. In taking a minimum of what were considered to be necessary theoretical components, and particularly those components that were restricted to the strategic aspect of Institutional Theory, this thereby enabled the accounting-based researchers to generate a relatively simple (parsimonious) explanation that also then became attractive to many other researchers beyond accounting. As already noted in this chapter, Lindblom (1993) was particularly important to the development of Legitimacy Theory (even though she did not use the term ‘legitimacy theory’) and she developed her four (now famous) legitimising strategies based upon material appearing in Dowling and Pfeffer (1975) and Sethi (1979), both of which would be considered to be papers embedded within an Institutional Theory paradigm. However, Lindblom, who was an accounting researcher, focused primarily on the strategic aspect of organisational legitimacy, and she ignored much of the institutional context of organisations as discussed by authors such as Dowling and Pfeffer (1975) and Sethi (1979).8 She specifically emphasised the strategic use of corporate disclosures for gaining, maintaining or restoring corporate legitimacy. Subsequently, other early adopters of ‘Legitimacy Theory’ within the accounting literature, including Guthrie and Parker (1989), Patten (1992), Gray, Kouhy and Lavers (1995), Deegan and Rankin (1996) and Deegan and Gordon (1996) – all of which are among the most highly cited papers in the accounting literature – also embraced the strategic aspect of organisation legitimacy. Since that time, Legitimacy Theory has become a staple theory within the social and environmental accounting literature. Therefore, it was in the social and environmental accounting literature that references were being made to ‘Legitimacy Theory’ and the theory then had a life that existed beyond the broader institutional literature from which it had its 8
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These theorists also considered how broader institutional factors (many outside the control of managers), such as local regulations, cultural expectations, professional affiliations and so forth, influence what actions and behaviours – including reporting efforts – are necessary for an organisation to be considered ‘legitimate’. Proponents of Legitimacy Theory, as developed within the accounting literature, tended to omit consideration of such influences, instead focusing on how managers strategically influence legitimacy through actions under their control.
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genesis. This meant that insights about different cultural, normative and regulative components (pillars) of organisations, and the related forms of legitimacy (such as pragmatic, moral and cognitive legitimacy), were typically ignored in favour of a situation where ‘legitimacy’ was linked to compliance with a ‘social contract’. While the way Legitimacy Theory has frequently been applied is very simplistic, and although it has been the subject of criticism (some of the reasons for which are discussed shortly), it nevertheless has provided some very useful insights. For example, the extensive body of research, complete with all of its simplifying assumptions, has provided valuable insights into the apparently strategic nature of corporate social and environmental reporting. The evidence provided by Legitimacy Theorists, some of which we have discussed, overwhelmingly suggests that social and environmental disclosures are often made by managers for survival and profitability-related reasons rather than for reasons of objectively demonstrating proper responsibility, and associated accountability, for the social and environmental impacts created by an organisation. This extensive body of research, therefore, provides a strong basis for users of corporate reports to be quite sceptical about the social and environmental disclosures being made by managers – an important insight and an insight that should be of particular importance to those people (regulators) who have the potential power to put in place regulations pertaining to corporate social and environmental disclosures. Unfortunately, despite the overwhelming body of evidence provided by Legitimacy Theorists (and others), the disclosure of social and environmental information remains predominantly voluntary, which remains a topic of bewilderment to many people who are concerned about the lack of accountability that many organisations demonstrate in relation to the social and environmental aspects, and impacts, of their operations (Gray and Milne, 2015). Perhaps the regulators are not convinced of the mounting and sustained evidence of biased reporting practices, or they are not of the opinion that suitable reporting frameworks are currently available. Another important insight from Legitimacy Theory is that in finding that managers frequently use social and environmental disclosures as part of their suite of legitimising strategies, this should be a source of major concern and the basis for a ‘call to action’. Rather than being benign, a finding that legitimising actions in the realm of social and environmental performance continue to abound, at the same time as global social and environmental problems continue to worsen, should be nothing short of alarming. If there is ever a need for managers to be accountable then now is the time (or indeed, decades ago might have been the time), yet as researchers show, the strategic (and biased) nature of corporate social and environmental disclosures continues to proliferate. At a time when we absolutely need real changes in business practices, legitimising disclosures – which have been very clearly identified within the literature for many years – arguably act to sustain historically damaging ‘business as usual’ practices, and act to counter any real efforts to create real and necessary change. As Legitimacy Theorists have shown time and time again, corporate accountability has effectively been obfuscated, and any progress towards meaningful accountability effectively hindered by the strategic and legitimising corporate disclosure practices commonly embraced by (profit-seeking, self-interested) managers.
Some issues that are not currently addressed by Legitimacy Theory Given the widespread use of Legitimacy Theory, particularly in the social and environmental accounting literature, it is interesting for us to consider apparent gaps or deficiencies. As indicated in our discussion above, there are clearly some limitations to the widely used theory that adopters of the theory, and readers of related research, should appreciate. We consider some of these ‘gaps’ in the literature as well as some other general criticisms of Legitimacy Theory in the discussion that follows. Identifying gaps or limitations in a theory is an important part of being a good researcher. 451
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A lack of detail about how ‘legitimacy’ can be measured As we have already seen in this chapter, a number of studies have investigated corporate reporting behaviour around the time of major adverse social and environmental events. The argument typically used is that the events caused an erosion in the ‘legitimacy’ of the organisation, thereby necessitating disclosures aimed at restoring lost legitimacy. That is, the adverse social or environmental event causes the perceived legitimacy of the organisation to fall following the event. But can we actually place a measure on this reduction in legitimacy? Can we actually measure it before and after the adverse social or environmental event? As students of accounting theory, this issue of measuring an underlying theoretical construct (in this case, ‘legitimacy’) is something that should interest us. Of course, whether we are measuring what we think we are measuring is not always clearly demonstrated.9 Most researchers do not attempt to measure any perceived reduction in legitimacy. Researchers applying Legitimacy Theory typically assume, or infer, that the particular adverse event caused a reduction in legitimacy and the organisation will thereafter respond strategically with legitimacy-enhancing disclosures. However, this failure to measure legitimacy changes is something that has attracted criticism from fellow researchers. Obviously, placing a measurement on ‘legitimacy’ would be a very subjective exercise, influenced by a number of factors, not the least of which would be the researchers’ own values and perspectives. Therefore, rather than trying to gauge an organisation’s legitimacy directly, we can perhaps infer its existence through the actions of various parties within society. One way to do this is to consider the flow of resources going to an organisation – something that can be more objectively determined (Hybels, 1995; Tilling and Tilt, 2010). As Hybels (1995, p. 243) states: Legitimacy itself has no material form. It exists only as a symbolic representation of the collective evaluation of an institution, as evidenced to both observers and participants perhaps most convincingly by the flow of resources. Resources must have symbolic import to function as value in social exchange. But legitimacy is a higherorder representation of that symbolism. Terreberry well explained the relationship between resources and organizational legitimacy nearly thirty years ago when he said ‘the willingness of firm A to contribute to X, and of agency B to refer personnel to X, and C to buy X’s product testifies to the legitimacy of X’ (1968, p. 608).
The view being promoted in the above quote is that if people continue to provide resources to an organisation then, in a sense, they must believe that organisation is worthy of support. Conversely, they would not be expected to provide resources to an entity that they believe acts inappropriately. Hence, the level of resource transfer can be used, perhaps somewhat imperfectly, as a measure of the legitimacy of an organisation. As Hybels (1995, p. 245) states: Legitimation derives from increases in the flow of resources, while delegitimation occurs as the flow of resources declines. I do not mean to imply, however, that resources and legitimacy are synonymous, only that resource flows are among the best evidence of legitimacy. Resources evidence legitimacy not simply because legitimation provokes the transfer of resources, but because resources are media by which approval and consent
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While not related to the issues we are studying in this chapter, we can consider some other constructs used in other research. For example, some researchers in the social sciences develop theories to explain what makes people ‘happy’, but how would they measure happiness? As with legitimacy, ‘proxies’ would be used to measure happiness. For example, we might measure certain physiological reactions, such as increased activity in the brain’s left prefrontal lobe and decreased amounts of cortisol (a stress hormone) coursing through the bloodstream – apparent indicators that somebody is happy. Alternatively, we might measure wealth (if we assume a wealthier person is a happier person), health or perhaps levels of achievement of key goals. What is being emphasised here is that an interesting (even fun!) aspect of research is determining how to come up with a practical way to measure the key variables/constructs in our research.
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are expressed. Legitimacy exists only so long as it is instantiated in the transferral of resources, and that transfer must be ongoing to ensure the continual reproduction of legitimacy. This means that each act of exchange is a moment of legitimation. The flow of resources and the building of legitimacy are mutually reinforcing dynamics…. Since legitimacy is an intrinsically abstract concept, it is necessary to infer its existence from the behavior of people involved.
As Hybels (1995, p. 244) explains, we can consider the resource flows from different stakeholder groups. The ‘public in general’ consume goods and supply labour – they are therefore critical to survival. Therefore, ‘because of these influences, public opinion is watched closely by the guardians of corporate legitimacy’ (Hybels, 1995, p. 244). A reduction in the consumption of an organisation’s products might then be reflective of a change in perceived legitimacy from the perspective of the public (of course, there could also be other contemporaneous events, such as a change in preference for particular products or a change in the prosperity of consumers). The government (or as it is sometimes called ‘the state’) provides crucial resources in terms of legislation, regulation, grants and so on (which can provide a positive or negative influence on the organisation). Therefore, perhaps, the introduction of negative legislation, which might extract resources from the organisation (negative resource flows), could be reflective of a change in the perception of government officials about the legitimacy of an organisation (and the changes in laws would be reflective of broader community expectations, albeit possibly with some lag). Investors provide financial capital inflows. The media also can be considered as providing a powerful resource in terms of influencing the resource allocation decisions of other members of the community (either positively or negatively). By measuring resource flows from different groups within society, we can see whether views are different across different groups and whether legitimacy threats appear particularly apparent. Therefore, with this discussion in mind, researchers in the future might consider monitoring the change in resource flows of an organisation as a basis for confirming their belief that the legitimacy of an organisation has declined following major legitimacy-threatening events. Certainly this would seem to fit casual observations that have shown that share prices have fallen following major environmental events, or that the sales of an organisation’s products fell following major adverse social events. As Hybels (1995, p. 243) states: To build a well-grounded theory of legitimation of organizations, it is necessary above all to identify the critical actors, both internal and external, whose approval is necessary to the fulfilment of an organization’s functions. Each influences the flow of resources crucial to the organization’s establishment, growth, and survival, either through direct control or by the communication of goodwill.
From the above brief discussion, we can see how a difficult construct, such as legitimacy, might be measured (albeit, imperfectly) by measuring resource flows. Researchers will often be confronted with the difficulty of determining how to measure complex constructs.
Which disclosures are more effective in the legitimation process? Another potential limitation of research that applies Legitimacy Theory is that, to date, relatively little insight has been provided into the type of disclosures that are most effective in establishing, maintaining or repairing legitimacy. That is, more theoretical development is necessary. The sorts of issues that are largely unaddressed include the following: • What medium of disclosure is most effective – for example, are disclosures in annual reports, sustainability reports, on websites, in advertisements or in some other form of disclosure more effective in the legitimation process? • Further, do different groups of stakeholders react differently to different types of disclosures, or disclosures provided in different media? To date, most social and environmental accounting researchers review changes in disclosures in annual reports, sustainability reports and on 453
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websites, and they typically do not consider how different stakeholders react to the different disclosures. Greater precision would be helpful. • Relatedly, which social groups actually confer legitimacy? Further, do different groups have different interests and legitimising power at different points in time? Also, how do we balance different interests at a point in time, particularly if some of the interests or expectations are irreconcilable between groups?
Assumptions that disclosure strategies are driven by self-interest Legitimacy Theorists often embrace the simplifying assumption, often linked to neoclassical economics, that managers are motivated purely by survival and profitability considerations, which are ultimately linked to considerations of their own self-interest. That is, the strategic focus of Legitimacy Theory embraces the simplistic assumption that managers will adopt whatever strategies are necessary to bring legitimacy to the organisation and, ultimately, this is deemed to be to the self-interest of the managers. Adopting such a view restricts our ability to develop richer understandings of managerial disclosure decisions. Clearly (or at least, hopefully), not all people are motivated purely by self-interest. As Akbar (2018) shows, there could be various cultural or normative reasons why certain strategic disclosure behaviours will not be adopted by managers, regardless of the consequences this might have for organisational legitimacy, organisational success or for their own direct self-interest. In Chapter 8 we discussed Positive Accounting Theory. As we learned, there was a simplifying assumption made within PAT (and many economic theories) that all actions by all individuals are driven by self-interest, and this assumption has drawn criticism from various other researchers. Similar criticisms could therefore be made of Legitimacy Theory in that it assumes that actions, such as corporate reporting, are strategically undertaken for advancement and/or survival purposes. Obviously, this is a rather simplistic assumption. As Oliver (1991, pp. 148–9) points out, socially responsible organisations may choose to undertake actions beyond self-interest: For example, corporate social responsibility and the maintenance of sound organizational ethics may not be invariably reducible to strategic behaviours induced by the anticipation of organizational gain. Organizations may act ethically or responsibly not because of any direct link to a positive organizational outcome (e.g., greater prestige or more resources) but merely because it would be unthinkable to do otherwise. In this way, organizational behavior may be driven not by processes of interest mobilization (DiMaggio 1988), but by preconscious acceptance of institutionalized values or practices.
Further, certain actions may become ‘institutionalised’. That is, managers and organisations themselves will be influenced by their social environments and will naturally embrace certain social norms and values, rather than consciously and instrumentally choosing actions – such as making disclosures – for strategic survival or advancement purposes (for legitimacy). Oliver (1991, p. 148) argues that when external social norms and practices ‘obtain the status of a social fact, organizations may engage in activities that are not so much calculative or self-interested’. That is, ‘the exercise of strategic choice may be pre-empted’ (p. 148) when managers and organisations unconsciously conform to taken-for-granted social norms and practices.
Researchers who apply Legitimacy Theory typically do not consider actions that are aimed at legitimising the broader social system While the research we have discussed in this chapter has mainly looked at how organisations attempt to legitimise their own existence within a particular society, disclosures might also be taken to legitimise particular aspects of the broader social system in place at a particular point in time. Archel et al. (2009) suggest that while individual organisations might be making disclosures to create ‘organisational-level legitimacy’, the same organisations as well as governments (the 454
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state) might also be making related disclosures to legitimise particular systems that they hope will become institutionalised within the broader society. As noted earlier in this chapter, Legitimacy Theory is typically considered to be derived from Political Economy Theory. We also learned that Political Economy Theory has been divided into two broad streams, which have been labelled ‘classical’ and ‘bourgeois’ political economy. Classical Political Economy Theory explicitly places sectional (class) interests, structural conflict, inequity and the role of the state at the heart of the analysis. By contrast, ‘bourgeois’ Political Economy Theory largely ignores these elements and perceives the world as essentially pluralistic, meaning that many classes of stakeholders are assumed to have the power to influence various decisions by corporations, government and other entities and no one group dominates another. Most researchers who apply Legitimacy Theory embrace a view consistent with the ‘bourgeois’ branch of Political Economy Theory. According to Archel et al. (2009, p. 1288), once we start considering the role of government (the state) in supporting particular processes, including an analysis of government disclosures, then: This conceptualisation of the State moves us into a more critical branch of Legitimacy Theory that has more in common with classical political economy theory (Gray et al., 1995, 1996). Whereas the bourgeois branch of Legitimacy Theory exhibits a more immediate concern with how the firm becomes legitimate in the eyes of its stakeholders, the critical branch of Legitimacy Theory ‘raises questions about the legitimacy of the system (e.g. capitalism) as a whole’ (Gray et al., 1995, p. 47). Studying social and environmental disclosures through the lens of this second variant of Legitimacy Theory links the legitimising strategies identified at an organisational level with an economic, political and social setting that is at odds with the essentially pluralist one assumed by the bourgeois approach (see for example, Tinker and Neimark, 1987; Tinker et al., 1991; Neimark, 1992)…. Through the lens of this variant of Legitimacy Theory grounded in the Classical branch of Political Economy Theory, not only can social and environmental disclosures serve to legitimise firms’ outputs, methods and goals but it can also serve to legitimise the economic, social and political system as a whole (Gray et al., 1995, 1996). Therefore, when authors support the Legitimacy Theory argument by analysing the firm’s behaviour, that is, when they show how firms are trying to inform, educate or manipulate society using social information, they could be identifying strategies with a broader impact. This has not been explicitly considered in previous Legitimacy Theory studies, including those that investigate how companies try to circumvent public policy processes and regulation.
Archel et al. (2009) applied this more ‘critical perspective’ to consider the disclosures made by the car producer Volkswagen (VW) in Navarra, Spain, between the years 1986 to 2005. During this period the car manufacturer moved from a standardised and common method of car manufacture to a new production process (known as lean production). This new process was deemed to have led to a severe deterioration in working conditions for employees, but was good for profits and share value and was also favoured by government because of the increased efficiency and economic benefits it would create in the region. However, there was much negative publicity to the changed production processes. Applying Legitimacy Theory, Archel et al. (2009) argued that the corporate and government disclosures had two purposes. They were not only undertaken to legitimise the existence of the company within society (which is the view traditionally embraced by advocates of Legitimacy Theory), but they were also taken to try to legitimise the particular production process within the broader society (which is an aspect most Legitimacy Theory-related research does not consider). As they state (p. 1299): When the legitimacy of lean production and flexibility was questioned within the media and by labour-rights organisations, the government weaved a discourse [made 455
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disclosures] significantly aligned to the discourse [disclosures] of VW. In this way competitiveness and flexibility were aligned with the objective of economic growth. The government expressed serious concerns that the failure to implement lean production would affect VW’s competitiveness, would jeopardise future investment and would hinder the wider economic growth of the region. The micro-level objectives of the firm were discursively aligned with the macro-level objectives of the State, both being presented as interdependent. As nebulous and contentious as the objective of economic growth may be, it is projected by the State as in the ‘public interest’. Thus, in supporting VW’s discourse on flexibility and lean production, the State simultaneously elevates these operational changes to the status of national importance and indirectly projects them as being in the interest of all of society. The paradox is that in spite of all its evocation of the public interest, the State’s discourse failed to express any concern for the deterioration in working conditions that the new scenario was causing workers. This lack of concern for the plight of the workforce can be explained by the concern that anything jeopardising the new production process at VW was presumed to stand in the road of VW’s productivity in the first instance, and Navarra’s economic growth in the second.
Effectively, the disclosures made by the company and the government reinforced each other, something that would not be seen if a researcher only investigates the corporation’s disclosures in isolation. Because the government was publicly supporting the company’s processes, this reduced the need for the company to undertake certain legitimation strategies. As Archel et al. (p. 1299) noted: If the State’s discourse was more aligned with the discourse of the workforce and emphasised the conflict at the plant, then it would have been more difficult for VW to not address the conflict, either materially or discursively. A more antagonistic discourse emanating from the State might have encouraged VW to make significant material concessions to employees and even have forced the organisation into some sort of recognition in its annual reports that the new production process had engendered conflict at the plant…. VW’s discourse was given more than just a rubber-stamping by the government; it was raised to the level of national importance by aligning it with macro societal objectives. As such, VW’s own discourse is given a certain kudos that increases its legitimating power.
According to Archel et al. (2009), the government sided with the company rather than with the workers because the government believed that the new production process would increase corporate profits and encourage further corporate investment in the state, despite the adverse impacts upon employees. The government was therefore placing the interests of economic growth and corporate profits (and therefore, shareholders) above the interests of employees. In concluding their paper, Archel et al. (2009) suggest that researchers should think more broadly about the legitimation strategies undertaken by organisations. While disclosure strategies might be undertaken to inform, educate or even manipulate society in a manner intended to provide legitimacy to the organisation, researchers should also consider whether the disclosures might have a broader impact in terms of efforts to legitimise particular economic, social and political systems that potentially undermine the interests of particular stakeholders (such as employees). Researchers should also consider complementary disclosures that might also be made by government, as the disclosures made by government could influence the necessity for legitimising disclosures by a corporation.
The process of legitimation is really no different to reputation risk management According to Bebbington, Larringa and Moneza (2008), an alternative and more compelling explanation for corporate disclosures (in particular, corporate social responsibility disclosures) 456
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is that corporate disclosure can be considered as a key part of an organisation’s reputation risk management (RRM) strategies (Friedman and Miles, 2001; Hasseldine, Salama and Toms, 2005; Toms, 2002), rather than as part of a process of legitimation. Bebbington, Larringa and Moneza rely in large part on the work of Benoit (1995), a noted author in the RRM literature. They state (p. 342): Benoit (1995) summarises the image restoration literature and provides a conceptual link between RRM activities undertaken by organisations and discourses that one may observe as a result of the need for image restoration strategies. The image restoration literature studies individuals’ accounts, excuses and apologies as well as corporate responses to criticism. Benoit’s work, for example, includes explanations of the accounts given by Exxon, Union Carbide and Tylenol in response to the crises (reputation damaging events) they faced (respectively an oil spill; a chemical discharge from a plant that killed and maimed a large number of people; and poisoning of products which led to consumer deaths). According to Benoit, the impetus for image restoration attempts arise from the inescapable fact that humans are embroiled in activities which will lead to conflict and potential damage to reputation. At the same time, he proposed that humans have a deep-seated need to have and maintain ‘face’. These two factors explain the persuasiveness of accounts of behaviour that emerge when actions are, or may be, disapproved of.
Relying upon Benoit (1995), Bebbington, Larringa and Moneza (2008) identify a number of RRM strategies that organisations might undertake when their reputation is deemed to be under attack, including: • denial (including simple denial and shifting the blame) • evading responsibility due to: provocation; defeasibility; accident; and/or good intentions • reducing offensiveness of the event by means of: bolstering; minimisation; attack accuser; compensation; corrective action; and/or mortification. However, looking at the above strategies, we can see that they are very similar to the four legitimation strategies suggested by Lindblom (1993), as discussed earlier in this chapter. Therefore, in this instance, we can see how different researchers might suggest similar strategies to address an issue, although they might label the issue somewhat differently (for example, reputation management rather than legitimation). Although there is a depth of RRM literature, some of the explanations given to corporate behaviour are very similar to the explanations provided by Legitimacy Theory, even though the two bodies of literature may have developed in a somewhat independent manner. Nobody, including Bebbington, Larringa and Moneza, has clearly identified the key differences between ‘reputation’ and ‘legitimacy’. Do we think there is a difference? In this regard, Adams (2008, p. 368) made the following somewhat critical comments in respect to the work of Bebbington, Larringa and Moneza (2008): If legitimacy has been interpreted as reputation in the social accounting literature, haven’t the links between reputation and reporting been studied at length? … Should we rename legitimacy theory reputation theory? Would that solve the problem? The authors themselves have difficulty differentiating Benoit’s image restoration strategies from Lindblom’s (1993) legitimating strategies and finally acknowledge that they are largely cognate … Further, neither legitimacy theory nor the reputation risk management thesis adequately explain non-disclosure (although the authors argue this could be part of a ‘denial’ image restoration strategy) … I wonder whether researchers in the field have already expended too much time and energy on in-depth analysis (whether from a legitimacy or reputation risk management perspective) of individual disclosures to shed light on what is perceived as a carefully considered detailed grand plan to influence readers.
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While Bebbington, Larringa and Moneza (2008) have been unable to clearly articulate the difference between legitimation and reputation management, it does raise issues for researchers in terms of what are the differences, if any. Do any differences matter?10 Are the strategies for managing reputation interchangeable with those for managing legitimacy? Also, given that the RRM literature has developed independently of the literature that addresses corporate legitimacy, then interested researchers who currently apply Legitimacy Theory might find it useful to review the RRM literature for any insights that might not otherwise be apparent. We could list more potential criticisms of, or gaps in, Legitimacy Theory. But the point of this discussion is to show that there will always be competition among theories, and various researchers will try to advance alternative theories in place of those that might be accepted. Researchers might also advance refinements that improve the usefulness of particular theories. We must remember that no ‘theory’ will ever be perfect.
Why do I need to know about the limitations, or shortcomings, of Legitimacy Theory? We then need to consider whether the apparent shortcomings of the theory are sufficient enough to undermine the extent to which we will rely on the results of the research. However, we must remember that all theories will have potential shortcomings.
If we become accounting researchers and consider applying a particular theory, or if we rely on the results of research applying Legitimacy Theory as a means of understanding particular disclosure practices, then it is important that we appreciate the nature of the theory being applied, and the related shortcomings.
REFLECTION QUESTION 9.5 Theories will have shortcomings Solution Not at all! While Legitimacy Theory does have some shortcomings – as we have highlighted – it nevertheless provides some useful insights. In particular, the theory highlights the strategic nature of corporate reporting and in doing so emphasises the point that corporate disclosures will not always be made on a purely objective basis.
Question Do the shortcomings inherent in Legitimacy Theory mean that it is not a useful theory for understanding what motivates managers to make certain disclosures, such as disclosures relating to social and environmental performance?
LO9.1
Stakeholder Theory Has both an ethical and managerial branch and is effectively an umbrella term representing a number of alternative theories that address various issues associated with an organisation’s relationship with its stakeholders.
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LO9.4
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Stakeholder Theory
We now turn our attention to Stakeholder Theory – a theory that is also used, among other things, to provide an explanation for corporate disclosures. It has both an ethical (moral) or normative branch (which is also considered as prescriptive), and a positive (managerial, or as it is also sometimes called, instrumental) branch. The term ‘Stakeholder Theory’ itself can be confusing. Many different researchers have stated that they have used Stakeholder Theory in their research, yet when we look at the research, we see that different theories with different aims and assumptions have been employed, and all have been labelled ‘Stakeholder Theory’. As 10
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While it is difficult to clearly differentiate legitimacy from reputation, Deephouse and Carter (2005) believe legitimacy is a condition that an organisation will either have or will not have (so it is a binary concept), whereas reputation is a relative concept that reflects how much more or less legitimate one organisation is regarded compared to other organisations. Of course, many people would probably challenge this basis of differentiation.
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Hasnas (1998, p. 26) states: Stakeholder Theory is somewhat of a troublesome label because it is used to refer to both an empirical theory of management and a normative theory of business ethics, often without clearly distinguishing between the two.
More correctly, perhaps, we can think of the term ‘Stakeholder Theory’ as an umbrella term that actually represents a number of alternative theories that address various issues associated with relationships with stakeholders, including considerations of the rights of stakeholders, the power of stakeholders or the effective management of stakeholders. Organisations increasingly provide information publicly about how they engage stakeholders, and it is now common for organisations to emphasise how their ability to be informed about stakeholder expectations is critical to how they manage the organisation and the strategies they adopt. This is reflected in material provided by National Australia Bank on its ‘Stakeholder Management’ webpage (National Australia Bank, 2022). On this webpage the bank states: Why is this [stakeholder engagement] important? Communication and understanding are key to any successful business, especially one with as many diverse external stakeholders as ours. By continually engaging with our wide range of stakeholders we can understand what is expected of us, identify issues, and discover opportunities to serve customers well and help our communities prosper. … Connecting with our many and varied stakeholders is an important part of our strategy. Maintaining an open and constructive dialogue with our stakeholders helps us to identify emerging issues, contributes to risk management, and allows us to discover opportunities to improve our performance. It also helps us understand community expectations and explore opportunities to collaborate with our partners on issues of mutual interest. … Through annual assessments, we can observe how perceptions of these issues change over time. This provides a useful indication of whether our work to respond to material issues is meeting stakeholder expectations. We also use ongoing engagement activities throughout the year to inform our determination of prioritised material themes.
In the discussion that follows, the ethical branch of Stakeholder Theory is considered first, followed by the positive (managerial) branch, which explicitly considers various groups (of stakeholders) that exist in society, and how the expectations of particular stakeholder groups may have more (or less) impact on corporate strategies. This in turn has implications for how the stakeholders’ expectations are considered or managed. When organisations discuss their stakeholder engagement, it is not always clear whether they are engaging their stakeholders for the purpose of maximising the financial performance or value of the organisation (that is, for managerial strategic reasons), or whether they are doing it in order to manage the organisation in a way that benefits a cross-section of stakeholders, other than just those with a financial interest in the organisation. In the discussion that follows, we see that there are many similarities between Legitimacy Theory and Stakeholder Theory, and, as such, to treat them as two totally distinct theories would be incorrect. As Gray, Kouhy and Lavers (1995, p. 52) state: It seems to us that the essential problem in the literature arises from treating each as competing theories of reporting behaviour, when ‘stakeholder theory’ and ‘legitimacy theory’ are better seen as two (overlapping) perspectives of the issue which are set within a framework of assumptions about ‘political economy’.
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As Deegan (2002, 2019) indicates, both theories conceptualise the organisation as part of a broader social system wherein the organisation impacts on, and is affected by, other groups within society. While Legitimacy Theorists typically discuss the expectations of society in general (as encapsulated within the ‘social contract’), Stakeholder Theory provides a more refined resolution by referring to particular groups within society (stakeholder groups). Essentially, Stakeholder Theory accepts that, because different stakeholder groups will have different views about how an organisation should conduct its operations, there will be various social contracts ‘negotiated’ with different stakeholder groups, rather than one contract with society in general. While implied within Legitimacy Theory, the managerial branch of Stakeholder Theory explicitly refers to issues of stakeholder power, and how stakeholders’ relative power affects their ability to ‘coerce’ the organisation into complying with the stakeholders’ expectations. Hence, as already stated, this chapter treats Legitimacy Theory and Stakeholder Theory as largely overlapping theories that provide consistent but slightly different insights into the factors that motivate managerial behaviour (Gray, Kouhy and Lavers, 1995; O’Donovan, 2002). Differences between the theories largely relate to issues of resolution; Stakeholder Theory focuses on how an organisation interacts with particular stakeholders, while Legitimacy Theory as usually applied considers interactions with ‘society’ as a whole. A consideration of both theories is deemed to provide a fuller explanation of management’s actions. Gray, Kouhy and Lavers (1995, p. 67) state in relation to social disclosure-related research: The different theoretical perspectives need not be seen as competitors for explanation but as sources of interpretation of different factors at different levels of resolution. In this sense, legitimacy theory and stakeholder theory enrich, rather than compete for, our understandings of corporate social disclosure practices.
Whether driven by managerial (and ‘profit-centred’) reasons, or ethical (broader stakeholderoriented) reasons, it is nevertheless a firmly accepted part of business practices that stakeholder engagement is a core and vital component of organisational practice. As the AA1000 Stakeholder Engagement Standard (AA1000SES) released by the global standard-setter, AccountAbility (2015, p. 6) states: Stakeholder engagement is the process used by an organisation to engage relevant stakeholders for a clear purpose to achieve agreed outcomes. It is now also recognised as a fundamental accountability mechanism, since it obliges an organisation to involve stakeholders in identifying, understanding and responding to sustainability issues and concerns, and to report, explain and answer to stakeholders for decisions, actions and performance.
The Global Reporting Initiative (GRI) also emphasises the crucial nature of stakeholder engagement and specifically requires, as part of its Sustainability Reporting Standards (which we discuss in Chapter 10) in Disclosure 102-43 (GRI, 2016, p. 31) that: The reporting organization shall report the following information: a The organization’s approach to stakeholder engagement, including frequency of engagement by type and by stakeholder group, and an indication of whether any of the engagement was undertaken specifically as part of the report preparation process.
Different stakeholder groups, such as NGOs, community groups and public sector organisations (PSOs), have knowledge and expertise potentially unknown to managers, and engaging with such groups will help an organisation access knowledge previously unavailable or unknown to it. Therefore, it is useful for readers of organisational reports to know the extent to which an organisation has engaged with different stakeholder groups and how this engagement was undertaken.
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The ethical branch of Stakeholder Theory The moral or ethical (also referred to as the ‘normative’) perspective of Stakeholder Theory argues (or ‘prescribes’) that all stakeholders have the right to be treated fairly by an organisation, and that issues of stakeholder power are not directly relevant. That is, the impact of the organisation on the life experiences of a stakeholder should be what determines the organisation’s responsibilities to that stakeholder, rather than the extent of that stakeholder’s (economic) power over the organisation. As Hasnas (1998, p. 32) states: When viewed as a normative (ethical) theory, stakeholder theory asserts that, regardless of whether stakeholder management leads to improved financial performance, managers should manage the business for the benefit of all stakeholders. It views the firm not as a mechanism for increasing the stockholders’ financial returns, but as a vehicle for coordinating stakeholder interests, and sees management as having a fiduciary relationship not only to the stockholders, but to all stakeholders. According to normative stakeholder theory, management must give equal consideration to the interests of all stakeholders and, when these interests conflict, manage the business so as to attain the optimal balance among them. This of course implies that there will be times when management is obliged to at least partially sacrifice the interests of the stockholders to those of the other stakeholders. Hence, in its normative form, the stakeholder theory does imply that business has true social responsibilities.
Within the ethical branch of Stakeholder Theory, there is a view that stakeholders have intrinsic rights (for example, to safe working conditions and fair pay), and that these rights should not be violated.11 That is, each group of stakeholders merits consideration for its own sake and not merely because of its ability to further the interests of some other group, such as the shareholders (Donaldson and Preston, 1995, p. 66). As Stoney and Winstanley (2001, p. 608) explain, fundamental to the ethical branch of Stakeholder Theory is a: concern for the ethical treatment of stakeholders which may require that the economic motive of organizations – to be profitable – be tempered to take account of the moral role of organizations and their enormous social effects on people’s lives.
The ‘intrinsic rights’, as referred to above, which different researchers believe that managers should respect, will be linked to the philosophical beliefs of the respective researchers about not only who, or what, are stakeholders, but also what are the respective rights of such stakeholders. For example, some researchers might be particularly focused on workers’ rights, while other researchers might be particularly focused on the rights of local communities or of customers. Some researchers might focus on animals as key stakeholders and prescribe the information that should be disclosed by an organisation in order to demonstrate accountability for animal welfare. The point to be emphasised here is that while we can refer to the ‘ethical branch’ of Stakeholder Theory, the prescriptions emanating from the respective researchers in this branch will be influenced by their own perceptions about what is ‘ethical’, and what is not, and that will be influenced by their own value beliefs and philosophies. For example, with the interests of problem gamblers in mind, Loh, Deegan and Inglis (2015) provide prescriptions about what information gambling-based organisations (casinos) should disclose. Many of their prescriptions do not coincide with what casinos actually disclose. Similarly, Haque, Deegan and Inglis (2016) focus on the rights of future generations and prescribe various
11
This perspective can be contrasted with that provided in Friedman (1962). He states: ‘few trends could so thoroughly undermine the very foundation of our free society as the acceptance by corporate officials of a social responsibility other than to make as much money for their stockholders as possible. This is a fundamentally subversive doctrine’ (p. 133).
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climate-change disclosures that high carbon-emitting organisations should make. Many of the prescribed disclosures are not made by the sample companies. However, because these studies are normative in nature, the fact that many of the prescribed disclosures are not made by the sample organisations does not invalidate the prescriptions of the researchers. Obviously, a normative discussion of stakeholder rights requires some definition of ‘stakeholders’. One definition of stakeholders that we can use – and one which is very regularly cited – is that provided by Freeman and Reed (1983, p. 91). According to these researchers, stakeholders are: Any identifiable group or individual who can affect the achievement of an organisation’s objectives, or is affected by the achievement of an organisation’s objectives.
While commonly cited, the above definitions of stakeholders is very broad and does not ‘drill down’ to what types of ‘influences’ or ‘effects’ are in focus. Therefore, it is not overly helpful in identifying the specific range of stakeholders that are being considered by particular organisations. Interestingly, this broad definition of stakeholders is very similar to the definition of stakeholders provided by VW in its Sustainability Report 2021. VW states (p. 24): Our stakeholders are individuals, groups or organizations who have a material influence on, or are materially influenced by, the way in which the Group reaches its corporate decisions and the implications of those decisions. Our customers and employees are at the center of our stakeholder network. Around this core, eight further groups have been identified – NGOs/non-profit organizations, residents and local authorities, news media, academics and experts, competitors, business partners and suppliers, investors and analysts, policymakers and associations.
In a similar fashion, in its Sustainability Report 2021, the large Australian-listed company Amcor Ltd defines its stakeholders (p. 55) as those: who have a direct relationship with, or are impacted by, our business. They include our people, customers, investors, suppliers, consumers, industry bodies, governments, NGOs, regulators, local communities, and the environment.
Clearly, many people (or organisations) can be classified as ‘stakeholders’ if the above definitions are applied (for example, shareholders, creditors, government, media, employees, employees’ families, local communities, local charities, future generations and so on). With this in mind, Clarkson (1995) sought to divide stakeholders into ‘primary’ and ‘secondary’ stakeholders. A primary stakeholder was defined as ‘one without whose continuing participation the corporation cannot survive as a going concern’ (p. 106). Secondary stakeholders were defined as ‘those who influence or affect, or are influenced or affected by, the corporation, but they are not engaged in transactions with the corporation and are not essential for its survival’ (p. 107). According to Clarkson, primary stakeholders are the ones that must primarily be considered by management, because for the organisation to succeed in the long run it must be run for the benefit of all primary stakeholders. Clarkson’s definition of primary stakeholders would be similar to the definition of stakeholders applied by many researchers working within a managerial perspective of Stakeholder Theory, but this focus on primary stakeholders would be challenged by proponents of the ethical branch of Stakeholder Theory, who would argue that all stakeholders have a right to be considered by management. Another way in which stakeholders have been categorised is as either ‘internal’ or ‘external’ (Reed, 1999). Internal stakeholders would be those, such as employees and managers, who work within the organisation and who have formal, official or contractual responsibilities. External stakeholders would be those who are not employed by the organisation but are able to affect, or are effected by, the organisation’s activities. Such stakeholders would include customers, local communities, NGOs and government. 462
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The broader ethical (and normative) perspective that all stakeholders (both primary and secondary) have certain minimum rights that must not be violated can be extended to a notion that all stakeholders also have a right to be provided with information about how the organisation is affecting them (perhaps through pollution, community sponsorship, provision of employment, safety initiatives and so on), even if they choose not to use the information, and even if they cannot directly have an impact on the survival of the organisation (see, for example, O’Dwyer, 2005). In regard to the notion of stakeholder rights to information, consider Gray, Adams and Owen’s (2014) perspective of accountability, as used within their ‘accountability model’ (something we explored in depth within Chapter 2). They define accountability (2014, p. 50) as: The duty to provide an account (by no means necessarily a financial account) or reckoning of those actions for which one is held responsible.
According to Gray, Adams and Owen, accountability involves two responsibilities or duties: 1 the responsibility to undertake certain actions (or to refrain from taking actions) 2 the responsibility to provide an account of those actions.
Under their accountability model, reporting is assumed to be responsibility-driven rather than demand-driven. The view being projected is that people in society have a right to be informed about certain facets of the organisation’s operations.12 By considering rights, it is argued that the model avoids the problem of considering users’ needs and how such needs are established (Gray, Owen and Maunders, 1991). Applying the accountability model to corporate social reporting, Gray, Owen and Maunders (p. 15) argue that: … the role of corporate social reporting is to provide society-at-large (the principal) with information (accountability?) about the extent to which the organisation (the agent) has met the responsibilities imposed upon it (has it played by the rules of the game?).
That is, the role of a corporate report is to inform society about the extent to which actions for which an organisation is deemed to be responsible have been fulfilled. Under the accountability model, the argument is that the principal (society) can elect to be entirely passive with regard to its demand for information. Nevertheless, the agent (the organisation) is still required to provide an account – the passive, non-demanding principal is merely electing not to use the information directly. Gray, Owen and Maunders state (p. 6) that ‘if the principal chooses to ignore the account, this is his prerogative and matters not to the agent who, nevertheless, must account’. Hurst (1970) also emphasises the importance of accountability. He states (p. 58) that ‘an institution which wields practical power – which compels men’s wills or behaviour – must be accountable for its purposes and its performance by criteria not in the control of the institution itself’. In considering the normative perspectives of how organisations should behave with respect to their stakeholders (relating to intrinsic rights, including rights to information), it should be noted that these perspectives pertain to how the respective researchers believe organisations
12
Within the model, they refer to society as the ‘principal’ and the organisation (that owes the accountability) as the ‘agent’. However, according to Gray, Owen and Maunders (1991, p. 17), their ‘principal–agent model must be distinguished from “agency theory” or “economic principal–agent theory” as employed in, for example, Jensen and Meckling (1976), Ronen (1979), Fellingham and Newman (1979), Jensen (1983, 1993), Watts and Zimmerman (1986). Economic agency theory is grounded in neo-classical economics and takes its assumptions from it. Most significant among these are the assumptions about the single-minded greed of the principal and agent who are actively seeking to gain at the other’s expense. The principal–agent model we are using makes no such assumptions and adopts no assumptions from economics, but rather owes its genesis to jurisprudence (Macpherson, 1973)’.
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should act, which is not necessarily going to be the same as how they actually do act.13 Hence, the various perspectives cannot be validated or confirmed by empirical observation, as might be the case if the researchers were providing descriptive or predictive (positive) theories about organisational behaviour. As Donaldson and Preston (1995, p. 67) state: In normative uses, the correspondence between the theory and the observed facts of corporate life is not a significant issue, nor is the association between stakeholder management and conventional performance measures a critical test. Instead, a normative theory attempts to interpret the function of, and offer guidance about, the investorowned corporation on the basis of some underlying moral or philosophical principles.
Although there are researchers who promote a perspective that all stakeholders should be considered as important in their own right, irrespective of the resources they individually control, this ethical or moral view is not necessarily embraced by all. For example, the Chamber of Commerce and Industry of Western Australia (2005), in its submission to the 2005 Australian Government Inquiry on Corporate Social Responsibility,14 stated: Stakeholder views and practices should be accommodated only so far as they improve or safeguard shareholder value.
In another submission to the same inquiry, the Business Council of Australia (2005) stated: The litmus test for any activity or responsibility is whether the performance of that activity or responsibility can reasonably be seen to be contributing to the growth of the shareholder value.
Rather than embracing the ethical branch of Stakeholder Theory, the parties making the above comments would appear to embrace a perspective consistent with the managerial branch of Stakeholder Theory, which we discuss next.
REFLECTION QUESTION 9.6 The normative and positive perspectives of Stakeholder Theory Question Would the ethical (or normative) branch of Stakeholder Theory be a useful theory for researchers seeking to explain particular reporting practices? Solution The ethical branch of Stakeholder Theory prescribes how stakeholders should be treated. That is, it is normative in nature.
It does not represent a body of research that explains or predicts how managers actually engage with stakeholders. Therefore, it is not the appropriate theory to explain managers’ reporting practices. Researchers working within the normative/ethical branch of Stakeholder Theory tend to suggest ‘ideals’ in terms of how organisations should behave, and these ‘ideals’ could be very different to how organisations actually behave.
Nevertheless, Donaldson and Preston (1995) argue that observation suggests that corporate decisions are frequently made on the basis of ethical considerations, even when doing so could not enhance corporate profit or shareholder gain. According to Donaldson and Preston, such behaviour is deemed to be not only appropriate but desirable. They argue that corporate officials are not less morally obliged than any other citizens to take ethical considerations into account, and it would be unwise social policy to preclude them from doing so. 14 In 2005 and 2006, the Australian Government held an inquiry into whether specific social and environmental performance and reporting requirements should be added to the Corporations Act 2001. Ultimately, the government elected not to add such requirements. 13
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Why should I understand some of the insights provided by researchers working within the ethical (normative) branch of Stakeholder Theory? We should understand some of the insights provided by these researchers as the insights will enable us to appreciate different perspectives about how organisations can, or should, treat particular groups of stakeholders from an ethical perspective. The views or prescriptions might also challenge our own prior views. The views of the ethical stakeholder theorists will act to challenge
views that might otherwise be held by managers. If managers respond to such a challenge, then in the longer term this can be expected to lead to improvements in the way the organisation interacts with stakeholders. This should be beneficial to both the organisation, and its stakeholders.
The managerial branch of Stakeholder Theory We now turn to perspectives of Stakeholder Theory that attempt to explain when corporate management will be likely to attend to the expectations of particular (typically powerful) stakeholders. According to Gray, Adams and Owen (2014), this alternative perspective tends to be more ‘organisation centred’. They state (p. 85): Here (under this perspective), the stakeholders are identified by the organisation of concern, by reference to the extent to which the organisation believes the group needs to be managed in order to further the interests of the organisation (what Mitchell, Agle & Wood, 1997 call ‘salience’). The interests of the organisation need not be restricted to conventional profit-seeking assumptions. The more important (salient) the stakeholder to the organisation, the more effort will be exerted in managing the relationship. Information – including financial accounting and social accounting information – is a major element that can be employed by the organisation to manage (or manipulate) the stakeholder in order to gain their support and approval, or to distract their opposition and disapproval.
Unlike the ethical branch of Stakeholder Theory, such (organisation-centred) theories can and are often tested by way of empirical observation. As mentioned earlier, within Legitimacy Theory the audience of interest is typically defined as the society. Within a descriptive managerial branch of Stakeholder Theory, the organisation is also considered to be part of the wider social system, but this perspective of Stakeholder Theory specifically considers the different stakeholder groups within society and how they should best be managed if the organisation is to survive (hence, we call it a ‘managerial’ perspective of Stakeholder Theory). Like Legitimacy Theory, it is considered that the expectations of the various stakeholder groups will impact on the operating and disclosure policies of the organisation. The organisation will not respond to all stakeholders equally (from a practical perspective, they probably cannot), but rather will respond to those stakeholders that are deemed to be ‘powerful’ (Bailey, Harte and Sugden, 2000; Buhr, 2002). Nasi et al. (1997) build on this perspective to suggest that the most powerful stakeholders will be attended to first. This is consistent with Wallace (1995, p. 87), who argues that ‘the higher the group in the stakeholder hierarchy, the more clout they have and the more complex their requirements will be’. Within the managerial branch of Stakeholder Theory, a stakeholder’s (for example, owner’s, creditor’s or regulator’s) power to influence corporate management is viewed as a function of the stakeholder’s degree of control over resources required by the organisation (Ullmann, 1985). The more critical the stakeholder’s resources are to the continued viability and success of the organisation, the greater the expectation that the stakeholder’s demands will be addressed. A
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successful organisation is considered to be one that satisfies the demands (sometimes conflicting) of the various powerful stakeholder groups.15 In this respect Ullmann (1985, p. 541) states: … our position is that organisations survive to the extent that they are effective. Their effectiveness derives from the management of demands, particularly the demands of interest groups upon which the organisation depends.
Power in itself will be stakeholder-organisation specific, but may be tied to such things as command of limited resources (finance, labour), access to influential media, ability to legislate against the company or ability to influence the consumption of the organisation’s goods and services. The behaviour of various stakeholder groups is considered a constraint on the strategy that is developed by management to match corporate resources as best it can with its environment. Failure to meet some stakeholders’ expectation can create various risks for an organisation. In discussing the risks that confront it, the large global mining company, BHP provides a number of ‘examples of potential threats’ including (BHP, 2021, p. 58) risks associated with: Failing to meet stakeholder expectations in connection with our legal and regulator obligations, relationships with indigenous communities, community wellbeing and the way we invest in communities.
Some researchers have considered stakeholder power in conjunction with other stakeholder attributes. For example, Mitchell, Agle and Wood (1997) provide a framework to identify stakeholders according to the relative importance of each type of stakeholder in terms of an organisation meeting its objectives. They argue that there are three features of a stakeholder that need to be considered, these being power, legitimacy and urgency. Power refers to the extent that a stakeholder can exert its influence on the organisation. A stakeholder has legitimacy when its demands conform to the norms, values and beliefs of the wider community. Urgency is the extent to which stakeholder demands require immediate attention from an organisation. The greater the extent to which organisations believe that stakeholders possess these three attributes, the greater their importance to an organisation. Building on this perspective, Parthiban, Bloom and Hillman (2007) also found that organisations are more likely to respond to the expectations of stakeholders with power, legitimacy and urgency. Freeman (1984) discusses the dynamics of stakeholder influence on corporate decisions. A major role of corporate management is to assess the importance of meeting stakeholder demands in order to achieve the strategic objectives of the firm. Further, as Friedman and Miles (2002) also point out, the expectations and power relativities of the various stakeholder groups can change over time. Organisations must therefore continually adapt their operating and disclosure strategies. Roberts (1992, p. 598) states: A major role of corporate management is to assess the importance of meeting stakeholder demands in order to achieve the strategic objectives of the firm. As the level of stakeholder power increases, the importance of meeting stakeholder demands increases also.
Reflecting how managers must be responsive to changing stakeholder expectations, a 2021 report by the large accounting firm EY, entitled Top 10 Business Risks and Opportunities for Mining and Metals in 2022, includes the following (p. 3): As environmental, social and governance (ESG) factors become a bigger priority for investors, shareholders and a broader group of stakeholders, miners are doing more to integrate ESG into corporate strategies, decision-making and stakeholder reporting. 15
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In considering the managerial perspective of Stakeholder Theory, Hasnas (1998, p. 32) states: ‘when viewed as an empirical theory of management designed to prescribe a method for improving a business’s performance, the stakeholder theory does not imply that business has any social responsibilities’.
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Stakeholder pressure over issues such as biodiversity and water management are likely to intensify, requiring miners to progressively plan for mine closures and better manage the water-energy nexus to satisfy expectations.
If we accept the view that a ‘good’ management is one that can successfully attend to various and sometimes conflicting demands of various (important) stakeholder groups, then we might, consistent with Evan and Freeman (1988), actually redefine the purpose of the organisation. According to Evan and Freeman (1988), ‘the very purpose of the firm is, in our view, to serve as a vehicle for coordinating stakeholders. It is through the firm that each stakeholder group makes itself better off through voluntary exchanges’ (p. 82). As indicated above, as the level of stakeholder power increases, the importance – from a managerial (profit or value-based) perspective – of meeting stakeholder demands increases. Some of this demand may relate to the provision of information about the activities of the organisation. According to a number of writers, for example Ullmann (1985) and Friedman and Miles (2002), the greater the importance to the organisation of the respective stakeholder’s resources/support, the greater the probability that the particular stakeholder’s expectations will be incorporated into the organisation’s operations. From this perspective, various activities undertaken by organisations, including public reporting, will be directly related to the expectations of particular stakeholder groups. Furthermore, organisations will have an incentive to disclose information about their various programs and initiatives to the respective stakeholder groups to indicate clearly that they are conforming with those stakeholders’ expectations. Organisations must necessarily balance the expectations of the various stakeholder groups. Unerman and Bennett (2004) are among others who argue that as these expectations and power relativities can change over time, organisations must continually adapt their operating and reporting behaviours accordingly. Within the managerial perspective of Stakeholder Theory, information (including financial accounting information and information about the organisation’s social performance) can be used as part of a strategy to manage stakeholders. This is consistent with the legitimation strategies suggested by Lindblom (1993), as discussed earlier in the chapter. In relation to corporate social disclosures, Roberts (1992, p. 599) states: … social responsibility activities are useful in developing and maintaining satisfactory relationships with stockholders, creditors, and political bodies. Developing a corporate reputation as being socially responsible through performing and disclosing social responsibility activities is part of a strategy for managing stakeholder relationships.
Having provided an overview of both the ethical and managerial branches of Stakeholder Theory, we can now refer to Figure 9.5, which is a simplified diagrammatic representation of some differences between the two broad branches of Stakeholder Theory. The attributes of the ethical branch of Stakeholder Theory are provided on the left of the diagram, while the attributes of the managerial branch are provided on the right.
Empirical tests of Stakeholder Theory Using Stakeholder Theory to test the ability of stakeholders to impact corporate social responsibility disclosures, Roberts (1992) found that measures of stakeholder power and their related information needs could provide some explanation about levels and types of corporate social disclosures. Neu, Warsame and Pedwell (1998) also found support for the view that particular stakeholder groups can be more effective than others in demanding social responsibility disclosures. They reviewed the annual reports of a number of publicly traded Canadian companies operating in environmentally sensitive industries for the period 1982–91. A measure of correlation was
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FIGURE 9.5 A diagrammatic representation of differences between the ethical and managerial branch of Stakeholder Theory Stakeholder Theory
ETHICAL BRANCH
KEY ISSUES
MANAGERIAL BRANCH
Normative in orientation
Positive or normative in orientation?
Positive in orientation
Concerned with stakeholders who can affect the organisation as well as those who are affected by the organisation
Which stakeholders are considered?
Concerned with stakeholders who can affect the organisation
Manage the organisation for the benefit of all stakeholders
What is the role of the organisation?
Manage the organisation for the benefit of the owners and powerful stakeholders
Stakeholder power is not relevant – all stakeholders deserve consideration in their own right
What is the relevance of stakeholder power?
Stakeholder power is relevant and stakeholders will be identified on the basis of the extent to which their needs must be managed in order to further the interests of the organisation
Corporate reporting is responsibility driven and linked to considerations such as ‘right-to-know’. Corporate reports will inform stakeholders about the extent to which the actions for which the organisation is deemed to be responsible have been fulfilled
What is the role of corporate reporting?
Corporate reporting is used as a strategy to manage the interests and influence of powerful stakeholders so as to further the interests of the organisation
sought between increases and decreases in environmental disclosure and the concerns held by particular stakeholder groups. The results indicated that the companies were more responsive to the demands or concerns of financial stakeholders and government regulators than to the concerns of environmentalists. They considered that these results supported a perspective that, where corporations face situations where stakeholders have conflicting interests or expectations, the corporations will elect to provide information of a legitimising nature to those stakeholders deemed to be more important to the survival of the organisation, while down-playing the needs or expectations of less ‘important’ stakeholders. We could expect that since the time this research was undertaken the power of NGOs to shape community concerns has increased such that similar research would tend to show that the views of NGOs are more likely to shape organisational behaviour. In another study that investigated how stakeholder power influences corporate disclosure decisions, Islam and Deegan (2008) investigated the social and environmental disclosure
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practices of a major trade organisation operating within a developing country. Specifically, they investigated the social and reporting practices of the Bangladesh Garments and Manufacturing Enterprise Association (BGMEA). This organisation is authorised by the government in Bangladesh to provide export licences to garment manufacturers, thereby enabling local garment manufacturers to sell their products to foreign buyers, many of which are large multinational companies. Islam and Deegan interviewed senior executives from BGMEA. The executives indicated that the operating and disclosure policies of BGMEA and its member organisations were particularly influenced by the demands and expectations of multinational buying companies (such as Nike, Gap, Reebok and Hennes & Mauritz), the group they considered to be their most powerful stakeholders. The senior executives also stated that they believed that the demands and expectations of the multinational buying companies directly responded to the expectations of Western consumers, and that the expectations of Western consumers were influenced by the Western news media (consistent with Media Agenda Setting Theory, as discussed earlier in this chapter). In this regard, the executives of BGMEA noted that, prior to the mid-1990s, multinational companies placed no requirements or restrictions on the Bangladesh manufacturing companies in relation to factory working conditions or the use of child labour. However, once the Western news media began running stories on the poor working conditions in ‘sweatshop’ factories and stories on the use of child labour, this caused concern for Western consumers, who started to boycott the products of the large multinational sportswear and clothing companies. The Western consumers were powerful stakeholders of the multinational companies. At this point, the multinational companies started imposing operating and reporting requirements on suppliers in terms of their employee conditions and their use of child labour. Reflective of the changes in perceived pressures, and the resultant reactions of BGMEA and its members, one of the senior executives of BGMEA stated (Islam and Deegan, 2008, p. 860): The 1990 multinational buyers only wanted product, no social compliances were required and no restriction was placed on the employment of child labour. Now multinational buying companies have changed their attitudes towards us, perhaps because of the pressures from western consumers. We had to change ourselves following buyers’ requirements and to fit with global requirements and restrictions. Western consumers and human rights organisations pressured foreign buyers, and then foreign buyers pressured us. We responded.
Stakeholder Theory of the ‘managerial’ variety does not directly provide prescriptions about what information should be disclosed other than indicating that the provision of information, including information within annual reports, sustainability reports and corporate websites, can, if carefully considered, be useful to the continued operations and financial success of a business entity. Of course, if managers accept this view of the world, they would still be left with the difficult problem of determining who their most important (powerful) stakeholders are, what their respective information demands are and what is the most effective media for disclosure.16 16
Again, it is emphasised that this will not always be an easy exercise. For example, and for the purpose of illustration (but actually based on a ‘real-life’ case), we may find that a company has elected to provide an elderly person who lives in a modest house nearby with a report that details when coal dust can be expected to be released from the company’s furnaces so that the person can ensure that no washing is left out at this time. At face value, such a person may not appear to be a powerful stakeholder and we as outsiders might question why the company provides such disclosures. However, we may find that the individual has a daughter who is a popular, high-profile radio personality who will readily complain on air, at some cost to the company in terms of community support, each time her parent’s washing is covered with coal dust. Through connections the elderly person is a powerful stakeholder, and, to alleviate the problems, coal-dust release information is provided so that the person can schedule washing. In relation to this illustration, it should be noted that an ethical/moral view of stakeholder information rights would perhaps be that this person has a right to information regardless of the fact that the affected person’s daughter works in the media.
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The above discussion has separately considered the normative moral/ethical perspective of Stakeholder Theory and the managerial (power-based) perspective of Stakeholder Theory. However, a risk of discussing these two branches separately is that it could be construed that management might be either ethically/morally aware or solely focused on the survival or financial success of the organisation, whereas in practice there is likely to be a continuum of possible positions between these two absolute points. Considering the two perspectives separately will give a partial view only, as it is unlikely that the managers of any organisation will be at one or other of the absolute extremes of the continuum. Instead, the managers of many organisations will arguably be driven by both ethical considerations and performance-based decisions, not just one or the other. As Wicks (1996) argues, many people have embraced a conceptual framework in which ethical considerations and market considerations are seen as constituting a categorically and independent realism. Wicks argues that this view is unrealistic, since it implies that people cannot introduce ‘moral imaginations when they act in the market world’. In terms of research in Stakeholder Theory, Rowley (1998) provides some interesting advice. He states (p. 2): The blurring of normative and descriptive analysis is problematic for the field; however, dividing them into separate camps is equally hazardous. I believe that if our most challenging issues 10 years from now are to be different from today, we will need to collectively understand the complementary roles that normative and descriptive research play in our research questions. Like market and society, we cannot think of one without the other.
REFLECTION QUESTION 9.7 Engaging stakeholders for ethical or managerial reasons? The large Australian bank Westpac made the following statements in its 2021 Sustainability Supplement (pp. 7, 9): Through our data-driven sustainability materiality assessment process and ongoing stakeholder engagement, we identify the opportunities and challenges relating to our business that matter most to our stakeholders. We seek to maintain an open dialogue with our broad range of stakeholders, enabling us to understand and respond to their evolving expectations and concerns.We use these insights to understand the issues that most materially impact our ability to create long-term value for our stakeholders. Question Would the above statements be reflective of managers embracing an ethical or a managerial approach to stakeholder engagement?
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Solution To be successful from a financial perspective, managers need to respond to stakeholders’ expectations, particularly those stakeholders who have the power to influence the financial performance of the organisation. The above statements are consistent with this. From an ethical perspective, an organisation should respond to the concerns of stakeholders, particularly those stakeholders who are most affected by the organisation’s operations. The above statement is also consistent with this perspective. Further, by referring to opportunities and challenges ‘that matter most to our stakeholders’ and to ‘long-term value for our stakeholders’there seems to be an acceptance by the managers that different stakeholders have different perspectives of ‘value’ creation, and hold different concerns that need to be considered, and this is also consistent with a view that the organisation is considering its stakeholders quite broadly. As these quotes demonstrate, it is often difficult to determine the motivations driving managers to take particular actions, and it is quite likely that the managerial motivations will be part ethical, and part managerial. Business organisations do need to survive in the marketplace, which requires them to consider the stakeholders that provide necessary resources, but hopefully in doing so, they behave ethically.
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Why should I understand some of the insights provided by researchers working within the managerial (positive) branch of Stakeholder Theory? As a positive theory, the managerial branch of Stakeholder Theory seeks to explain and/or predict managers’ actions, inclusive of their reporting decisions. Therefore, if we are wanting to understand why managers might be responding to the information demands or needs of some stakeholders, and not
others, then the insights provided by the managerial branch would be useful. By contrast, if we were seeking to evaluate (not explain or predict) the disclosures being made, then we might refer to the ethical branch.
REFLECTION QUESTION 9.8 The relevance of research to regulators Question Should regulators who regulate corporate disclosures be interested in the insights provided by the ethical branch of Stakeholder Theory and/or the insights provided by the managerial branch of Stakeholder Theory? Solution Regulators should know about both branches. Before potentially mandating particular disclosures, regulators should understand why managers might currently be making particular disclosures. Without knowing the reasons why managers are making existing
(unregulated) disclosures, any efforts to mandate alternative disclosures might encounter various hurdles and opposition. When determining what disclosures should be made by organisations, regulators should also be aware of some of the prescriptions that have been made by researchers working in the ethical branch of Stakeholder Theory. Such research might explain what demands different stakeholders have, why they have such demands, and might provide insights into how these demands or needs can best be met. Hence, regulators can use related research emanating from both the managerial and ethical branches of Stakeholder Theory.
Again, we are left with a view that particular theories (of accounting) can provide us with only a partial view, and hence it is sometimes useful to consider the insights provided by different theoretical perspectives. One additional systems-oriented theoretical perspective, which is increasingly being applied to the analysis of voluntary corporate reporting decisions, is Institutional Theory. Institutional Theory supports the determinant of ‘legitimacy’. Institutional Theory explains that organisations are faced with institutional pressures and, as a result of these pressures, organisations within a field tend to become similar in their forms and practices. LO9.1
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Institutional Theory
Institutional Theory has a long history. According to Scott (2008a), the earliest institutional arguments were developed in the 1880s, and in particular, within the social sciences. Initially, early works utilising Institutional Theory in economics, political science and sociology did not directly pay attention to organisations or organisational forms. However, later developments from the 1970s, such as those of Meyer and Rowan (1977), linked organisations’ formal structures and practices to certain expectations held within society. The basic view of organisations, as perceived by such theorists, was that an ‘organisation’ is an institutionalised form reflecting not only the technical necessities required to efficiently perform its functions but, importantly, the form and appearance that organisations take also reflect the cultural rules and beliefs operating within the social environments at the time (Scott, 2008b). That is, and according to Carruthers (1995), these latter Institutional Theorists viewed the world as being socially constructed and filled with taken-for-granted meanings and rules. The social and institutional context within which organisations operate influences organisational structures (Meyer and Rowan, 1977). This newer (post-1970) perspective of Institutional Theory is often labelled as ‘neo-institutional
Institutional Theory A theory that explains how various practices, processes and organisational forms become similar or ‘institutionalised’ within society. Explains that organisations within particular ‘institutional environments’ will become similar because of various coercive, normative and mimetic pressures. This process of becoming similar is referred to as isomorphism. The theory also predicts that there will be a decoupling of formal (seen) structures or forms and actual structures or forms.
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theory’. In this chapter, when we refer to Institutional Theory, we are actually referring to what is often also called ‘neo-institutional theory’.17 According to Scott (2014), Institutional Theory has been developed in the disciplines of sociology, economics and political science. While there are many commonalities between the theoretical developments, there are also various differences. The insights used within Legitimacy Theory, as previously discussed within this chapter, predominantly come from what is considered to be the sociological branch of Institutional Theory. It is the sociological branch of Institutional Theory that has effectively been embraced by accounting researchers. Researchers applying Institutional Theory will typically embrace either an ‘institutional aspect’ or a ‘strategic aspect’ (or both) to explain why managers take various actions, or why organisations take various forms. The ‘institutional aspect’ acknowledges and explains how the institutional environment/organisational context within which organisations operate influences the processes and practices used by an organisation. This aspect is typically ignored by Legitimacy Theorists. The ‘strategic aspect’ of Institutional Theory, which as we explained earlier in this chapter, is the aspect embraced by many Legitimacy Theorists, explores how managers can shape the institutional environment in which they operate through various ‘strategic actions’ that they are in control of, including by way of corporate social and environmental disclosures. While different researchers will note that they are using ‘Institutional Theory’ (thereby, potentially inferring that there is one unified theory), there are effectively many variants of Institutional Theory, such that Institutional Theory is effectively an ‘umbrella term’ that has the institutional context of an organisation at the core of the analysis. These different ‘Institutional Theorists’ often utilise a multitude of institutional/contextual-related variables in various types of research that is undertaken to consider how the institutional context within which organisations operate influences how organisations, for example, operate internally or how they project themselves externally through various types of reporting practices. As we explained earlier in this chapter, the same can be said for theories such as Stakeholder Theory, and other theories, where researchers identify as using a particular theory, but the variables, assumptions and so forth that they individually introduce or apply can show great variety. The concept of ‘institution’ – something central to Institutional Theory (obviously) – is a key construct within sociology (DiMaggio and Powell, 1991). However, the idea of ‘institution’ is very diverse in meaning and application (for examples of diverse approaches see Scott, 1987) and hence no definitive all-inclusive definition is possible. However, Scott (2008b, p. 48) proposed a ‘broad and dense definition’ of institutions as follows: Institutions are comprised of regulative, normative and cultural-cognitive elements that, together with associated activities and resources, provide stability and meaning to social life.
Meyer, Boli and Thomas (1987, p. 13) provide a slightly different meaning of ‘institution’, but one which is consistent with the above definition: We see institutions as cultural rules giving collective meaning and value to particular entities and activities, integrating them into larger schemes.
When actions, processes or organisational forms become ‘institutionalised’, they become accepted as ‘the way to do things’. When things become highly institutionalised, they effectively are ‘beyond the discretion of individuals and organisations’ (Meyer and Rowan (1977, p. 344). They are taken for granted as legitimate and, because of the ‘taken for granted’ status, the processes or organisational forms tend to perpetuate. As such, the ‘institutions’ are often not evaluated by their impacts or technical outcomes. 17
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When used as a prefix, ‘neo’ means new or recent, or something of modern form.
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While some formal structures and practices might be considered by society as legitimate, this does not necessarily mean they are the most efficient choice in terms of technical efficiency. Organisations conform to institutionalised approaches (also referred to as ‘myths’ within the literature) by building gaps or ‘buffers’ between the formal structures of the organisation which people actually see (the ‘myths’ that maintain legitimacy) and the actual work processes that create internal functional and technical efficiency which ‘outside’ people do not necessarily see (Meyer and Rowan, 1977). Later in our discussion, we refer to this creation of ‘buffers’ as ‘decoupling’. Institutions arise, develop and function in a pattern of social self-organisation, and this goes beyond the conscious intentions of the individual people involved. Therefore, at this point, we can say that ‘institution’ can be used to refer to very wide cultural or social facts, such as marriage, democracy, the rule of law, professions and organisational forms. Hence, from this brief attempt to define ‘institution’, we should accept that it actually becomes somewhat difficult to precisely define what it means. If we refer to the definition of institutions provided above by Scott, then we can see that reference is made to three elements, these being regulative, normative and cultural-cognitive elements. According to Scott, these regulative, normative and cultural-cognitive elements serve as three vital ‘pillars’ of ‘institutions’. The pillars influence the legitimacy attributed to organisations. As described by Scott (2014), legitimacy is ‘a condition reflecting cultural alignment, normative support, or consonance with relevant rules or laws’. The regulative pillar involves rules, laws and associated sanctions. This pillar stresses that it is a legal requirement to do things in a particular way – otherwise, sanctions may apply. The regulative pillar is maintained through various ‘coercive’ mechanisms, many of which are enforced by government (perhaps through laws with associated fines for non-compliance) or powerful constituents (who can perhaps withhold needed resources from the organisation) that organisations are dependent upon. Organisations generally accede to the rules for reasons of expedience, preferring not to suffer penalty from non-compliance. In a sense, compliance with rules and laws is perceived to be based upon a ‘have to’ mentality (rather than an ‘ought to’ or a ‘want to’ mentality). Complying with the laws brings one form of legitimacy, which has been referred to within the literature as ‘pragmatic legitimacy’. The second pillar, the normative pillar, incorporates value and norms reflecting certain social obligations or expectations – that is, certain processes or structures become socially accepted as the ‘right or moral ways’ to do things. Expectations about the ‘right or proper’ ways to do things will in turn be influenced by various processes, such as professional and educational experiences. This normative pillar is maintained through processes such as accreditations, professional endorsement and formal education. In a sense, compliance with this pillar is based upon an ‘ought to’ mentality and complying with the normative expectations of a particular institutional environment has been argued to generate ‘moral legitimacy’. The third pillar, the cultural-cognitive pillar, is the major distinguishing feature of Institutional Theory (Scott, 2008b). Various ‘taken-for-granted assumptions are at the core of social action’ (Zucker, 1987, p. 443). That is, this cultural-cognitive pillar consists of taken-for-granted symbolic systems and meanings. Cognitive beliefs are subjectively held but exist as ‘a fact, as part of objective reality, and can be transmitted on that basis’ (Zucker, 1977, p. 726).18 Cultures and beliefs are transmitted as ‘this is the way how these things are done’ or ‘this is the way that other legitimate parties are undertaking an activity’ (Scott, 2008b, p. 125) so that doing otherwise effectively becomes unthinkable. Over time, understandings become instilled within, and synonymous with, the culture – or ways of being and acting – in society and reflect a sense of normality and culturally actable behaviour. This pillar works in a subtle, hard to detect, but 18
Decoupling Refers to the situation in which the formal organisational structure or practice is separate and distinct from actual organisational practice.
‘Cognitive beliefs’ can be considered as an interrelated set of beliefs, assumptions and knowledge that an individual might hold about abstract or concrete items. They consist of an individual’s ‘world views’ and influence how they see or filter information that is received.
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Isomorphism A constraining process that forces one unit in a population to resemble other units that face the same set of environmental conditions.
nevertheless powerful way and is maintained by the mimetic mechanisms in which organisations tend to imitate (or copy) others. In a sense, compliance with the cultural pillar can be seen as being based on a ‘want to’ mentality. Complying with the prevailing cultural and cognitive expectations within a particular institutional environment has been linked to what is labelled as ‘cognitive legitimacy’. Effectively, there is a balancing act between the different types of legitimacy described above, and the managers of an organisation cannot, in the longer term, ignore any form of legitimacy. Therefore, while Legitimacy Theorists, as previously discussed in this chapter, typically perceive that ‘legitimacy’ as a whole is determined by society, some Institutional Theorists consider that legitimacy is influenced by conformance with the regulative, normative and cultural-cognitive institutions (pillars) in place within a particular institutional environment, and to maintain overall ‘legitimacy’, managerial attention has to be directed to each of the three forms of legitimacy. Institutional Theorists also stress how organisations operating within a given institutional environment will, in an effort to appear legitimate, necessarily tend to take on similar forms, which is referred to as a process of ‘isomorphism’. This isomorphic process can occur through coercive or normative pressures, or through mimetic processes (DiMaggio and Powell, 1983). Figure 9.6 reflects some of the above discussion. Reflecting Scott’s (2008b) view, the three organisational pillars are vital to organisational legitimacy, and therefore organisational success. Damaging or removing one of the pillars, and the associated legitimacy, brings instability, with the result that the organisation might ‘fall’. FIGURE 9.6 A diagrammatic representation of the three pillars theorised within Institutional Theory The Organisation Regulative pillar
Normative pillar
Cultural cognitive pillar
brings
brings
brings
Pragmatic legitimacy
Moral legitimacy
Cognitive legitimacy
These three ‘pillars’ will, in combination, move the acceptability of certain structures or processes from ‘the conscious to the unconscious, and from the legally enforced to the taken for granted’ (Hoffman, 2001, p. 36), and the three pillars are ‘central building blocks of institutional structure’ (Scott, 2008b, p. 49) that both constrain and empower social behaviour through coercive, mimetic and normative mechanisms (DiMaggio and Powell, 1983). These three pillars are interrelated and coexist at any time, and one or more pillars may play a dominant role at a particular point in time (Hoffman, 2001). They also ‘elicit three related, but distinguishable bases of legitimacy’ (Scott, 2008b, p. 61). Each pillar provides legitimacy, which might be based upon an assessment that actions of institutional constituents are consistent with laws, are aligned with particular cultures, and are supported by, or supportive of, existing norms. We can therefore contrast this perspective with Legitimacy Theory, in which legitimacy is typically not subdivided into three such components. The formal structures and procedures of an organisation, which are the structures and procedures projected to others, reflect the rationalised institutional rules of the wider institutional environments in which organisations operate. The status of an organisation’s legitimacy reflects the ‘social fit’ of the organisation within its environments. Across time, and due to institutional effects, organisations’ structures tend to become homogeneous – that 474
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is, isomorphic effects (effects that tend to make organisations resemble each other) occur with rationalised, impersonal and taken-for-granted ‘myths’ being embraced in order to gain and maintain legitimacy. While organisations’ formal structures (those that are seen by the community) are isomorphic with their institutional environments (to appear legitimate), a tension develops between these formal (and visible) structures and the informal (and often unseen) elements within organisations. To mediate the existence of this tension, organisations could ‘decouple’ their informal structure and practices from the formal ones (which are visible to external parties and are subject to external scrutiny). DiMaggio and Powell (1983) further Meyer and Rowan’s (1977) notion of ‘isomorphism’ to include three mechanisms that can act to diffuse and sustain new organisational forms and practices – the mechanisms being coercion (by powerful parties), normative pressures and actions that mimic other organisations. Corporate reporting, including social reporting, is a means of gaining legitimacy, and simply producing such a report (regardless of its contents) may enhance the apparent legitimacy of the focal organisation’s operation within its social environments. Social reporting thus becomes an element of organisational institutionalisation, despite the fact that there might be a disconnection (decoupling) between how the organisation projects itself in its public reports and the internal (unseen) operational structures and practices within the organisation (LarrinagaGonzalez, 2007). Therefore, as with Legitimacy Theory, legitimacy is the core concept of Institutional Theory (Suchman, 1995) as it provides a linkage between organisations and their social environment (DiMaggio and Powell, 1983). Consistent with previous discussion in this chapter, and according to Suchman (1995, p. 574), legitimacy is: … a generalised perception or assumption that the actions of an entity are desirable, proper, or appropriate within some socially constructed systems of norms, values, beliefs, and definitions.
These ‘socially constructed systems’ referred to by Suchman are effectively ‘institutional frameworks’ (Scott, 2008b, p. 59). Organisations not only operate separately at a micro level, but they also constitute and operate within a larger macro social system. Again, organisations are legitimate if they: conform to relevant laws and regulations (regulative institution); conform to the prevailing values and norms (normative institution); or/and conform to a ‘common definition of the situation, frame of reference, or a recognisable role or structural template’ (cultural-cognitive institution) (Scott, 2008b, p. 61). From the above discussion, we can now understand that Institutional Theory considers the forms organisations take and provides explanations for why organisations within a particular ‘organisational field’ tend to take on similar characteristics and form.19 While a theory such as Legitimacy Theory discusses how particular disclosure strategies might be undertaken to gain, maintain or regain legitimacy, Institutional Theory explores how, at a broader level, particular organisational forms might be adopted in order to bring legitimacy to an organisation. According to Carpenter and Feroz (2001, p. 565): Institutional theory provides another lens through which to view economic resource dependency incentives for accounting rule choice. Institutional theory views organizations as operating within a social framework of norms, values, and takenfor-granted assumptions about what constitutes appropriate or acceptable economic behaviour (Oliver, 1997). According to Scott (1987), ‘organizations conform [to
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DiMaggio and Powell (1983, p. 147) define an ‘organisation field’ as ‘those organizations that, in the aggregate, constitute a recognized area of institutional life: key suppliers, resource and product consumers, regulatory agencies, and other organizations that produce similar services or products’.
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institutional pressures for change] because they are rewarded for doing so through increased legitimacy, resources, and survival capabilities’ (p. 498).
A major paper in the development of Institutional Theory was DiMaggio and Powell (1983). These authors investigated why there was such a high degree of similarity between organisations. Specifically, in undertaking their research, they state (p. 148): We ask why there is such startling homogeneity of organizational forms and practices; and we seek to explain homogeneity, not variation. In the initial stages of their life cycle, organizational fields display considerable diversity in approach and form. Once a field becomes well established, however, there is an inexorable push towards homogenization.
According to DiMaggio and Powell, there are various forces operating within society that cause organisational forms to become similar. As they state (1983, p. 148): Once disparate organizations in the same line of businesses are structured into an actual field (as we shall argue, by competition, the state, or the professions), powerful forces emerge that lead them to become more similar to one another.
While Institutional Theory has become a major and powerful theoretical perspective within organisational analysis, it has also been embraced by accounting researchers. Several management accounting researchers have used Institutional Theory. It has also been used by some researchers who investigate aspects of audit, and others who research aspects of the development and role of the accounting profession. More directly related to financial accounting theory, Fogarty (1992) applied Institutional Theory to an analysis of the accounting standard-setting process. Dillard, Rigsby and Goodman (2004, p. 506) state that: Institutional theory is becoming one of the dominant theoretical perspectives in organization theory and is increasingly being applied in accounting research to study the practice of accounting in organizations.
Gray, Owen and Adams (2010) also make reference to Institutional Theory. As they state in relation to social accounting research (p. 3): theory is often used in social accounting, and despite the range of theory available, there has been a strange herding tendency, especially around legitimacy theory (for an introduction see, e.g., Deegan, 2002). And we also have a sneaking feeling that institutional theory may be coming up fast as the next theory around which to herd.
Although the above view of theory selection might not be overly flattering given that researchers should ideally select theories based on some intrinsic worth (rather than as a result of being ‘herded’), it does nevertheless reflect what some people believe is happening, this being the increasing use of Institutional Theory, and, as a result, the potential future demise of the apparent dominance currently held by Legitimacy Theory within the social and environmental accounting literature.20 A key reason why Institutional Theory is relevant to researchers who investigate voluntary corporate reporting practices is that it provides a complementary perspective to both Stakeholder Theory and Legitimacy Theory, in understanding how organisations understand and respond to changing social and institutional pressures and expectations. Among other factors, it links organisational practices (such as accounting and corporate reporting) to the values of the society 20
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While not pursued within this chapter (it is briefly covered in Chapter 1), this view of how theories are ‘overthrown’ is somewhat different to how researchers, such as Thomas Kuhn, view theory development. Kuhn (1970) argues that theories mature, they reach a crisis, new theories are proposed, there is a revolt and a new theory takes precedence until a new crisis is established, and the cycle continues.
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in which an organisation operates and to a need to maintain organisational legitimacy. There is a view that organisational form and practices might tend towards some form of homogeneity – that is, the structure of the organisation (including the structure of its reporting systems) and the practices adopted by different organisations tend to become similar to conform to what society, or particular powerful groups, consider to be ‘normal’. This process of ‘institutionalisation’ is also a process of homogenisation (also referred to as isomorphism). Organisations that deviate from being of a form that has become ‘normal’ or expected within a given institutional environment will potentially have problems in gaining or retaining legitimacy. As Dillard, Rigsby and Goodman (2004, p. 509) state: By designing a formal structure that adheres to the norms and behaviour expectations in the extant environment, an organization demonstrates that it is acting on collectively valued purposes in a proper and adequate manner.
Dillard, Rigsby and Goodman (p. 507) explain that Institutional Theory: … concerns the development of the taken for granted assumptions, beliefs and values underlying organizational characteristics … [with accounting-based studies] suggesting the importance of social culture and environment on the practice of accounting; the use of accounting practices as rationalizations in order to maintain appearances of legitimacy; and the possibilities of decoupling these rationalizing accounting practices from the actual technical and administrative processes.
Institutional Theory therefore provides an explanation of how mechanisms through which organisations may seek to align perceptions of their practices and characteristics with social and cultural values (in order to gain or retain legitimacy) become institutionalised in particular organisations. Such mechanisms could include those proposed by both Stakeholder Theory and Legitimacy Theory, but could conceivably also encompass a broader range of legitimating mechanisms. This is why these three theoretical perspectives should be seen as complementary rather than competing.
REFLECTION QUESTION 9.9 The institutional context impacts disclosure relevance Question Given the insights available from Institutional Theory, would it be realistic to expect that some social and environmental disclosure recommendations which are relevant in some countries will be relevant in all countries? Solution What Institutional Theory tells us is that particular organisational practices, including reporting practices, that are appropriate in some countries will not necessarily be appropriate, or embraced, within others. For example, a standard-setter such as the GRI might prescribe disclosures about workplace health and safety, or about animal welfare. Whether managers in particular countries will subsequently embrace the disclosure requirement/ recommendations will be influenced by the pressure exerted upon them (the regulatory pillar), by the extent to which local
educational and professional institutions support or encourage such disclosures (the normative pillar), and by whether the cultural environment is one which prioritises workplace safety or animal welfare (the cultural-cognitive pillar). It would be naive of standard-setters to believe that their prescribed disclosures will be equally accepted or embraced across all institutional environments. The institutional environment is based on the interconnection between the regulatory pillar, which most commonly takes the form of laws or rules and emphasises rule setting, monitoring and sanctioning activities; the normative pillar, which comprises standard operating procedures or occupational standards based on ethical and moral values; and the culturalcognitive pillar, which represents cultural rules or frameworks that influence organisational behaviour.
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Isomorphism and decoupling as important components of Institutional Theory As already indicated, there are two interesting dimensions to Institutional Theory. The first of these is termed isomorphism, while the second is termed decoupling. Both of these can be of central relevance to explaining voluntary corporate reporting practices. Isomorphism is considered first. The term ‘isomorphism’ is used extensively within Institutional Theory, and DiMaggio and Powell (1983, p. 149) have defined it as ‘a constraining process that forces one unit in a population to resemble other units that face the same set of environmental conditions’. That is, organisations that adopt structures or processes (such as reporting processes) that are at variance with other organisations might find that the differences attract criticism. Carpenter and Feroz (2001, p. 566) further state: DiMaggio and Powell (1983) label the process by which organizations tend to adopt the same structures and practices as isomorphism, which they describe as a homogenization of organizations. Isomorphism is a process that causes one unit in a population to resemble other units in the population that face the same set of environmental conditions. Because of isomorphic processes, organizations will become increasingly homogeneous within given domains and conform to expectations of the wider institutional environment.
Coercive isomorphism Arises where organisations change their practices to conform to accepted institutional practices because of pressure from those stakeholders upon whom the organisation is dependent.
Mimetic isomorphism Involves organisations seeking to emulate (perhaps copy) or improve upon the institutional practices of other organisations; often for reasons of competitive advantage in terms of legitimacy.
Normative isomorphism Relates to the pressures arising from group norms to adopt particular institutional practices.
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Dillard, Rigsby and Goodman (2004, p. 509) explain: ‘Isomorphism refers to the adaptation of an institutional practice by an organisation’. As voluntary corporate reporting by an organisation is an institutional practice of that reporting organisation, the processes by which voluntary corporate reporting adapts and changes in that organisation are isomorphic processes. If we refer to the definition of ‘institutions’ provided earlier by Scott we can see that reference was made to three elements, these being regulative, normative and cultural-cognitive. As we noted, these regulative, normative and cultural-cognitive elements serve as three vital ‘pillars’ of institutions, each of which is linked to a particular form of legitimacy. DiMaggio and Powell (1983) directly link isomorphic processes to these three pillars of institutions. DiMaggio and Powell (1983) developed an analytical framework for identifying ways in which rationalised procedures spread across organisations. They set out three different isomorphic processes (processes whereby institutional practices such as voluntary corporate reporting adapt and change), referred to as coercive isomorphism, mimetic isomorphism and normative isomorphism (that is, institutionalisation occurs through a process of coercion, normative mechanisms and mimetic mechanisms). The first of these processes, coercive isomorphism, arises where organisations change their institutional practices because of pressure from those stakeholders upon whom the organisation is dependent (that is, this form of isomorphism is related to ‘power’). According to DiMaggio and Powell (1983, p. 150): Coercive isomorphism results from both formal and informal pressures exerted on organizations by other organizations upon which they are dependent and by cultural expectations in the society within which organizations function. Such pressures may be felt as force, as persuasive, or as invitations to join in collusion.
DiMaggio and Powell (1983, p. 154) provide two general hypotheses that relate to coercive isomorphism: Hypothesis 1: The greater the dependence of an organization on another organization, the more similar it will become to that organization in structure, climate and behavioral focus. Hypothesis 2: The greater the centralization of organization A’s resource supply, the greater the extent to which organization A will change isomorphically to resemble the organization on which it depends for resources.
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Coercive isomorphism is related to the managerial branch of Stakeholder Theory (discussed earlier in the chapter), whereby an organisation will, for example, use ‘voluntary’ corporate disclosures to address the economic, social, environmental and ethical values and concerns of those stakeholders who have the most power over the organisation. The organisation is therefore coerced (in this case usually informally) by its influential (or powerful) stakeholders into adopting particular voluntary reporting practices. The idea of coercive isomorphism has been applied to various practices adopted by organisations. For example, applying coercive isomorphism to a government’s selection of accounting procedures, Carpenter and Feroz (2001, p. 571) state: Other organizations that can provide resources, such as the credit markets, can exercise power over government entities. This power can be used to dictate the use of certain institutional rules – such as GAAP.
An organisation could be coerced into adapting its existing voluntary reporting practices (including the issues on which it reports) to bring them into line with the expectations and demands of its powerful stakeholders (while possibly ignoring the expectations of less powerful stakeholders). Because these powerful stakeholders might have similar expectations of other organisations as well, there will tend to be conformity in the practices being adopted by different organisations – institutional practices will tend towards some form of uniformity. In relation to the ability to create change, Tuttle and Dillard (2007, p. 393) state: Change is imposed by an external source such as a powerful constituent (e.g., customer, supplier, competitor), government regulation, certification body, politically powerful referent groups, or a powerful stakeholder. The primary motivator is conformance to the demands of powerful constituents and stems from a desire for legitimacy as reflected in the political influences exerted by other members of the organisational field. These influences may be formal or informal and may include persuasion as well as invitations to collude. If the influencing group has sufficient power, change may be mandated.
As discussed elsewhere in this chapter, in the mid-1990s there was a great deal of concern from Western consumers that multinational clothing companies were sourcing their products from developing countries where local supply factories were using child labour (Islam and Deegan, 2008). As a result of pressure (coercive pressure) from consumers, the Western news media and various lobby groups, most organisations put in place processes to help in ensuring that supply factories did not use child labour. Similar pressures on all multinational companies ultimately led to similar disclosure responses. It has also been argued that a funding body such as the World Bank, which often lends funds for projects being undertaken in developing countries, has the power to coerce borrowers to adopt accounting and reporting rules that comply with its requirements. In this way, those entities that receive funding from the World Bank tend to adopt the same reporting practices – a case of coercive isomorphism. As Neu and Ocampo (2007, p. 367) state: These organizations [such as the World Bank] operate in a variety of different institutional fields thereby ‘spanning’ fields. They also possess the economic capital necessary both to enter distant fields and to facilitate the diffusion of specific practices. The economic capital of the World Bank and International Monetary Fund, as evidenced by their lending activities, provides them with the ability to encourage coercive isomorphism (DiMaggio & Powell, 1983) thereby changing the day-to-day practices of previously autonomous fields … Contained within the loan agreements are requirements that borrower countries adopt and utilize specific accounting practices such as budgeting,
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auditing and financial reporting practices. In this way, the lending agreements facilitate the diffusion of accounting/financial practices across heterogeneous fields.
The second isomorphic process specified by DiMaggio and Powell (1983) is mimetic isomorphism. This involves organisations seeking to emulate (or copy) or improve upon the institutional practices of other organisations, often for reasons of competitive advantage in terms of legitimacy. That is, an organisation might imitate another organisation that they believe appears ‘successful’. In explaining mimetic isomorphism, DiMaggio and Powell (1983, p. 151) state: Uncertainty is a powerful force that encourages imitation. When organizational technologies are poorly understood, when goals are ambiguous, or when the environment creates symbolic uncertainty, organizations may model themselves on other organizations.
Therefore, according to DiMaggio and Powell, as uncertainty increases organisations will be more likely to model themselves on other organisations. In providing an example of modelling (mimetic isomorphism), they state (p. 151): One of the most dramatic instances of modelling was the effort of Japan’s modernizers in the late nineteenth century to model new governmental initiatives on apparently successful western prototypes. Thus, the imperial government sent its officers to study the courts, Army, and police in France, the Navy and postal system in Great Britain, and banking and art education in the United States. American corporations are now returning the compliment by implementing (their perceptions of) Japanese models to cope with thorny productivity and personnel problems in their own firms. The rapid proliferation of quality circles and quality-of-work-life issues in American firms is, at least in part, an attempt to model Japanese and European successes. These developments also have a ritualistic aspect; companies adopt these ‘innovations’ to enhance their legitimacy, to demonstrate that they are at least trying to improve working conditions.
DiMaggio and Powell (1983, p. 155) provide two general hypotheses that relate to mimetic isomorphism: Hypothesis 3: The more uncertain the relationship between means and ends, the greater the extent to which an organization will model itself after organizations it perceives to be successful. Hypothesis 4: The more ambiguous the goals of an organization, the greater the extent to which the organization will model itself after organizations that it perceives to be successful.
Applying the idea of mimetic isomorphism to corporate social reporting, Unerman and Bennett (2004) explain: Some institutional theory studies … have demonstrated a tendency for a number of organisations within a particular sector to adopt similar new policies and procedures as those adopted by other leading organisations in their sector. This process, referred to as ‘mimetic isomorphism’, is explained as being the result of attempts by managers of each organisation to maintain or enhance external stakeholders’ perceptions of the legitimacy of their organisation, because any organisation which failed (at a minimum) to follow innovative practices and procedures adopted by other organisations in the same sector would risk losing legitimacy in relation to the rest of the sector
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(Broadbent, Jacobs & Laughlin, 2001; Scott, 1995). Drawing on these observations, in the absence of any legislative intervention prescribing detailed mechanisms of debate, a key motivating force for many managers to introduce mechanisms allowing for greater equity in the determination of corporate responsibilities would therefore be their desire to maintain, or enhance, their own competitive advantage. They would strive to achieve this by implementing stakeholder dialogue mechanisms which their economically powerful stakeholders were likely to perceive as more effective than those used by their competitors. It is unlikely that these managers would readily embrace mechanisms designed to facilitate widespread participation in the determination of corporate responsibilities unless their economically powerful stakeholders expected the interests of economically marginalised stakeholders to be taken into account in this manner, and these managers are only likely to implement the minimum procedures that they feel their economically powerful stakeholders would consider acceptable.
The above argument links pressures for mimetic isomorphism with pressures underlying coercive isomorphism. Unerman and Bennett (2004) maintain that without coercive pressure from stakeholders, it is unlikely there would be pressure to mimic or surpass the social reporting practices (institutional practices) of other companies. The final isomorphic process explained by DiMaggio and Powell (1983) is normative isomorphism. This relates to the pressures arising from group norms to adopt particular institutional practices. In the case of corporate reporting, the professional expectation that accountants will comply with accounting standards acts as a form of normative isomorphism for the organisations for whom accountants work to produce accounting reports (an institutional practice) that are shaped by accounting standards. In terms of voluntary reporting practices, normative isomorphic pressures could arise through less formal group influences from a range of both formal and informal groups to which managers belong, such as the culture and working practices developed within their workplace. These could produce collective managerial views in favour of or against certain types of reporting practices, such as collective managerial views on the desirability or necessity of providing a range of stakeholders with social and environmental information through the medium of corporate reports. DiMaggio and Powell (1983, p. 155) provide two general hypotheses that relate to normative isomorphism: Hypothesis 5: The greater the reliance on academic credentials in choosing managerial and staff personnel, the greater the extent to which an organization will become like other organizations in its field. Hypothesis 6: The greater the participation of organizational managers in trade and professional associations, the more likely the organization will be, or will become, like other organizations in its field.
These two hypotheses stress that particular groups with particular training will tend to adopt similar practices (including reporting practices); otherwise they will appear to be out of line with their ‘group’ – which, in itself, might lead to formal or informal sanctions being imposed by ‘the group’ on those parties that deviate from the accepted or expected behaviour. As another example of normative isomorphism, Palmer, Jennings and Zhou (1993) found that chief executive officers (CEOs) who attended elite business schools were likely to adopt an approach to organising a business known as the multi-divisional form (MDF) of organisation (the organisation being separately organised into different product divisions). The multi-divisional form of organisation was taught as part of conventional wisdom in elite business schools. This emphasis was passed on to students who subsequently became CEOs. The actions of these similarly trained executives resulted in organisational similarity within specific types of organisational fields.
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Laine identifies ‘professional networks’ as key means of institutionalising particular processes. He states (2009, p. 1032): Professional networks form an important medium for the rapid dissemination of new models, innovations and practices. There are, for instance, professional networks for those responsible for organizations’ corporate social responsibility and sustainability issues. These formal or informal networks organise meetings, training sessions and small scale conferences, in which information on new ways of doing things diffuses (Carruthers, 1995). Such events and networks could form channels for the dissemination of new reporting innovations such as the Global Reporting Initiative. On the whole, the ideas of corporate environmental management, social responsibility and sustainability have become increasingly institutionalized only in recent years, which may also have given additional significance to professional networks in this area.
Having described the three forms of isomorphic processes (coercive, mimetic and normative isomorphism), it is interesting to note that such processes, while important for conferring legitimacy to particular processes and organisational forms, are not necessarily expected to make the organisations more efficient. As DiMaggio and Powell (1983, p. 153) state: It is important to note that each of the institutional isomorphic processes can be expected to proceed in the absence of evidence that they increase internal organizational efficiency. To the extent that organizational effectiveness is enhanced, the reason will often be that organizations are rewarded for being similar to other organizations in their fields. This similarity can make it easier for organizations to transact with other organizations, to attract career-minded staff, to be acknowledged as legitimate and reputable, and to fit into administrative categories that define eligibility for public and private grants and contracts. None of this, however, ensures that conformist organizations do what they do more efficiently than do their more deviant peers.
Related to the above point, Carpenter and Feroz (2001, p. 569) state: Institutional theory assumes that organizations adopt structures and management practices that are considered legitimate by other organizations in their fields, regardless of their actual usefulness. Legitimated structures or practices can be transmitted to organizations in a field, through tradition (organization imprinting at founding), through imitation, by coercion, and through normative pressures … Institutional theory is based on the premise that organizations respond to pressure from their institutional environments and adopt structures and/or procedures that are socially accepted as being the appropriate organizational choice … Institutional techniques are not based on efficiency but are used to establish an organization as appropriate, rational, and modern … By designing a formal structure that adheres to the prescription of myths in the institutional environment, an organization demonstrates that it is acting in a proper and adequate manner. Meyer and Rowan (1977) maintain that myths of generally accepted procedures – such as generally accepted accounting procedures (GAAP) – provide a defence against the perception of irrationality and enhanced continued moral and/or financial support from external resource providers.
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Although three types of isomorphism have been described above, in practice it will not necessarily be easy to differentiate between the three. As Carpenter and Feroz (2001, p. 573) state: DiMaggio and Powell (1983) point out that it may not always be possible to distinguish between the three forms of isomorphic pressure, and in fact, two or more isomorphic pressures may be operating simultaneously making it nearly impossible to determine which form of institutional pressure was more potent in all cases.
In applying the various notions of isomorphism embraced within Institutional Theory to accounting, the decision to disclose particular items of information may be more about ‘show’ (or ‘form’) than about ‘substance’. As Carpenter and Feroz (2001, p. 570) state in relation to accounting practices adopted by government: One manifestation of organizations in need of institutional legitimacy is the collecting and displaying of huge amounts of information that have no immediate relevance for actual decisions. Hence those state governments that have adopted GAAP, yet do not use GAAP information in making financial management decisions (e.g. budgetary decisions), may have adopted GAAP for purposes of institutional legitimacy.
Carpenter and Feroz (2001) used Institutional Theory to explain four US state governments’ decisions to switch from a method of accounting based on recording cash flows to methods of accounting based on GAAP. In describing the results of their analysis, they state (p. 588): Our evidence shows that an early decision to adopt GAAP can be understood in terms of coercive isomorphic pressures from credit markets, while late adopters seem to be associated with the combined influences of normative and mimetic institutional pressures … The evidence presented in the case studies suggests that severe, prolonged financial stress may be an important condition affecting the potency of isomorphic pressures leading to an early decision to adopt GAAP for external financial reporting.
They further explain (p. 592): All states were subject to normative isomorphic pressures from the accounting profession, coercive isomorphic pressures from the credit markets, and from the federal government to adopt GAAP from 1975 through 1984. Coercive isomorphic institutional pressures were significantly increased in 1984 with the passage of the Single Audit Act (SAA) and the formation of the Government Accounting Standards Board (GASB). Since it is likely that both normative and coercive isomorphic pressures act in concert to move state governments to GAAP adoption, it may be impossible to empirically distinguish the two forms of isomorphic pressure … We note that all state governments were subject to potent institutional pressure to adopt GAAP after 1973. These institutional pressures were created by the federal government, professional accounting associations, and representatives of the credit markets. Thus state governments were subjected to at least two forms of isomorphic pressures: normative and coercive … We predict that all state governments in the USA will eventually bow to institutional pressures for change and adopt GAAP for external financial reporting. Our prediction is based on insights from institutional theory, coupled with insight on the potency of the institutional pressures for change identified in our four case studies.
We now turn our attention to another key dimension of Institutional Theory (other than isomorphism) – ‘decoupling’. Decoupling implies that while managers might perceive a need
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for their organisation to be seen to be adopting certain institutional practices, and might even institute formal processes aimed at implementing these practices, actual organisational practices can be very different from these formally sanctioned and publicly pronounced processes and practices. As Laine (2009, p. 1031) states: Factual organizational activities may become decoupled from the accounts given outside (Carruthers, 1995; Meyer and Rowan, 1977), leading to window dressing (Mouritsen and Skaerbaek, 1995). The external appearance may be rationalized and used to help the organization meet the social expectations and to ‘confer legitimacy upon the organization’ (Carruthers, 1995, p. 315; also Meyer and Rowan, 1977), even though the underlying factual organizational reality may remain unchanged.
Thus, the actual practices can be decoupled from the institutionalised (apparent) practices. In terms of voluntary corporate reporting practices, this decoupling can be linked to some of the insights from Legitimacy Theory, whereby social and environmental disclosures can be used to construct an organisational image that might be very different from the actual organisational social and environmental performance. Thus, the organisational image constructed through corporate reports might be one of social and environmental responsibility when the actual managerial imperative is maximisation of profitability or shareholder value. As Dillard, Rigsby and Goodman (2004, p. 510) put it: Decoupling refers to the situation in which the formal organizational structure or practice is separate and distinct from actual organizational practice. In other words, the practice is not integrated into the organization’s managerial and operational processes [it is decoupled]. Formal structure has much more to do with the presentation of an organizational-self than with the actual operations of the organization (Carruthers, 1996). Ideally, organizations pursue economic efficiency and attempt to develop alignment between organizational hierarchies and activities. However, an organization in a highly institutionalized environment may face conflicts and inconsistencies between the demands for efficiency and the need to conform to ‘ceremonial rules and myths’ of the institutional context (Meyer and Rowan, 1977). In essence, institutionalized, rationalized elements are incorporated into the organization’s formal management systems because they maintain appearances and thus confer legitimacy, whether or not they directly facilitate economic efficiency.
Why do I need to understand the idea of ‘decoupling’, and why, and potentially when, it might occur? The idea of ‘decoupling’ as developed within Institutional Theory provides a very useful foundation to enable us to understand why what we actually see with respect to an organisation (its reports and its various organisational forms, committees, publicly projected policies and so forth) might be very different to how the organisation acts internally. For example, while an organisation might project an image that it is very environmentally aware (perhaps through publicly
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releasing details of its environmentally related policies and procedures), the actual factors that influence its decisionmaking processes (perhaps linked to profit-related motivations) might be quite different, or decoupled, from its publicly projected image. Institutional Theory, and its use of concepts like isomorphism and decoupling,encourages us to question whether what we see actually reflects the underlying reality.
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REFLECTION QUESTION 9.10 Standard-setters’ awareness of Institutional Theory Question Should regulators or standard-setters, such as the Global Reporting Initiative, which develops Sustainability Reporting Standards, or the International Accounting Standards Board, which generates International Financial Reporting Standards (IFRS), be aware of the insights from Institutional Theory? Solution Absolutely they should be aware! The extent to which their reporting standards will be embraced, and complied with internationally, will be influenced by the various regulatory environments in which the standards are being used (for example, whether the standards are required to be followed within the country, and the sanctions that might, or might not be applied, if there is a lack of compliance with the standards);
by the societal norms within a particular country (the normative pillar, which will be influenced by the local professional organisations, educational institutions and so forth, and it is possible that some disclosure requirements are not consistent with the educational or professional priorities in some countries and, by the cultural expectations held within a particular country (the cultural-cognitive pillar). It would be unrealistic to expect that particular rules or standards will be equally embraced, and equally relevant and legitimate, across all countries and standard-setters need to understand the institutional impediments that could exist across the various countries where they expect their standards to be applied. They would need to understand whether these institutional impediments can realistically be addressed and solved.
Further empirical tests of Institutional Theory Jensen and Berg (2012) apply Institutional Theory to compare organisations that embrace the Integrated Reporting Framework ( Framework) developed by the International Integrated Reporting Council (IIRC) with those, that by contrast, undertake ‘traditional’ sustainability reporting, and they show that cultural and institutional factors influence the choice. They report that organisations that adopt the Framework are more likely to be located in countries with higher levels of education, investor protection and market coordination. Such results would be, or should be, of great interest to standard-setters. Akbar and Deegan (2021) explored how the institutional context influences workplace safety-related disclosures of apparel industry organisations following a crisis, most notably, the crisis in 2013 when the Rana Plaza building collapsed in Bangladesh causing the death of 1129 factory workers and over 2000 injuries. They explored and contrasted the disclosures made by large global apparel buyers (from North America and Europe) with those made by Bangladeshi garment suppliers. Their findings indicate that there was an increase in workplace-related disclosures by large Western apparel buyers following the crisis and these are deemed to be influenced by institutional factors, including the Western value system and societal expectations (cultural cognitive pillar), which places importance on workplace safety; the ethical and moral principles upheld (normative pillar), which influences the introduction of safety standards; and the adoption of new safety initiatives (regulative pillar), whose implementation is strictly monitored. By contrast, the workplace disclosures of the local Bangladeshi garment suppliers did not change significantly, and the authors assert this is because the Bangladesh institutional environment does not place great importance on workplace safety issues, such that the garment manufacturers are mainly focused on buyers’ demands and business survival concerns. The authors state (p. 3587): The study findings demonstrate that apparel buyers that operate in a Western environment, in a culture prioritising workplace safety, are found to employ corporate
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crisis communication strategies (such as bolstering, simple denial and corrective actions strategies) that emphasise and detail enhanced workplace safety practices, which can be directly attributed to institutional pressures, rather than efforts to improve safety in supplier factories. In contrast, garment suppliers that operate in a developing country context that does not promote adequate safety culture use corporate crisis communication strategies (such as bolstering and corrective actions strategies) to a limited extent and for a limited period, mainly in response to buyer pressure and survival concerns.
Akbar, Deegan and Inglis (2017) explored how workplace safety initiatives (governance practices) changed in Bangladesh following loss of lives due to building collapses and factory fires. Central to their investigation was a consideration of whether it is reasonable (or perhaps by contrast, actually naive) to expect or believe that the implementation of workplace safety governance initiatives – largely developed in a way that is consistent with values and ideals of Western culture – will lead to long-term improvements in workplace safety in a developing country such as Bangladesh. They state (p. 5): In our study we argue that introducing workplace safety governance initiatives (i.e. establishing an apparently strong regulative pillar for the Bangladesh RMG industry) will not create lasting effects unless the revised pillar is consistent with the influences/ support of the other two pillars (cultural/cognitive pillar and normative pillar). If attention is primarily directed towards one pillar (for example, the regulative pillar) then the creation of a preferred (safer) institutional environment will not succeed, particularly if the monitoring/enforcement is only set to be in place for a minimum time (as is the case for the workplace safety governance initiatives in Bangladesh). The governance changes being made in Bangladesh cannot be expected to last in the longterm unless all three institutional pillars are properly addressed.
What the authors report is that following the massive loss of life in 2013 after the collapse of the Rana Plaza building in Dhaka, a building where many different clothing suppliers made clothes for Western buying companies, there was an introduction of particular building safety codes and initiatives which suppliers and buyers were expected to commit to. Of concern to the authors was whether, in the institutional environment of Bangladesh, the introduction of particular rules would be enough to increase workplace safety. The authors report: Increasing the costs of non-compliance creates an environment that could effectively force, or coerce, suppliers to comply with particular rules or policies. Short term change is to be expected if sanctions are strong and monitoring is effective. However, if the other (cultural/cognitive and normative) pillars do not reinforce the need or desire to comply, then quests to improve workplace safety will be problematic. Arguably, we might perceive that in such a scenario, regulation might create short term change, and this could solve legitimacy threats that have arisen. However, if efforts to enforce and monitor compliance fall – as they might once the legitimacy threat seems to be over for the industry – then cultural/cognitive and normative pillars, if left relatively unchanged, may act to return the institutional environment to what it previously was – dangerous and unsafe for factory workers. Indeed, evidence already suggests that whilst there seemed to have been a great deal of activity early on (which in a sense
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might have created some ‘legitimacy’ for the industry) monitoring has been slow, and remedial action has been patchy (Baumann-Pauly et al. 2018).
The authors questioned whether attention to the regulative pillar alone is sufficient to ensure a level of safety (perceived as appropriate and necessary by constituents operating outside Bangladesh – NGOs, buyers, global consumers) within the garment industry. They note: Therefore, the point we are stressing is that the ‘success’ of regulation is not context free. Some regulations will create the desired effects because they are consistent with local norms and values (Kostova and Roth 2002). Indeed, when developed within a particular institutional context, laws often reflect the values and expectations of people within that environment, albeit with some time lag. However, this might not be the case when particular rules are developed outside of that particular institutional environment. That is, if regulations are developed based upon Western ideals and values and then simply ‘implanted’ elsewhere, then there must be some question as to whether they are likely to work in the long term.
Tilt (2016, 2018) also provides an opinion that expecting social reporting guidance, regulations or approaches that have been created within a developed country context (with particular regulative, cultural/cognitive and normative influences) to work, or be embraced, within both a developed country context and a developing country context is rather naive. As institutional contexts change, the acceptance of, and motivations for, particular social and environmental disclosure approaches also likely change. Tilt (2016, 2018) specifically notes the need to recognise how contextual factors, such as the level of economic development, extent of civil liberties, national focus on economic growth versus sustainability, level and type of government control, religion, government ideology, media freedom and prevailing language, might impact upon the propensity to which managers elect to report various forms of social and environmental performance information. In concluding this overview of Institutional Theory, we note that there will be various forces that cause organisations to take on particular forms or adopt particular reporting practices. While theories such as Legitimacy Theory and Stakeholder Theory explain why managers might embrace specific strategies (such as making particular disclosures to offset the legitimacythreatening impacts of particular events), Institutional Theory tends to take a broader macro view to explain why organisations take on particular forms or particular reporting practices. Institutional Theory also provides an argument that, while organisations might put in place particular processes, such processes might be more for ‘show’ than for influencing corporate conduct. In the discussion of Legitimacy Theory, we saw how managers might undertake particular activities, such as disclosure activities, to alter perceptions of legitimacy. By contrast, researchers who adopt Institutional Theory typically embrace a view that managers are expected to conform with norms that are largely imposed upon them (though there are a number of Institutional Theorists who also emphasise how, across time, actions of particular organisations feed back into and influence perceptions about legitimate institutions). Nevertheless, it needs to be appreciated that there is much overlap between Institutional Theory, Legitimacy Theory and Stakeholder Theory.
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STUDY TOOLS CHAPTER SUMMARY This chapter provides a number of perspectives about why management elects to make particular disclosures. Specifically, it reviews Legitimacy Theory, Stakeholder Theory and Institutional Theory – three theories that can be classified as systems-oriented theories. Systems-oriented theories see the organisation as being part of a broader social system. Legitimacy Theory, Stakeholder Theory and Institutional Theory are all generally considered to be linked to Political Economy Theory, wherein the political economy constitutes the social, political and economic framework within which human life takes place and social, political and economic issues are considered as inseparable. Political Economy Theory can be classified as either classical or bourgeois. Bourgeois Political Economy Theory ignores various tensions within society and accepts the world as essentially pluralistic with no particular class dominating another. Legitimacy Theory and Stakeholder Theory generally adopt the bourgeois perspective. Institutional Theory can adopt either the bourgeois or classical perspective. Legitimacy Theorists often rely upon the notion of a social contract, which is an implied contract representing the norms and expectations of the community in which an organisation operates. An organisation is deemed to be legitimate to the extent that it complies with the terms of the social contract. Legitimacy and the right to operate are considered to go hand in hand. Accounting disclosures are considered to represent one way in which an organisation can legitimise its ongoing operations. Where legitimacy is threatened, disclosures are an important strategy to restore legitimacy. In practice, policies to maintain or restore corporate legitimacy are sometimes articulated in terms of reputation risk management. Most research that uses Legitimacy Theory restricts its analysis to ‘organisational legitimacy’ rather than broader ‘institutional legitimacy’. Two different categories of Stakeholder Theory have been reviewed – the ethical (or normative) branch and the managerial branch. The ethical branch discusses issues associated with rights to information, rights that should be met regardless of the power of the stakeholders involved. Within the ethical branch, disclosures are considered to be responsibility-driven. The managerial branch, on the other hand, predicts that organisations will tend to satisfy the information demands of those stakeholders who are important to the organisation’s ongoing survival. Whether particular stakeholders receive information will be dependent on how powerful they are perceived to be, with power often considered in terms of the scarcity of the resources controlled by the respective stakeholders. The disclosure of information is considered to represent an important strategy in managing stakeholders. Institutional Theory provides a complementary, and partially overlapping, perspective to both Legitimacy Theory and Stakeholder Theory. It explains that managers will be subject to pressures to change, or adopt, certain voluntary corporate reporting practices. These pressures can be coercive, mimetic or normative, and the resulting institutional image can sometimes be more apparent than real. As already noted, what should be obvious now is that there is a high degree of overlap between the three theories and hence the earlier warning provided within this chapter, that the theories should not be considered as discrete or stand-alone, can now hopefully be appreciated. For example, and as we have emphasised, the idea of coercive isomorphism from Institutional Theory has much in common with the insights provided by the managerial branch of Stakeholder Theory. We have also learned in this chapter that the idea of ‘legitimacy’ is central to both Legitimacy Theory and Institutional Theory. Most Legitimacy Theorists restrict their analysis to investigating how individual organisations legitimise themselves within a particular society – commonly known as ‘organisational legitimacy’ – and these researchers typically assume, often implicitly, that the business environment, government, social systems and so forth are static. However, a limited number of Legitimacy Theorists (for example, Archel et al. [2009], as discussed earlier in this chapter) consider how legitimation
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strategies might be undertaken with the aim that certain organisational structures and processes (institutions) gain the acceptance of society – this often being referred to as ‘institutional legitimacy’. Once we consider this ‘macro form’ of legitimation, then legitimacy and institutionalisation are very difficult to differentiate. So, with Chapters 8 and 9 in mind, we can see that we have a variety of different insights into why management might voluntarily elect to make particular disclosures or to embrace particular organisational forms. However, it should also be appreciated that there are a number of other theories ‘out there’ that we have not discussed and which also provide insights into what motivates managers to undertake particular activities, inclusive of reporting. Researchers therefore have much choice when selecting amongst competing theories.
ANSWER TO OPENING QUESTION At the beginning of the chapter, we asked the following question. As a result of reading this chapter, you should be able to provide an informed answer to this question – ours is shown below. In May 2020, and as part of an exploration project targeting iron ore, the large global mining company Rio Tinto destroyed two important and very sacred rock shelters at Juukan Gorge in the Pilbara Region of Western Australia. These sites revealed evidence of continual human habitation dating back at least 46 000 years and were of great cultural significance to local Indigenous communities and to communities generally. Following news of the destruction – and there was much news media coverage of the destruction – there was great public outrage. Would you expect the company to react to such negative news media publicity, and if so, what would be the likely nature and objective of any reaction? Embracing a ‘systems-oriented’ view, wherein organisations are part of a broader social, economic and political system, we can expect that the organisation would be negatively impacted as a result of creating such extreme damage. Doing what it did would not comply with ‘the social contract’ (or ‘community licence’) negotiated with society. If we apply the insights provided by Legitimacy Theory – one of the theories examined in this chapter – we would expect the organisation to react with various strategies (legitimation strategies) to address the apparent loss of legitimacy. Central to these actions would be public disclosures (legitimising disclosures) by the company, which could be made in its annual report, sustainability report or by way of other disclosure media. These disclosures would be expected to acknowledge remorse for the actions and explain how the company has changed its governance procedures in an attempt to ensure that such an event never occurs again. Central to the changes would be an expectation that the organisation improves its various stakeholder engagement mechanisms, with particular emphasis on improving engagement with the traditional owners of the lands on which it operates. Consistent with Stakeholder Theory, the organisation clearly ignored expectations of key stakeholders, who subsequently were able to impose various costs and sanctions on the organisation. The organisation has since refined its policies with respect to stakeholder engagement. Reflecting on the insights from Institutional Theory, what the organisation did appeared to disregard the cultural expectations of the communities in which it was operating.
QUESTIONS 9.1 9.2 9.3 9.4 9.5
Explain the notion of a social contract, and what relevance the social contract has with respect to the legitimacy of an organisation. LO9.5 What is organisational legitimacy and why might it be considered to be a ‘resource’? LO9.2 Explain why organisational legitimacy is place – and time – specific. LO9.6 What does the notion of legitimacy and social contract have to do with corporate disclosure policies? LO9.5 How would corporate management determine the terms of the social contract (if this is indeed possible) and what would be the implications for a company if it breached the terms of the contract? LO9.6 489
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9.6
9.7
9.8 9.9 9.10 9.11 9.12 9.13
9.14 9.15
If an organisation’s management considered that the organisation might not have operated in accordance with community expectations (it broke the terms of the social contract), then consistent with Legitimacy Theory, what actions would you expect management to undertake in the subsequent period? LO9.4 If an organisation was involved in a major accident or incident, would you expect it to use vehicles such as an annual report or a sustainability report to try to explain the incident? If so, explain how and why it would use reports in this way. LO9.1 Do the resource flows into an organisation provide an indication of the legitimacy of the organisation? Explain your answer. LO9.2 What is a ‘legitimacy gap’ and why could such a gap suddenly occur? LO9.6 What is the difference between legitimising strategies that are ‘symbolic’ and those that are ‘substantive’? Is one type more effective than the other? LO9.1 Identify the various phases an organisation might be in with regard to its legitimation strategies. LO9.6 Why might an organisation abandon efforts to regain lost legitimacy? LO9.6 Consistent with the material provided in this chapter, would you expect management to make disclosures in relation to real-world events or, alternatively, in relation to how it believed the community perceived the real-world events? Why? LO9.1 What insights from Political Economy Theory are particularly relevant to accounting? LO9.3 Explain the following statement from Guthrie and Parker (1990, p. 166): The political economy perspective perceives accounting reports as social, political, and economic documents. They serve as a tool for constructing, sustaining, and legitimising economic and political arrangements, institutions, and ideological themes which contribute to the corporation’s private interests. Disclosures have the capacity to transmit social, political, and economic meanings for a pluralistic set of report recipients. LO9.3
9.16 Do you think we can measure legitimacy directly? If not, are there other indicators that we could use to provide an indication of changes in corporate legitimacy? LO9.4 9.17 Briefly outline the central arguments of Media Agenda Setting Theory as presented in this chapter and explain why this theory would be of relevance to accounting researchers. LO9.2 9.18 Legitimacy Theory, Stakeholder Theory and Institutional Theory are considered to be systemsoriented theories. What does this mean? LO9.8 9.19 Is Stakeholder Theory a single well-defined theory or a broad ‘umbrella term’ for a whole lot of different theories? Explain your answer. LO9.8 9.20 a How do you think that information could be used to manage an organisation’s relationships with its powerful stakeholders? b Do you think that this is an ‘appropriate’ rationale for producing information? LO9.7 9.21 Evaluate the following statement: For an organisation seeking to be perceived as legitimate, it is not the actual conduct of the organisation that is important; it is what society collectively knows or perceives about the organisation’s conduct that shapes legitimacy. LO9.5
9.22 Assume that you were undertaking a research project that was investigating how a particular adverse environmental event negatively impacted the legitimacy of an organisation. How would you determine that legitimacy was eroded? LO9.6 9.23 This chapter divided Stakeholder Theory into the ethical branch and the managerial branch. Explain the differences between the two branches in terms of the alternative perspectives about when information will, or should, be produced by an organisation. LO9.8 9.24 Evaluate the following claim (Gray, Adams and Owen, 2014, p. 85): The more important (salient) the stakeholder to the organisation, the more effort will be exerted in managing the relationship. Information – including financial accounting and social accounting information – is a major element that can be employed by the organisation to manage (or manipulate) the stakeholder in order to gain their support and approval, or to distract their opposition and disapproval. LO9.7
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9.25 What does ‘accountability mean’? If a company accepted that it had an accountability, or responsibility, to provide information to a broad group of stakeholders about the various social and environmental consequences of its operations, then what theory within this chapter would seem to fit such actions? LO9.8 9.26 Under the managerial perspective of Stakeholder Theory, when would we expect an organisation to meet the information demands of a particular stakeholder group? LO9.7 LO9.9 LO9.10 9.27 Can researchers empirically test the prescriptions provided by both the ethical and managerial branches of Stakeholder Theory? LO9.8 9.28 Identify and explain some of the possible limitations or gaps within the Legitimacy Theory literature. LO9.13 9.29 What is the difference, if any, between ‘organisational legitimacy’ and ‘institutional legitimacy’? LO9.2 9.30 In this chapter we presented a view that Legitimacy Theory provides a relatively parsimonious explanation of what motivates managers to report social and environmental performance information. What do we mean when we say this? LO9.13 9.31 In a newspaper article entitled ‘Crown Casino faces massive fine over China scandal’ (Rooney, 2022), it was reported that: Crown Casino is facing a $100 million fine from the state’s new watchdog as it takes the site to task over the illegal movement of funds from China. The Victorian Gambling and Casino Control Commission on Tuesday revealed it had begun the process of punishing Crown for a scheme dubbed the ‘China Union Pay Process’. The saga was detailed during the latest Royal Commission into the casino. It involved high rollers being billed false hotel room charges to Chinese credit cards, which were then paid out as cash or chips in the casino. The scheme was allegedly dreamt up to get around restrictions on money being transferred out of China between 2012 and 2016.
Why would Crown Casino be concerned about such publicity, and how might the casino react from a corporate disclosure perspective? LO9.4 LO9.9 9.32 Would you expect management to worry about the various attitudinal surveys that are often conducted with community members wherein community members identify or rank the various issues that are creating ongoing concern for them? Explain your answer, as well as explaining how such surveys might impact on the disclosure policies of an organisation. LO9.6 9.33 Assume that you have been appointed by Nike or Apple to formulate a strategy to respond to the following comments that were reported in the Sydney Morning Herald in an article entitled ‘Nike, Apple among dozens of major brands implicated in report on forced labour’ (Bagshaw, 2020). Applying Legitimacy Theory, explain the strategies you might adopt to react to this publicity. LO9.6 Nike, Apple and a major manufacturer building trains in Australia are among the dozens of global brands implicated in a new report on forced labour in China, amid growing international concern over the treatment of the Uighur people. The report, by the US State Department-funded Australian Strategic Policy Institute, alleges some factories that supply the brands appear to be using Uighur workers sent directly from re-education camps. The Chinese government maintains the camps, which it describes as vocational education facilities, are needed to combat terrorism in the Xinjiang region and to ‘ensure its smooth economic transition’. It has dismissed claims that up to a million members of the Uighur [M]uslim minority have been detained in the camps as ‘fake news’.
9.34 If a high-profile radio announcer makes several negative comments about a company on her prime-time broadcast, would you expect the company to be concerned about the comments, and if so, how might you expect its manager to react? LO9.6 9.35 What does isomorphism and decoupling mean with respect to their application within Institutional Theory? LO9.11 LO9.12 9.36 Why might an organisation decouple its actual internal process from those processes that it portrays to the ‘outside world’ (and which have become institutionalised)? LO9.12
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9.37 Explain the concepts coercive isomorphism, mimetic isomorphism and normative isomorphism. How can these concepts be used to explain voluntary corporate reporting practices? LO9.11 9.38 Pursuant to Institutional Theory, do particular processes and practices become institutionalised because they are considered to be the most efficient processes and practices? LO9.12 9.39 The large accounting firm KPMG performs regular surveys of sustainability reporting practices. In 1993 it reported that 13 per cent of the top 100 companies in 10 countries published a separate report about their environmental and social impacts. In 2020 it reported that 80 per cent of the top 100 companies across 52 countries publicly report about sustainability. You are to use institutional theory to explain these large-scale shifts in the propensity of organisations to report information pertaining to sustainability. LO9.2 9.40 To what extent do Stakeholder, Legitimacy and Institutional Theories provide competing, mutually exclusive, explanations of voluntary corporate reporting practices? LO9.2 9.41 As we saw in this chapter, the Volkswagen Sustainability Report 2021, makes the following statement under the heading, ‘Our Stakeholders’: Our stakeholders are individuals, groups or organizations who have a material influence on, or are materially influenced by, the way in which the Group reaches its corporate decisions and the implications of those decisions. Our customers and employees are at the center of our stakeholder network. Around this core, eight further groups have been identified – NGOs/non-profit organizations, residents and local authorities, news media, academics and experts, competitors, business partners and suppliers, investors and analysts, policymakers and associations.
Is the above definition of ‘stakeholders’ consistent with the managerial or ethical branch of Stakeholder Theory? LO9.8 9.42 As noted in this chapter, in the 2021 Annual Report of the large global mining company, Rio Tinto, the organisation refers to a number of objectives it wants to achieve. It then makes the statement (p. 13) that: None of our objectives described above would be possible without trust, meaningful relationships and mutually beneficial partnerships. This is our social licence to operate. It is judged by others and is essential for our long-term future.
What does the organisation mean by ‘social licence to operate’?
LO9.5
9.43 Explain from an Institutional Theory perspective whether accounting students who attend a university that embeds sustainability throughout its core accounting subjects/units will be more likely to ultimately embrace ‘accounting for sustainability’ when they are in the workplace relative to students who attend a university that pays little attention to sustainability within its accounting units. LO9.11 9.44 The organisation known as People for the Ethical Treatment of Animals (PETA, see https://www. peta.org) is the largest animal rights organisation in the world. It runs various high-profile campaigns aimed at eradicating the many cruel practices that animals are exposed to as part of their use (abuse) by various organisations throughout the world. It runs various investigations, one of which reports (PETA, 2022): A disturbing, first-of-its-kind PETA Asia investigation reveals exactly how pythons are being killed for LVMH’s snakeskin bags and shoes. Investigators visited two Indonesian slaughterhouses that supply LVMH – which owns Louis Vuitton, Dior, Celine, and other fashion brands – and documented workers bashing snakes in the head with hammers, suspending them in the air, pumping them full of water, and cutting off their skin, likely while they were still conscious.
Applying some of the theoretical insights provided within this chapter: a Would you expect the governance practices associated with animal welfare to be the same across all countries? b Would you expect the Indonesian factories to change their practices as a result of such investigations? c Would you expect organisations such as Louis Vuitton, Dior and Celine to respond to this information and, if so, what forms would you expect such reactions to take? d Do you think that the investigations run by organisations such as PETA are likely to be scrutinised on an ongoing basis by large international organisations that use animal-related products? LO9.6 492
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EXTENDING CORPORATE ACCOUNTABILITY: THE PRACTICE OF SOCIAL AND ENVIRONMENTAL REPORTING LEARNING OBJECTIVES On completing this chapter, readers should: LO10.1
have some knowledge of the history of social and environmental reporting
LO10.2 be aware of the meanings attributed to social, environmental, sustainability and triple bottom line reporting LO10.3 be aware of various, and sometimes competing, perspectives about the responsibilities of organisations LO10.4 be able to provide an explanation of the relationship between organisational responsibility and organisational accountability 1 LO10.5 be aware of the relationship between accounting and accountability LO10.6 be able to apply an accountability model to sustainability reporting (with the model addressing: why report? to whom to report? what to report? and how to report?) LO10.7 be aware of various theoretical perspectives that can be used to explain why organisations voluntarily elect to provide publicly available information about their social and environmental performance LO10.8 be aware of some research that explores stakeholders’ demand for, and reaction to, social and environmental information LO10.9
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be able to explain the concept of sustainable development and be able to explain how organisations report their progress towards the goal of sustainable development
LO10.10 have some knowledge about the global problem of climate change and be aware of some issues associated with accounting for climate change LO10.11 be able to identify some of the limitations of traditional financial accounting with respect to enabling users of reports to assess a reporting entity’s social and environmental performance LO10.12 be aware of the organisation known as the Global Reporting Initiative (GRI) as well as have knowledge of the GRI’s Sustainability Reporting Standards LO10.13 understand the meaning of ‘integrated reporting’ and be aware of the reporting guidance developed by the International Integrated Reporting Council (IIRC), and other standard-setting bodies LO10.14 1 understand some of the problems associated with accounting for the externalities being generated by an organisation LO10.15 understand the meaning of, and the reason for undertaking, social audits LO10.16 understand the meaning of ‘modern slavery’ and associated accountability issues LO10.17 understand the role of ‘counter accounts’ and ‘dialogic accounts’ in enhancing organisational accountability LO10.18 understand the role of ‘personal social responsibility’ in addressing ongoing social and environmental issues confronting society and the planet.
Extending corporate accountability: the practice of social and environmental reporting CHAPTER 10
OPENING QUESTIONS Before reading this chapter, please consider how you would answer the following five questions. We will return to these questions at the end of the chapter, where we suggest some answers. Many companies throughout the world publish reports that discuss their sustainabilityrelated performance. A report by KPMG entitled Big shifts, small steps (KPMG, 2022) notes that in 2022, 79 per cent of the top 100 companies by market capitalisation from 58 countries, and 96 per cent of the top 250 global companies, report on sustainability. This contrasts with KPMG’s first survey in 1993 when only 12 per cent of the top companies reported on sustainability. 1 Producing sustainability-related information requires organisations explicitly to consider various facets of their economic, social and environmental performance. But why would companies embrace sustainability as a corporate goal rather than simply aiming for increased and continued economic growth and profitability? 2 Why might there have been such an increase in reporting between 1993 and 2020? 3 If an entity embraces ‘sustainability reporting’, then what does this imply about the perceived accountability of business? 4 Many professional accounting bodies throughout the world have sponsored research that investigates various social and environmental reporting and accountability issues. But should sustainability reporting issues be within the domain of professional accounting bodies? 5 What sort of sustainability-related information should organisations disclose (a normative question), and to whom should they make the disclosures (that is, who are the relevant stakeholders)? Do you think your views about organisations’ accountabilities would be the same as those of your fellow readers?
Introduction Organisations create a variety of social and environmental impacts. Different stakeholders have different expectations about how accountable managers should be for the various social and environmental impacts that the managers’ decisions ultimately create – and managers’ decisions will create many social and environmental impacts (both directly and indirectly). Across time, there has been an increase in society’s expectations concerning organisational social and environmental performance, particularly in respect to issues such as organisational contributions to climate change, animal welfare, use of water, waste generation and the treatment of workers throughout supply chains, inclusive of issues to do with the potential existence of ‘modern slavery’. As a result of these heightened expectations, the incidence of organisations producing publicly available ‘accounts’ addressing various aspects of their social and environmental performance has also increased significantly over past decades. This has in turn led to an increase in the number of social and environmental/sustainability reporting and measurement frameworks that have been developed by different organisations throughout the world. The previous chapters of this book predominantly focus on issues related to the role of externally published financial accounting information in providing information about the economic/financial performance of an entity. As would be appreciated from a study of financial accounting, in most countries financial accounting is heavily regulated according to applicable corporation laws, securities exchange requirements and financial reporting standards. By contrast, however, there is a relative absence of regulatory requirements relating to the public disclosure of information about the social and environmental, and sustainability-related, performance of an entity – the topic of attention in this chapter. For example, the many accounting standards
Sustainable Something is sustainable if it is able to be maintained at a specific level for a period of time. From a social and environmental perspective, practices are sustainable if they do not compromise the ability of current and future generations of people, and the other inhabitants of the planet, to meet their respective needs.
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Climate change Major changes in temperature, rainfall, snow or wind patterns lasting for decades or longer.
Corporate social responsibility (CSR) The continuing commitment by business to behave ethically and to contribute to economic development while protecting the environment and improving the quality of life of the workforce and their families as well as that of the society.
issued by the International Accounting Standards Board (IASB) and Financial Accounting Standards Board (FASB) focus on various issues associated with financial performance, but they typically do not have social or environmental performance as their core focus. That said, in late 2021 the Trustees of the IFRS Foundation (who provide governance and oversight of the IASB) announced the creation of the International Sustainability Standards Board (ISSB). The ISSB released two exposure drafts in early 2022 (pertaining to General Requirements for Disclosure of Sustainability-related Financial Information and Climate-related Disclosures). These standards will focus on providing sustainability-related financial disclosures for capital markets, including disclosures that address the financial implications associated with climate change. Further, the requirements incorporated within the corporations legislation around the world and the listing requirements of various securities exchanges throughout the world tend to fixate on financial performance, with much less consideration being given to performance of a non-financial nature, such as social and environmental performance, unless it creates risks for an organisation’s financial performance and position. This is despite the growing concerns about issues such as climate change and modern slavery and the very real contributions that large corporations make to such problems (and the capacity they have to help devise solutions). Chapters 2 and 9 examined issues related to accountability for the broader (non-financial) aspects of an organisation’s activities by exploring an ‘accountability model’, as well as theories that explain voluntary (unregulated) reporting practices. This chapter develops our theoretical understanding of these issues by examining aspects of the rapidly growing body of research that investigates the social and environmental reporting practices being adopted by an increasingly large number of organisations. These social and environmental reporting practices are often referred to as ‘CSR reporting’ or ‘sustainability reporting’, with the latter covering aspects of (the more traditional) financial/economic performance or sustainability, in addition to social and environmental sustainability. Social and environmental reporting typically involves the provision, to a range of stakeholders, of information about the performance of an entity with regard to its interaction with its physical and social environment, inclusive of information about an entity’s support of employees, local and overseas communities, safety record and use of natural resources. Corporate social responsibility (CSR) itself has been defined in a variety of ways. In large part, this is because there are different perspectives about what the social (and environmental) responsibilities (and accountabilities) of business are. There are various definitions of CSR. For example, according to the Australian Human Rights Commission (2022): The concept of Corporate Social Responsibility (CSR) is generally understood to mean that corporations have a degree of responsibility not only for the economic consequences of their activities, but also for the social and environmental implications. This is sometimes referred to as a ‘triple bottom line’ approach that considers the economic, social and environmental aspects of corporate activity. Various terms are used to describe CSR initiatives, including ‘Corporate Responsibility,’ ‘Corporate Accountability’, ‘Corporate Citizenship’ and ‘Sustainability’. The meaning and value of CSR may differ in various contexts, depending on local factors including culture, environmental conditions, and the legal framework.
The above quote is consistent with the following definition provided by the Commission of European Communities (CEC, 2001, p. 6), in which it stated that CSR is: a concept whereby companies integrate social and environmental concerns in their business operations and in their interaction with their stakeholders on a voluntary basis. Being socially responsible means not only fulfilling legal expectations, but also
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going beyond compliance and investing more into human capital, the environment and the relations with stakeholders.
The above definitions highlight that perspectives of corporate social responsibilities typically extend the responsibilities of organisations beyond their shareholders/owners, and incorporate activities over and above those relating to the usual provision of goods and services. However, whether corporations, which are owned by shareholders, can realistically be expected to balance the needs of other ‘stakeholders’ – many without any financial power or influence – with the fundamental quest of maximising the wealth of shareholders is a question that will evoke a different reaction from different people. While many believe that corporations and ‘markets’ have a responsibility to make choices that benefit society and the environment, there are others who believe that the fundamental quest of corporations is to maximise profits and shareholder value. Some also believe it is unrealistic, and even dangerous, to leave social responsibilities in the hands of organisations that are guided by ‘enlightened self-interest’. As we will see, there are many interesting opinions and debates in the broad area of CSR. However, the underpinning philosophy is that corporations have social and environmental impacts that are beyond their economic impacts, and these can enhance or diminish the collective good, or wider societal progress. These new accountabilities are being demanded by civil societal groups, with business leaders often responding to, rather than leading, the debate. Because the area of CSR reporting is relatively new (relative to financial reporting, which has a history of several hundred years) and continually evolving (and also relatively unregulated), it is a very exciting area for accountants and accounting researchers to be involved in. We now see new ‘breeds’ of accountants – environmental accountants, social accountants, sustainability accountants, climate change accountants – who work alongside ‘traditional’ financial and management accountants. While there is a general lack of regulation requiring corporations to provide a public account of their social and environmental impacts and performance, many large companies voluntarily provide reasonably comprehensive accounts of their performance in these areas.
The meanings of social, environmental and sustainability reporting LO10.1
CSR reporting is often considered to represent both social and environmental reporting. We discuss these in turn below.
Social reporting Social reporting provides information about an organisation’s impacts upon particular people and societies. Social reports might provide information about an organisation’s: • training of employees • diversity and equal opportunity policies as they relate to employees • health and safety aspects of products • support of community projects • treatment of employees within the supply chain • actions taken to respect indigenous cultures and values • customer privacy policies • compliance with occupational health and safety requirements • compliance with various social codes of conduct. Information about all the items in the above list can be considered to be generated by an ‘accounting system’, despite the potential absence of measurements being made in financial terms.
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Environmental reporting Environmental reporting provides information about an organisation’s impacts upon living and non-living natural systems, including land, air, water and ecosystems. Environmental reporting addresses issues associated with: • materials used • effluent and waste generated • energy consumed • emissions (including carbon dioxide) generated • water consumed • impacts of transportation • environmental assessments of suppliers • wastewater generated and impacts of this wastewater • impacts (positive and negative) on biodiversity • compliance with environmental regulations.
Sustainability reporting Sustainability reporting, which is another term used in relation to CSR reporting, is obviously linked to the idea of sustainable development. The sustainability reporting practices of organisations should ideally provide insights into how they are performing in relation to the goal of ‘sustainable development’, which is generally accepted as: ‘Development that meets the needs of the present world without compromising the ability of future generations to meet their own needs’ (World Commission on Environment and Development, 1987). There is much variation in the nature of sustainability reporting, and again it needs to be appreciated that (arguably wrongly) the term ‘sustainability reporting’ is often used interchangeably with other terms, such as ‘CSR reporting’. According to the GRI: A sustainability report is a report published by a company or organization about the economic, environmental and social impacts caused by its everyday activities. A sustainability report also presents the organization’s values and governance model and demonstrates the link between its strategy and its commitment to a sustainable global economy. Sustainability reporting can help organizations to measure, understand and communicate their economic, environmental, social and governance performance, and then set goals, and manage change more effectively. A sustainability report is the key platform for communicating sustainability performance and impacts – whether positive or negative. Sustainability reporting can be considered as synonymous with other terms for nonfinancial reporting; triple bottom line reporting, corporate social responsibility (CSR) reporting, and more. It is also an intrinsic element of integrated reporting; a more recent development that combines the analysis of financial and non-financial performance. Source: Global Reporting Initiative (2018b).
To be a ‘true’ sustainability report, it could reasonably be expected that a report must actually address the concept of sustainable development, and how the organisation’s activities and initiatives are helping the planet move towards a sustainable existence and sustainable future. However, in practice, organisations typically fall short of this expectation. They often provide a selection of economic, social and environmental indicators or measures that do not necessarily link or sit well together, nor do managers typically put their performance in a context that clearly shows how they have helped society move towards the goal of sustainable development.
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Also, addressing sustainability at the individual organisational level is problematic. Sustainable development is really a big concept that involves the consideration of larger environmental and societal requirements, something that is beyond the confines of any single organisation. The quest for sustainable development requires the coordinated actions of all organisations, governments and communities. We defined CSR above. An interesting and useful definition of CSR reporting is provided by Gray and Laughlin (2012, p. 240), who state (using the more general term ‘social accounting’): Social accounting is concerned with exploring how the social and environmental activities undertaken (or not, as the case may be) by different elements of a society can be and are expressed. In essence, how they are made speakable, even knowable. So, the process of social accounting then offers a means whereby the non-financial might be created, captured, articulated, and spoken. The analysis of such accounts and their absence provides a basis through which social accountability can clarify how the relationships which are largely dominated by the economic might be renegotiated to accommodate or even to prioritise the social and the environmental within these relationships.
Gray, Adams and Owen (2014, p. 4) further note that the resulting social and environmental ‘accounts’ that emanate from this form of accounting: may serve a number of purposes but discharge of the organisation’s accountability to its stakeholders must be the clearly dominant reason and the basis upon which the social account is judged.
On the ‘function’ of accounting, Gray (2013, p. 467) notes: A world in which the larger organisations disclosed such things as eco-balances and ecological footprints; in which the interactions in all relationships between organisations and stakeholders were exposed, warts and all; when society could know the full extent of an organisation’s compliance with law and quasi law; would be unlikely to look a great deal like the world we now inhabit. This, I suggest, should be the function of social, environmental and sustainability accounting or, as I prefer to call it, ‘accounting’. LO10.1
The incidence of CSR reporting
If we were to look at evidence of past practices of social and environmental reporting, we would find that prior to the 1990s there was very little social and environmental reporting activity going on (some organisations were doing it, but they were in the minority). This perhaps reflected a lower awareness in society of, and concern for, the impacts of organisations on the environment, or a perception that organisations did not really have extensive social and environmental responsibilities or the need to be accountable for such responsibilities. In the early 1990s, however, reporting practices started to change, and in many countries, organisations – particularly, larger ones operating in environmentally sensitive industries – started producing various types of information about aspects of their environmental performance. Interestingly, this increase in reporting seemed to occur at the same time as the community membership numbers of many environmental groups around the world also greatly increased (Deegan and Gordon [1996], provide evidence of this association), which was reflective of society globally becoming more concerned about the deteriorating state of the environment (see Reflection question 10.1).
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REFLECTION QUESTION 10.1 The link between community concern for the environment and corporate reporting In an early research project that explored the incidence of social and environmental reporting, Deegan and Gordon (1996) noted how an increase in the number of organisations producing social and environmental information seemed to coincide with increases in the total membership numbers of environmental groups. Question Could this relationship just be a coincidence? Solution There is much evidence (see Chapter 9) that the reporting practices of organisations are responsive to stakeholders’ and community expectations. Therefore, a change in stakeholder expectations could be expected to have an effect on organisational reporting practices. Growing membership numbers of environmental groups can be seen as reflective of growing community concern about the environment. This environmental concern is likely to be associated with a growing
Reflection
interest in how different organisations’ activities are impacting the environment and how accountable they are being for this impact. Therefore, if what is being reported by organisations is typically related to stakeholders’ expectations of organisations’ responsibilities, then increasing community concern for the environment would be expected to be matched (perhaps with some short time lag) with the information being produced about corporate environmental performance. This would suggest that the connection between an increase in social and environmental reporting and increased membership of environmental groups is more than just a coincidence. An issue here, however, is that if such a relationship exists, what if no-one cared about the environment? Would this mean that companies would not monitor, control and report various aspects of their environmental performance? Perhaps.
Following the increase in environmental reporting in the early 1990s, there was an expansion in the mid to late 1990s in the amount of social disclosures, with many organisations starting to produce separate social reports as well. In subsequent years, the practice evolved and organisations started to produce reports that combined various aspects of their social and environmental performance. Ultimately, we have now moved to a situation where many organisations produce reports that include a range of economic, social and environmental information, and these are often now referred to as ‘sustainability reports’. Indeed, the practice is now quite mainstream in nature (although there is also an emerging trend towards providing financial, social and environmental information in single ‘integrated reports’). One organisation that performs a regular survey of CSR reporting is the large global accounting firm KPMG. The results of their latest available survey were released in 2022 (KPMG, 2022). KPMG used two broad samples for its research. It surveyed the reporting practices of a global sample of 5800 companies, which was made up of the top 100 companies from 58 different countries (referred to as the N100 companies). It also surveyed the reporting practices of the world’s largest companies by revenue based on the Fortune 500 ranking of companies (referred to as the G250 companies). KPMG (2022) reports that 96 per cent of G250 companies and 79 per cent of N100 companies publicly report about sustainability. The leading reporting countries are Japan, Singapore, South Korea, Thailand, Ireland, Malaysia, United States, Sweden, Spain, France, South Africa, United Kingdom, Taiwan, Canada and Germany, with reporting rates for the N100 companies in these countries ranging from 94 to 100 per cent. For the minority of large companies that do not report sustainability-related information, KPMG (2020, p. 7) warns: The small minority of companies not yet reporting will find themselves seriously out of step with global norms. This misalignment with accepted global practice in itself poses risks to non-reporting companies, but the leaders of these companies should also be aware that sustainability reporting cannot easily be solved overnight with a quick fix. Reporting methodologies and approaches are complex and dynamic, requiring deep professional knowledge and expertise and must be backed up with robust sustainability strategies and risk management processes. So, the advice to any company that has yet
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to start the sustainability reporting journey is to take it seriously and begin now. The laggards will soon be left behind.
Other findings within the KPMG 2022 survey reveal the following:
• Some industries have higher rates of reporting than others. For example, at the
higher end of reporting, 85 per cent of N100 companies in the technology, media and telecommunications sectors embrace sustainability reporting, as do 84 per cent of N100 companies in the mining sector. • The assurance of sustainability-related information by independent third parties has increased in recent years. Sixty-three per cent of G250 companies now have their sustainability information assured by independent third parties, while 47 per cent of N100 companies have their sustainability-related information assured. A favourable opinion from an independent assurer or auditor helps to increase the credibility of the information being reported. • In terms of the most commonly used reporting framework, it is the Standards of the Global Reporting Initiative (GRI) that are most commonly used. Seventy-eight per cent of the G250 companies and 68 per cent of the N100 companies use the GRI standards as the basis of their reporting. • Many of the companies – 74 per cent of G250 companies and 71 per cent of N100 companies – link their CSR activities to the UN Sustainable Development Goals, which we discuss later in this chapter. In this regard, KPMG (2022, p. 57) states:
Global Reporting Initiative (GRI) A multi-stakeholder, network-based organisation headquartered in Amsterdam. It has developed the world’s most widely used standards for sustainability reporting – the GRI Standards.
The 17 SDGs were introduced by the United Nations as a blueprint to achieve a better and more sustainable future for all by addressing global challenges including poverty, inequality, climate change, environmental degradation, peace and justice. Companies find the SDGs helpful to align their sustainability initiatives with their contribution to solving the world’s biggest problems.
• In relation to targets pertaining to climate change (an important issue that we discuss in more
depth later in this chapter), the majority of G250 companies (80 per cent) disclose targets to cut their carbon emissions; 71 per cent of N100 companies also disclose these targets. As KPMG noted in its previous 2020 review of sustainability reporting (KPMG, 2020, p. 41): Any leading company that does not yet report carbon targets is now clearly out of step with global good practice.
• Apart from producing information about carbon and other greenhouse gas emissions,
information about the business risks of climate change is also described as useful. In this regard, the number of companies that acknowledge the risk of climate change has increased significantly since an earlier 2017 survey by KPMG. Forty-six per cent of N100 companies (up from 28 per cent in 2017) and 64 per cent of G250 companies (up from 48 per cent in 2017) acknowledge this risk in their reports. In discussing this increase, KPMG (2022, p. 45) notes: These figures reflect a growing trend among countries and companies to make TCFDaligned climate reporting mandatory. In 2021, the G7 nations agreed to mandate TCFD-aligned climate-related financial reporting. New Zealand was the first country to mandate disclosure among its largest companies in the financial sector (from 2023). The Task Force stated in 2021 that more than 2,600 organizations across 89 countries, territories and jurisdictions use the recommendations.
• KPMG (2022) reports that 34 per cent of N100 company and 61 per cent of G250 company reports are in line with the recommendation of the TCFD. These recommendations were launched in 2017, with the purpose of improving corporate reporting on climate-related risks and to enable financial stakeholders (investors, lenders and insurers) to factor climate-related risks into their decisions. We consider the recommendations of the TCFD in more depth later in this chapter.
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• KPMG (2022) also referred to the need for improved reporting relating to ‘biodiversity risk’.
All of us, including businesses, are reliant upon biodiversity. Biodiversity is a term that often creates confusion. ‘Bio’ means life, while ‘diversity’ means variability. Properly functioning ecosystems rely upon a great diversity of plant and animal life. No organism or animal exists in isolation and a healthy ecosystem requires a multitude of species. There is a great deal of interconnectedness and interrelationship between different species, much of which is not understood. However, it is accepted that the long-term survival of the planet relies upon maintaining biodiversity. There has even been some speculation that the degradation of biodiversity enabled COVID-19 to jump from nature to humans, although there is not definitive proof (see, for example, Morand and Lajaunie, 2021). At a narrower level, biodiversity is also a fundamental requirement for business survival. As KPMG (2022, p. 51) states: … the recognition of this risk has become more urgent and pronounced with biodiversity and nature risks impacting businesses and their supply chains. Acknowledgement of this risk is the first step for companies to address the critical issue of increasing biodiversity and nature loss ... reporting requires rapid development, as strengthening biodiversity and nature has an impact on mitigating climate change.
KPMG (2022) reports that only about a quarter of N100 and G250 companies deemed to be at high or medium risk from biodiversity loss report information about the risks that biodiversity losses pose to the business. KPMG points to this as an area of reporting that requires rapid improvement. It notes a number of sectors that are at high risk from biodiversity loss, including construction and building materials, leisure and hotels, food and drug retailers and mining. Readers with an interest in biodiversity risks and losses can refer to the following publications for further information: • WWF (2020), Living Planet Report 2020, https://livingplanet.panda.org/en-us • United Nations (2020), The Global Biodiversity Outlook, https://www.unep.org/resources/ report/global-biodiversity-outlook-5-gbo-5. Also, the Task Force on Nature-related Financial Disclosures (TNFD) was launched in 2021 and is expected to generate specific guidance in relation to biodiversity reporting. The KPMG report also highlights that, internationally, governments and securities exchanges are looking at increasing the regulation of CSR-related disclosures, and this will have obvious implications for increasing the amount of disclosures being made. Therefore, the evidence is clear. This focus of reporting is here to stay, and accountants and managers need to be very well aware of it! Although social and environmental reporting practices have become widespread since the early to mid-1990s, this does not tell the whole story of the development of these practices. Some studies have found and analysed voluntary non-financial disclosures for periods commencing long before the 1990s, and have demonstrated that forms of social and environmental reporting have existed for many decades. For example, Guthrie and Parker (1989) examined social disclosures made by the Australian company Broken Hill Proprietary (BHP) for a 100-year period from 1885; Unerman (2000a, 2000b) found evidence of social disclosures in a variety of reports produced annually by the Anglo-Dutch oil company Shell dating back to 1897, with these disclosures becoming more prevalent from the 1950s; Hogner (1982) found evidence of social reporting practices at US Steel dating back to 1905; Tinker and Neimark (1987, 1988) and Neimark (1992) analysed social-type disclosures in the annual reports of the US company General Motors from 1916; and Adams and Harte (1998) analysed forms of social reporting in UK banks and retailers from 1935. Therefore, while CSR reporting is much more widespread than it was 50 to 100 years ago, some forms of it nevertheless did exist back then. But has the quality of reporting improved? 506
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With the increase in the incidence of reporting, it could be speculated that reporting quality has improved across time, particularly with the advent of such global initiatives as those instigated by the GRI, the TCFD and the ISSB. However, the view among many prominent researchers in the area is that quality has not greatly improved, and that perhaps various initiatives have been ‘captured’ by business interests with the intent of stifling any real efforts that might broaden the accountability of business. Many reporters still appear to use social and environmental accounting as a means of legitimising their existence and potentially forestalling efforts, including legislative efforts, that might require them to be more accountable for the many social and environmental impacts they are generating. Key information that would challenge claims about the sustainability of organisations is overwhelmingly omitted. LO10.9
Developing notions of sustainability
Since the 1970s, there has been much discussion in various forums about the implications of continued economic development for the environment and, relatedly, for humankind. Sustainable development is not something that will be easily achieved, and many consider that, at least at this stage, it is nothing more than an aspirational ideal. A significant step in placing sustainability on the agenda of governments and businesses worldwide was a report initiated by the General Assembly of the United Nations. The report, entitled Our Common Future, was presented in 1987 by the World Commission of Environment and Development, chaired by Gro Harlem Brundtland, the then Norwegian prime minister. This important document subsequently became known as the Brundtland Report. The brief of the report was to produce a global agenda for change in order to combat or alleviate the ongoing pressures on the global environment – pressures that were clearly unsustainable. It was generally accepted that business organisations must change the way they do business and they must learn to question traditionally held business goals and principles. As already indicated, the Brundtland Report defined sustainable development as: ‘Development that meets the needs of the present world without compromising the ability of future generations to meet their own needs’ (World Commission on Environment and Development, 1987). The Brundtland Report clearly identified that equity issues, and particularly issues associated with intergenerational equity, are central to the sustainability agenda. That is, globally we must ensure that our generation’s consumption patterns do not negatively impact upon future generations’ quality of life. Specifically, we should be in a position to say that the planet that we leave our children is in as good shape as the planet we inherited (and preferably in better shape given the damage already done to the planet). The move towards sustainability implies that something other than short-term self-interest should drive corporate and personal decision making (this is a normative position). It implies that wealth creation for current generations should not be held as the all-consuming pursuit, and that consumption and personal wealth creation by us (now), while perhaps being considered as economically ‘rational’ (using the definition often applied in the economics literature), is not necessarily rational from a global and an intergenerational perspective.1 Also implicit in the definition of sustainability is a requirement that intra-generational equity issues be addressed – that is, the needs of all ‘of the present world’ inhabitants need to be met, which requires strategies to alleviate the poverty and starvation that currently beset the peoples of various countries. While from a moral perspective efforts should clearly be undertaken with a view to eradicating poverty and starvation (again, this is a normative assertion), from a broader 1
Brundtland Report A report published by the United Nations World Commission on Environment and Development (WCED) in 1987. Its targets were multilateralism and interdependence of nations in the search for a sustainable development path.
Hence, the quest towards sustainable development ultimately relies on people not being driven solely by their own self-interest, and not putting wealth creation above all else. If we believe the assumptions embraced by Positive Accounting Theorists, as described in Chapter 8, that all action is driven by self-interest, there would be little hope that people would ever consider the needs of future generations. Let’s hope the assumptions of PAT theorists are not always right – or else this planet is in very big trouble!
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perspective communities cannot be expected to focus on local or global environmental issues (necessary for sustainability) if they are in desperate need of money. If they are starving, can they really be expected to keep their forests intact when such forests provide a means of ‘free’ heating and income? Decisions by particular impoverished nations, such as to remove large tracts of rainforest, can have huge global implications. Any vision of sustainability clearly needs to address poverty on a global scale. More recently, initiatives such as the development of the United Nations Sustainable Development Goals and the work of the Intergovernmental Panel on Climate Change (IPCC – see https://www.ipcc.ch) have increased the level of attention being devoted to sustainable development. Adopting perspectives provided by several of the theories explored in Chapter 9, it can be further argued that if sustainability becomes part of the expectations held by society (that is, it becomes part of the ‘social contract’), it must become a business goal. As the concept of sustainable development continues to become part of various communities’ expectations, communities will expect to be provided with information about how organisations, governments and other entities have performed against the central requirements of sustainability. As already indicated within this chapter, for an organisation (or a community) to be sustainable, it must achieve an optimum balance between financial security (as evidenced through such measures as profitability), minimise (or ideally eliminate) its negative environmental impacts, and act in conformity with societal expectations. These three aspects of sustainability tend to converge over long time horizons. In the short term, it is possible to generate profits while negatively impacting on society and the environment. In the medium term, given that businesses operate within society, negative impacts on society caused by some business activities might lead to a breakdown in social functions that are necessary to continued business profitability. The argument here is that most businesses rely on the effective functioning of many social systems, such as physical infrastructure (transport systems, utilities and so on), well-ordered markets and a respect for property rights (law and order). If any of these systems break down, future profitability will be threatened. In the long term, the argument for equating economic, social and environmental sustainability is reasonably straightforward. This argument is that the economy (including business activities) and all social systems operate within the natural environment. If business (and other human) activities contribute to the destruction of the biosphere, there will be no humans left to run businesses, buy the products of businesses or operate social systems. In an extreme scenario, destruction of the environment leads to destruction of the human race, following which there would clearly be no profits and no social systems. Thus, in the long term, environmental sustainability is necessary for both social and economic sustainability, so attention to minimising negative impacts in respect of the environment is necessary to ensure a sustainable social and economic future. The implication of these arguments is similar to the implication of the intergenerational requirement of sustainability (discussed earlier) – it might be necessary to sacrifice some short-term economic profitability to ensure long-term sustainable economic profits within a sustainable social and ecological system. Dillard, Brown and Marshall (2005, p. 81) explain that, in practice, an obstacle to the integrated approach to sustainability is that ‘social systems have come to dominate and exploit natural systems’ – in particular, economics-based (profit-based) social systems are dominant. They argue that moves towards sustainability will therefore require an explicit reversal of this socially constructed dominance of the ‘economic’ over the ‘ecological’. We can only ponder whether such a reversal can occur.
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Steps within the sustainability reporting process LO10.4
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Having established that social and environmental reporting is not a new phenomenon, and having discussed the concept of sustainable development, we now turn our attention to various assessments or decisions that need to be made as part of the process of reporting aspects of an organisation’s social and environmental performance. In doing so, we will utilise the four-step accountability model we introduced in Chapter 2 (see Figure 2.5) to explore the steps managers go through when deciding to report sustainability-related information. The four steps require consideration of: 1 Why is the organisation collecting and reporting particular information? 2 To whom is the organisation reporting the information? 3 What information is it collecting and reporting? 4 How is it reporting the information – where is the information appearing and what reporting or measurement frameworks are being used? The first step – why would an entity decide to disclose information? – relates to management’s motivations to report. For example, managers need to consider whether they are reporting because they believe they have a responsibility and an associated accountability to various stakeholders, or whether, perhaps, they are reporting because they want to win the support of powerful stakeholders. That is, the broad objectives driving any particular organisation to undertake sustainability reporting can range from an ethically motivated desire to ensure that the organisation benefits society, or does not have a negative impact on society and the natural environment, through to an economically focused motive to use social and environmental reporting to protect or enhance shareholder value. Aspects of this range of motives were discussed in Chapter 9, when the ethical/moral (or normative) and the managerial branches of Stakeholder Theory were explored. Once it is determined why managers decide to report, this decision will in turn inform the decision as to whom the information will be directed (the second step above). Referring back to the discussion in Chapter 9 of the ethical/moral and the managerial branches of Stakeholder Theory, it should be clear that, if a corporation’s social and environmental reporting is motivated exclusively by managerial reasoning and strategising, then the stakeholders to whom that corporation’s social and environmental reporting is directed might be narrowly defined as those who hold and exercise the greatest economic power over the corporation. Conversely, social and environmental reporting motivated by ethical/moral reasoning (the ethical branch of Stakeholder Theory) will seek to address the information needs of a broader range of stakeholders. Specifically, a broader ‘ethical’ approach to reporting would direct the reports towards those stakeholders most affected by the operations of the organisation. Once managers have determined which stakeholders are the target recipients of the reports, they can then consider the information demands of these particular stakeholders. This will then influence what types of information will be disclosed (the third step above) and what issues the social and environmental reporting should address. Identifying what issues an entity is held responsible and accountable for involves dialogue between the organisation and its identified target stakeholders. Once an organisation has identified the objectives of the reporting process (why report), the stakeholders to be addressed by the reporting process (for whom is the report intended) and the information requirements of these stakeholders (for what issues the entity is held responsible and accountable by its stakeholders, or what issues the report should cover), the final stage in the social and environmental reporting process is the production of a report or ‘account’ (or more than one form of report or account) that addresses these issues (or stakeholders’ information needs). 509
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In the following sections, the examination of sustainability reporting will be structured in accordance with the why–to whom–for what–how stages of social and environmental reporting explained above (it is also more fully explained within Chapter 2). The discussion begins with a detailed exploration of the motivations for managers to engage in CSR/ sustainability reporting.
Objectives of the social and environmental reporting process – the ‘why report?’ stage LO10.6
Answers to questions about what motivates managers to report are directly tied to our beliefs about what drives individual behaviour. A necessary first step in the reporting process is for managers to consider ‘why’ they are reporting. The answer to this question will then help put the ‘to whom’, ‘for what’ and ‘how’ stages in context. That is, answers about ‘why the organisation is reporting’ then shape the balance of the entire reporting process. Moves by many organisations throughout the world to implement reporting mechanisms that provide information about their social and environmental performance imply that the managers of these organisations consider that they have an accountability, not only for their economic performance, but also for their social and environmental performance. While this is a view held by many individuals, it is not necessarily a view that is accepted universally. For example, if we were to adopt a fairly extreme view that corporations do not have social or moral responsibilities beyond simply generating profits for the benefits of owners (the shareholders), then we might not see the need to produce social and environmental accounts, except to the extent that such accounts would enhance corporate profitability. For example, consider the views of the famous economist Milton Friedman. As we discussed within Chapter 2, in his widely cited book Capitalism and Freedom, Friedman (1962) rejects the view that corporate managers have any moral obligations beyond maximising their profits. In relation to the view that organisations have social responsibilities, he notes (p. 133) that such a view: … shows a fundamental misconception of the character and nature of a free economy. In such an economy, there is one and only one social responsibility of business, to use its resources and engage in activities designed to increase its profits as long as it stays within the rules of the game, which is to say, engages in open and free competition, without deception or fraud.2
This is obviously a very narrow view of organisation responsibilities and one that hopefully is now rejected by managers. If managers and their accountants were to accept that an organisation has a responsibility and a related accountability for its social and environmental performance, then they would see it as a duty to provide an account of the organisation’s social and environmental performance. If they did not accept this, they would not be motivated to provide such an account. To answer the question of ‘why’ organisations might report, we must keep in mind that we can never be sure about what the real motivation might be, nor can we ever hope to provide a comprehensive list of motivations. Further, in practice, there will likely be multiple motivations
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According to Clarkson (1995, p. 103), ‘Friedman chose to interpret social issues and social responsibilities to mean non-business issues and non-business responsibilities. He, like so many neo-classical economists, separated business from society, which enabled him to maintain that “the business of business is business”. By placing the two abstractions of business and society into separate compartments, Friedman was able to deny the necessity, or even the validity, of the concept of CSR, decrying it as a fundamentally subversive doctrine’. This perspective would be inconsistent with the systems-oriented view of organisations and society as discussed in Chapter 9.
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driving managers’ reporting decisions. With this said, motivations for disclosing social and environmental information could include: • a belief on the part of managers that the entity has an accountability (or a duty) to provide particular information • to comply with legal requirements • to forestall efforts by government to introduce more onerous disclosure regulations • to influence the perceived legitimacy of the organisation • to align the organisation with its institutional environment • to manage particular (and possibly powerful) stakeholder groups • to increase the wealth of the shareholders and the managers of the organisation. In the material that follows, we consider each of the above motivations in turn.
An acceptance of accountability to provide information One obvious reason why managers will decide to report information about their social and environmental impacts and performance is that they believe they have a moral or ethical responsibility, and associated accountability, to do so irrespective of the business case for or against it. Chapter 2 explored an accountability model that links organisational responsibilities to organisational accountabilities and ultimately to organisational accounting/reporting practices. Under this normative model, which has much in common with the ethical branch of Stakeholder Theory discussed in Chapter 9, managers have many responsibilities (at a minimum, as required by law, but expanded by society’s expectations that have not also been codified within the law), and with every organisational responsibility comes a set of rights for stakeholders, including rights to information from the organisation to demonstrate its accountability in relation to the stakeholders’ expectations. Obviously, determining responsibilities is not a straightforward exercise – different people will have different perspectives of the responsibilities of business and hence the accountability of business. Therefore, in terms of why an organisation might externally report social and environmental performance information, it might be because various stakeholders external to the organisation are deemed, by managers, to have a right to information and managers feel a responsibility, and accountability, to provide it. Central to a lot of debate in the social and environmental accounting literature has been the issue of ‘accountability’ and, specifically, quests to extend the level of accountability being demonstrated by organisations so that stakeholders can at least make informed decisions about whether to support an organisation or not – the view often being that information provides ‘power’ to the holders of the information in enabling them to differentiate between organisations. This does assume, of course, that society is relatively pluralistic in nature, with some level of shared power to create change. While potentially being seen as a simple concept, the reality is that ‘accountability’ is a concept often (and strangely) ignored in accounting education and is arguably quite a radical concept if applied in a way that creates fundamental changes to business practices. As Owen (2014, p. 77) states: Accountability is a fundamentally radical (and perhaps even subversive) concept particularly in view of the absolute refusal of present-day politicians, bankers, corporate executives and their ilk to accept any degree of personal accountability whatsoever for the adverse consequences of their decisions.
Managers of organisations often appear to reject calls for increased accountability, including efforts to legislate broader-based accountability. Indeed, it could be argued that, in the presence of all the (distracting) good news being disclosed by organisations, corporate accountability is
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worse than it has ever been. In relation to efforts to restrict accountability, Gray, Adams and Owen (2014, p. 325) note: Powerful people the world over appear to know just how transformative a full accountability and transparency would be and work very hard to prevent it coming to fruition. It seems difficult to avoid this conclusion, however unsettling it might be.
Therefore, ‘full accountability’ is somewhat of an ideal.
To comply with legal requirements Organisational disclosure of information about various facets of social and environmental performance is, in most countries, predominantly a voluntary exercise. However, countries typically have legislative requirements that some social and/or environmental performancerelated information be disclosed directly to government, including in relation to such matters as: • occupational health and safety (for example, accidents and injuries) • workplace equality indicators, including information about workplace composition, flexible working arrangements (for example, within Australia, the Workplace Gender Equality Act 2012 requires various disclosures by larger organisations – see https://www.wgea.gov.au/about) • the risks that modern slavery is present within the organisation’s supply chains, which are addressed in various countries by way of national Modern Slavery Acts. For example, within Australia, the Modern Slavery Act 2018 applies to larger organisations, specifically those with annual consolidated revenue of $100 million or more. It requires organisations to report annually, by way of a ‘Modern Slavery Statement’, on the steps they are taking to address and monitor the risk that modern slavery is present within their supply chains. These statements must also include information about actions taken to address those risks. All modern slavery statements are to be submitted to a government-backed repository, meaning that the publicly available reports will all be accessible at one place. Some, but not all, organisations also make the modern slavery statements available on their own corporate website. We consider reporting about ‘modern slavery’ in more depth later in this chapter • carbon emissions – for example, within Australia, the National Greenhouse and Energy Reporting Act 2007 (NGER Act) requires heavily emitting organisations to make disclosures to the government, which are then publicly accessible (see http://www.cleanenergyregulator. gov.au/NGER). Many countries have such requirements • the release of dangerous chemicals. For example, the United States has the Toxics Release Inventory (TRI) Program, which was established in 1986 (see https://www.epa.gov/toxicsrelease-inventory-tri-program), and Australia has the National Pollutant Inventory (NPI), which was established in 1996 (see http://www.npi.gov.au). Both programs require that organisations that have emitted or released an amount above a certain threshold of any of certain stipulated substances are to report the emissions or releases annually to government. The information is made publicly available on government websites. The rationale behind the creation of publicly assessable databases such as the TRI or NPI, or those relating to modern slavery, is that communities have a ‘right to know’ about various aspects of an organisation’s social and environmental performance, and that when the government makes the information publicly available this will generate an incentive for organisational change through a combination of public pressure and heightened corporate awareness. That is, the purpose of having such government databases is effectively to ‘name and shame’ poorly performing organisations and to create pressures for them to change. But pressure for change is dependent upon people in the community actually knowing about the databases (and how many readers have heard about these databases?). The intended impacts of such government initiatives also rely on concerns managers have about their ‘reputational risk’, wherein reputational risk can be considered to relate to the potential of negative publicity, or negative public perceptions, to 512
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create adverse impacts on a company’s reputation, thereby affecting its revenue streams and therefore its profitability. The further assumption here is that managers, being concerned about their reputational risk, will take actions to improve the respective aspects of their social and environmental performance. While the information related to the above five points will often be published and made publicly available on government-backed websites, the choice by the managers of an organisation to disclose information about various aspects of their social and environmental performance – for example, within the organisation’s standalone sustainability reports, annual reports or on corporate websites – is often entirely voluntary. This can be contrasted to financial reporting, which, as we explained in earlier chapters, is very regulated, particularly for larger organisations. When it comes to the contents of the reports to be produced by larger organisations, corporation laws within many countries tend to fixate on providing information about financial performance. As we know, in most countries, larger organisations are required by corporations law to comply with financial reporting standards. However, there are minimal requirements within financial reporting standards that relate to social and environmental performance. For example, IAS 16 Property, Plant and Equipment does have some requirements pertaining to accounting for the financial costs of restoring sites on which property, plant and equipment is located. Also, IAS 37 Provisions, Contingent Liabilities and Contingent Assets has some requirements relating to accounting for future obligations relating to contaminated sites. Guidance released by the IASB, under Practice Statement 2: Making Materiality Judgements, has also stated that accountants and auditors need to consider how issues to do with climate change have, or have not, been factored into the determination of asset impairment and fair values, useful lives, potential provisions and contingent liabilities. Specifically, the IASB has indicated that an entity may need to explain whether and how it has considered climate-related risks in their impairment calculations and that financial statement auditors need to consider such risks. As noted earlier, the trustees of the IFRS Foundation established the ISSB in late 2021 and its aim is to provide information to capital markets about the financial implications that moves towards sustainable development will have for organisations. Corporate law requirements in some countries also include requirements that the annual report disclose information about compliance with environmental laws and that the annual report includes an ‘operating and financial review’ (OFR), which discloses information about the risks and opportunities that different social and environmental issues, such as climate change, pose for an organisation. But apart from these types of requirements, corporations law in many countries is relatively silent with respect to providing information about social and environmental performance from a non-financial perspective. Although the establishment of the ISSB in 2021 will ultimately increase corporate reporting globally with respect to the financial implications of sustainability-related issues, such an initiative does little to compel organisations to disclose impacts that cannot be quantified in monetary terms. Therefore, if we consider existing mandatory corporate reporting frameworks as constituted by accounting standards, and corporations law and securities exchange reporting requirements, it would appear that external reporting requirements have focused predominantly on providing financial performance information to parties with a financial stake in the corporation. Such a narrow approach to accountability by regulators, according to which attention is primarily focused on the needs and expectations of shareholders (rather than stakeholders generally), is commonly referred to as the ‘shareholder primacy’ view of corporate reporting. The shareholder primacy approach generally adopted within many countries is increasingly being challenged by various interest groups. Up until now, however, governments have tended to leave corporations, their industry bodies and ‘the market’ to determine the extent of corporate social and environmental disclosure. In a regulatory sense, the focus of corporate legislation has been about accountability to investors rather than to society more generally. 513
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When calls are made to legislate various aspects of social and environmental reporting, business organisations predominantly oppose such actions on the basis that legislation would inappropriately introduce a ‘one-size-fits-all’ approach to reporting, would ‘stifle innovation’, ‘create a compliance mentality’ and ‘increase compliance costs’, even though the logic of such claims is greatly flawed (Deegan and Shelly, 2014; Owen, Shaw and Cooper, 2005). Governments tend to believe that social and environmental reporting should overwhelming remain voluntary and determined by ‘market forces’ and by the ‘enlightened self-interest’ of the respective reporting entities (Deegan and Shelly, 2014). In relation to regulation, Gray, Adams and Owen (2014, p. 327) state: Little will attract aggression in this field more directly than calls for law. It is quite clear that governance needs to be legally and/or regulation driven and that such legal backing must be imaginative and substantial. The opposition to such a call for law especially in some countries and regions of the world verges on the fanatical.
We can also consider theories of regulation when trying to understand the lack of regulation in relation to social and environmental reporting. In Chapter 4, we discussed the economic interest theory of regulation (or, as it is sometimes called, the private interest theory of regulation). In that theory, all participants in the regulatory process are considered to be motivated by selfinterest. Organisations and other stakeholders are predicted to seek legislation that is beneficial to themselves. Also, regulators and legislators are assumed to seek re-election and will provide legislation to those stakeholder groups that can provide the necessary assistance to help them remain in office. Consistent with this perspective, research (for example, Cho, Chen and Roberts, 2008) caution us that it is naïve to believe that regulators and politicians will always act in the public interest. Given the general lack of regulation in many countries with respect to organisations being required to generate social and environmental and sustainability reports, it could be because the private interests of regulators are best served by leaving it to managers to voluntarily report. Having discussed some of the mandated reporting requirements that exist as they pertain to social and environmental performance, we are probably safe to conclude that the extent of reporting being initiated by organisations is generally not being driven by a motivation to comply with legal requirements. It should be noted that some countries have been a lot more proactive in mandating greater amounts of public social and environmental reporting (for example, France, Denmark, Norway and South Africa). In relation to the general lack of mandatory disclosure regulations globally, PwC (2021, p. 6) argues: The lack of universally adopted standards and regulatory guidance on ESG reporting means companies may omit information that some stakeholders think is important, and it’s often hard for these stakeholders to compare [Environmental, Social and Governance] performance from company to company.
To forestall efforts to introduce more onerous disclosure regulations Continuing our discussion of ‘why’ organisations might report, another possible motivation for voluntarily producing social and environmental performance information might be that the management of particular organisations, and officials within particular industry bodies, introduce social and environmental reporting policies in an endeavour to forestall the possibility of government imposing potentially more onerous reporting requirements upon them. This view of the motivation for social and environmental reporting is consistent with some of the responses provided by representatives of the minerals industry, as documented in Deegan and Blomquist (2006). In 1996, the Australian minerals industry introduced the Code 514
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of Environmental Management, which included a reporting requirement for members of the industry. A number of respondents from the minerals industry noted that, had the industry not taken the initiative of introducing a code, the government, in response to pressure from various non-government organisations (such as the Australian Conservation Foundation), might have imposed its own reporting requirements upon the industry. Deegan and Blomquist asked senior representatives of the Minerals Council of Australia about what they believed might have motivated the minerals industry to develop the original Code of Environmental Management. Responses included: I guess to be frank, it [the Code] was developed to try and stop somebody else developing it … The Australian Conservation Foundation had specifically developed its own code and that had quite a bit of support from a number of other NGOs [nongovernment organisations] and they were putting pressure on the Federal Government to do something, and there was some murmurings that the Federal Government might do something, so really I guess from that perspective it forced the Minerals Council’s hand.
Hence, perhaps a motivation for voluntarily reporting social and environmental and sustainability-related information might be that if information is not being reported, then government might mandate particular reporting requirements and these mandated requirements could potentially be quite onerous.
To influence the perceived legitimacy of the organisation Another motivation for reporting could be to gain, maintain or regain organisational ‘legitimacy’. In Chapter 9, we explored Legitimacy Theory in depth. Legitimacy Theory has been used to explain the decisions by managers to report social and environmental information. What various research studies have shown (see Chapter 9) is that when the legitimacy of an organisation is threatened, managers will take various actions to protect or restore that legitimacy. As we learned in Chapter 9, Legitimacy Theorists also often rely on Media Agenda Setting Theory to explain how the news media are able to influence community concerns, such that when the news media run several negative articles about an organisation, that organisation will often respond by making public disclosures aimed at winning back support or lost legitimacy. For more discussion of corporate disclosure in the wake of media attention, see Reflection question 10.2.
REFLECTION QUESTION 10.2 Corporate disclosure reactions to media attention Evidence shows that organisational social and environmental reporting is often a response to negative media attention. Such evidence supports the view that managers will publicly disclose information as a means of strategically managing different stakeholders, including winning stakeholder support. Question Should this evidence be of concern to us? Solution Some accounting researchers argue that the voluntary nature of social and environmental disclosures enables managers to react to particular crises as they arise and to project an image of corporate concern and responsibility, while at the same time
Reflection
enabling them to carry on operating in a ‘business as usual’ manner. To many accounting researchers, this is a matter of concern as they believe that real changes in the operating practices of organisations are necessary. This is because current business practices are creating long-term adverse social and environmental impacts. There is also evidence showing that the greater the perceived threat to an organisation’s legitimacy (or reputation), the greater the likelihood that managers will respond with public disclosures primarily aimed at restoring this legitimacy, which we might refer to as ‘legitimising disclosures’. Deegan, Rankin and Tobin (2002) note some concern in respect of such managerial responses:
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Legitimising disclosures are linked to corporate survival. In jurisdictions where there are limited regulatory requirements to provide social and environmental information, management appear to provide information when coerced into doing so. Conversely, where there is limited concern, there will be limited disclosures. The evidence suggests that higher levels of disclosure will only occur when community concerns are aroused, or alternatively, until such time that specific regulation is introduced to eliminate managements’ disclosure discretion. However, if corporate legitimising activities are successful,
then perhaps public pressure for government to introduce disclosure legislation will be low and managers will be able to retain control of their social and environmental reporting practices. The ideal situation would be that managers make social and environmental disclosures because it is the right thing to do and because stakeholders have a right to know about particular aspects of an organisation’s operations. Not all managers will be opportunistic with their disclosures, but whether they should be left with so much discretion in terms of what they disclose is debatable.
According to the central tenets of Legitimacy Theory, failure to undertake activities that are expected by society may result in the entity no longer being considered legitimate (it is perceived as breaching its social contract) and this, in turn, will impact upon the support it receives from the community, and hence its survival. Success is contingent upon complying with the ‘social contract’. Within Legitimacy Theory, organisational legitimacy is considered to be a valuable resource that can be influenced by the disclosure policies used by the organisation. Pursuant to Legitimacy Theory (which for many years has been the dominant theory in social and environmental accounting – see Deegan, 2019), accounting disclosure policies are considered to constitute a strategy for influencing an organisation’s relationships with the parties, or stakeholders, with which it interacts. The organisation is seen as part of a wider social system in which its continued operation and success are dependent on it complying with the expectations of the society in which it operates. Failure to comply with particular expectations might lead to sanctions being imposed by society on the organisation in the form of legal restrictions on its operations, limited provision of resources such as financial capital and labour, and reduced demand for its products.
To align the organisation with its institutional environment In Chapter 9, we also discussed Institutional Theory. As that chapter explains, organisations often embrace various organisational forms, and implement various policies and procedures, because they are deemed to be appropriate, or legitimate, for reasons that are linked to the respective regulative, normative and cultural-cognitive expectations and pressures that the organisations and their managers face. Within Chapter 9, we explained that conforming to the various institutional pressures (and the associated ‘institutional pillars’) provides different forms of legitimacy. Because different institutional environments create particular institutional pressures, and because organisations within given institutional environments often face similar pressures, there tends to be a level of homogeneity in the organisational forms and processes undertaken by organisations in similar institutional settings. This can explain, in part, why organisations within particular institutional settings seem to embrace similar reporting styles. Therefore, a reason why managers might decide to report particular information, or to report the information in a particular manner, might be to conform to institutional pressures. Social and environmental reporting thus becomes an element of organisational institutionalisation, despite the fact that there might be a disconnection (decoupling) between how the organisation projects itself in its public reports and the internal (unseen) operational structures and practices it
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adopts internally. Institutional Theory tells us that particular organisational practices, including reporting practices, that are appropriate in some countries will not necessarily be appropriate, or embraced, within others. Whether managers in particular countries will embrace particular disclosure requirements/recommendations, such as those recommended by organisations like the GRI or the ISSB, will be influenced by the pressure exerted upon them (the regulatory pillar), by the extent to which local educational and professional institutions support or encourage such disclosures (the normative pillar) and by whether the cultural environment is one that prioritises social and environmental accountability (the cultural-cognitive pillar).
To manage particular stakeholder groups Another reason why managers might voluntarily disclose information is that it might be a way of managing or controlling particular stakeholders. In Legitimacy Theory, as discussed above, the audience of interest is typically defined as ‘the community’. A related theoretical perspective is Stakeholder Theory, which was also discussed in depth in Chapter 9. In Stakeholder Theory also, the organisation is considered to be part of the wider social system, but this theory specifically considers the different stakeholder groups within society. Like Legitimacy Theory, Stakeholder Theory holds that the expectations of the various stakeholder groups will affect the operating and disclosure (reporting) policies of the organisation. Stakeholder Theory is considered to have two main branches, these being the managerial branch and the ethical branch. The organisation will not respond to all stakeholders equally – from a practical perspective, it cannot – but rather (in the managerial branch of Stakeholder Theory), it will respond to the groups that are deemed to be ‘powerful’. The power of stakeholders, such as owners, creditors or regulators, to influence corporate management is viewed as a function of stakeholders’ degree of control over resources required by the organisation (Ullmann, 1985). The more critical the stakeholder resources are to the continued viability and success of the organisation, the greater the expectation that stakeholder demands, including demands for information, will be addressed. Power will be stakeholder- or organisation-specific, but it might be tied to such things as the stakeholder’s: • command of limited resources (for example, finance, labour) • access to influential media • ability to legislate against the company • ability to influence the consumption of the organisation’s goods and services. Freeman (1984) discusses the dynamics of stakeholder influence on corporate decisions. A major role of corporate management is to balance stakeholder demands with achieving the strategic objectives of the firm. As the level of stakeholder power increases, so does the importance of meeting stakeholder demands. These demands may include the provision of information about the activities of the organisation. According to the basic tenets of Stakeholder Theory, an organisation needs to identify the stakeholders that it seeks to satisfy. This is clearly not an easy exercise. If stakeholders are selected on the basis of the managerial branch of Stakeholder Theory, the organisation will seek to satisfy the stakeholders that have the greatest relative power, which in itself requires much consideration. Alternatively, if we adopt the ethical branch of Stakeholder Theory (also discussed within Chapter 9),then the organisation may seek to provide information to the stakeholders with the greatest ‘right to know’ about the organisation’s operations, perhaps on the basis of which stakeholders are most affected by the impacts of the organisation’s operations. A choice needs to be made. An organisation might seek simply to provide information aimed at satisfying, at least partially, the needs of all interested parties through the vehicle of a general-purpose report. However, it is possible, and arguably probable, that such a report will fail to meet the specific information needs of particularly important groups.
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To increase the wealth of the shareholders and the managers of the organisation Chapter 8 focuses upon Positive Accounting Theory (PAT), which predicts that all people are driven by self-interest. As such, this theory predicts that particular social and environmental activities, and their related disclosure, would occur only if they had positive wealth implications for the managers involved. Therefore, if we accept the central assumptions of this theory, then managers will decide to disclose social and environmental performance information if they think this will positively influence their own wealth. A theory such as PAT is not one that provides a great deal of hope in terms of moves towards sustainable development – moves which, if we accept the Brundtland Report definition of sustainability discussed earlier in the chapter, would require current generations to consider forgoing consumption and wealth generation to ensure that future generations’ needs are met. Sacrificing current consumption and wealth creation for the benefit of future generations could be deemed to be mutually inconsistent with PAT’s central assumption of self-interest. A number of research studies have also indicated support for the view that managers adopt various social responsibility-related initiatives, and associated reporting, because it helps maximise the value of the organisation and therefore the wealth of shareholders (and also managers, who typically own shares in the organisation or receive bonuses linked to share value). A motivation to produce social and environmental information to maximise organisational (and share) value effectively places shareholders at the top of the ‘pecking order’ of all stakeholders. Again, we can question whether a fixation on maximising the wealth of one group of stakeholders (investors) will provide long-term solutions to real and evolving problems such as climate change – arguably not. Returning to the restricted view of corporate responsibility, which fixates on the interests of shareholders and maximising corporate profitability (the shareholder primacy perspective that many corporate executives seem to be embracing), there are some people who argue that this rather self-interested position will actually benefit everybody within society. They argue that if the actions of all individuals (and businesses) are motivated solely by a self-interested desire to maximise personal wealth, then this will benefit all in society because (through the resulting economic growth) the wealth generated by the successful individuals will ‘trickle down’ to the less successful. With this view, they argue, the conditions of all in society will be improved if all people in society actively pursue their own self-interest, with this being a morally desirable outcome. Indeed, this ‘trickle-down’ theory is commonly repeated as a key moral justification for the capitalist system. The main problem with this moral justification for a narrow and exclusive focus on maximising shareholder wealth (or shareholder value) is that there is little, if any, evidence to show that it occurs. As Gray (2005, pp. 6–7) states: It is disturbing … to discover that there is no direct evidence to support this precarious construction. The view relies, for its empirical support, on the generalised argument that, for example, we are all better off than we have ever been; that we are all getting better off all the time; and that this increase in well-being has coincided with the triumph of international capitalism. Such arguments are, at best, contestable. While for many in the West this statement has a superficial veracity, it ignores the growing gap between rich and poor.
A considerable amount of economic evidence shows that not only is there lack of support for the existence of a generalised ‘trickle-down’ effect, but the reverse may have occurred. Hence, many people question whether the social and environmental responsibilities and associated accountabilities of organisations should be left largely unregulated. Despite an apparent lack of
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empirical support for this ‘moral’ position underlying a narrow focus on shareholder value, we could be excused for thinking that many individuals working within the contemporary financial media hold the same view as Milton Friedman. The financial media continues to praise companies for increased profitability and to criticise companies that are subject to falling profitability. It often does this with little or no regard for any social costs or social benefits being generated by the operations of the particular entities – costs and benefits not directly incorporated within reported profit. There have also been various studies that have tried to find a causal relationship between social and environmental reporting and profitability, but the results are inconclusive. There is some evidence of a modest link between corporate social performance and financial performance, and there is also some evidence to support a link between corporate social reporting, social and environmental performance and financial performance (Brooks and Oikonomou, 2018). While the above discussion has identified some possible motivations for disclosure of social and environmental performance information, it should again be emphasised that managers might have several motivations, some of which might not have been considered in the above material. At a more general level, the GRI also identifies various reasons why an organisation should undertake this reporting (see Table 10.1), although it refers to them as the benefits of reporting. As should be expected, there will be some overlap between the discussion above and the contents of Table 10.1. Many of the benefits in Table 10.1 are economic in nature. TABLE 10.1 The benefits for organisations of reporting sustainability-related information, as identified by the GRI Internal benefits include:
External benefits include:
Increased understanding of risks and opportunities
Mitigating or reversing negative environmental, social and governance impacts
Emphasising the link between financial and non-financial performance
Improving reputation and brand loyalty
Influencing long-term management strategy and policy, and business plans
Enabling external stakeholders to understand the organisation’s true value and tangible and intangible assets
Streamlining processes, reducing costs and improving efficiency
Demonstrating how the organisation influences, and is influenced by, expectations about sustainable development
Benchmarking and assessing sustainability performance with respect to laws, norms, codes, performance standards and voluntary initiatives Avoiding being implicated in publicised environmental, social and governance failures Comparing performance internally, and between organisations and sectors Source: Global Reporting Initiative (2018a). Global Reporting Initiative (GRI) is the independent international organization – headquartered in Amsterdam with regional offices around the world – that helps businesses, governments and other organizations understand and communicate their sustainability impacts. For latest information please check GRI website.
Why do I need to know about the potential reasons or motivations that might be driving an organisation to disclose particular social and environmental information? Why
This is important because it allows us to understand the context of the disclosures. If, for example, we believe that the managers of an organisation are disclosing information simply to improve
the image and profitability of their organisation (perhaps in reaction to negative news media articles), then we might be less inclined to believe such disclosures.
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Before concluding our discussion on why an organisation might report social and environmental information, we can briefly consider one other factor (not a motivation) that has been found to impact the extent of disclosure – this being gender. It has been argued that females are more likely to embrace sustainability reporting than males. For example, it has been argued (for example, Glass, Cook and Ingersoll, 2016) that female members of boards of directors are likely to show greater inclination towards different stakeholders’ concerns and various social and environmental risks than their male counterparts and are more likely to favour longer-term performance indicators relative to shorter-term indicators such as profits. Haque and Jones (2020) provide evidence that, for example, boards of directors with greater female representation have a greater likelihood of providing information about an organisation’s impacts on biodiversity. They find (p. 15): These results indicate that boards with greater gender diversity show greater sensitivity towards the legitimate concerns of institutions and societal stakeholders such as the GRI framework and the EU biodiversity strategy. Gender diverse boards tend to be more proactive in disclosing biodiversity initiatives of a firm, supporting these initiatives by counselling, greater participation and lower conflict in the board decisionmaking process, and sharing information with stakeholders. This eventually mitigates the biodiversity-related risks of a firm and enhances corporate legitimacy. However, given the relatively low degree of overall biodiversity disclosures, critics might argue that board gender diversity tends to support corporate hypocrisy by influencing firms to engage in impression management.
Having now considered the issue of why managers might be reporting particular social and environmental information, and the implications our assessment of this question might have on the level of reliance we are prepared to place upon the information within these reports, the next issue we can consider is ‘To whom to report?’ social and environmental information. LO10.6
Identifying stakeholders – the who stage
As Figure 2.5 in Chapter 2 shows, once we have considered the factors that motivate managers to report – that is, once we have answered the ‘why report?’ question – then we are better informed to be able to determine ‘to whom’ the reporting entity will, or should, report social and environmental information. That is, we will be able to determine which ‘stakeholders’ will be provided with the information they seek. As was explained in Chapter 9, a commonly used definition of ‘stakeholders’ is one provided by Freeman and Reed (1983, p. 91). According to this definition, stakeholders are: Any identifiable group or individual who can affect the achievement of an organisation’s objectives, or is affected by the achievement of an organisation’s objectives.
Referring to the above definition, those stakeholders able to ‘affect the achievement of an organisation’s objectives’ would generally be considered to be powerful stakeholders, whereas those stakeholders who are ‘affected by the achievement of an organisation’s objectives’ may or may not have power to influence the operations and actions of an organisation and its managers. If stage 1 of our analysis (the ‘why report’ stage) indicates that reporting appears to be based upon the motivation of satisfying the expectations of powerful stakeholders (consistent with the managerial branch of Stakeholder Theory as discussed within Chapter 9), then an organisation engages (communicates with) such stakeholders to find out what information they want. However, who is deemed a ‘powerful stakeholder’ can change over time. For example, in an organisation that requires a large number of semi-skilled employees and sells its products in
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reasonably competitive markets, consumers may have considerable economic power in times of economic recession but may lose some of this power in times of economic boom (when consumer demand grows faster than supply). Conversely, the semi-skilled workforce may become more economically powerful during an economic boom if unemployment falls and a general shortage of semi-skilled workers arises. In this case, the economically powerful stakeholders whose views the company will seek to address, in accordance with the managerial branch of Stakeholder Theory, may shift from the organisation’s consumers to its employees. Conversely, if – consistent with the ethical branch of Stakeholder Theory as discussed within Chapter 9 – the decision to report information to stakeholders is based more upon ‘ethical reasoning’ and by a motivation to provide information to those stakeholders most impacted by the organisation’s activities, then some form of engagement or ‘audit’ (social audit) would be undertaken of various stakeholders to see how they are impacted by the organisation. In practice, the operations of all organisations are likely to have some form of impact on many people, animals and other elements of nature, and to try to take account of all of these potential effects, and to seek to communicate to all of those potentially affected, would be an impossible task. Some prioritisation is therefore necessary to identify which stakeholders seem to be most impacted and therefore, arguably, have the greatest right to know. These stakeholders would then be engaged to determine what information they need in order to make informed decisions about whether to support or oppose the organisation. Another point to be made in relation to who might be the target audience of disclosures (stakeholder identification) is that managers’ ranking or prioritisation of ‘important stakeholders’ can vary between different countries. For example, Adams (2002) shows that views regarding which stakeholders are the most ‘important’ varied between a sample of UK managers and German managers. We would expect that differences in the institutional environments in which organisations operate (with different legal, normative and cultural-cognitive ‘pillars’, as explained within Chapter 9) influences managers’ perceptions about ‘to whom’ they owe a responsibility and an associated accountability. For example, in some institutional environments there might be relatively little or no consideration given to the welfare of animals or the concerns of stakeholders that act on behalf of animals (and we can refer to these groups as ‘surrogate stakeholders’ for the direct stakeholders that are not able to exercise ‘voice’ on their own behalf – we referred to the idea of ‘surrogate accountability’ and ‘surrogate stakeholders’ in Chapter 2). Conversely, in those institutional environments or cultures that prioritise animal welfare, we would expect managers to engage with animal welfare groups, such as People for the Ethical Treatment of Animals (PETA), and to provide ‘accounts’ of what is being done to advance animal welfare. Similarly, in some institutional environments, there is relatively little consideration of the workplace safety for factory workers, which results in minimal workplace safety-related disclosures. As Akbar and Deegan (2021) show, cultural-cognitive differences between countries explain certain international differences in workplace safety-related disclosure practices. In practice, whichever approach to stakeholder prioritisation is taken by an organisation – whether prioritising stakeholders on the basis of those stakeholders most able to exert an influence on the organisation’s profits (or shareholder value), prioritising stakeholders on the basis of those whose lives are most affected by the organisation’s activities, or adoption of a position somewhere on the continuum between these extreme positions – once the organisation has identified the stakeholders whose social and environmental needs and expectations it will address, it then has to identify what the information needs and expectations of these identified stakeholders are. This takes us to the third stage of the why–to whom–what–how process of social and environmental reporting.
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Identifying stakeholder information needs and expectations – the ‘what do we report?’ stage LO10.6
As we have just learned, in determining what information to produce (which is the third stage in the accountability model – see Figure 2.5 in Chapter 2), we have to consider ‘to whom’ we are going to direct the disclosures (which is stage 2 in the accountability model). For example, if we are going to direct our reporting to satisfy the needs of particular stakeholders, then we might seek to specifically ask such stakeholders (perhaps through interviews or surveys) what information they want or need to know. At an aggregated or broad level, research studies show that there is a demand for corporate social and environmental performance information. This demand has been evidenced in a number of ways, including through surveys with particular stakeholder groups, or through the vehicle of capital markets studies. For example, in terms of surveys, Deegan and Rankin (1997) demonstrated that a broad cross-section of stakeholders want, or demand, information about the social and environmental performance of business organisations. Another approach to determining whether people demand or react to certain disclosures is to review share price reactions to particular disclosures – that is, to undertake capital markets research. The underlying theory used in such research is based upon the use of the efficientmarkets hypothesis, which proposes that the information content of news announcements, if relevant to the marketplace (investors), will be immediately and unbiasedly impounded within share prices (capital markets research is explained in Chapter 11). That is, if an item of information about an organisation can be associated with a change in the share price of that organisation, it is assumed that the information is of importance to investors and they have reacted to the disclosure of the information (with the reaction being reflected by the change in share price). For example, in a study that explored the capital market’s reactions to greenhouse gas disclosures, Griffin, Lont and Sun (2017) provided evidence which indicated that share prices react negatively to greenhouse gas emission disclosures, with greater levels of emissions being linked to greater levels of negative movements in share prices. The change in share price was deemed to mean that investors were reacting to the information. Numerous other studies (for example, Anderson and Frankle, 1980; Belkaoui, 1976; Brooks and Oikonomou, 2018; Griffin and Sun, 2012; Ingram 1978; Jaggi and Freedman, 1982) have also shown that investors react to the release of corporate social and environmental performance information. Hence, as a group, investors appear to find such information ‘useful’. However, identifying that stakeholders do use, and therefore that there is a demand for, social and environmental information, does not tell us precisely for what issues the stakeholders of a particular organisation will hold that organisation responsible and accountable. To identify these issues at the level of an individual organisation requires the organisation to enter into some form of dialogue, or engagement, with its stakeholders. But such engagement needs to be undertaken with caution, as stakeholders might not actually know what information is potentially available and hence might not know what information to ask for or what information could be potentially useful for the various decisions they might make. According to Gray, Owen and Maunders (1991, p. 15), and adopting a broader ethical perspective, even if particular stakeholders do not read particular ‘accounts’, the entity nevertheless has a responsibility to provide an account. Hence, just because a stakeholder group has not identified a need for particular information does not necessarily mean that it ought not to be provided. As seen earlier, managers motivated to engage in CSR (or sustainability) reporting for strategic managerial economic reasons (in accordance with the managerial branch of Stakeholder Theory) will tend to identify relevant stakeholders as being those who are able to exert the most influence over their organisation’s ability to generate profits (or maximise shareholder value). Such managers will seek to convince these economically powerful stakeholders that 522
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their organisation’s policies and actions accord with the social, environmental, economic and ethical views and expectations of these stakeholders, with social and environmental reporting being one of the mechanisms that might be used to convince (manage) these stakeholders. For social and environmental reporting to be effectively used to convince these stakeholders that the organisation has operated in accordance with their expectations, the organisation will need to know and understand these expectations, which will define what information is provided in the organisation’s social and environmental reports. Conversely, following the ethical branch of Stakeholder Theory, managers who seek to minimise their organisation’s negative impact on a wide range of stakeholders will need to know and understand how their organisation is likely to impact the lives of a range of stakeholders. The attitudes and experiences of these stakeholders regarding actual and potential organisational impacts are an important element of developing this knowledge and understanding. Furthermore, ethical reasoning indicates that people should be allowed to participate in making decisions on matters that are likely to affect their lives. Therefore, where managers are motivated by broader ethical considerations, they will actively encourage all those stakeholders who are (or might be) affected by the organisation’s activities to participate in decision making regarding these activities. To be able to participate in this manner, a wide range of stakeholders will need information about the effects the organisation has (or is likely to have) on them, and managers will need to provide this information. Managers need to understand their relevant stakeholders’ views, needs and expectations to determine ‘for what’ economic, social and environmental issues they will provide an account. Ascertaining these views, needs and expectations is likely to be more straightforward where social and environmentally related actions have been motivated by a strategic economic desire to maintain or increase the support of economically powerful (or influential) stakeholders, as many of these stakeholders will often be close to, and therefore relatively easily identifiable by, the organisation. However, for organisations whose social responsibility and social and environmental reporting are motivated by ethical reasoning in order to minimise the organisation’s impact on those most affected by its operations (and to allow these stakeholders to participate in decision making on issues that significantly affect their lives), ascertaining these stakeholders’ views, needs and expectations is likely to be more problematic. First, it is probable that there will be a broader range of stakeholders whose views need to be ascertained. Second, while many of the stakeholders who are significantly affected by an organisation’s activities (such as employees) might be close to the organisation, many others (such as those affected indirectly but substantially by environmental damage caused by the organisation’s operations, or workers employed by subcontractors in remote parts of the world) are likely to be remote from the organisation itself. Third, as demonstrated by O’Dwyer (2005), some of the stakeholders who are considerably affected by an organisation’s operations might feel constrained by concerns about the consequences of ‘upsetting’ the organisation if they express their ‘true’ feelings, in which case the organisation can be regarded as being in a position of power, which prevents open and honest dialogue with some stakeholders. Fourth, Adams (2004, p. 736) reports that there is often a ‘lack of stakeholder awareness of, and even concern for, corporate impacts’, and this can reduce the capacity of some stakeholders to engage in dialogue with the organisation. Finally, if we include future generations, non-humans and nature within our definition of stakeholders who are potentially significantly negatively affected by an organisation’s current operations, it is difficult to conceive of how an organisation could engage in dialogue effectively with these stakeholders to ascertain directly their views, needs and expectations regarding current organisational policies and practices. To overcome some (but not all) of these difficulties, organisations need to use a variety of channels of communication to engage in active (and not just reactive) dialogue with their stakeholders (Unerman, 2007). For example, many organisations use the interactive 523
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Social audit A process by which an organisation determines whether its operations are meeting the expectations of particular stakeholder groups or satisfying the social performance criteria set by the organisation. The results of a social audit often form the basis for the contents of a social report.
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communication facilities of the internet to solicit the views of stakeholders worldwide regarding the social, environmental, ethical and economic responsibilities that should be applied to their organisation (Rinaldi and Unerman, 2009). However, as Unerman and Bennett (2004) have contended, because the internet is not accessible to all those potentially affected by an organisation’s activities (particularly in many developing nations), internet-based communication with stakeholders needs to be supplemented with other channels of communication that, between them, are available (and likely to be accessed by) a large proportion of the stakeholders on whom an organisation’s operations might have an impact. Such communications can include, for example, face-to-face meetings with a variety of stakeholders, questionnaire surveys, opinion polls, focus groups and invitations to write to the company about specific issues. O’Dwyer (2005, p. 286) indicates that, whatever channels of communication are used to engage stakeholders in a dialogue, to be effective, these communication channels need to be adapted to the ‘cultural differences encountered’ between different groups of stakeholders. When we were previously discussing the second step of our accountability model (the ‘who’ stage), we referred to social audits. In addressing the ‘what to report’ stage, we can also use social audits. In discussing how we might engage with different stakeholders, we can refer to some of these forms of engagement as ‘social auditing’. As we have noted already in this chapter and in Chapter 9, if an organisation does not comply with community expectations (often referred to as breaching the ‘social contract’) or the expectations of particularly powerful stakeholders, this can have negative implications for the survival of the organisation. One way of seeing whether the organisation’s performance is conforming with the expectations of various stakeholder groups is to undertake what is referred to as a ‘social audit’. According to Elkington (1997, p. 88), the purpose of social auditing is for an organisation to assess its performance in relation to society’s requirements and expectations. This is often done by directly soliciting the views of various stakeholder groups. Obviously, different management teams will be interested in the views of different stakeholder groups. Managers that take a broader ethical perspective to identifying their stakeholders will typically seek the opinions and views of a broader cross-section of stakeholders. Social audits allow a company to examine its social impacts and to establish whether it is meeting its own social objectives. The results of a social audit often form the basis of an entity’s publicly released social accounts (thereby increasing the apparent transparency of the organisation), and the outcomes of social audits can be considered as an important part of the ongoing dialogue with various stakeholder groups. At an international level, organisations such as Nike have performed social audits for a number of years. Nike has implemented social audits where it employed independent third parties to visit various supply factories in developing countries and to seek the views of employees. The social audits formed the basis for the establishment of various operating policies and for Nike’s social reports. Prior to undertaking social audits (which commenced back in the early 2000s), Nike had been receiving much criticism internationally for its outsourcing practices, wherein production of Nike products was being undertaken in factories with poor workplace health and safety practices. The use of questionnaires is a common approach to determining stakeholders’ concerns and expectations as part of a social audit. Such reviews provide details of where improvements are necessary from the perspective of the stakeholders. In undertaking a review of an organisation’s actual social performance and, importantly, the stakeholders’ expectations about performance, there is a view that it is preferable to anticipate potential stakeholder backlash before a given activity is undertaken. Reflective of the growing interest in social auditing, social auditing standards have been developed by a number of organisations throughout the world. Once activities such as social audits are undertaken, they can act as a catalyst for organisations and, importantly, for senior management to embrace new values. A ‘sustainable organisation’ needs to ensure that it complies
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with community expectations. As such, activities such as social audits make good business sense. Evidence seems to suggest that some organisations are undertaking social audits as a means of gaining (or regaining) some legitimacy from the perspective of their stakeholders. Undertaking a social audit, particularly if the audit is conducted by a credible, independent party, should act to increase the perceived transparency of the organisation. Before concluding this section on ‘what information to produce’, it should be noted that the demand for social and environmental performance information by some specific stakeholder groups has been documented as increasing across time. An increasing source of demand for corporate social and environmental information is the growing socially responsible investment (SRI) market, and fund managers are also using their power to demand that corporations provide social and environmental performance information. As the financial benefits of good social and environmental governance (for example, through improved risk management) have begun to be recognised by mainstream (non-SRI) investment managers, these investment managers have also started to demand higher levels of information about the social and environmental sustainability risks, policies and practices of the companies in which they invest (or in which they are considering investing). Many organisations are also demanding that suppliers provide them with details of their social and environmental performance prior to entering supply arrangements. The next section moves on from a discussion of ‘what to report’ to consider some perspectives regarding how social and environmental reports can be constructed.
Theoretical perspectives on some social and environmental reporting procedures – the how stage LO10.7
Because there is a general lack of regulation in the area of social and environmental reporting, as well as an absence of an accepted (or mandated) conceptual framework for social and environmental reporting, there is much variation in how this reporting is being done in practice. Some reporting approaches represent quite radical changes from how financial accounting has traditionally been practised. This section starts by analysing whether the rules and procedures of financial accounting alone could provide suitable mechanisms for capturing and reporting the social and environmental impacts of organisations. We do this because many people trained in financial accounting believe that what they have learned can also be applied to report information about social and environmental performance and because some organisations that develop CSR reporting frameworks tend to rely upon financial reporting conventions and principles when developing the frameworks. If, as we show, financial accounting practices are unable to effectively capture and report information about social and environmental impacts, it is necessary to develop other (or additional) social and environmental reporting mechanisms. One very broad mechanism that has been proposed as a method for reporting the social and environmental (in addition to the economic) performance and impact of organisations is triple bottom line (TBL) reporting, and the key features and some drawbacks of TBL reporting are discussed in a following section of this chapter. The idea of TBL reporting came to prominence in the 1990s, particularly with the publication by Shell (in 1998) of The Shell Report: Profits or Principles – Does There Have to Be a Choice? While the term ‘TBL reporting’ is not used as extensively now as it was throughout the 1990s and early 2000s, it is still a term that is commonly used. In the discussion that follows, we also focus on one of the more influential (and more detailed) sustainability reporting guidelines, specifically the GRI’s Sustainability Reporting Standards, which can be regarded as a form of conceptual framework for social and environmental reporting.
Triple bottom line reporting A reporting technique that allows organisations to assess and report their performance against economic, environmental and social criteria.
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Limitations of traditional financial accounting in respect of its ability to reflect social and environmental performance Unfortunately, when it comes to evaluating organisational ‘performance’, particularly of business organisations, many stakeholders focus on reported ‘profits’. However, as we show below, ‘profits’ ignores many social and environmental aspects of organisational performance. Financial accounting, which this book focuses on, is often criticised on the basis that it ignores many of the externalities caused by reporting entities. Externalities, which we explore in more depth later in this chapter, can be defined as impacts that an entity has on parties (not necessarily restricted to human beings) that are external to the organisation, parties that typically have no direct relationship with the organisation. Some of these effects or impacts relate to the social and environmental implications of the reporting entity’s operations and include such things as the adverse health effects of pollution produced by the entity, injuries caused to consumers by the entity’s products or the adverse social effects of retrenchment of part of a workforce. Some of the perceived limitations of generally accepted accounting principles, which act to exclude recognition of these externalities, are considered below. Specifically, financial accounting: • tends to focus or fixate on the information needs of stakeholders with a financial interest in the organisation • applies the ‘entity assumption’ • excludes from ‘expenses’ the impacts on resources not controlled by the entity • applies the recognition criteria of ‘measurability’ and ‘probability’ • focuses on short-term results • applies the concept of ‘materiality’ • adopts the practice of discounting liabilities. We now consider some of the shortfalls of financial accounting in more depth.
Focusing on the information needs of stakeholders with a financial interest Financial accounting focuses on the information needs of parties involved in making resource allocation decisions. That is, the focus tends to be restricted to stakeholders with a financial interest in the entity, and the information that is provided tends consequently to be primarily of a financial or economic nature. In the IASB Conceptual Framework for Financial Reporting (IASB, 2022), the objective of general purpose financial reporting is identified at paragraph 1.2 as being: 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.
Such a definition has the effect of denying or restricting access to relevant information by those parties or individuals who are affected in any way that is not financial. However, as we can appreciate, organisations can voluntarily provide social and environmental information. Publications such as The Corporate Report (issued in 1975 by the Accounting Standards Steering Committee of the Institute of Chartered Accountants in England and Wales) have clearly indicated that information about corporate performance (including information of a non-financial nature) should be provided to a wider group than simply those with a financial interest. As paragraph 25 of The Corporate Report (Accounting Standards Steering Committee, 1975) states: The public’s right to information arises not from a direct financial or human relationship with the reporting entity but from the general role played in our society by economic 526
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entities. Such organisations, which exist with the general consent of the community, are afforded special legal and operational privileges, they compete for resources of manpower, materials and energy and they make use of community owned assets such as roads and harbours.
The entity assumption Financial accounting adopts the ‘entity assumption’, which requires an organisation to be treated as an entity distinct from its owners, other organisations and other stakeholders. The entity assumption or concept is typically taught to students of accounting at the introductory stages. According to this concept, an organisation is treated as an accounting unit that is quite distinct and separate from the owners and other organisations, and the accountant must define the organisation’s area of interest in such a way as to limit the events and transactions to be included in the financial statements. The organisation and the stakeholders of that organisation, including ‘the environment’, are treated as separate entities. According to the entity assumption, if a transaction or event does not directly affect the entity, the transaction or event is to be ignored for accounting purposes. This means that from a financial reporting perspective, the externalities caused by reporting entities will typically be ignored and that performance measures (such as profitability) are incomplete from a broader societal (as opposed to a ‘discrete entity’) perspective. We can relate the entity principle to the profits that might be reported, for example, by a tobacco manufacturer. It is generally accepted that cigarettes cause many health problems, yet externalities that relate to the products of a reporting entity are ignored for financial reporting purposes. That is, reported profits are not affected by such externalities. In a similar vein, we can consider the operations of casinos. They are often very ‘profitable’; however, such profit measures ignore the social costs gambling creates in the community, and how the actions of gambling providers, in supplying gambling opportunities, contribute to such social costs. Arguably, any moves towards accounting for sustainability would require a modification to, or a move away from, the entity assumption.
The way we define the elements of financial accounting acts to exclude many social and environmental costs For financial reporting purposes, ‘expenses’ are defined to exclude the recognition of any impacts on resources that are not ‘controlled’ by the organisation (such as the environment), unless fines or other cash flows result. Pursuant to the IASB Conceptual Framework, expenses are defined as follows: Expenses are decreases in assets, or increases in liabilities, that result in decreases in equity, other than those relating to distributions to holders of equity claims.
An understanding of expenses therefore requires an understanding of assets. An asset is defined in the IASB Conceptual Framework as: a present economic resource controlled by the entity as a result of past events. (emphasis added)
The recognition of assets therefore relies upon ‘control’. Environmental resources, such as air and water, are shared and not controlled by the organisation and hence cannot be considered to be ‘assets’. Therefore, their use and/or abuse are not considered expenses. For financial reporting purposes, the recognition of an expense arises at the same time as: 1 the initial recognition of a liability, or an increase in the carrying amount of a liability, or 2 the derecognition of an asset, or a decrease in the carrying amount of an asset.
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As discussed in Deegan (1996), and using a rather extreme example, imagine that an entity destroys the quality of water in its local environment, thereby killing all local sea creatures and coastal vegetation. Under conventional financial accounting, if the entity incurs no fines or other related cash flows as a result of its actions, then no externalities would be recognised. Reported profits, calculated by applying generally accepted accounting principles, would not be directly affected, nor would reported assets. The reason no expenses would be recognised is that resources such as the local waterways are not controlled by the reporting entity and therefore they would not be recognised as the entity’s assets. Thus, the use (or abuse) of resources would go unrecognised. If conventional financial reporting practices were followed, the performance of such an organisation could, depending on the financial transactions undertaken, be portrayed as very successful. In this regard, Gray and Bebbington (1992, p. 6) provide the following opinion of traditional financial accounting: there is something profoundly wrong about a system of measurement, a system that makes things visible and which guides corporate and national decisions, that can signal success in the midst of desecration and destruction.
Motivated by their concern about the limitations of traditional financial accounting, Gray and Bebbington sought to develop alternative methods of accounting – methods that embrace the sustainability agenda and which calculate a notional sustainable cost, which is subtracted from accounting profits to provide a measure of performance known as sustainable profits. We consider Gray and Bebbington’s prescriptions later in this chapter. The news media often seem to praise the efforts of corporate managers who reduce wages expense without having any regard for the hardship that such sackings or redundancies might create for the employees and their families. For example, an article in the Australian Financial Review (Eyers and de Kretser, 2022) reported that the large Australian bank, Westpac, initiated a 20 per cent reduction in head office positions to keep ‘costs under control’. It was noted that more than 1100 jobs were cut in the previous three months, with around the same number to go in the following three months. It was noted in the article that, as a result, profits rose by about $1.58 billion in the three months ended 31 December, apparently ‘beating expectations because of stronger revenue and faster cost-cutting’. At issue is whether we should really say that ‘cost-cutting’ has occurred when so many people will potentially become unemployed. This is an instance where expenses, as defined by financial accounting, will indeed fall, but unrecorded ‘social costs’ will climb. In a similar way, an article in The Age (Hatch, 2022, p. 28) noted that the international airline Qantas will be able to report a profit while flying emptier planes than its rivals because of an ‘aggressive pandemic cost-cutting drive’, which financial analysts were reported as saying would help shield Qantas from its competitors. The number of passengers Qantas would need in order to be profitable was reduced ‘thanks to its costcutting efforts, which included laying off almost one-third of its workforce’. Again, this ignores potential ‘social costs’. As another example of where the discussion of costs seems to totally ignore social costs, we can refer to a newspaper article in the Sydney Morning Herald (Grieve, 2021) in which it was reported that some bank staff would potentially be made redundant as a result of the Commonwealth Bank of Australia outsourcing some of its service roles to India. Within the article, the national secretary of the Finance Sector Union was quoted as saying ‘it is disappointing for our members that despite the CBA making $8.65 billion in profits, the bank’s management is still prepared to slash jobs and risk customer service standards in pursuit of more profits’. This quote again emphasises the point that the social costs associated with ‘slashing jobs’ are not recognised within reported profits. ‘Expenses’, as defined by the financial accountant, excludes or ignores such costs. As a last example (and there are many more examples we could have used), an article in The Age (Dankert, 2019, p. 1) reported
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that ‘National Australia Bank’s incoming boss Ross McEwan has signalled plans to ramp up a massive transformation program that includes thousands of job cuts, which the troubled bank hopes will return it to success’. As we can see here, the article equates the slashing of thousands of jobs with ‘cost-cutting’ and ‘success’. Again, the fixation on financial expenses and profits tends to motivate managerial actions that are not always in the interests of all members of society, and this reinforces the claim that we have made many times throughout this book that accounting is a practice that impacts upon many people throughout society, thereby making accounting a social practice. As you can see, positive improvement in financial accounting profits often seems to be given more priority than the impacts on workers and their families. Perhaps it would be better if the news media had an interest in broader aspects of organisational performance, other than just profits. This would be consistent with a more ‘caring’ society. While we consider climate change in more depth later in this chapter, it can be argued that the failure to place a cost on the externalities created by organisations is one of the contributing factors to current problems associated with climate change. Until recently, carbon emissions have not been incorporated in the production costs of organisations and hence there has not been great motivation for organisations to reduce carbon emissions. The advent of emissions trading schemes and carbon taxes in some countries will mean that carbon emissions will be priced, typically, on the basis of tonnes of emissions. Pricing the emissions will then effectively turn an unrecorded externality into an internally recognised expense. This will lead to incentives for organisations to reduce their emissions and therefore their emissionrelated costs.
REFLECTION QUESTION 10.3 Recognising the social costs of gambling Gambling is a source of enjoyment for some people, but it is a source of misery for others. Gambling is known to have destroyed the lives of many people, who are often referred to as problem gamblers, as well as badly impacting the family and friends of these problem gamblers. Question Why are the social costs of gambling not recognised as an ‘expense’ in the financial reports of casinos? Solution The social costs of gambling can be immense. However, these costs do not appear as an expense of a casino because there is no decrease in the value of any ‘asset’ controlled by the organisation and there is no increase in any ‘liabilities’ of the organisation. The failure to account for such costs is also consistent with the entity principle, which is a key convention of financial accounting. The entity principle effectively requires that an organisation be treated as an entity that is separate to its owners and the communities in which it operates. Where do these social costs appear? These social costs of gambling do not appear in the financial statements of casinos. However, indirectly, these costs impact
Reflection
the financial performance of other entities. For example, organisations that provide services to problem gamblers, and organisations that find housing for those people who become homeless, have their services used by problem gamblers and this creates expenses for them. Government support, in terms of various social services, is also affected by problem gambling. Therefore, while the ‘services’ provided by casinos, and which impact problem gamblers, cause social problems that are not recognised in the financial accounts of the casinos, the gambling services create expenses for many other organisations that have to care for the affected problem gamblers. That is, the services provided by casinos generate various externalities that are imposed on various stakeholders within the community. Is a profitable casino a ‘good’ organisation? This is a matter of opinion. Some people believe that if an organisation is operating in accordance with the law and generates profits, then it is a good organisation. However, for those people who are opposed to gambling or who see the devastation caused by problem gambling, then no casino, whether it is profitable or not, can be seen as a good organisation.
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The recognition criteria of ‘measurability’ and ‘probability’ The IASB Conceptual Framework also provides recognition criteria for the elements of financial reporting. For a transaction or event to be recognised within the financial statements, there are requirements within the Conceptual Framework that: • the definition of the respective element of accounting be satisfied (the five elements being assets, liabilities, income, expenses and equity) • the information about the respective element be considered both relevant (which requires consideration of factors such as ‘existence uncertainty’ and assessments about the probabilities of the related outflow or inflow of economic benefits) and ‘representationally faithful’ (which requires consideration of factors such as ‘measurement uncertainty’). In relation to considerations relating to the perceived probability of future outflows of economic benefits, the greater the uncertainty in terms of predicting the likelihood of future cash flows occurring, the less relevant would be the disclosure of information about an item of income or expense, or the related asset and liability. Hence, for all the five elements of financial accounting, both probability and measurability are key considerations. Evidence suggests that many liabilities, particularly those related to the environment, are ignored, often on the basis that they are too difficult to reliably measure and therefore do not satisfy the recognition criteria. As discussed in Chapter 7, in examining how Australian companies disclose information about contaminated sites, Ji and Deegan (2011) undertook an investigation of a number of large Australian companies that were known to have some significantly contaminated land sites under their control. Overwhelmingly, the companies failed to disclose information about liabilities associated with remediating (cleaning up) the contaminated sites, often stating that they were unable to ‘reliably measure’ the associated liabilities, and using this as a justification (or an excuse) for non-disclosure. If the liabilities are not recognised on the basis of a supposed inability to measure the liabilities with reasonable accuracy, then the associated expenses will also not be recognised, thereby arguably leading to an overstatement of profits. The analysis in Ji and Deegan (2011) showed that the sample companies, known to have contaminated sites, used arguments about the difficulty of providing a reliable measurement of the liability, and also issues about the likelihood of ultimate payment (probability), to justify not recognising obligations for cleaning up contaminated sites. The failure to recognise provisions in relation to contaminated sites occurred despite the fact that ‘provisions’ are to be created in situations where there is some uncertainty about the ultimate payment. Indeed, the defining characteristic of a ‘provision’, as opposed to other ‘liabilities’, is that the timing of the ultimate payment, and perhaps the amount of the ultimate payment, are uncertain. In describing ‘provisions’, paragraph 11 of IAS 37 (IFRS Foundation, 2022) states: Provisions can be distinguished from other liabilities such as trade payables and accruals because there is uncertainty about the timing or amount of the future expenditure required in settlement.
Such a description arguably coincides with the obligations many entities would have in relation to contaminated sites. The accounting standard makes it explicit that some uncertainty about timing and amount is acceptable when recognising a provision. Paragraph 25 of IAS 37 notes that: The use of estimates is an essential part of the preparation of financial statements and does not undermine their reliability. This is especially true in the case of provisions, which by their nature are more uncertain than most other statements of financial position items. Except in extremely rare cases, an entity will be able to determine a range of possible outcomes and can therefore make an estimate of the obligation that is sufficiently reliable to use in recognising a provision. 530
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Therefore, if a present obligation exists in relation to a contaminated site, only with exceptions ‘in extremely rare cases’ should the obligation not be recognised as a provision and, hence, not recognised in the statement of financial position. Thus, and based on the above reporting requirements, Ji and Deegan (2011) expected to find that the companies identified from publicly available information as having significant obligations associated with remediating contaminated sites would recognise and disclose associated provisions for remediation – again, a failure to do so should occur only in ‘extremely rare cases’. Nevertheless, the companies in question used the issue of ‘measurability’ in a number of situations as a rationale for non-disclosure. Indeed, some organisations used this as the basis for not recognising a provision in relation to numerous sites known to be contaminated. In reflecting on their results, Ji and Deegan (2011, p. 150) state: The results indicate that there is clearly a lack of accountability in relation to the impacts of organisations in terms of creating contaminated sites. Whilst many authors suggest various reporting approaches be embraced to advance corporate accountability beyond the minimum required by regulation, our results show that the sample companies do not even provide a minimum level of accountability that would reasonably be expected through compliance with existing corporate reporting requirements. With little information being available it is very possible that various stakeholder groups will continue to support organisations that they might not otherwise support if they were by contrast to know how corporate activities were impacting upon the physical environment, or if they knew that the organisations were not recognising the associated financial obligations necessary to remediate the various sites. The general lack of disclosure, and therefore lack of available public information, in effect might act to sustain a ‘business as usual’ approach with organisations potentially not being challenged as they might otherwise be about their environmental performance. It is of interest that the organisations in our sample produce publicly available sustainability reports in which they all publicly embrace sustainable development (in the sustainability reports there is little or no discussion of contaminated sites). Any movement by societies towards sustainable development requires people to make informed choices about the activities and organisations they should support. In part, such choices will be based on the ecological sustainability of organisations’ operations. In the absence of greater disclosure about acts contributing to land contamination, damaging activities may – on the basis of lack of information – continue to be supported by various (uninformed) stakeholder groups. Any organisation that publicly commits to sustainable development – as our sample companies have publicly done – has a responsibility to be open and transparent about its environmental performance – our evidence suggests that companies in our sample have not been as open and transparent as we would hope (and perhaps as future generations require).
Yankelovich (1972) also addressed the ‘measurement issue’ and his opinion is still pertinent today. He described a four-step hypothetical decision process that may be faced by an accountant in attempting to report a variety of environmental issues (p. 72): The first step is to measure whatever can be easily measured. This is OK as far as it goes. The second step is to disregard that which can’t be easily measured or give it an arbitrary quantitative value. This is artificial and misleading. The third step is to presume that what can’t be measured easily really isn’t important. This is blindness. The fourth step is to say that what can’t be easily measured really doesn’t exist. This is suicide.
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Focus on short-term results Another problem inherent in financial reporting is its focus on the short term. As we would appreciate, the focus of the news media is typically on the annual, or perhaps at times on the half-yearly and quarterly, financial results of an entity. As accountants, we tend to emphasise short-term (annual) performance through our practices of dividing the life of the organisation up into somewhat artificial periods of time. Managers are also often rewarded in terms of measures of performance such as annual profits. This can have the effect of discouraging managers from making long-term investments in new technologies (including those that will provide longerterm social and environmental benefits).
The concept of ‘materiality’ The focus on the information needs of stakeholders with a financial interest is one of the cornerstones of financial accounting: the notion of ‘materiality’. This has tended to preclude the reporting of social and environmental information, given the difficulty of quantifying social and environmental costs. ‘Materiality’ is an issue involving the exercise of a great deal of professional judgement. If something is not considered to be material, it does not need to be disclosed in the financial statements or supporting notes. Unfortunately, this has meant that if something cannot be quantified (as is the case for many social and environmental externalities), it is generally not considered to be ‘material’ from a financial reporting perspective and therefore does not warrant separate disclosure. This obviously implies that ‘materiality’ – as used by financial accountants – might not be a relevant criterion for the disclosure of environmental performance data. Social performance and environmental performance are quite different from financial performance. Yet many accountants have been conditioned through their education and training to adopt the materiality criterion to decide whether information should be disclosed. ‘Materiality’ is indeed something that can be interpreted very subjectively. The 2000 version of GRI’s Sustainability Reporting Guidelines provided a useful comment on materiality: The application of the materiality concept to economic, environmental, and social reporting is more complex than in financial reporting. In contrast to financial reporting, percentage-based or other precise quantitative materiality yardsticks will seldom be appropriate for determining materiality [for sustainability reporting purposes]. Instead, materiality is heavily dependent upon the nature and circumstances of an item or event, as well as its scale or magnitude. For example, in environmental terms, the carrying capacity of the receiving environment (such as a watershed or airshed) will be just one among several factors in the materiality of the release of one tonne or one kilogram of waste, air emissions, or effluent. Similarly, health and safety information is likely to be of considerable interest to sustainability report users despite its typical insignificance in traditional financial accounting terms. (Cited in Deegan, 2020, p. 1283)
The practice of discounting liabilities to present value In respect of liabilities, there is a general requirement that liabilities to be repaid in more than 12 months should be discounted to their present value. Specifically, paragraph 45 of IAS 37 (IFRS, 2022) states: Where the effect of the time value of money is material, the amount of a provision shall be the present value of the expenditures expected to be required to settle the obligation.
While discounting liabilities to their present value makes good economic sense (indeed it is not questionable that a dollar in the future is worth less than a dollar now), it does not necessarily make good ecological sense because it effectively downplays the importance of the future clean-up. 532
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Perhaps it encourages the entity to undertake activities that will damage the environment but that will not need to be remedied for many years. In a sense, the practice of discounting encourages us to shift problems of an environmental nature onto future generations, something that is arguably inconsistent with the sustainability agenda. If we discount future obligations, then, in the current period, they often are not considered to be ‘material’ (as just discussed) and will not even be seen on corporate balance sheets. Nevertheless, future generations will be left with obligations to remediate the environment. For example, imagine that we are an organisation whose current activities are creating a need for future environmental expenditure of a remedial nature, but that such work will not be undertaken for many years. As a result of discounting, we will recognise little or no cost now. For example, if we were anticipating that our activities would lead to a clean-up bill of $100 million in 30 years’ time, and if we accept that our normal earnings rate is 10 per cent, the current expenses and matching liability to be recognised in our financial statements under generally accepted accounting principles would be $5.73 million. Gray, Owen and Adams (1996) argue that discounting future obligations, such as future cleanup costs, might encourage an entity to undertake activities that will damage the environment but that will not need to be remedied for many years. This view is consistent with Perks (1993, p. 100), who suggests that the use of costing approaches that rely upon such factors as present values has the effect of hindering the introduction of renewable energy and other sources of ‘cleaner’ energy. He states: Accountancy is also implicated in the environmental crisis in advocating investment appraisal techniques that emphasize the short term rather than the long term, particularly in relation to electricity generation. Energy from renewable resources such as wind, wave, tide and water tend to have heavy capital expenditure and are seen to be economic only over a very long period. Accountants’ methods, particularly where high discount rates are used in discounted cash flow calculations, tend to favour the quick and dirty types of power generation.
While the above discussion of the limitations of financial reporting is lengthy, it has identified a number of principles and conventions of financial reporting that limit the ability of financial reporting, as it is currently practised, to provide meaningful information about an organisation’s social and environmental performance. Therefore, in considering the fourth step of the accountability model represented in Figure 2.5 from Chapter 2 – this being ‘how’ to report – we can reasonably argue that financial accounting does not provide an appropriate vehicle for CSR reporting. In this regard, Deegan (2013) states: Financial accounting simply was not designed to incorporate considerations of the social and environmental impacts of organisations. Financial accounting calculates the financial position and performance of an entity as a result of recording measurable and probable transfers of economic benefits in conformity with generally accepted financial accounting procedures … Financial reporting conventions do not provide a platform for any argument that financial reporting is a sound or even sensible vehicle through which to account for the social and environmental externalities generated by an entity. Therefore, I do find it frustrating to often hear people suggesting that financial reporting provides a potential panacea for important social and environmental problems, such as climate change. My concern is the extent to which such people understand the many obstacles/roadblocks that financial reporting puts in the way of recognising social and environmental costs. That is not to say that financial accounting does not provide useful information for some decision makers. It certainly does. But let us not kid ourselves that it provides a viable platform for accounting for the social and environmental impacts of a reporting entity – it simply does not. 533
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Why do I need to know about the limitations that generally accepted financial reporting principles have with respect to accounting for the social and environmental impacts of an organisation? The most visible performance measure of an organisation is its ‘profits’, and this is a measure that, for larger organisations, is frequently referred to in the news media as an indicator of ‘success’, or as a rationale for organisations to pursue particular strategies (such as job cuts in times of low ‘profits’).
Why
However, ‘profits’ do not take account of many of the social and environmental ‘costs’ (or benefits) generated by organisations. Therefore, once we know this, we will be more cautious about interpreting the meaning of ‘profits’ in terms of it being an indicator of organisational ‘success’.
However, before considering triple bottom line reporting and the GRI, which we do next, we consider a measure of performance often used at a national level – the gross domestic product (GDP). While criticisms abound (some provided above) about how businesses calculate their financial performance in accordance with generally accepted accounting practice, criticisms can also be made about how countries calculate their economic success. For example, the performance of governments (and thus of nations) is often related to the outputs of their systems of national accounts, a well-known output being GDP. With such a system, the greater the levels of production, the better the numbers. Obviously, such a metric does not consider issues of resource efficiencies or the equities associated with how the resources are distributed. Current methods of calculating GDP provide some strange outcomes. For example, if we build more jails (perhaps reflective of a breakdown in society), this will have positive implications for GDP, as would the sale of harmful tobacco products to developing nations. Sustainability requires a reduced reliance upon indicators such as GDP. Criticisms of GDP abound internationally. Arguably, economic policy should be driven by a concern for human welfare. Therefore, it is unfortunate that governments, and economists, have such a fixation on GDP. Increases in GDP will not solve problems like climate change. Hence, in discussing ‘how’ to report social and environmental information, we justifiably have concerns about doing it through existing financial reporting systems. Financial accounting and reporting alone is therefore unsuitable as a mechanism to provide an account of these social and environmental impacts and to meet stakeholders’ information needs and expectations. Consequently, other mechanisms need to be employed to provide a suitable social and environmental account to these stakeholders. One broad mechanism that has been discussed widely in the business world as a way to provide a desirable balance of information about the social and environmental performance of organisations, in addition to the economic, is triple bottom line reporting.
Triple bottom line reporting As previously indicated, triple bottom line (TBL) reporting is based on the TBL approach to business sustainability discussed earlier in the chapter, where a balance is sought between economic, social and environmental sustainability. Advocates of TBL reporting argue that, if properly implemented, it should provide information to enable others to assess how sustainable an organisation’s or a community’s operations are. Hence, perhaps TBL reporting provides one answer to the question of ‘how’ we should report. The perspective taken is that for an organisation (or a community) to be sustainable (a long-run perspective), it must be financially secure (as evidenced by such measures as profitability), it must minimise (or ideally eliminate) its negative environmental impacts and it must act to give proper consideration to the social aspects of its operations. TBL reporting therefore provides a very broad answer to the question of how an organisation should report on its social, environmental and economic impacts (or performance). 534
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Brown, Dillard and Marshall (2005) demonstrate that, while there has been much discussion of TBL reporting, there have been few concrete proposals to realise this reporting model. They highlight several problems with implementing the TBL reporting model in practice. First, although the use of the ‘bottom line’ metaphor has been useful in capturing the attention of managers for issues of social and environmental impact, the metaphor is severely restricting, as the term ‘bottom line’ conveys the impression of something that can be measured in a single number. The economic profit figure is the summation, in a common currency, of all the income and expenses figures over a period of time. Brown, Dillard and Marshall (2005) demonstrate that it is highly problematic, and probably impossible in practice, to reduce all environmental impacts, or all social impacts, to a common currency. Indeed, most reports that have claimed to be based on a TBL approach have tended to report on social and environmental impacts using a combination of narrative reports and a number of different metrics. If neither social nor environmental factors can be reduced to a single currency, then it is not possible to equate trade-offs between these factors. A trade-off between ‘maximising’ economic performance, social performance and environmental performance appears to be a key element (or requirement) of the TBL. Second, the economic bottom line is commonly understood among managers as being a metric that should be maximised. Brown, Dillard and Marshall (2005) argue that it is difficult to apply this objective of maximisation to nature. While there could be agreement on maximising a factor such as biodiversity, there is no commonly accepted understanding of what this might mean and how it could be measured. Even more problematic is knowing which social metric should be maximised. Thus, attempting to equate the notion (and management) of the social and environmental bottom lines with the more conventional economic bottom line is not possible in practice. Therefore, attempting to report on, or manage, all three bottom lines in a common manner is not appropriate. Third, if it is not possible to adopt metrics that treat each of the bottom lines equally, then the notion of three separate bottom lines might give the impression that the economic, social and environmental are not interconnected. For reasons explained earlier in the chapter, this would be a fundamental misconception, and from a social and environmental sustainability viewpoint could be highly damaging. Brown, Dillard and Marshall (2005) believe that, due to these problems in the TBL concept, management and reporting on the TBL is likely to result in a focus on the economic bottom line to the detriment of social and environmental sustainability. It therefore appears that the process of TBL reporting is not very helpful in providing guidance to organisations regarding the details of how to produce a sustainability report that will address the specific information needs of their stakeholders. Perhaps what is required is a conceptual framework for social and environmental reporting. The GRI, which is discussed in the next subsection, could possibly be considered to be an example of a move towards a conceptual framework for social and environmental reporting.
The Global Reporting Initiative – a conceptual framework for social and environmental reporting? As an attempt to codify best reporting practice, several bodies have been active in developing social and environmental reporting guidelines. Globally, the most commonly used framework for CSR and sustainability reporting is that of the GRI, an organisation we have already referred to numerous times in this chapter. According to its website (GRI, 2022b): GRI (Global Reporting Initiative) is the independent, international organization that helps businesses and other organizations take responsibility for their impacts, by providing them with the global common language to communicate those impacts. We provide the world’s most widely used standards for sustainability reporting – the GRI standards. 535
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GRI has been releasing new and revised guidance for about 25 years. In 2016, the GRI transitioned from producing what it referred to as ‘guidelines’ to developing ‘standards’, which it refers to as the ‘GRI Standards’. Figure 10.1 summarises the history of the GRI up until 2022. The GRI Standards are a modular system of interconnected standards that are released as three different types of Standards, these being: 1 Universal Standards 2 Sector Standards 3 Topic Standards. The GRI Standards identify ‘disclosures’ that reporting entities should make. The disclosures include both ‘requirements’ and ‘recommendations’. The ‘requirements’ list the information that an organisation must report in order to comply with the Standards, whereas the ‘recommendations’ encourage certain disclosures. FIGURE 10.1 The history of the GRI Standards
Source: https://www.globalreporting.org/about-gri/mission-history as accessed June 2022.
GRI stakeholders In terms of the potential users of the GRI Standards, GRI (2022a, p. 2) states: Any organization, large or small, public or private, from any sector or location, can use the GRI Standards. Reporters, stakeholders, and other information users draw on the Standards. Reporters within an organization use the Standards to report on the organization’s impacts in a credible way that is comparable over time and in relation to other organizations. The Standards also help stakeholders and other information users understand what is expected from an organization to report on and use the information published by organizations in various ways. 536
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The organization can use the disclosed information to assess its policies and strategies or to guide decision-making, such as setting goals and targets. Stakeholders can also use this information. For example, investors can use the reported information to assess how an organization integrates sustainable development into its strategy to identify financial risks and evaluate its long-term success. The information provided can also help other information users, such as analysts and policymakers in benchmarking and forming policy, and academics in their research.
As we can see from the above quotation, the GRI Standards are intended to be of relevance to a broad cross-section of ‘stakeholders’. This can be contrasted to financial reporting, which identifies investors, potential investors, lenders and other creditors as the target audience of general purpose financial reports (that is, standard-setters such as the IASB, which develops financial reporting guidance, have a much more restricted perspective of ‘stakeholders’ relative to that of the GRI). In relation to ‘stakeholders’, GRI 1 (2021a, p. 10) also states:3 Stakeholders are individuals or groups that have interests that are affected or could be affected by an organization’s activities. Common categories of stakeholders for organizations are business partners, civil society organizations, consumers, customers, employees and other workers, governments, local communities, non-governmental organizations, shareholders and other investors, suppliers, trade unions, and vulnerable groups. … Stakeholder interests can be negatively or positively affected by the organization’s activities. Due diligence focuses on identifying stakeholder interests that are or could be negatively affected by the organization’s activities. Stakeholders may not always have a direct relationship with the organization. For example, the workers in the organization’s supply chain can also be its stakeholders, or there can be individuals or groups living at a distance from the organization’s operations who can be affected or potentially affected by these operations. … Engaging with stakeholders helps the organization identify and manage its negative and positive impacts. The organization should identify the stakeholders whose interests have to be taken into account in connection with a specific activity (i.e., ‘relevant stakeholders’). Where it is impossible to engage with all relevant stakeholders directly, the organization can engage with credible stakeholder representatives or proxy organizations (e.g., nongovernmental organizations, trade unions).
The position embraced within the GRI Standards is that managers need to create processes that enable their organisation to be accountable for significant impacts (which then are considered as ‘material topics’) imposed upon the organisation’s stakeholders, particularly from the perspective of ‘sustainable development’. GRI 1 (2021a, p. 4) states: Through their activities and business relationships, organizations can have an effect on the economy, environment, and people, and in turn make negative or positive contributions to sustainable development. Sustainable development refers to ‘development which meets the needs of the present without compromising the ability of future generations to meet their own needs’. The objective of sustainability reporting using the GRI Sustainability Reporting Standards (GRI Standards) is to provide transparency on how an organization contributes or aims to contribute to sustainable development. The GRI Standards enable an organization to publicly disclose its most significant impacts on the economy, environment, and people, including impacts on their human 3
Note that the definition of ‘stakeholders’ reflects one of the two components of the definition provided by Freeman and Reed (1983) as discussed earlier in this chapter.
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rights and how the organization manages these impacts. This enhances transparency on the organization’s impacts and increases organizational accountability.
The GRI Standards are structured as a set of interrelated standards. An overview of the GRI Standards is presented in Figure 10.2. Referring to Figure 10.2, we can see that the Universal Standard GRI 1: Foundation 2021 is the starting point. GRI 1 includes the ‘reporting principles’ that need to be adopted by reporters in relation to report content and quality, and which are fundamental to good-quality reporting. GRI 1 also identifies some ‘key concepts’ that lay the foundation for sustainability reporting. These key concepts are: 1 impact 3 due diligence process 2 material topics 4 stakeholder. These four key concepts are explained by GRI as follows: • An ‘impact’ is defined in the Glossary to GRI 1 (GRI, 2021a, p. 28) as an: effect the organization has or could have on the economy, environment, and people, including on their human rights, which in turn can indicate its contribution (negative or positive) to sustainable development
The general principle is that an organisation should understand its impacts and thereafter report on impacts that are judged as significant.
FIGURE 10.2 The structure of the GRI Standards framework
Source: Global Reporting Initiative (2021a), Universal Standard – GRI 1: Foundation 2021, Amsterdam: GRI, p. 6.
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• ‘Material topics’ are defined in the Glossary to GRI 1 (GRI, 2021a, p. 28) as: topics that represent the organization’s most significant impacts on the economy, environment, and people, including impacts on their human rights
GRI 1 notes that the organisation needs to be accountable for its ‘material impacts’. GRI 1 (GRI, 2021a, p. 8) states: When using the GRI Standards, the organization prioritizes reporting on those topics that represent its most significant impacts on the economy, environment, and people, including impacts on their human rights. In the GRI Standards, these are the organization’s material topics.
• ‘Due diligence process’ is defined in the Glossary to GRI 1 (GRI, 2021a, p. 27) as the: process to identify, prevent, mitigate, and account for how the organization addresses its actual and potential negative impacts
GRI 1 requires reporting organisations to report information about the due diligence processes that have been implemented. • The fourth ‘key concept’ identified within GRI 1 (as indicated above) is ‘stakeholder’. We have already discussed how the GRI Standards address ‘stakeholders’. Apart from the key concepts that we have just discussed, the reporting organisation is required to apply the reporting principles referred to in GRI 1 if it is to claim that its sustainability report has been prepared in accordance with the GRI Standards. The reporting principles are: • accuracy • completeness • balance • sustainability context • clarity • timeliness • comparability • verifiability. If we look at the attributes above (or qualitative characteristics) that sustainability-related information should have, we will see that these are similar to the attributes we identified in Chapters 2 and 7 as being relevant to all accounting information, whether it be financial, social or environmental in nature. The qualitative characteristics identified by GRI as necessary for information to be useful are also very similar to the qualitative characteristics expected of useful financial information as documented in the IASB Conceptual Framework (see Chapter 7). While the above qualitative characteristics are what the GRI expects sustainability-related information to possess, the evidence suggests that corporate environmental reporting does not, in general, comport with these qualitative characteristics (Garcia-Torea, Fernandez-Feijoo and De La Cuesta, 2020). Although the quantity and sophistication of corporate environmental reporting has increased significantly (KPMG, 2022), legitimacy and image management remain a primary motivation (Cho et al., 2015; Talbot and Boiral, 2018). As a consequence, the decision usefulness of corporate environmental reports varies between entities. For a discussion of consideration of the views of stakeholders, see Reflection question 10.4.
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REFLECTION QUESTION 10.4 Identifying and considering the views of stakeholders Consider the following statement from GRI 101 (GRI, 2016, p. 8): When making decisions about the content of its report, the organization is to consider the reasonable expectations and interests of stakeholders. This includes those who are unable to articulate their views and whose concerns are presented by proxies (for example, NGOs acting on their collective behalf); and those with whom the organization cannot be in constant or obvious dialogue. The organization is expected to identify a process for taking such views into account when determining whether a topic is material. Question What is the role of a proxy stakeholder? Solution Many organisational stakeholders who might be greatly impacted by the operations of an organisation do not have the ability to voice their expectations, or interests, regardless of how valid or important these concerns might be. They therefore rely upon others to do so for them, and we might refer to these other people or groups as ‘proxies’ or ‘surrogate stakeholders’. We discussed surrogate accountability and surrogate stakeholders in Chapter 2. Some examples of proxy stakeholders and the impacts they can have on organisations are: • Environmental groups – these groups voice the concerns of many people in the community who might not otherwise be able to be heard. They also act on behalf of threatened and endangered species, as well as future generations of people. Organisations would be wise to have ongoing communications with environmental groups. • Animal welfare groups – these groups speak on behalf of various animals, which again are unable to have a voice. In working on behalf of animals, these groups can make information known about cruel and inhumane practices that are perhaps unknown to stakeholders. For example, currently, many animal protection organisations are publicising information about particular countries’ treatment of the animals used in the production of various items of clothing, and associated accessories, and this has caused a number of large clothing companies to change their practices. Many
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such companies now directly engage with animal welfare groups as an important part of managing their business. • Consumer groups – these groups speak on behalf of individual consumers who, again, individually might not have much power over an organisation. Large consumer groups have been able to create various changes in company operations and reporting practices. It is sensible for managers to work with these groups, as they are able to bring valuable expertise, as well as valuable insights from the community. • Labour groups – these groups speak on behalf of individual workers who might be employed directly by an organisation, or are employed throughout supply chains. Many times, these groups will provide insights into organisations that were previously unknown to managers. For example, various labour groups are known to gain access to factories in developing countries and then publicise information about the working conditions there. Since these proxy, or surrogate, stakeholder groups can impact an organisation’s operations, it makes sense that managers should try to work with them (rather than ignore them), and that they should try to understand, and if possible produce, some of the information the groups expect to receive. Because business organisations are part of the broader society, it is imperative that they are responsive to the expectations of society. The groups identified above are able to provide insights into what certain parts of society expect. A further issue is whether such proxy (surrogate) stakeholders would be expected to be motivated by self-interest. As we know, various accounting and economic theories (for example, Agency Theory and Positive Accounting Theory, as discussed within Chapter 8) assume that all individuals are motivated by their own self-interest. While ‘self-interest’ might, on average, be useful for explaining the actions of some managers and capital market participants, it is difficult to accept that ‘self-interest’ motivates the actions of the above stakeholder groups.
A review of Figure 10.2 shows that, once we have considered GRI 1, we then need to consider GRI 2 and GRI 3. We will not cover these two standards in depth (for interested readers, these two standards are also freely accessible on the GRI website), but briefly: • GRI 2: General Disclosures 2021 requires organisations to report information about their reporting practices; activities and workers; governance; strategy, policies, and practices; and stakeholder engagement. This information gives insight into the profile and scale 540
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of organisations and provides a context for understanding their impacts. The Standard is structured as follows: – Section 1 contains five disclosures, which provide information about the organisation, its sustainability reporting practices and the entities included in its sustainability reporting. – Section 2 contains three disclosures, which provide information about the organisation’s activities, employees and other workers. – Section 3 contains 13 disclosures, which provide information about the organisation’s governance structure, composition, roles and remuneration. – Section 4 contains seven disclosures, which provide information about the organisation’s sustainable development strategy and its policies and practices for responsible business conduct. – Section 5 contains two disclosures, which provide information about the organisation’s stakeholder engagement practices and how it engages in collective bargaining with employees. • GRI 3: Material Topics 2021 provides step-by-step guidance for organisations with respect to how to determine material topics. It also explains how the Sector Standards are used in this process. ‘Material topics’ are topics that represent an organisation’s most significant impacts on the economy, environment and people, including impacts on their human rights. GRI 3 requires organisations to report information about their process for determining material topics (which is commonly referred to as the ‘materiality determination process’), their list of material topics and how they manage each of their material topics. The Standard is structured as follows: – Section 1 provides step-by-step guidance on how to determine material topics. – Section 2 contains three disclosures, which provide information about the organisation’s process of determining material topics, its list of material topics and how it manages each topic. GRI 3 (2021b, p. 7) provides a useful diagrammatic overview of how to determine ‘material impacts’. It is reproduced below as Figure 10.3. FIGURE 10.3 Process to determine material impacts Identify and assess impacts on an ongoing basis
Determine material topics for reporting Test the material topics with experts and information users
Engage with relevant stakeholders and experts
1
2
3
4
Understand the organisation’s context
Identify actual and potential impacts
Assess the significance of the impacts
Prioritise the most significant impacts for reporting
Use the Sector Standards to understand the sectors’ context
Consider the topics and impacts described in the Sector Standards
Material topics
Test the material topics against the topics in the Sector Standards
Source: Global Reporting Initiative (2021b), Universal Standard – GRI 3: Material Topics 2021, Amsterdam: GRI, p. 7.
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In discussing how an organisation reports information about how it determined its material impacts, GRI 3 (2021b, p. 7) notes: The organization should document its process of determining material topics. This includes documenting the approach taken, decisions, assumptions, and subjective judgments made, sources analyzed, and evidence gathered.
GRI 3 identifies a number of other disclosure requirements, including:
• Disclosure 3-1 Process to determine material topics – this disclosure requirement requires
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organisations to document their ‘materiality determination process’. Specifically, the organisation shall (GRI, 2021b, p. 16): a describe the process it has followed to determine its material topics, including: i how it has identified actual and potential, negative and positive impacts on the economy, environment, and people, including impacts on their human rights, across its activities and business relationships; ii how it has prioritized the impacts for reporting based on their significance; b specify the stakeholders and experts whose views have informed the process of determining its material topics. The materiality determination process (also referred to by other titles such as ‘materiality assessment process’) is an important process that organisations undertake to determine what particular items of information to publicly report. It involves various forms of engagement with stakeholders and a prioritisation of particular stakeholders’ information demands. Reporting information about the materiality determination process helps to provide context about the information being reported. • Disclosure 3-2 List of material topics – the organisation shall (GRI, 2021b, p. 18): a list its material topics; b report changes to the list of material topics compared to the previous reporting period • Disclosure 3-3 Management of material topics specifies that for each material topic reported under Disclosure 3-2, the organisation shall (GRI, 2021b, p. 19): a describe the actual and potential, negative and positive impacts on the economy, environment, and people, including impacts on their human rights; b report whether the organization is involved with the negative impacts through its activities or as a result of its business relationships, and describe the activities or business relationships; c describe its policies or commitments regarding the material topic; d describe actions taken to manage the topic and related impacts, including: i actions to prevent or mitigate potential negative impacts; ii actions to address actual negative impacts, including actions to provide for or cooperate in their remediation; iii actions to manage actual and potential positive impacts; e report the following information about tracking the effectiveness of the actions taken: i processes used to track the effectiveness of the actions; ii goals, targets, and indicators used to evaluate progress; iii the effectiveness of the actions, including progress toward the goals and targets; iv lessons learned and how these have been incorporated into the organization’s operational policies and procedures; f describe how engagement with stakeholders has informed the actions taken (3-3-d) and how it has informed whether the actions have been effective (3-3-e).
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The concept of ‘materiality’ referred to above is very important. Information is considered to be material if it is likely to impact the decisions that stakeholders make about an organisation. Determining whether particular items of information might be important to stakeholders requires an organisation to engage with stakeholders to determine what information they would prefer the organisation to disclose. As we have already noted, this process is often referred to as a ‘materiality determination process’ (see Reflection question 10.5).
REFLECTION QUESTION 10.5 The importance of disclosing information about the materiality determination process Information about the materiality determination process outlines the processes that the managers of an organisation establish to determine which items of information are considered important enough to disclose and, conversely, to explain why other information is excluded from reports. Question What are the benefits to report readers of knowing about the materiality determination process? Solution Where the disclosure of information is predominantly voluntary, as is the case with much social and environmental information,
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then it would be reasonable for readers to question the logic, or merit, of why particular information was, or was not, disclosed. If managers are able to provide a clear, overall rationale for why particular information was deemed important enough to disclose, then even though readers might not agree with the materiality determination processes that the managers have employed, the disclosure about the processes should enable readers to better understand the context for why some information is reported and other information is not, and this should increase the understandability of the report.
Reporting with the Sector Standards The GRI Sector Program, which commenced in 2021, is expected to ultimately develop standards for 40 sectors, starting with those that have the highest impact. The Sector Standards are designed to help identify a sector’s most significant impacts and reflect stakeholder expectations for sustainability reporting. They describe the sustainability context for a specific sector, outline organisations’ likely material topics based on the sector’s most significant impacts and list the disclosures that are likely to be relevant for the sector to report on. O il and gas, coal, agriculture, aquaculture and fishing were the first sectors prioritised under the Sector Program, based on their significant environmental, social and economic impacts. The first Sector Standard, GRI 11: Oil and Gas Sector 2021, was released in 2021 with an effective date of 1 January 2023. It identifies likely material topics for organisations in the oil and gas sector, and the required disclosures. GRI 11 (2021c, p. 13) identifies the likely material topics for the oil and gas sector. Each topic describes the sector’s most significant impacts related to the topic and lists disclosures that are considered relevant for reporting on by oil and gas organisations. Likely ‘material topics’ for organisations within the oil and gas sector are identified in GRI 11 as: GHG emissions; Climate adaptation, resilience, and transition; Air emissions; Biodiversity; Waste; Water and effluents; Closure and rehabilitation; Asset integrity and critical incident management; Occupational health and safety; Employment practices; Non-discrimination and equal opportunity Topic; Forced labour and modern slavery; Freedom of association and collective bargaining; Economic impacts; Local communities; Land and resource rights; Rights of indigenous peoples; Conflict and security; Anti-competitive behaviour; Anti-corruption; Payments to governments; and Public policy. Sector Standards for coal (GRI 12) and agriculture, aquaculture and fishing (GRI 13) were released in 2022.
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Topic-specific standards The GRI 200, 300 and 400 series Standards were released in 2016 (with some limited modifications thereafter) and include numerous topic-specific standards. These are used to report information on an organisation’s impacts related to economic, environmental and social topics. The standards to be applied by an organisation will be determined by whether the managers believe that the respective topics are material in the context of the organisation’s operations. In terms of the GRI 200: Economic Standards, these standards are (with each of the standards having a number of specific disclosures which we are not reproducing here): • GRI 201: Economic performance • GRI 205: Anti-corruption • GRI 202: Market presence • GRI 206: Anti-competitive behavior • GRI 203: Indirect economic impacts • GRI 207: Tax (introduced in 2019). • GRI 204: Procurement practices In terms of the GRI 300: Environmental Standards, these standards are (with each of the standards having a number of specific disclosures which we are not reproducing here): • GRI 301: Materials • GRI 306: Effluents and wastes • GRI 302: Energy • GRI 307: Environmental compliance • GRI 303: Water • GRI 308: Supplier environmental assessment. • GRI 304: Biodiversity • GRI 305: Emissions In terms of the GRI 400: Social Standards, these standards are (with each of the standards having a number of specific disclosures, which we are not reproducing here): • GRI 401: Employment • GRI 410: Security practices • GRI 402: Labour/management relations • GRI 411: Rights of indigenous people • GRI 403: Occupational health and safety • GRI 412: Human rights assessment • GRI 404: Training and education • GRI 413: Local communities • GRI 405: Diversity and equal opportunity • GRI 414: Supplier social assessment • GRI 406: Non-discrimination • GRI 415: Public policy • GRI 407: Freedom of association and • GRI 416: Customer health and safety collective bargaining • GRI 417: Marketing and labelling • GRI 408: Child labour • GRI 418: Customer privacy. • GRI 409: Forced or compulsory labour
Selective reporting of GRI data While it is generally agreed that the GRI Standards have brought about improvements to CSR and sustainability reporting, it must be acknowledged that, with the standards generally not being mandatory, many organisations are selective about which GRI indicators they choose to use in their reporting, often selecting those that project the best impression of the organisation. Nevertheless, such organisations might still indicate that they are using the GRI standards, thereby potentially gaining the legitimacy associated with using the guidelines. This possibility is supported by Boiral (2013), who reviewed the sustainability reports of 23 mining and energy companies that were identified as being highly compliant with the GRI requirements. Boiral utilised various sources of publicly available information about the social and environmental performance of the companies and then compared this with the information produced in the ‘GRI-compliant sustainability reports’. His results showed that 90 per cent of the significant adverse events identified from alternative publicly available sources were either not discussed at all in the sustainability reports or were discussed in a fairly biased manner. The reports were also found to be very biased in terms of providing information about positive achievements and in terms of prioritising ‘self-praise’. Hence, we really need to be careful in assuming that, just because a reporting guideline exists and is apparently being applied by an organisation, the
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reports themselves are credible reflections of actual performance. As Hutchings and Deegan (2022, p. 1155) state: Consistent with Legitimacy Theory, evidence suggests that GRI-based reporting is generally incomplete (Lock and Seele, 2016), biased (Talbot and Boiral, 2018), ambiguous (Nazari et al., 2017) and has low comparability (Michelon et al., 2015). Even the very best GRI-based sustainability reports appear to be driven by a legitimisation motive (Talbot and Boiral, 2018), with little correlation between disclosures and actual environmental performance (Boiral, 2013; Michelon et al., 2015). Consequently, it may be difficult for stakeholders to accurately assess corporate environmental management and performance, with potentially adverse ramifications for the efficiency of capital and lending markets, supply chain risk assessments and accountability.
This is where some level of third-party (independent) assurance, or auditing, of the reports can be useful in adding credibility to the reports. LO10.13
Integrated reporting
Another approach to corporate social-responsibility reporting that is attracting a great deal of attention is ‘integrated reporting’. Integrated reporting can take a variety of forms and can be defined in a number of ways, but it would generally be perceived as involving the generation of reports that integrate information about the social, economic/financial and environmental implications and impacts of an organisation’s operations. Most larger organisations produce an annual report that includes a number of financial statements and associated note disclosures, as required by financial reporting standards, corporations law and securities exchange listing requirements. The same organisations also often release a separate CSR or sustainability report, or a range of social and environmental reports. However, there is often little or no link between the separate reports (and they are often prepared by different people), and this led to calls for a form of reporting (i.e. integrated reporting) in which various types of information necessary for assessing and evaluating an organisation’s performance from a more holistic basis are reported in a comprehensive fashion within an integrated report. An organisation known as the International Integrated Reporting Council (IIRC) released its first International Integrated Reporting Framework, also referred to as the International Framework, in December 2013. This was then revised and reissued in January 2021. In June 2021, the Framework was subsequently placed under the control of an organisation known as the Value Reporting Foundation, before ultimately being transferred to the control of the ISSB in June 2022. We discuss the ISSB later in this section. The Framework is a principles-based framework, rather than one that stipulates lists of required disclosures, so it is quite different to the GRI standards previously discussed. As stated in the Framework (IIRC, 2021, p. 5): The Framework takes a principles-based approach. The intent is to strike an appropriate balance between flexibility and prescription that recognizes the wide variation in individual circumstances of different organizations, while enabling a sufficient degree of comparability across organizations to meet relevant information needs. It does not prescribe specific key performance indicators, measurement methods, or the disclosure of individual matters, but does include a small number of requirements that are to be applied before an integrated report can be said to be in accordance with the Framework.
The Framework provides ‘guiding principles’ and ‘content elements’ that are to be used to govern the overall content of an integrated report and to explain the fundamental concepts that underpin the report. These principles and elements are reproduced in Figure 10.4. Reading 545
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FIGURE 10.4 International Framework Guiding Principles and Content Elements Seven Guiding Principles underpin the preparation and presentation of an integrated report, informing the content of the report and how information is presented:
• Strategic focus and future orientation. An integrated report should provide insight into the organisation’s strategy, and how it relates to the organisation’s ability to create value in the short, medium and long term, and to its use of and effects on the capitals • Connectivity of information. An integrated report should show a holistic picture of the combination, interrelatedness and dependencies between the factors that affect the organisation’s ability to create value over time • Stakeholder relationships. An integrated report should provide insight into the nature and quality of the organisation’s relationships with its key stakeholders, including how and to what extent the organisation understands, takes into account and responds to their legitimate needs and interests • Materiality. An integrated report should disclose information about matters that substantively affect the organisation’s ability to create value over the short, medium and long term • Conciseness. An integrated report should be concise • Reliability and completeness. An integrated report should include all material matters, both positive and negative, in a balanced way and without material error • Consistency and comparability. The information in an integrated report should be presented: (a) on a basis that is consistent over time; and (b) in a way that enables comparison with other organisations to the extent it is material to the organisation’s own ability to create value over time.
An integrated report includes eight Content Elements that are fundamentally linked to each other and are not mutually exclusive:
• Organisational overview and external environment. What does the organisation do and what are the circumstances under which it operates? • Governance. How does the organisation’s governance structure support its ability to create value in the short, medium and long term? • Business model. What is the organisation’s business model? • Risks and opportunities. What are the specific risks and opportunities that affect the organisation’s ability to create value over the short, medium and long term, and how is the organisation dealing with them? • Strategy and resource allocation. Where does the organisation want to go and how does it intend to get there? • Performance. To what extent has the organisation achieved its strategic objectives for the period and what are its outcomes in terms of effects on the capitals? • Outlook. What challenges and uncertainties is the organisation likely to encounter in pursuing its strategy, and what are the potential implications for its business model and future performance? • Basis of presentation. How does the organisation determine what matters to include in the integrated report and how are such matters quantified or evaluated? Source: International Integrated Reporting Council (2021), The International Framework, January 2021, IIRC, pp. 7–8.
through them, you will probably agree that they seem to be logical and, if applied properly, would assist an organisation to produce reports that are relatively more useful to external stakeholders (relative to reports that are prepared without following such principles). You should also be able to see that there is some overlap between these guiding principles and the principles for defining report quality included within the GRI standards, as previously discussed. This should not be unexpected, as such principles are generally relevant to any information that an organisation produces for the use of different stakeholders, whether it relates to social, environmental or financial performance. A more in-depth review of the framework reveals a number of other interesting (and some concerning) aspects of the guidelines, some of which are discussed below.
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Value creation versus accountability Accountability itself is referred to at the start of the Framework. Specifically, it is stated (IIRC, 2021, p. 2) that: aims to enhance accountability and stewardship for the broad base of capital (financial, manufactured, intellectual, human, social and relationship, and natural) and promote understanding of their independencies.
Unfortunately, accountability is not really explored in a useful way within the Framework. Paragraph 3.14 does note that an integrated report enhances transparency and accountability, which are essential to building ‘trust and resilience’, while paragraph 3.15 states: Accountability is closely associated with the concept of stewardship and the responsibility of an organization to care for, or use responsibly, the capitals that its activities and outputs affect. When the capitals are owned by the organization, a stewardship responsibility is imposed on management and those charged with governance via their legal responsibilities to the organization.
It would have been useful for the Framework to more fully explore the stakeholders to whom an organisation is responsible and for what aspects of performance it is ‘accountable’. As emphasised in this book, accountability is a central and logical component of accounting, and hence any reporting framework needs to be clear about accountability in terms of why an organisation should report, to whom the organisation should report, what it shall report and how it should report. According to the Framework, ‘integrated reporting’ is defined (IIRC, 2021, p. 52) as: A process founded on integrated thinking that results in a periodic integrated report by an organization about value creation, preservation or erosion over time and related communications regarding aspects of value creation, preservation, or erosion.
The above definition is interesting. The focus of this Framework – which has gained much attention globally, hence the reason we are discussing it in so much depth here – is on value creation, and its preservation or erosion, rather than on ‘accountability’. This lack of focus on accountability was of concern to the many people who had hoped that the emphasis of integrated reporting was to increase the transparency of organisations to a broad group of interested stakeholders, many of whom are not directly interested in value creation. This is not to say that a focus on ‘value creation’ is wrong. Rather, perhaps the goal of demonstrating a high level of accountability should also be strongly prioritised.
Materiality The Framework also emphasises the centrality of ‘materiality’ to the reporting process. This is important, as assessments of materiality/significance are central to any reporting framework. It needs to be made very clear why an organisation elects to report certain information, but not report other information. In terms of the guiding principle of materiality, we know from Figure 10.4 that it states: An integrated report should disclose information about matters that substantively affect the organization’s ability to create value over the short, medium and long term. (IIRC, 2021, p. 7)
The Framework further states (paragraph 3.20, p. 30): To be most effective, the materiality determination process is integrated into the organization’s management processes and includes regular engagement with providers of financial capital and others to ensure the integrated report meets its primary purpose as noted in paragraph 1.7. 547
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This provides a very narrow view of materiality, and therefore, if applied by managers, it could greatly impede the accountability that organisations might demonstrate. When we then review the Framework to see the perspective adopted with respect to the ‘primary purpose’ of an integrated report, we find: The primary purpose of an integrated report is to explain to providers of financial capital how an organization creates, preserves or erodes value over time. (IIRC, 2021, paragraph 1.7, p. 11)
To many people, the restricted definition of the perceived users of integrated reports is extremely disappointing. For example, Gibassier, Rodrigue and Arjalies (2018) undertook research about how the Framework was embraced by a multinational company in the consumer goods industry. The representatives of the organisation reported that they were disappointed with how the IIRC had fixated on the interests of investors. As a result, the organisation went on their own journey of integrated reporting which they considered to be ‘aspirational’ – they saw the journey towards preparing an integrated report as challenging with many subjective judgements to be made, the implication of which was that they believed comparability of results with other organisations would be difficult. As we know, this perspective in which shareholders and debt providers are seen as the focal stakeholders of an organisation is often referred to as the ‘shareholder primacy perspective’. They are elevated to being the most important stakeholders. This acts to limit the usefulness of a reporting framework to provide accountability to a broader group of stakeholders beyond shareholders. What perhaps needs to be accepted is that an organisation – which operates within society, and effectively with the permission to operate being given by that society – has a responsibility, and therefore an accountability, to a broad group of stakeholders and not just to those parties that provide financial capital. Nevertheless, the restricted view of accountability apparently embraced within the Framework does reflect the views of many people in business (but not all people!). The pity is that such people, with this heavily restricted view of accountability, seemed to capture the standard-setting processes operating within the IIRC when the Framework was developed. As Rowbottom and Locke (2016) also stress, once a framework such as the Framework becomes dominant, it has the potential to become the ‘taken for granted’ approach to reporting and to shape broader reporting practices. Rowbottom and Locke (2016, p. 100) also suggest that there was a view held by many people who were active in the development of the Framework that if a broader stakeholder perspective had been embraced, as many had hoped, then the resulting reports would have been very long and segmented – and, hence, from a pragmatic perspective, focusing on the needs of just the capital providers allowed a ‘less cluttered, less complex yet more communicative report’, albeit one that departed from the original stakeholder perspective. Rowbottom and Locke (2016, p. 101) further note that ‘due to broad philosophical differences between the shareholder and stakeholder perspective, there was a contest to influence the interests inscribed in the IIRC Framework’. In relation to the ‘shareholder primacy’ view of accountability, Rowbottom and Locke (2016, p. 101) report: The International Corporate Governance Network explicitly set out guidance from a ‘shareholder and investor perspective’ and warned against a ‘wild profusion of peripheral, trivial or irrelevant measures’. The UK Financial Reporting Council and Accounting Standards Board also specifically advocated a shareholder-based interpretation by warning that integrated reporting could ‘run the risk of being captured by particular stakeholder groups and the reporting of issues that are not material to the needs of long-term investors’ while guarding against ‘increasing the length and complexity of the annual report’.
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Rowbottom and Locke (2016) report that there were also many alternative views that a broader ‘stakeholder perspective’ should be adopted within the Framework. However, the broader stakeholder perspectives were overridden, such that the way in which the IIRC ultimately identified the key users of integrated reports – being investors – represented a ‘key detour’ from early views about what integrated reporting would or should represent. In doing so, this created the potential to alienate the interests of stakeholders who had participated in the integrated reporting project from its inception. According to La Torre et al. (2020, p. 1): The IIRC was born out of a necessity to create a reporting model that can tackle the sustainability challenges of the 21st century. But arguably, the Framework abandoned the original ideology of its promoters in favour of a capitalist ideology aligned with stock market capitalism… It is the ideology that managers should be intent solely on creating and maximising shareholder value to maximise economic efficiency and global welfare … The current focus of is not only vastly different to what its promoters envisaged, but it also diverts corporate reporting further away from sustainability accounting and stewardship … Chaidali and Jones (2017, pp. 1-20) speculate that this ideological transformation is an artefact of the IIRC’s trust-building process to ensure its survival. They show that, in the IIRC’s attempts to leverage the trust, authority, and reputation of professional accounting bodies and other experts, they became subservient to the capitalist ideology they now represent – a capitalism based on the stock market (Brown & Dillard, 2014; Thomson, 2015).
Furthermore, the way in which materiality is described in the Framework tends – perhaps, expectedly – to emphasise the risks and opportunities for the reporting organisation, and how it can mitigate or capitalise on those risks and opportunities. If materiality was considered from a broader sustainability perspective (one of the focuses of this chapter), then perhaps more consideration would be explicitly given to an organisation’s impacts on the ‘outside world’.
The capitals A particularly interesting aspect of the Framework is that it makes reference to ‘capitals’, in particular to six different capitals. The Framework notes (IIRC, 2021, p. 6) that: An integrated report aims to provide insight about the resources and relationships used and affected by an organization – these are collectively referred to as ‘the capitals’ in the Framework. It also seeks to explain how the organization interacts with the external environment and the capitals to create, preserve and erode value over the short, medium and long term.
The capitals are stocks of value that are increased, decreased or transformed through the activities and outputs of the organisation. They are categorised in the Framework as financial, manufactured, intellectual, human, social and relationship, and natural capital, although organisations preparing an integrated report are not required to adopt this categorisation or to structure their report along the lines of the capitals. Therefore, for the purposes of the Framework, the value being created by an organisation resides in capitals. Organisations tend to focus on different aspects of value that they seek to add, and therefore different organisations might find a need to consider using capitals other than those described in the Framework. The Framework states (IIRC, 2021, p. 18): 2.10 All organizations depend on various forms of capital for their success. In the Framework, the capitals comprise financial, manufactured, intellectual, human, social and relationship, and natural, although as discussed in paragraphs 2.17–2.19, organizations preparing an integrated report are not required to adopt this categorization. … 549
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2.12 The overall stock of capitals is not fixed over time. There is a constant flow between and within the capitals as they are increased, decreased or transformed. For example, when an organization improves its human capital through employee training, the related training costs reduce its financial capital. The effect is that financial capital has been transformed into human capital. Although this example is simple and presented only from the organization’s perspective, it demonstrates the continuous interaction and transformation between the capitals, albeit with varying rates and outcomes.
In relation to changes in capital, it is further stated in the Framework (IIRC, 2021, p. 18): Although organizations aim to create value overall, this can involve the diminution of value stored in some capitals, resulting in a net decrease to the overall stock of capitals. Figure 10.5 reproduces the value creation process depicted within the Framework.
Natural capital (the environment) is defined in the Framework (IIRC, 2021, p. 19) as: All renewable and non-renewable environmental resources and processes that provide goods or services that support the past, current or future prosperity of an organization. It includes:
• air, water, land, minerals and forests • biodiversity and eco-system health. Again, there are some broader philosophical issues to consider. As we can see from the above definition of ‘natural capital’, the environment seems to be considered on the basis of how it supports ‘the past, current or future prosperity of an organization’. We might question whether the environment should be considered in such an organisation-centric manner. Is this not one of the very reasons that the planet has its current environmental and social problems? Referring FIGURE 10.5 The process through which value is created, preserved, or eroded as depicted in the Framework
Source: International Integrated Reporting Council (2021), The International Framework, January 2021, IIRC, p. 22.
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to the environment as part of ‘capital’ also seems to promote a view that it can be ‘drawn down’ to support growth in other capitals. Again, this view that the environment can justifiably be utilised and degraded in exchange for economic gains is a major contributory factor to our current global problems. The other point to be made here is that given the main audience of integrated reports are deemed to be the providers of investment capital, notions of value will be determined from the investors’ perspective – and investors, in general, are notoriously short term in orientation and tend to focus on financial gains, rather than considering social and environmental costs and benefits. Therefore, it is difficult from a logical perspective to understand how this focus on value creation from the perspective of investors (which has little to do with broader notions of ‘accountability’) can help the long-term sustainability of business operations or provide any real hope in addressing problems such as climate change. Surely there is a high degree of incompatibility between value creation from the perspective of shareholders, and environmental and social sustainability? In relation to the various trade-offs, the Framework (IIRC, 2021, p. 51) states: It is important, however, that an integrated report disclose the interdependencies that are considered in determining its reporting boundary, and the important trade-offs that influence value creation over time, including trade-offs:
• Between capitals or between components of a capital (e.g., creating employment through an activity that negatively affects the environment)
• Over time (e.g., choosing one course of action when another course would result in superior capital increment but not until a later period)
• Between capitals owned by the organisation and those owned by others or not at all.
However, it is again emphasised that many people would argue that, when it comes to the environment, there should be no ‘trade-off’.
Some shortfalls and some strengths of the International Framework We could provide further comment on the International Framework, but suffice to say that it was a disappointment to many people, particularly those who initially hoped that integrated reporting would provide improvements in the social and environmental accountability being demonstrated by organisations, especially larger business organisations. It is not at all clear that the Framework provides much hope in terms of extending the accountability of organisations in regard to the various non-financial aspects of their operations. By discussing this framework in the manner we have, it should demonstrate to you that people have dissenting views about the worth of different reporting frameworks. As ‘thinking people’, we should critically challenge things we do not agree with, but, hopefully, do so in a way that is constructive. Challenging such frameworks, if we see problems with them, is a way for us to try to move forward the accountability of organisations. However, while a number of negative aspects of the Framework have been identified, we should also, for balance, acknowledge some of the positive aspects (just as we previously noted that the principles were logical and helpful). These include that the Framework: • specifically encourages ‘integrated thinking’, which is defined in the Framework as ‘the active consideration by an organization of the relationships between its various operating and functional units and the capitals that the organization uses or affects’. Integrated thinking leads to integrated decision making and actions that consider the creation of value over the short, medium and long term • requires consideration of connectivity/interdependencies within an organisation. When we consider how different operations/activities within an organisation influence one another, this can lead to important changes and cost savings. For example, we might even terminate some products/processes that otherwise looked profitable in isolation
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• requires explicit consideration of the context within which the organisation operates. This
is important as information can lack relevance if not enough information is provided about the environment within which an organisation operates • requires explicit commentary on why particular items are reported – that is why they are material – which arguably enhances the understandability of reports • requires explanation of how the reporting boundary has been identified • requires explicit consideration of the social, environmental and economic challenges/risks confronting the organisation. Again, at a general level, this makes sense • encourages information to be disclosed about how remuneration and incentives are linked to value creation in the short, medium and long term, including how they are linked to the organisation’s use of, and effects on, the capitals. Knowing how managers are remunerated in terms of various assigned key performance indicators (KPIs) is important as it provides insights into what aspects of performance are prioritised within an organisation, despite corporate rhetoric • encourages use of diagrams of inputs, business activities and outputs, all of which can assist in increasing people’s understanding of what is being reported • requires answers to: ‘Where does the organisation want to go and how does it intend to get there?’ Such ‘road maps’ are a valuable addition to reporting • requires the identification of significant frameworks and methods used to quantify or evaluate material matters included within the report. Again, this is important for placing the reported information within proper context • emphasises there is no set time dimension for reporting. This is also a useful point as a fixation on short accounting periods can act to create a short-term mindset • requires the organisation to note how its governance structure supports the organisation’s ability to create value in the short, medium and long term. While details of the governance structure should extend beyond just their role in creating value, the view that more information about governance is required also has merit. In terms of the future of the International Framework, as we noted earlier, the Framework was transferred to the control of the ISSB in June 2022. The Framework will be reviewed by the ISSB and, ultimately, is expected to form the foundation of a conceptual framework for connecting financial and sustainability-related disclosures.
Why do I need to know about the nature of integrated reporting? ‘Integrated reporting’ is a term that is increasingly being used globally. Therefore, it is important for us to understand what it means – and it is also important for us to understand that
there are many variations of integrated reporting, of which the IIRC Framework represents one approach.
Why
The International Sustainability Standards Board In late 2021, the Trustees of the IFRS Foundation, which oversees the IASB (which, as we know, develops International Financial Reporting Standards [IFRS]), announced the creation of the International Sustainability Standards Board (ISSB). The IFRS Foundation will also oversee the operations of the ISSB. The ISSB is to release IFRS Sustainability Disclosure Standards in 2023 that will focus on providing sustainability-related financial disclosures for capital markets, including disclosures that address the financial implications associated with climate change. For the purposes of the Standards, sustainability-related financial disclosures are disclosures about sustainability-related risks and opportunities that are deemed to be useful to users of general purpose financial reports when they seek to assess an entity’s ‘enterprise value’, including 552
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information about its governance, strategy and risk management, and related metrics and targets. In terms of the Standards: • IFRS S1 General Requirements for Disclosure of Sustainability-related Financial Information requires companies to disclose information about all their significant sustainability-related risks and opportunities • IFRS S2 Climate-related Disclosures focuses on climate-related risks and opportunities. It incorporates the recommendations of the TCFD – to be discussed shortly – and includes metrics tailored to industry classifications derived from the industry-based Sustainability Accounting Standard Board (SASB) Standards (also to be discussed shortly). The requirement is that sustainability-related financial disclosures would be published at the same time as the reporting entity’s financial statements. The contents of the proposed Standards rely upon concepts included within the IASB Conceptual Framework (including relying upon the qualitative characteristics of relevance, faithful representation, comparability, verifiability, timeliness and understandability), as well as requirements embodied within particular IFRS, including IAS 1 Presentation of Financial Statements and IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors. The objective of the IFRS S1 is to require an entity to disclose information about its significant sustainability-related risks and opportunities that is useful to the primary users of general purpose financial reporting (that are identified as investors, potential investors, lenders and other creditors) when they assess ‘enterprise value’ and decide whether to provide resources to the entity. Within IFRS S1, ‘enterprise value’ is defined as the total value of the entity and is the sum of the value of the entity’s equity (market capitalisation) and the value of the entity’s net debt. The sustainability-related financial information would be linked to an organisation’s governance, strategy and risk management, and the metrics and targets it uses to measure, monitor and manage significant sustainability-related risks and opportunities. In relation to governance, the requirement is that the information disclosed should be sufficient to enable investors to understand the governance processes, controls and procedures used by the organisation to monitor and manage significant sustainability-related risks and opportunities right throughout its supply chains. Risks would encompass both physical risks and transition risks. IFRS S2 Climate-related Disclosures has a more restricted objective (relative to S1) and has been developed to require an entity to disclose information about its exposure to significant climate-related risks and opportunities that will potentially impact entities’ financial position, financial performance and cash flows for the current reporting period, and the anticipated financial effects over the short, medium and long term. The climate-related risks to be considered will include both physical risks and transition risks – risks we discuss shortly when we look at the requirements issued by the TCFD. Among other things, IFRS S2 also requires reporting entities to disclose their greenhouse gas emissions throughout their supply chains, and there would be a requirement that the emissions would be calculated using a measurement framework known as the GHG Protocol, which we discuss later in this chapter. In terms of the mandatory nature of the Standards, it would be up to national regulators to determine whether, like IFRS, the Standards should be mandatory for certain forms of reporting entities. What is clear is that the ISSB Standards are quite restricted in the stakeholders whose information needs they are designed to address (limited to financial stakeholders), and in terms of their focus being restricted to financial measurements. The application of the materiality concept, as used in general purpose financial reporting, means that no disclosures would be made if it was assessed that the risks – physical or transitional – could not be linked to some form of financial measurement. Therefore, while arguably important to financial stakeholders, these 553
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Standards really do not encourage greater organisational accountability in relation to various social and environmental impacts that cannot be measured in ways other than financial. Therefore, whether we can consider these Standards to be ‘Sustainability Standards’ is questionable – an issue we discuss in Reflection question 10.6.
REFLECTION QUESTION 10.6 Does the ISSB really release ‘sustainability reporting standards’? As noted above, the Trustees of the IFRS Foundation established the International Sustainability Standards Board (ISSB) in 2021. In 2022, the ISSB released two exposure drafts. In terms of why the ISSB published the exposure drafts, it is stated (ISSB, 2022, p. 5) that: These proposals respond to calls from primary users (investors, lenders and other creditors) of general purpose financial reporting for more consistent, complete, comparable and verifiable sustainability-related financial information to help them assess an entity’s enterprise value. Question Given the above purpose, does it seem appropriate that the standard-setting body has been named the International Sustainability Standards Board? Solution As we have noted in this chapter, the concept of ‘sustainability’ addresses the interests and welfare of all inhabitants of the planet, both current and future, and human and non-human. It requires
Reflection
us all to consider and address various social, environmental and economic impacts being generated now, and properly balance and manage them in a way that does not undermine the interests of current and future generations. Considerations of ‘sustainability’ require considerations of impacts beyond financial impacts and of the interests of a broader group of stakeholders other than simply ‘investors, lenders and other creditors’. The standards to be released by the ISSB are much more restricted in focus than would be expected of ‘true’ sustainability reporting standards. Therefore, arguably, it does seem that the name of the standard-setting board – International Sustainability Standards Board – is potentially misleading. Of course, we could make a similar point in relation to the name of the former Sustainability Accounting Standards Board – its standards were also aimed primarily at investors and did not consider broader social and environmental impacts that are not linked to current or projected financial performance. Perhaps these standard-setting bodies believe that the names they have adopted, with their usage of ‘sustainability’, bring some form of enhanced ‘legitimacy’ to their organisations.
The Sustainability Accounting Standards Board Another organisation that attracted attention in respect of providing guidance for CSR and sustainability reporting was the Sustainability Accounting Standards Board (SASB), which was established in 2011. As with the IIRC, the standards of the SASB were transferred to the control of the ISSB in June 2022. The SASB standards will provide the starting point for the ISSB’s industryspecific standards and are expected to be used until such time as the ISSB produces industryspecific requirements. Therefore, it is worth discussing them, even though the SASB no longer operates in its own right. The standards were developed with investors in mind, to assist them to understand those sustainability-related risks and opportunities confronting organisations and which are likely to ultimately impact on an organisation’s financial performance. The SASB standards were developed on the basis that different industries are exposed to different social and environmental risks and opportunities, and so specific disclosure guidance for different industries was needed. The SASB arranged industries into a classification system, which it referred to as its Sustainable Industry Classification System (SICS), based on the similarity of companies’ sustainability challenges and opportunities. The SASB then identified those sustainability topics that it believed were particularly relevant to investors in those companies within each respective SICS industry code. Seventy-nine industries were identified, each seen as belonging within one of 11 sectors. As an example of some of the industry guidance provided, Table 10.2 reproduces a table that appears in the Automobiles Sustainability Accounting
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Standard. The accounting standards provide further written advice on each of the ‘accounting metrics’ identified within the table below. Review Table 10.2 and consider whether you agree that the respective accounting metrics provide information that would likely be of interest to investors who have interests in the companies operating in the automobile industry. Furthermore, you could also consider whether you believe the information would be of interest to stakeholders other than investors (and, perhaps, why it would be of interest). Again, unlike the GRI standards that we discussed earlier in this chapter, and which are designed to provide guidance to a wide variety of stakeholders, the SASB standards were designed with investors’ needs in mind – they focus on issues that are considered likely to ultimately create risks and opportunities that could impact upon financial performance. The management of the respective organisations is ultimately responsible for determining which information is material. Hence, as is often the case with accounting disclosures, managers need to determine whether the information is likely to affect decisions being made by the users of those reports. If it is considered likely, then disclosures should be made. The SASB acknowledged that establishing what is material in relation to information that is fundamentally non-financial can be a rather complex task. As noted, going forward, the standards developed by the SASB are expected to form the foundation of the industry-specific standards to be developed by the ISSB. TABLE 10.2 Extract from the SASB Automobiles Sustainability Accounting Standard Topic
Accounting metric
Category
Unit of measure
Code
Product safety
Percentage of vehicle models rated by NCAP programs with an overall 5-star safety rating, by region
Quantitative
Percentage (%)
TR-AU-250a.1
Number of safety-related defect complaints, percentage investigated
Quantitative
Number, percentage (%)
TR-AU-250a.2
Number of vehicles recalled
Quantitative
Number
TR-AU-250a.3
Percentage of active workforce covered under collective bargaining agreements
Quantitative
Percentage (%)
TR-AU-310a.1
(1) Number of work stoppages and (2) total days idle
Quantitative
Number, Days idle
TR-AU-310a.2
Sales-weighted average passenger fleet fuel economy, by region
Quantitative
Mpg, L/km, gCO2/km, km/L
TR-AU-410a.1
Number of (1) zero emission vehicles (ZEV), (2) hybrid vehicles, and (3) plug-in hybrid vehicles sold
Quantitative
Number
TR-AU-410a.2
Discussion of strategy for managing fleet fuel economy and emissions risks and opportunities
Discussion and analysis
n/a
TR-AU-410a.3
Materials sourcing
Description of the management of risks associated with the use of critical materials
Discussion and analysis
n/a
TR-AU-440a.1
Materials efficiency and recycling
Total amount of waste from manufacturing, percentage recycled
Quantitative
Metric tons (t), percentage (%)
TR-AU-440b.1
Weight of end-of-life material recovered, percentage recycled
Quantitative
Metric tons (t), percentage (%)
TR-AU-440b.2
Average recyclability of vehicles sold
Quantitative
Percentage (%) by salesweighted metric tons (t)
TR-AU-440b.3
Labour practices
Fuel economy and use-phase emissions
Source: Sustainability Accounting Standards Board, Automobiles (2018).
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The Task Force on Climate-related Financial Disclosures A failure to address the ongoing release of carbon will expose organisations to significant risks associated with the real physical impacts (including the impacts on assets from changing weather patterns, floods, droughts and so on) that result from climate change. Such risks will mean that many current business models will not be viable because of the likely destruction of assets and breakdowns in supply chains. To address these physical risks, organisations and societies need to transition to low/zero-carbon economies and this required transition will expose organisations to other risks – transition risks – including regulatory, reputational and market risks. The required transition to a zero-carbon economy will also generate many business opportunities in terms of the development of new technologies and products. From a financial perspective, financial stakeholders such as investors and lenders will require information about these physical and transitional risks and opportunities and many investors and lenders are demanding such information. To address the information needs of financial stakeholders, the TCFD developed the CEO Guide to Climate-related Financial Disclosures (TCFD, 2017), available at https://www.wbcsd.org/ Overview/Resources/General/CEO-Guide-to-climate-related-financial-disclosures). The TCFD was established by the Financial Stability Board, an international body that monitors and makes recommendations about the global financial system: In April 2015, at the request of G20 Finance Ministers and Central Bank Governors, the Financial Stability Board (FSB) convened representatives of the private and public sector to review how the financial sector could take account of climate-related issues. The conclusion was that financial markets need better, more comparable and complete information about climate change. In response, the FSB established the Task Force on Climate-related Financial Disclosures (TCFD) in December 2015. Source: TCFD (2017), p. 7.
The TCFD published a set of climate-related financial disclosure recommendations in July 2017 that address the financial risks and opportunities an organisation faces due to climate change. This approach to reporting can be compared to other sustainability reporting frameworks, such as the GRI, which focus upon how an organisation contributes to climate change, for example through its own carbon emissions. It needs to be appreciated that even if an organisation has acted very responsibly in relation to reducing or eliminating its own contributions to climate change, it will nevertheless be exposed to climate-related risks caused by other organisations. We return to the important issue of climate change later in this chapter, but it is becoming increasingly obvious that there is an expectation that organisations are accountable for their actions in alleviating, or contributing to, climate change. They are also increasingly being held accountable for providing information about the risks and opportunities climate change creates for their organisation. Table 10.3 reproduces a table from the TCFD Recommendations (p. 7) that summarises the recommendations and supporting recommended disclosures. Review these disclosures and consider whether you agree that they would be useful for you in assessing the climate change-related risks that an organisation might be exposed to. These disclosures are commonly made within an organisation’s annual report (which includes all the financial statements), and also often in separate sustainability reports. Many organisations are also releasing separate statements that they refer to as Climate Change Position Statements (or a similar title), which specifically address various risks and opportunities associated with climate change. The TCFD Guide also provides guidance for how organisations can identify climate risks and opportunities. Consistent with the discussion above, climate risks and opportunities are classified into two distinct categories by the TCFD: 556
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TABLE 10.3 Recommended disclosures pertaining to the risks and opportunities associated with climate change Governance
Strategy
Risk management
Metrics and targets
Disclose the organisation’s governance around climate-related risks and opportunities.
Disclose the actual and potential impacts of climate-related risks and opportunities on the organisation’s businesses, strategy, and financial planning where such information is material.
Disclose how the organisation identifies, assesses, and manages climate-related risks.
Disclose the metrics and targets used to assess and manage relevant climate-related risks and opportunities where such information is material.
Recommended disclosures
Recommended disclosures
Recommended disclosures
Recommended disclosures
a) Describe the board’s oversight of climaterelated risks and opportunities.
a) Describe the climate-related risks and opportunities the organisation has identified over the short, medium, and long term.
a) Describe the organisation’s processes for identifying and assessing climaterelated risks.
a) Disclose the metrics used by the organisation to assess climaterelated risks and opportunities in line with its strategy and risk-management process.
b) Describe management’s role in assessing and managing climaterelated risks and opportunities.
b) Describe the impact of climaterelated risks and opportunities on the organisation’s businesses, strategy, and financial planning.
b) Describe the organisation’s processes for managing climate-related risks.
b) Disclose Scope 1, Scope 2, and, if appropriate, Scope 3 greenhouse gas (GHG) emissions, and the related risks.
c) Describe the resilience of the organisation’s strategy, taking into consideration different climaterelated scenarios, including a 2°C or lower scenario.
c) Describe how processes for identifying, assessing, and managing climate-related risks are integrated into the organisation’s overall risk management.
c) Describe the targets used by the organisation to manage climaterelated risks and opportunities and performance against targets.
Source: Final Report: Recommendations of the Task Force on Climate-related Financial Disclosures (June 2017) © 2019 Task Force on Climate-Related Financial Disclosures. All rights reserved.
1 Transition risks, which reflect the risks and opportunities associated with changes in
the economy, including growth impacts, sector re-weighting and other macroeconomic factors. 2 Physical risks, which reflect changes in the physical climate (for example, altered rainfall amounts, intensities, and timings) that may impact future business activities. Figures 10.6 and 10.7 show the TCFD guidance relating to identifying climate risks and opportunities respectively. When the ISSB developed IFRS S2 Climate-related Disclosures (previously discussed) it incorporated the recommendations of the TCFD.
The United Nations Sustainable Development Goals Addressing sustainability at the individual organisational level is problematic. Sustainable development is a big concept that involves the consideration of larger environments and societal requirements, something that is beyond the confines of any single organisation. The quest for sustainable development requires the coordinated actions of all organisations, governments and communities. Regardless of these concerns about the appropriateness, or otherwise, of single organisations producing sustainability reports, an increasing number of organisations now report against the 17 Sustainable Development Goals (SDGs) of the United Nations (UN; see https://www.undp.org/content/undp/en/home/sustainable-development-goals.html). These goals are shown in Figure 10.8. The 17 SDGs have been developed by the UN as part of a resolution in 2015 entitled ‘Transforming Our World: The 2030 Agenda for Sustainable Development’, which was agreed to by all member states of the UN. The aim is to provide guidelines and targets for countries 557
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FIGURE 10.6 TCFD guidance regarding identifying climate risks
Source: FSB Task Force on Climate-related Financial Disclosures, p.10.
FIGURE 10.7 TCFD guidance regarding identifying climate opportunities
Source: FSB Task Force on Climate-related Financial Disclosures, p.11.
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FIGURE 10.8 The United Nations Sustainable Development Goals
Source: UN Sustainable Development Goals, https://www.un.org/sustainabledevelopment/. The content of this publication has not been approved by the United Nations and does not reflect the views of the United Nations or its officials or Member States.
to adopt in accordance with their own priorities and the social and environmental challenges of the world at large. The SDGs provide a ‘common lens’ through which organisations can review and report their progress towards sustainable development. Each SDG is supported by various components of documentation and guidance. The 17 SDGs are supported by 169 underlying targets, with 231 indicators (see https://unstats.un.org/sdgs/indicators/indicatorslist). Organisations are encouraged to focus upon those goals on which their activities are most likely to have significant impacts. The view taken by the UN is that addressing the SDGs requires a partnership of governments, the private sector, civil society and citizens in order to leave a better planet for future generations to enjoy. As an example of an organisation that publicly refers to the SDGs, the ANZ Bank states: We are committed to the United Nations Sustainable Development Goals (SDGs) and believe that business has an important role to play in their achievement. Our 2022 ESG targets support 12 of the 17 SDGs. In 2019 we became a founding signatory to the UN Principles for Responsible Banking. Under the Principles we are required to set at least two targets that address our most significant (potential) positive and negative impacts, aligned with the SDGs and the Paris Climate Agreement. We have reported our progress towards implementing the Principles using the Reporting and Self-assessment Index, available on pages 66–74. Source: ANZ (2021), p. 4.
However, KPMG (2020, 2022) notes that reporting on the UN SDGs tends to focus almost exclusively on the positive contributions companies make towards achieving the SDGs, and the reporting tends to lack transparency in relation to negative impacts relative to the SDGs. Applying 559
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the theories discussed within Chapter 9, there is potentially some ‘legitimacy’ associated with publicly committing to the UN SDGs (from Legitimacy Theory). Also, as the SDGs become more commonly used within a particular institutional environment, the pressure to conform with the practices adopted by other organisations (which have embraced the SDGs) increases, although there is always the possibility that there will be some decoupling between an organisation’s public, or external, commitments to the SDGs and how, or if, the organisation actually embraces them internally (from Institutional Theory). KPMG (2020, p. 48) notes: Balanced SDG reporting is important to show that a company is aware of how it contributes to global problems as well as how it helps to solve them. Disclosing both positive and negative impacts on the SDGs provides enhanced transparency and can therefore help to build trust between the company and its stakeholders. Companies that turn a blind eye to their negative impacts and focus their reporting only on the positive, risk losing credibility and public trust. They also open themselves to accusations of ‘SDG washing’, the practice of using the SDGs as a platform to create positive PR for themselves rather than as a framework to deliver genuine change. Similarly, if companies are serious about helping to deliver the SDGs, then they need to set clear SDG-related performance goals and report on progress against them.
Also, KPMG found that while some of the 17 SDGs were widely reported, some were seldom reported by most organisations.
The United Nations Global Compact The Global Compact is an initiative of the UN (see https://www.unglobalcompact.org). This initiative represents a network of UN agencies, governments and business, labour and nongovernment bodies that have put in place plans to encourage organisations to voluntarily adopt 10 principles in the areas of human rights, labour, the environment and anti-corruption. The 10 principles were developed from the Universal Declaration of Human Rights, the International Labour Organization (ILO) Declaration on Fundamental Principles and Rights at Work, the Rio Declaration on Environment and Development, and the UN Convention against Corruption. As of 2022, there were over 19 000 participants from over 180 countries that publish, in either their annual reports or sustainability reports, descriptions of the actions they are undertaking to support the 10 principles, which are as follows: Human Rights Principle 1: Businesses should support and respect the protection of internationally proclaimed human rights; and Principle 2: make sure that they are not complicit in human rights abuses. Labour Principle 3: Businesses should uphold the freedom of association and the effective recognition of the right to collective bargaining; Principle 4: the elimination of all forms of forced and compulsory labour; Principle 5: the effective abolition of child labour; and Principle 6: the elimination of discrimination in respect of employment and occupation. Environment Principle 7: Businesses should support a precautionary approach to environmental challenges; Principle 8: undertake initiatives to promote greater environmental responsibility; and 560
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Principle 9: encourage the development and diffusion of environmentally friendly technologies. Anti-Corruption Principle 10: Businesses should work against corruption in all its forms, including extortion and bribery. Source: United Nations Global Compact (2022).
Those readers seeking to further understand the relationship between the above 10 principles and the 17 SDGs can refer to the UN’s 2016 White Paper: The UN Global Compact Ten Principles and the Sustainable Development Goals: Connecting, Crucially, available at https://www. unglobalcompact.org/docs/about_the_gc/White_Paper_Principles_SDGs.pdf.
Other frameworks We could discuss many more reporting guidance documents here. Some reporting frameworks have been developed for narrow aspects of social and environmental performance. For example, the use of water is one specific aspect of sustainability, and one organisation, the Water Accounting Standards Board (WASB) – an Australian Government-funded body – is an international leader in the area of accounting for water. The water accounting framework of the WASB (available at https://www.bom.gov.au/water/standards/wasb/awas.shtml) comprises three major documents: • Water Accounting Conceptual Framework • Water Accounting Standard 1 • Water Accounting Standard 2. Interestingly, for water accounts to satisfy the requirement of being useful to readers, the WASB makes reference to required qualitative characteristics, specifically relevance, faithful representation, comparability, verifiability, timeliness and understandability. These qualitative characteristics for water-related information are the same as the qualitative characteristics identified in the IASB Conceptual Framework. Again, we see that there are certain attributes that various types of information should possess if it is to be useful. In this section on reporting frameworks, we have shown that there is much guidance out there for organisations seeking to report. We have referred to some of the more commonly used frameworks, and it needs to be appreciated that there are many other reporting and measurement frameworks in existence. Furthermore, many industries have developed their own industry-specific disclosure guidance – for example, industry-specific guidelines have been developed by the mining industry, the property development industry, the electricity industry, the fishing industry and the timber industry. Also, many social, environmental and consumer (NGO) groups have developed reporting standards with which they expect organisations to comply, including proposed guidelines for the gambling industry, the clothing industry, organisations that source products that use animal-based products, and organisations that make or source products that use palm oil. Apart from embracing particular reporting frameworks, many reporting organisations also develop their own innovative approaches to reporting. Also, various business organisations – often referred to as sustainability ratings agencies – have developed ratings of organisations in respect of the organisations’ sustainability-related performance.
Sustainability ratings There are various sustainability ratings agencies (SRAs) in existence that rate various organisations and make these ratings available to certain stakeholders, such as institutional investors, for a fee. These ratings include those provided by Sustainalytics ESG Risk Ratings, MSCI ESG Ratings, FTSE Russell’s ESG Ratings and S&P Global ESG Scores. The ratings represent a different form of information about the social and environmental performance 561
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of an organisation. They provide an overall score, often out of 100, of the rated organisations’ sustainability-related performance, as well as scores for separate components of an organisation’s sustainability-related performance. However, the reliability and objectivity of these ratings have been brought into question in various studies. For example, in a study of some leading SRAs, Boiral et al. (2021) question whether the measures being provided are an accurate representation of the actual underlying reality, and argue that the measures being provided are somewhat of a ‘fiction’. This is quite inconsistent with how the ratings services are marketed, wherein they are represented as an objective measurement or rating of an organisation’s actual commitment to, and performance with respect to, sustainability. As Boiral et al. (2021, p. 1756) note: SRAs do not only act as translators by producing numerical information from scattered and often fuzzy performance data, they also tend to create a fictional appearance of order, measurability, and comparability, which is necessary in order for SRAs to function properly and meet stakeholders’ expectations.
Boiral et al. (2021) also point to the difficulties that SRAs face in assessing organisations because of both the non-standardised way in which organisations report sustainabilityrelated data and the inconsistencies in the ways data are audited or assured across different organisations. There was also some questioning of the independence of some SRAs, with some of them providing consulting services to the organisations they were rating. From an accounting research perspective, these ratings are often used by researchers either as an independent or a dependent variable. For example, some research has linked the sustainabilityrelated performance, as reflected by the rating provided by a ratings agency (an independent variable), to organisational profitability (the dependent variable); while some other research has investigated the relationship between board member attributes (such as gender or independence), which the researchers use as an independent variable, and sustainability-related performance (which would be the dependent variable in such research and would be reflected by the rating provided by an SRA). However, the authors that use the ratings provided by ratings agencies often direct no attention towards the inherent limitations in such ratings. Unfortunately, this is a little too common in the social and environmental accounting literature, wherein some authors assume quite simplistically that such ratings provide some form of ‘objective truth’ about social and environmental performance and that there is no need to actually look within the ‘black box’ of the ratings agency to determine how such performance assessments were made, or whether they privilege the interests of some stakeholders over others. As a notable example, consider the paper by Clarkson et al. (2008) published in the reputable journal Accounting, Organizations and Society. The authors simply used ratings provided by the Investor Responsibility Research Centre to ‘verify the accuracy’ of the other performance measures the authors had constructed based upon the US Toxic Release Inventory. The insights provided by Bessire and Onnee (2010) about ratings agencies could have been usefully considered by such researchers. According to Bessire and Onnee (2010, p. 446): Our study started with an action research project: we were asked by a social analysis and rating organisation which operates in France to conduct a critical analysis of the grid they used to assess corporate governance (CG), with the claimed objective of improving it.
In terms of the role of ratings organisations, Bessire and Onnee (2010, p. 453) note: Social analysis and rating organisations play a decisive role in the process of legitimation in the field of CSR. They can be considered as institutional entrepreneurs, that is ‘actors who create norms, values and scripts and by whose actions the new institution becomes accepted’. 562
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The authors see the ratings process as being part of a broader legitimation process (p. 454): Through their evaluations, social analysis and rating organisations legitimate asset managers’ activities towards their hierarchy and investors; they legitimate companies as regards their stakeholders; they legitimate index providers which in their turn legitimate companies. Social analysis and rating organisations are therefore at the core of a legitimation system which however appears to be fragile…. Obviously social analysis and rating organisations cannot deliver legitimacy to the different actors in the field if they have not ensured their own legitimacy. It appears that this legitimacy is fragile and that it is now subject to new challenges.
In terms of their results, the authors state (p. 463): Our study points to several points of concern. First, the selection of items to be rated, the scale used for measurement (number of points, linear or non-linear), the algorithm used to aggregate the series of individual ratings into a global rating (weight of each item, use of filters), appears more the result of an intuitive process than of a scientific process. The methodology appears still weaker when social analysis and rating organisations try to establish a kind of mechanistic correlation between rating and risk. … In short, these ratings do not measure social performance but economic performance in the most traditional sense, that is, according to the prescriptions of agency theory and of property rights theory, and more generally speaking, of neoclassical economics which give priority to shareholders. Since socially responsible stock market indexes are fed by social rating, it is obvious that they are even less reliable than the ratings themselves … we consider that research based on the exploitation of data bases provided by social analysis and rating organisations is irrelevant, not only from a methodological, but also from a theoretical point of view.
The insights provided by Bessire and Onnee (2010) are very relevant for people who are contemplating using particular social and environmental ratings as part of their research. A key point is that such ratings are increasingly being used globally and appear to influence many decisions being made within capital markets. Gray and Milne (2015) also highlight concerns about the use of various dubious ‘proxies’ of social and environmental performance within capital markets and within published academic research. With this said, various researchers are developing some forms of ratings that they believe will provide useful information to various stakeholders. For example, in the context of the mining industry, Hutchings and Deegan (2022) developed an accounting metric, the Environmental Best Practice Index (EBPi). This metric, which incorporates the qualitative characteristics utilised within financial reporting, is based upon an instrument that quantifies the comprehensiveness of a mine site’s environmental management to provide a measure that is scored out of 100. The researchers found that this measure was welcomed by various stakeholders associated with the mining industry, and different stakeholders considered that such a measure could be a useful complement to existing information about organisational environmental performance, which is often shown to be biased and driven by legitimisation efforts. LO10.14
Accounting for externalities
Reporting guidance such as that provided by the GRI – and which we discussed earlier in the chapter – provides numerous sustainability-related key performance indicators (KPIs), but it does not consider the issue of trying to ‘cost’ the externalities caused by businesses. For example, the GRI does not provide guidance about placing a cost on such things as the pollution being generated by an organisation or any adverse health effects caused by the products or processes 563
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of a reporting entity. As explained earlier, generally accepted financial accounting practices also ignore the social and environmental externalities generated by a reporting entity, in large part because of the way we define the elements of financial accounting with the reliance on ‘control’ and because of the reliance financial accountants place on the ‘entity principle’. As Unerman, Bebbington and O’Dwyer (2018, p. 498) state: As externalities are a product of market failures, and as financial prices from market transactions underlie most financial reporting data, financial reporting information will be flawed and incomplete in the almost inevitable presence of externalities. Accordingly, for financial reporting to provide a representationally faithful portrayal of an entity’s performance and position, additional information needs to be provided about material externalities that are not reflected in financial reporting’s marketderived financial data.
An externality can be defined as: an impact that an entity has on parties external to the organisation where such external parties did not agree or take part in the action causing, or the decisions leading to, the cost or benefit. (Deegan, 2020, p. 1251)
Externalities impose costs on third parties which can go uncompensated. Given that externalities are typically not recognised as an ‘expense’ of an organisation, they are therefore not considered when determining the price at which the related goods and services are sold. Their failure to be recognised, and therefore managed, means that goods and services are sold at a price well below the total ‘costs’ of the goods and services. The total costs would include the private costs (which are paid by the organisation), as well as the public costs (which would relate to the externalities), that are typically not paid for by the organisation. Public costs are also often referred to as social costs or environmental costs. The result is that we effectively have a form of market failure where the sales prices of goods and services fails to recognise the total costs, both private and public, associated with the production of the good or service. We can go as far as saying that the ongoing generation of externalities, such as climate change, is due to market failures. Further, because externalities are often ignored by financial accounting, and therefore by financial accountants, their existence does not generally have direct implications for short-term financial performance measures, such as profits. Therefore, longer-term decisions that use financial data, such as profits, will be suboptimal – particularly from a sustainability perspective – because they ignore externalities. Because many of the ‘costs’ of goods or services might be ignored or understated, a greater amount of a particular good or service will be produced and consumed than might otherwise be the case if the overall costs to society were considered. For example, if the air is treated as a ‘free good’ and a heavily polluting organisation does not pay, or incur liabilities, for the pollution it creates, then its measure of profit based upon generally accepted accounting principles may be considered inflated relative to what it would be if costs were assigned to the pollution. In a freely operating market that does not place a cost on pollution, there is the obvious implication that production will increase, profits will rise and, at the same time, the environment will become degraded. There are various ‘costs’ that go into products that are often ignored. For example, let us consider the everyday hamburger. What resources are actually consumed as part of making a hamburger? It has been reported (Harvey, 2015) that the creation of each McDonald’s hamburger requires about 660 litres of water – this relates to factors such as the consumption of water by the cow, and the water used to grow the pasture. In addition, each burger requires 6 kilograms of animal feed, which relies upon the farming of 6 square metres of land. In all, one Quarter Pounder burger also has a carbon footprint of almost 2 kilograms. There are also the ‘costs’ that can result 564
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from fertiliser (used to enhance the growth of grass and grain used to feed cattle) runoff into waterways (for example, rivers) that create damage to the waterways and the inhabitants thereof. Yet we pay only a few dollars for the burger. So, are the externalities being accounted for in terms of the price being charged for a hamburger? The direct financial cost of feeding the cattle and looking after the land would be included in the price of the meat going into the hamburger – these would be considered the ‘private costs’ that are captured within the price of the burger. But the externalities, including the water used, are not being fully accounted for, as most of the water is being treated as a free good. Methane emissions and the carbon footprint are also likely to be unaccounted for, as they do not constitute an immediate private cost either. However, as water scarcity increases in some areas, it is likely that the amount of water being used to generate the final product will tend to be accounted for more fully. So, are these hamburgers generating a ‘profit’? From a financial accounting perspective, McDonald’s is generating a financial profit, given that the water being used is probably being sourced at no, or very little, cost and because other costs (for example, relating to the impacts of the methane emissions), are also ignored from a financial perspective. If McDonald’s was to develop a more holistic notion of profit using some form of ‘full cost accounting’, and treated the water as a real cost, as well as considering the impact of a hamburger’s production on climate change, habitat and so forth, then it would become arguable as to whether McDonald’s is generating a true profit at all. Similar conclusions could also be made in relation to the goods and services provided by many other organisations (and, indeed, perhaps by most organisations). As another example, let us consider the broader ‘costs’ of using coal. The use of coal is often promoted as a low-cost method of generating power. But the generation of ‘cheap’ power through the use of coal is not really cheap once we consider the various social costs associated with the burning of coal. If organisations had to account for these social and environmental costs, there might have been a greater shift towards cleaner energy sources. In an article entitled ‘The hidden cost of Hazelwood’ (Arup and Morton, 2015, p. 12), it was reported that two Harvard researchers used a method created by the National Academy of Sciences in the United States as the basis for an analysis of Hazelwood and other Victorian power plants. Their estimate of the annual cost of the Hazelwood plant on the environment was estimated at $900 million. The estimate is based on damage from global warming on the agricultural sector, on property, and on health because of the reduced air quality. According to the researchers, renewable or clean energy sources could compete on an equal footing with polluters such as Hazelwood and the other coal power plants they investigated if the power companies had to account for the full costs of creating coal-generated electricity. Government intervention can be employed as a means of placing costs on the use of resources that might otherwise go unrecorded. For example, we can consider carbon-related taxes and emission trading schemes (ETS) where organisations incur expenses on the basis of the amount of carbon dioxide released into the atmosphere. Such releases would otherwise be ‘free’. By placing a cost on emissions, a government effectively acts to make organisations internalise costs that would otherwise be ‘externalities’. This can, in turn, motivate profit-seeking organisations to find ways to reduce their emissions levels. The higher the price per tonne of carbon dioxide emissions, the harder we might expect organisations that are affected by the tax to try to reduce their levels of emissions. While we have concentrated on externalities that are negative in nature, externalities can also be positive. That is, there are also many organisations that create social benefits that are not recorded in income or ‘profits’. For example, there might be a wildlife park that breeds threatened and endangered species of animals and then releases surplus animals back into the wild to regenerate local populations. If this organisation was assessed purely on its financial results (perhaps based on the fees charged to visitors and the expenses of running the park) 565
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Sustainable cost Can be defined as the amount an organisation must spend to put the biosphere at the end of the accounting period back into the state it was in (or its equivalent) at the beginning of the accounting period.
then, unless some income is attributed to the positive externalities generated by the organisation (related to the released animals), the reported results of the organisation might be considered to be understated. Similarly, the positive outcomes generated by community-based organisations, such as organisations that assist homeless people, typically go unrecognised in financial measures of performance, such as ‘profits’. Because corporate profits will not incorporate many externalities, we must treat such financial numbers with caution when considering the overall ‘performance’ of an entity. This is something we have already emphasised earlier in this chapter. Perhaps we can question whether a profitable company is also necessarily a ‘good’ company or extend our assessment to include both its short-term and long‑term profitability prospects if it is deemed by critical stakeholders to be profiting at the expense of society. For example, a large financial institution may close many smaller regional branches to reduce financial costs, which might improve financial performance (for example, reported profits). This measure of performance (profits) will not reflect many of the externalities caused by the decision to close regional branches (for example, the costs associated with unemployed workers thereafter receiving benefits from government or the inconvenience caused to regional communities from no longer having a local bank). However, if full cost accounting was employed, then a notional financial cost would be attributed to this social impact. In a departure from generally accepted financial accounting practices, a very limited number of organisations globally have attempted to put a cost on the environmental externalities (positive and negative) caused by their operations. We can call this a ‘full cost’ approach because it would more fully ‘cost’ the activities being undertaken by an organisation. The approaches adopted by some of these organisations include determining a notional ‘sustainable cost’. This is explained by Gray and Bebbington (1992, p. 15) as follows: Sustainable cost can be defined as the amount an organisation must spend to put the biosphere at the end of the accounting period back into the state (or its equivalent) it was in at the beginning of the accounting period. Such a figure would be a notional one, and disclosed as a charge to a company’s profit and loss account. Thus, we would be presented with a broad estimate of the extent to which the accounting profits had been generated from a sustainable source … our estimates suggest that the sustainable cost calculations would produce the sort of answer which would demonstrate that no Western company had made a profit of any kind in the last 50 years or so.
According to Bebbington and Gray (2001, p. 567), the sustainable cost calculation involves two elements: (i) a consideration of the costs required to ensure that inputs to the organisation have no adverse environmental impacts in their production. These are costs which arise in addition to those costs already internalised in the most environmentally sound products and services which are currently available; and (ii) the costs required to remedy any environmental impacts which arise even if the organisation’s inputs had a zero environmental impact. Bebbington and Gray (2001) undertook research that used an organisation known as Landcare Research New Zealand as their case study organisation. They performed a ‘sustainable cost calculation’ for the organisation. From the outset, the authors acknowledged that the sustainable cost calculation is an incomplete account of sustainability because the justice and equity elements of the concept are not addressed. One of the intentions of the work was to show that ‘businesses simply do not make a profit and that accounting in its measurement of a thing that suggests success is simply a lie’ (p. 562). The research borrowed from the concept of Hicksian income and
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associated capital maintenance ideas.4 According to the authors, ‘a level of sustainable activity is that which maintains the planet’s capital’ (p. 562). What the authors show is that once we start applying a sustainable cost calculation, which we then apply to adjust reported ‘profits’, profits generally become losses – and sometimes very significant losses. In undertaking their research, Bebbington and Gray (2001) identified four steps to take when applying full cost accounting: 1 Define the object and level that will be subject to the full cost accounting exercise. This could be a product, or it could be a process. 2 Establish the scope of the analysis. For example, which externalities will be considered. 3 Identify and measure the externalities in physical terms. 4 Monetise the impacts – there are a multitude of measurement techniques that could be used which can generate very different measures. All four steps require a great deal of professional judgement and the various judgements will impact the final results. Many full cost exercises will stop at step 3 because of the many problems and assessments that must be made in assigning a monetary cost to particular externalities. Another illustration of ‘full cost accounting’ was provided by Davies and Dunk (2015). They considered issues associated with the UK higher education sector. Specifically, they sought to determine the externalities associated with the carbon emissions relating to overseas students going to the United Kingdom, together with those generated by friends and family visiting them while they were studying. Another interesting approach to full cost accounting is provided by the UK organisation known as the Crown Estate. The Crown Estate uses an approach that it refers to as its ‘Total Contribution’ methodology (see https://www.thecrownestate.co.uk/media/1692/totalcontribution-report-2017.pdf). In its report entitled Total Contribution Report 2017 – Everything is Connected, the Crown Estate notes: Our Total Contribution methodology provides us with information and insight on the effect of our actions, enhancing our decision-making and enabling us to report the broader value of what we do. It plays a critical role in helping us to think in a wider, deeper and increasingly integrated way about the impact of our actions. It demonstrates how everything is connected. ... Working with colleagues across our business and in conjunction with advisors at Route2, we developed a framework based on the capitals we draw on and impact. The framework reflects the positive and negative flows of our business activities. Having evaluated other options, we put economic values on indicators for each capital. By introducing a common unit of measurement, we can compare and aggregate performance across different metrics. ... We recognise that putting economic values on non-financial indicators isn’t always a perfect solution and that figures aren’t absolute. However, it is a starting point and focus for discussion.
Another innovative approach to reporting has been developed by the German sports apparel and footwear brand PUMA. From 2012, it commenced producing its Environmental Profit & Loss (EP&L) account, wherein it places a financial value on its use of ‘natural capital’. The EP&L 4
Hicks developed a conception of income that was considered to be the maximum amount of consumption during a period that keeps wealth constant. Hicks (1946, p. 172) defines ‘a man’s income as the maximum value which he can consume during a week, and still expect to be as well off at the end of the period as he was at the beginning’.
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seeks to quantify not only PUMA’s direct environmental impacts, but those of its suppliers too. The methodology relies heavily upon the use of various estimation techniques. As part of the process, PUMA allocates a financial cost to products, such as shoes, for greenhouse gas, water, waste, air pollution, land use and other environmental costs. The French-based organisation Kering is another company that produces an environmental profit or loss. In explaining the need for such an ‘account’, the CEO of Kering stated (Kering, 2015, p. 5) that business and society rely ‘on natural resources and ecosystem services to function’ and that for business to be successful those natural systems need to thrive. While business has not integrated the ‘cost’ of the degradation of these natural systems in the past, as they are seen as externalities, ‘this needs to change given the realities confronting us as natural resources decline and the impacts of climate change increase’. What is clear is that, while in the minority, there are a number of organisations internationally that are being creative and coming up with new forms of ‘accounting’ that in some way provide a more holistic representation of ‘performance’ in financial terms than our conventional financial accounting systems are able to do. Of course, whether we should be measuring things like environmental or social performance in financial terms remains a contentious issue for many people. Some people believe that certain aspects of society and the environment should be respected for what they are, and humankind should not ever try to put a financial, or market-based, price on them. But we do need more imagination when it comes to developing new ‘accounting systems’ that will help assist organisations and societies generally to be more responsible and accountable for the ongoing impacts they generate. This will require the participation of ‘accountants’ and ‘accounting researchers’ who possess the ability for strong critical thinking and a real concern for current ecological and social problems As Gray, Adams and Owen (2014, p. 327) note: It seems highly likely that the really effective and influential financial initiatives and the really serious accounts of sustainability have yet to be imagined, let alone developed.
We now turn to Reflection question 10.7, which requires you to consider some factors you might think about if you were to apply full cost accounting to a casino.
REFLECTION QUESTION 10.7 Application of full cost accounting Assume that you are the general manager of Tiara Casino. Question You have considered the possibility of doing some form of ‘full cost accounting’. What are some of the factors you would need to consider in undertaking such a task? Solution You would need to first determine the key social and environmental impacts and externalities of the organisation and then choose which ones will be accounted for. The externalities would then need to be measured in physical or non-monetary terms. Then the organisation would need to determine the costs that would notionally be incurred to remedy the negative impacts created. A monetary value could then be assigned to the positive and negative social and environmental impacts (if any can be determined).
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Some of the negative social impacts would include the social harm done to problem gamblers and their families; the damage caused by patrons to surrounding areas; the crime that might occur because of undesirable people being attracted to the casino from within the country and overseas; waste generated by the casino; and the energy and water consumption of the casino. The costs that would be incurred to notionally remedy all of these social and environmental impacts would then be calculated using particular forms of financial modelling. These costs might then be deducted from calculated profit to see if any form of ‘real profit’ has been generated by the casino. This would be a very interesting exercise to do. Many people would predict that if the full social impacts associated with a casino were somehow attributed a cost, then casinos would always be running at a ‘loss’.
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In concluding our look at full cost accounting, it is again emphasised that very few organisations internationally employ some form of this method of accounting. Nevertheless, our discussion does show how different forms of ‘accounting’ can be used to measure and report an organisation’s social and environmental impacts, be they positive or negative. This all links to the fourth and final step of our ‘accountability model’ – the ‘how stage’. LO10.10
Climate change
As is clear to us all, a specific issue of great relevance to current and future generations – and to all the planet’s various ecosystems and the inhabitants thereof – is climate change. Due to its central importance to all of us, and the role of business organisations in contributing to it (and potentially providing solutions to it), it is worthwhile spending some time considering the issue of climate change. Many people believe that climate change is the most serious of all the problems confronting the planet. The activities of business organisations are a major contributor to climate change. Arguably, managers and accountants should therefore understand the science of climate change. In terms of its meaning, and according to the Australian Academy of Science (see https:// www.science.org.au), climate change is a change in the pattern of weather, and related changes in oceans, land surfaces and ice sheets, occurring over time scales of decades or longer. The issue of climate change can best be explained in terms of what is known as the greenhouse effect. Natural gases in the Earth’s atmosphere allow infra-red radiation from the sun to enter the Earth’s atmosphere, thereby warming the surface of the Earth. Our atmosphere stops a proportion of this heat from leaving (otherwise the whole world would freeze); however, a certain percentage of heat (about a third) is reflected away from the Earth by the atmosphere, by clouds and by the surface of the Earth. It is necessary that some of this heat does leave, otherwise the planet would overheat. One greenhouse gas is carbon dioxide, and like a number of other gases, it plays an important role in moderating the Earth’s temperature. Carbon dioxide is generated by animals and humans, the burning of biomass, the burning of oil and other fossil fuels, through oil and gas production, and so on. Human actions are increasing the concentration of greenhouse gases, including carbon dioxide. As these concentrations of greenhouse gases increase, less heat can be reflected from the planet (that is, more heat becomes ‘trapped’), and generally speaking, temperatures rise. The greenhouse effect is diagrammatically represented in Figure 10.9. The Australian Academy of Science (2015) has produced a fairly easy-to-understand overview of climate change called The Science of Climate Change: Questions and Answers, which is available at http://www.science.org.au/files/userfiles/learning/documents/climate-change-r.pdf. This report emphasises that the expected temperature rises will have dramatic economic, environmental and social impacts, and that it is absolutely crucial that we address the issue now (indeed, we should have done a great deal more already). It is particularly important that the managers of business organisations throughout the world address the issue. Climate change is expected to impact everyone, and from an organisational point of view, some organisations will be affected more than others. Those organisations relying on carbon-intensive production processes are expected to be greatly impacted upon, as will other organisations that are operating in areas that are particularly susceptible to weather and temperature changes and associated changes in water availability and sea levels. Organisations involved in electricity generation, resource extraction (particularly resources such as coal) and manufacturing are likely to be affected most by climate change, and by local and global initiatives to address it. For people interested in reading more about the science of climate change, and some of the very concerning projections, reference can be made to the Sixth Assessment Report of the Intergovernmental Panel on Climate Change (IPCC, 2022), which is the UN body assigned to assessing the science related to climate change (see https://www.ipcc.ch/assessment-report/ar6).
Greenhouse effect The phenomenon whereby the Earth’s atmosphere traps solar radiation, caused by the presence in the atmosphere of gases such as carbon dioxide, water vapour and methane that allow incoming sunlight to pass through but absorb heat radiated back from the Earth’s surface.
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FIGURE 10.9 A diagrammatic representation of the greenhouse effect
The Greenhouse Effect Some sunlight that hits the earth is reflected. Some becomes heat.
Atmosp
here
CO2 and other gases in the atmosphere trap heat, keeping the earth warm.
Source: Based on Gilles, Shakes (2018).
It is not unreasonable to expect that organisations would accept climate change as a key problem to address as part of their responsibilities, and we would also expect them to embrace some accountability in this regard, particularly those organisations in carbon-intensive industries, or those industries exposed to climate change-related risks and opportunities. As KPMG (2017, p. 36) states: In the coming years, we can expect to see a sharp increase in reporting on the financial risks from climate change, building on the rates demonstrated in this year’s survey. Climate change is introducing greater risk and uncertainty into the financial system, both by causing physical damage to companies’ assets, infrastructure and supply chains, and by catalyzing market transformations that threaten to make some traditional business models obsolete and create opportunities for others. As a result, investors and central banks are pushing for greater disclosure. The Financial Stability Board’s Task Force on Climate-related Financial Disclosures (TCFD) has also been influential in driving this and its recommendations of July 2017 will likely become the de facto framework for reporting of this kind in coming years.
KPMG also emphasises that organisations should not only disclose information about their actual emissions of GHGs, but they should also disclose information about the risks and opportunities climate change creates for them (2017, p. 36): Climate-related risk disclosure is very different from reporting carbon emissions or environmental impacts. It’s about turning the telescope around, understanding the impact of a changing climate on the company and asking searching questions. Does the company need to move its operations? Is its supply chain vulnerable to weather events? Will it be able to take out insurance in future? Should it change its business model entirely? This change in reporting approach will also require a change in roles and responsibilities. Traditionally, thinking about climate change has been the function of 570
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corporate responsibility or sustainability teams, but now the responsibility needs to sit with the executive who has the best understanding of a company’s financial risks and opportunities – namely the Chief Financial Officer. For companies that have just begun the process of reporting on climate-related financial risks, or have not yet started at all, a qualitative approach is a good foundation and the TCFD’s guidelines are helpful here. Companies should bring together the main stakeholders from around the business to look at the potential financial risks and opportunities presented by climate change, and then carry out qualitative scenario analysis. For example, if you are a brewing corporation, what would happen if you ran out of water in critical production locations or if the costs of water rise dramatically? If you’re an oil company, will you still have a market for your products in 10 or 20 years’ time? After that, companies can start building sophisticated models that properly project the full gamut of financial risks and opportunities associated with climate change, eventually integrating these models into their decision making and adapting the business strategy accordingly.
Some of the risks and opportunities that climate change creates for business organisations were identified earlier in this chapter when we discussed CSR-related disclosure frameworks and, in particular, the disclosures recommended by the TCFD. We learned then that the risks associated with climate change can be classified as either physical risks or transitional risks. One organisation that has some very useful and interesting resource materials available in relation to climate change is the Climate Reality Project (see https://www.climaterealityproject. org/truth), which is linked to famous advocate for addressing climate change, Al Gore. Figure 10.10 comes from the website of this organisation. It identifies some of the costs that will arise as a FIGURE 10.10 The implications (‘costs’) from continuing to rely upon carbon
$ Species Extinction
$ Political Instability $ Floods & Mudslides
The Cost of Carbon
$ Melting Glaciers
$ Wildfires
$ Famine
$ Drought
$ Water Scarcity
$ Storm Damage
$ Ecosystem Loss
$ Ocean Acidification
$ Our Way of Life
$ Infrastructure Loss
$ Infectious Diseases
$ Climate Refugees
$ “The #1 Threat to the Global Economy” ... And much, much more
$ Sea Level Rise
Source: The Climate Reality Project (2022); image: iStock.com/themoog
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result of the massive amounts of carbon that are being generated by human activities, thereby emphasising how crucial it is that all people take some responsibility for this – as managers, consumers, and product and service users. If you look at the nature of the costs, then you should appreciate that most of these would be externalities that would not be reflected within financial performance measures such as ‘profits’ or GDP. The website of the Climate Reality Project also provides information about global surface temperatures, which are reported as having gradually increased since about 1970, and global sea temperatures, which are reported as having increased since 1950. The website also indicates that 16 out of the 17 hottest years on record have occurred since 2001. In a commentary by Henry Paulson, the former US Treasury Secretary and CEO of Goldman Sachs, entitled ‘Short-termism and the threat from climate change’ (Paulson, 2015), he makes the following observations: The greenhouse-gas crisis, however, won’t suddenly manifest itself with a burst, like that of a financial bubble. Climate change is more subtle and cruel. It’s cumulative. And our current actions don’t just exacerbate the situation – they compound it. Indeed, our failure to make decisions today to avert climate disaster tomorrow is even more serious than our failure to avert the credit crisis in 2008. The carbon dioxide and other greenhouse gases that we emit into the atmosphere today will remain there for centuries, and government will not be able to avert catastrophe at the last minute ... Fewer than ten years ago, scientists projected that melting Arctic sea ice would result in virtually ice-free Arctic summers by the end of this century. Now, the ice is melting so rapidly that such a result could be a reality in the next decade or two. More troubling, two new studies reveal that one of the biggest thresholds has already been crossed. The West Antarctic ice sheet has begun to melt, a process that scientists say may take centuries but that could eventually raise sea levels by as much as 14 feet. Now that the melting has begun, we can’t undo the underlying dynamics, which scientists say are ‘baked in.’ ... We can’t afford to ignore this crisis. It’s as if we’re watching as we fly slow motion toward a giant mountain. We can see the crash coming, but we’re sitting on our hands instead of altering course.
The effects that climate change and associated mitigation efforts will have on organisations will differ depending upon the carbon intensity of the organisation’s operating practices, as well as on the location of the organisation’s operations (some locations will be more affected by weather and temperature changes and associated sea-level changes than others). Organisations involved in electricity generation, resource extraction, farming and manufacturing would be expected to be particularly affected. Nevertheless, given the initiatives aimed at reducing the use of carbon and the apparent changes in weather patterns that are occurring, it is hard to imagine that any organisations will be immune from climate change issues. From a corporate accountability and reporting perspective, it is easy to accept that organisations should be required to make disclosures pertaining to the implications for business of climate-change mitigation policies. Various stakeholders, including investors, will increasingly consider risks associated with climate change when making investment, consumption and other decisions. But are corporations responding quickly enough? Evidence would suggest not. In this chapter, we have already discussed various sources of guidance in relation to climate change-related disclosures. For example, we have discussed guidance from the TCFD, the ISSB and the GRI. Academic research also provides useful disclosure insights. For example, Haque, Deegan and Inglis (2016) note that to understand how organisations are addressing the risks associated with climate change, readers of reports need information about whether an organisation does, or does not, have particular climate change-related governance policies in place. This is also consistent with a report from the Australian Securities and Investments Commission (ASIC, 2018) in which ASIC states (p. 12) that: 572
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Transparency is one of the fundamental tenets of strong corporate governance. When climate risk is material, consideration should be given to disclosing the company’s governance and risk management practices around climate risk.
As a result of an extensive review of various guidance documents, as well as engaging various stakeholder groups, Haque, Deegan and Inglis (2016) developed a ‘best practice disclosure list’ of items that organisations should disclose in order to allow interested readers to know the extent to which an organisation is addressing climate change and the risks related thereto. Haque, Deegan and Inglis (2016) reviewed the annual reports and sustainability reports of a sample of Australia’s most highly carbon-intensive companies. Unfortunately, they found that very few of the items in their ‘best practice’ disclosure index were disclosed by the companies. This is consistent with the results reported within ASIC (2018), in which ASIC found that companies generally disclosed very little information about their climate change-related governance policies. Haque, Deegan and Inglis (2016) also undertook a series of interviews with corporate managers to understand the reasons behind the low levels of climate change-related corporate governance disclosure, and in this regard they note (p. 620) that: Interview results indicate that the low levels of disclosure by Australian companies may be due to a number of factors. A lack of proactive stakeholder engagement and an apparent preoccupation with financial performance and advancing shareholders’ interest, coupled with a failure by managers to accept accountability, seems to go a long way towards explaining low levels of disclosure.
Corporate governance Refers to the structures and processes put in place so that an organisation heads in a direction that is consistent with its overall mission.
Accounting standard-setters are also increasingly starting to release guidance and requirements in relation to climate change-related disclosures. As we noted earlier in this chapter, the IASB issued Practice Statement 2 (PS 2) in 2019, in which it advised that various factors may make climate-related risks ‘material’ to readers of financial reports and thereby warrant related disclosures when preparing financial statements, regardless of their numerical impact. Entities preparing financial statements are advised to consider the needs of report readers, particularly in regard to their requirement to know how climate-related risks have influenced various asset and liability valuations made within the organisation, as well as other operational decisions being made within the organisation. The potential financial implications arising from climate-related and other emerging risks may include, but are not limited to: • asset impairment • changes in the useful life of assets • changes in the fair valuation of assets due to climate-related and emerging risks • increased costs and/or reduced demand for products and services affecting impairment calculations and/or requiring recognition of provisions for onerous contracts • potential provisions and contingent liabilities arising from fines and penalties • changes in expected credit losses for loans and other financial assets. Therefore, the IASB makes it very clear that climate change-related risks are now an important issue to consider when preparing financial statements. Earlier in this chapter, we also noted the expectation of corporate regulators that financial risks associated with climate change should be discussed within a company’s Operating and Financial Review (OFR). However, we need to remember that the disclosures recommended by bodies such as the IASB and the ISSB are aimed at investors, potential investors, lenders and other creditors, and not ‘stakeholders’ more generally. The disclosures are also based upon generally accepted financial reporting practices and therefore tend to ignore the costs associated with the externalities created by climate change – something that we have emphasised in this chapter. Earlier in the chapter, we discussed various reporting frameworks that included disclosure requirements pertaining to climate change, including the GRI standards (particularly GRI 302 on energy and GRI 305 on emissions), the ISSB, the TCFD and the UN SDGs. The reporting frameworks do not necessarily tell us how to measure related aspects of performance, such as 573
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amounts of emissions (that is, they are reporting frameworks and not measurement frameworks). Therefore, we might need to also look at different measurement frameworks. Below, we consider one framework that we might use to measure greenhouse gas emissions. However, it is important to understand that there are many measurement frameworks available that cover a multitude of different social and environmental aspects of performance.
The Greenhouse Gas Protocol One approach to measuring greenhouse gas emissions is provided by the Greenhouse Gas Protocol. According to the GHG Protocol website (GHG Protocol, 2022): The GHG Protocol Corporate Accounting and Reporting Standard provides requirements and guidance for companies and other organizations preparing a corporate-level GHG emissions inventory. The standard covers the accounting and reporting of seven greenhouse gases covered by the Kyoto Protocol – carbon dioxide (CO2), methane (CH4), nitrous oxide (N2O), hydrofluorocarbons (HFCs), perfluorocarbons (PFCs), sulphur hexafluoride (SF6) and nitrogen trifluoride (NF3). It was updated in 2015 with Scope 2 Guidance, which allows companies to credibly measure and report emissions from purchased or acquired electricity, steam, heat and cooling.
The GHG Protocol is one of the most widely used international accounting tools for quantifying greenhouse gas emissions. Pursuant to the GHG Protocol, emissions can be divided into three categories: Scope 1, Scope 2 and Scope 3: • Scope 1 – those emissions directly occurring from sources that are owned or controlled by an institution, including: – combustion of fossil fuels – mobile combustion of fossil fuels in vehicles owned/controlled by the organisation – fugitive emissions. Fugitive emissions, referred to above, result from the intentional or unintentional release of GHGs (for example, the leakage of hydrofluorocarbons from refrigeration and airconditioning equipment). • Scope 2 – emissions generated in the production of electricity consumed by an organisation, where that electricity is generated outside of the organisation’s measurement boundary (that is, the electricity is generated by a different entity, namely an electricity generator). • Scope 3 – all of the other indirect emissions that are a consequence of the activities of an organisation, but which occur from sources not owned or controlled by the organisation, such as: – commuting – air travel for work-related activities – waste disposal – embodied emissions from the extraction, production and transportation of purchased goods – outsourced activities – contractor-owned vehicles – line loss from electricity transmission and distribution. The requirement to report information about different ‘scopes’ reflects the fact that some emissions (Scope 1) are considered easier to monitor and control than others. Different countries have different requirements in relation to reporting GHG emissions. In Australia, for example, entities and corporate groups that meet certain reporting thresholds (that is, large emitters) must report their Scope 1 and Scope 2 emissions under the National Greenhouse and Energy Reporting Act 2007 (NGER Act), and the GHG Protocol is considered an appropriate framework to measure these emissions. The ISSB standard IFRS S2 Climate-related Disclosures, as previously discussed in 574
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this chapter, requires disclosure of Scope 3 emissions. Should this standard become mandatory in some countries, then this will require reporting entities to develop ways to measure their Scope 3 emissions throughout their supply chains and also the emissions caused through the use of their products. Previously, many organisations did not measure their Scope 3 emissions. The Standard also requires that the GHG Protocol be used as the basis of measuring emissions.
Why do I need to know about climate change and understand some of the ways in which organisations can report information about their performance and initiatives in relation to climate change? As community members, researchers and potential business leaders, it is essential that we understand the global crisis represented by climate change. It is important that we comprehend the necessity for all people and organisations, including those we will work for, to address climate change and develop policies to reduce or, ideally, eliminate their carbon-related emissions. Because of the responsibility that all organisations have with respect to climate change, managers
Why
need to understand the various frameworks that are available to demonstrate their accountability with respect to climate change. We have also learned that even from a ‘traditional’ financial reporting perspective, climate change-related risks also have implications for how amounts are attributed to assets and liabilities within the financial statements.
The Carbon Disclosure Project The Carbon Disclosure Project (CDP; see https://www.cdp.net) was formed in 2000. The CDP has offices throughout the world and focuses on the implications of climate change for shareholder value and commercial operations. The CDP seeks information on the business risks and opportunities presented by climate change and greenhouse gas emissions for the world’s largest companies. It publishes emissions data for thousands of the world’s largest corporations, which are thought to account for over a third of the world’s anthropogenic emissions (the word ‘anthropogenic’ can be used to refer to any changes in nature that are caused by people). According to the project’s website (CDP, 2022): We want to see a thriving economy that works for people and planet in the long term. We focus investors, companies and cities and governments on taking urgent action to build a truly sustainable economy by measuring and understanding their environmental impact. CDP runs the global environmental disclosure system. We must act urgently to prevent dangerous climate change and environmental damage. That starts by being aware of our impact so that investors, companies, cities and governments can make the right choices now. Each year CDP supports thousands of companies, cities, states and regions to measure and manage their risks and opportunities on climate change, water security and deforestation. We do so at the request of their investors, purchasers and city stakeholders.
The view of the CDP is that carbon emissions and climate change represent significant business risks and, therefore, an organisation’s policies and performance in relation to climate change should be factored into investment decisions. Furthermore, the CDP has the view that information about greenhouse gas emissions is useful to investors, corporations and regulators in making informed decisions that take into account corporate risk from future government legislation, possible future lawsuits and shifts in consumers’ perceptions towards heavy emitters. Organisations wishing to publicly report their greenhouse gas emissions and climate change strategies can do so through the CDP, and interested parties can do searches on the CDP website by company name. The CDP is also now collecting information about organisations’ use of water, and the use of forestry-related resources. 575
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LO10.17
Accountability for modern slavery
Another very important area of organisational social responsibility relates to modern slavery. ‘Modern slavery’ refers to the use of human trafficking or forced labour that amounts to slavery, or slavery-like practices. It directly links to UN SDG 8: Promote sustained, inclusive and sustainable economic growth, full and productive employment and decent work for all. According to the International Labour Organization (ILO) Forced Labour Convention, 1930 (No. 29), ‘forced or compulsory labour’ is all work or service that is exacted from any person under the threat of a penalty and for which the person has not offered themselves voluntarily. Many millions of people are known to be victims of modern slavery, with a large proportion of these being women and children. Modern slavery occurs in every region of the world and many victims work within state-imposed forced labour arrangements. Apart from the immoral nature of modern slavery-related practices, there are many risks (which we might refer to as ‘reputational risks’) to an organisation if it is found to be associated with forced labour. For example, we can consider the vast amount of negative publicity the leading global surf company Rip Curl received back in 2016, which we referred to in Chapter 9. In one related newspaper article entitled ‘Surf clothing label Rip Curl using “slave labour” to manufacture clothes in North Korea’ (McKenzie and Baker, 2016), it was noted that workers at a clothing factory near the North Korean capital Pyongyang were contracted to make some of Rip Curl’s clothing. It was alleged that employees in such factories are forced to work long hours with minimal or sometimes no pay and workers who do not comply are often imprisoned in work camps. After the newspaper raised the issue with Rip Curl, the company’s chief financial officer was reported as releasing a statement that said the firm ‘takes its social compliance obligations seriously’ and that the organisation was aware of this issue, but only became aware of it after the production was complete and had been shipped to retail customers. Such publicity would have been extremely detrimental to the organisation’s reputation (which is effectively based on a healthy sporting image) and this would likely have had an impact on its profitability. That is, consumers and the market would have potentially punished the company for its apparent link to forced labour, which is the rationale for why the Australian Government (and other governments internationally, including the United Kingdom and Californian governments) have introduced a Modern Slavery Act. In Australia, the Modern Slavery Act 2018 aims, through corporate disclosures, to create awareness within organisations about where they are sourcing their goods from, and how employees in those supply chains are being treated (thereby hopefully averting situations like that in which Rip Curl got embroiled), as well as informing consumers and the public more widely about an organisation’s sourcing policies. Within Australia, the Modern Slavery Act applies to larger organisations, specifically those with annual consolidated revenue of $100 million or more. Such reporting applies to both ‘for-profit’ organisations and ‘not-for-profit’ organisations. Therefore, it applies to business organisations as well as to universities, churches and charities. Organisations that do not meet the $100 million threshold can still voluntarily elect to report in compliance with the Act – and many do. The Act within Australia requires organisations to report annually, by way of a ‘Modern Slavery Statement’, on the steps they are taking, across their supply chains, to address and monitor the risk that modern slavery is present within their supply chains. The modern slavery statement must be signed off by a nominated person in the peak governing body of the entity (such as the board of directors), thereby ensuring that the information is directly brought to the attention of the most senior people within an organisation. The Act does not apply any penalties to organisations for information uncovered and disclosed as a result of the audits of their supply chains. As already noted, the intention is to leave it to ‘the market’ and consumers to punish perceived poor behaviour. However, this relies upon key assumptions that: • consumers actually want to be aware of such information • they will then act negatively towards organisations that are associated with modern slavery. 576
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That is, the intended impacts of the Act rely on concerns managers have about their ‘reputational risk’, wherein reputational risk can be considered to relate to the potential of negative publicity, or negative public perceptions, to create adverse impacts on a company’s reputation, thereby affecting its revenue streams and therefore its profitability. The further assumption here is that managers, being concerned about their reputational risk, will take actions to ensure that elements of modern slavery are not in existence within their supply chains and that this, ultimately, will lead to a reduced incidence of modern slavery throughout the world. According to CPA Australia (2019, p. 12), some of the consequences of the new modern slavery laws would include: • managers revising their governance policies and developing revised policies and action plans, including updating or initiating supplier codes of conduct • implementing systematic reviews of human rights issues in procurement processes, tender processes and contractual terms (including supplier pre-qualification processes) • establishing targets and key performance indicators, internal awareness raising and training in the firm and with key or high-risk suppliers. The legislation does not actually define ‘supply chains’ and it has effectively been left to organisations to self-define their ‘supply chain’. Research reported in CPA (2019) reveals that the majority of organisations appear to be interpreting it very narrowly to mean suppliers with which they have a ‘direct payment relationship’ (which are often referred to as Tier 1 suppliers). It is hoped that this interpretation will broaden over time, but nevertheless it does require selfanalysis by organisations in terms of what they consider to be their ‘supply chain’. The effectiveness of Modern Slavery Acts relies upon organisations organising or commissioning appropriate auditing and monitoring processes throughout supply chains. For example, organisations will need to arrange audits within suppliers’ factories throughout various developing countries and to report the results of such audits. However, legislators and others need to be aware of the available evidence, which casts significant doubt over the robustness or objectivity of such audits, before, perhaps naïvely, simply believing the information being produced by apparently independent third-party auditors or assurance providers. In an in-depth investigation of compliance audits undertaken of the supply chains of multinational corporations (MNCs) in the context of the Bangladesh garments industry, Islam, Deegan and Gray (2018, p. 214) report: What seems to have emerged is a complex interplay of motives, assumptions and influences. The actual conduct of a social compliance audit is predominantly a requirement instituted by the MNC as a pre-condition of the supply contract. There is very little evidence that, all things being equal, the MNCs exert much in the way of resources or effort to assess the reliability of these audits which appear to have a symbolic role and allow the MNC to continue to make claims that appear to play well with western consumers ... Consequently, the audits are generally of a cursory nature and we found little evidence that they make much constructive impact on the lives of workers and communities. Such accountability as is owed to the relatively powerless workers and communities remains largely undischarged ... Thus, a social compliance audit becomes a ritualistic practice that supports MNCs’ maintenance of legitimacy to the wider community rather than creating real accountability.
Hence, as with all reported information, we must always be careful not to necessarily be naive and believe everything we read. We must consider the reputation of the parties involved in gathering and reporting the information, as well as the potential motivations for introducing an element of bias into the reported information. Interested readers might wish to refer to the Australian Government’s Online Register for Modern Slavery Statements at https://modernslaveryregister.gov.au.
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LO10.18
Counter and dialogic accounts
We have discussed various forms of ‘accounts’ and reports within this chapter as they relate to various aspects of an organisation’s social and environmental performance. We need to remember that all forms of accounting typically involve an element of judgement by those making the disclosures, and this is even more so when the form of reporting is largely unregulated, as is the case with much social and environmental/sustainability reporting. Therefore, the managers of an organisation might, through their disclosures, provide a particular perspective of their organisation’s performance (potentially a partisan perspective), but such perspectives of performance might not be shared by other stakeholder groups. There realistically could be, or will be, an element of bias to the reporting being undertaken. Apart from managers, stakeholder groups with an interest in an organisation, which may include particular employee groups, consumer groups, animal welfare groups, or environmental groups, might have access to particular information about that organisation and be able to provide ‘alternative accounts’ (alternative perspectives) about how an organisation has performed. That is, they might produce accounts or reports that challenge, or contest, the accounts released by the managers. These accounts, produced by stakeholders other than managers, are often referred to as counter accounts or shadow accounts. These accounts are often developed from different philosophical and political standpoints and can contradict the accounts prepared by managers. These counter accounts, if prepared, are sometimes released independently by the respective stakeholder group. However, there is some argument that when organisations prepare their CSR or sustainability reports, and particularly where there are contested perspectives about performance (that is, where different stakeholders do not share the same view as management about how well the organisation is performing), then the alternative views held by other stakeholders should arguably also be included within the reports being released by the organisation. For example, if an organisation produces social information relating to how it has advanced the interests of its employees, possibly through implementing various educational or training initiatives, or by introducing policies that assist in the employment of people with disabilities, it might also be useful to provide the views of particular labour union officials about whether they also believe the organisation has been successful in promoting the interests of employees. As we have discussed already in this chapter, various sustainability reporting frameworks encourage or require engagement with stakeholder groups so that the organisation can understand the different and potentially conflicting views of different stakeholders. Therefore, managers should be aware of the potentially ‘counter’ views held by stakeholders. Apart from particular organisations, such as NGOs, producing counter accounts which could contradict the reports being prepared and released by management, it is also possible that managers might work collaboratively with various stakeholder groups to prepare accounts that represent the viewpoint of not only managers, but those of various stakeholder groups as well. Brown (2009) provides an insightful discussion of this possibility, referring to the concept of dialogic accounting and focusing on the sustainability area for illustrative purposes. By dialogic accounting, Brown is referring to a situation in which there is typically more than one ‘logic’ that could be employed to assess organisational performance, and these different logics (based on different perspectives about what aspects of performance are important, or otherwise) could be used to develop different ‘accounts’. Producing dialogic accounts encourages debate between managers and different stakeholder groups and enhances possibilities for revisions in how managers manage the organisation. Brown provides an interesting comparison of dialogical accounting with monologic accounting – monologic accounts represent only one view or logic, this being that of the managers. As she explains, monologic accounting reflects the accounting traditions currently in place, wherein only the manager’s perspective of performance is reported to external stakeholders. This is the traditional approach to reporting to which we are accustomed. However, according 578
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to Brown, the non-reporting of other stakeholders’ perspectives inevitably provides bias in situations where there are conceivably alternative viewpoints. According to Brown (2009, p. 317), dialogic accounting, in recognising the existence of different views of organisational performance, allows for a situation where different and sometimes conflicting views are allowed to coexist. Pursuant to this view, corporate reporting could become a vehicle to foster democratic interaction. The aim of dialogic accounting is not necessarily to replace one dominant form of accounting with another, but rather to foster the development and use of more multidimensional accounting and accountability systems, capable of engaging a variety of perspectives and facilitating wide-ranging discussion and debate about organisational matters. This is a very interesting suggestion, one that runs counter to the views often proffered by many accounting practitioners and researchers, wherein there is presumed to be only one view of the world that can be captured by managers and objectively reflected within accounting reports. As Brown (2009, p. 318) states: Given the essentially contestable nature of sustainability, new accountings should not be aimed at producing incontrovertible accounts. Societal worth should be judged not in terms of the expert production of the ‘right answer’ but in the facilitation and broadening of debate … Accountants need to develop systems that prevent premature closure and which infuse debate and dialogue, facilitating genuine and informed citizen participation in decision making processes … A framework of a dialogical approach would: recognise ideological assumptions; avoid monetary reductionism; be open about the objective and contestable nature of calculations; enable accessibility of nonexperts; ensure effective participatory processes; be attentive to power relations; and recognise the transformative potential of dialogic accounting.
According to Brown, a form of accounting that embraces a dialogic approach will have considerable transformative potential in areas such as sustainable development. Again, the views embodied by Brown (2009) would seem to be of great value in informing debate to extend corporate accountability, and to project different views about corporate performance and success. However, despite its merits, it is probably unlikely that the current monologic practices, which tend to dominate reporting practices, will be displaced any time soon by dialogic approaches. For more on the inclusion of alternative views in organisational reporting, see Reflection question 10.8.
REFLECTION QUESTION 10.8 Including alternative views in corporate reports Organisations generally produce accounts that reflect the views of managers. Using the terminology of Brown (2009), such accounts would be monologic in orientation. At the same time, some other organisations that operate externally, such as NGOs, might be preparing alternative (counter) accounts about how the organisation has performed and these ‘accounts’ might contradict the representations being made by managers. Some managers might agree to include these counter accounts within the organisation’s own reports to highlight different stakeholders’ concerns, and managers might attempt to defend the differences
Reflection
in perspective or provide commentary on what they intend to do to address the stakeholders’ concerns. Questions 1 Would the introduction of counter accounts within corporate reports be useful to the readers of the reports? 2 Could the consideration of counter accounts or dialogic accounts increase the possibility that organisational practices will change? 3 Is such an approach likely to be implemented by managers?
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Solutions 1 The introduction of counter accounts would potentially be useful to readers of organisational reports. Traditional practice is that organisational reports only reflect the managers’ views of performance. This could include an element of bias – either intentionally or unintentionally introduced. Because there are different perspectives that can be taken of social and environmental performance, it can be useful to know about other stakeholders’ views, but we would also need to determine how reliable those views are and whether they are intentionally biased. 2 The argument is that reporting different stakeholders’ views of performance can stimulate debate about whether managers might be seeing or prioritising aspects of performance differently than others see or prioritise them. This could lead to further analysis, which in turn could
lead to changing the way the organisation conducts its operations and how performance is reported. It could also lead to the discovery of new opportunities or reveal potential risks that need to be addressed. Furthermore, if managers know that a counter account will be published alongside their account, they might be more proactive in reporting negative information in order to pre-empt the counter account. Knowing that they will need to report this information, they may then be more proactive in actually addressing the issues associated with such negative information in order to avoid their occurrence in the first place. 3 It is unusual for the reports released by organisations to include the opinions of other stakeholders, other than perhaps auditors or assurance providers. It is not certain that this will change in the future, despite the potential benefits.
Cooper, Coulson and Taylor (2011) also provide insights that are similar to those of Brown (2009). They discuss alternative approaches to providing information about corporate performance in relation to the protection of human rights and workplace safety. They suggest that different stakeholders should be permitted to provide their perspectives, or ‘accounts’, about particular workplace practices so that no one view is privileged over another. Cooper, Coulson and Taylor (2011, p. 755) suggest: We have set out a case that a new form of human and safety account should be produced by a balanced team comprising of the Health, Safety and Environment team, workers’ representatives, staff from a newly formed Scottish Hazards Advice Centre and/or Trade Union representative and a member of management. This collaboration serves to legitimise the role of information provision by actors who may normally be seen to be contributing to a social audit process and bring them into the accounting function. The resulting health and safety account should contain unabridged HSE Inspectors’ reports, the company risk assessment, a commentary by Scottish Hazards Advice Centre, workers and trade unions, together with a financial report containing both previous expenditure by the company on health and safety and costings of remedial work which have been highlighted in the HSE Inspectors’ report and workers’ response. A team approach to such collaboration will help to self-regulate the process of accounting and ensure transparency is achieved.
Therefore, both Cooper, Coulson and Taylor (2011) and Brown (2009) call for ‘multiple voices’ and an acceptance that providing the views or perspectives of different stakeholders in relation to the same situations or events – particularly, in relation to matters of a social or environmental nature that can be evaluated from numerous perspectives – is preferable to simply providing one view (perhaps the views of managers), which inevitably is biased and privileges the rights of some members of society over others. Chapter 13 further explores the topics of counter accounts and dialogic accounts from a critical accounting perspective.
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LO10.16
Personal social responsibility
While this chapter has focused on CSR and associated mechanisms to improve CSR – which certainly includes reporting – we conclude the chapter with a brief reflection upon our own personal social responsibilities (PSR). As individual consumers, or as members of an organisation, we can all make choices that will either increase or decrease our own contribution to various social and environmental outcomes, inclusive of climate change and modern slavery. To make informed choices we need quality information. As we explained within Chapter 1, relevant and reliable (or representationally faithful) information provides us with the ‘power’ to make informed choices. So, quality social and environmental and sustainability information – the focus of this chapter – is vital for the various choices we make. Rather than relying solely on CSR and/or the government to solve global problems, we must also consider PSR, which would require ongoing judgements, such as the necessity for particular travel and the mode of travel being used, how much energy we consume, how much waste our activities are generating, how social and environmental responsibilities were embraced by the suppliers of our clothing, and so forth. The emphasis here is that tackling important issues such as climate change, modern slavery and poverty alleviation requires ‘the community’ to also embrace the need for change and not to simply rely upon (or blame) organisations for the necessary improvements. One can also argue for PSR on the grounds that asking for CSR becomes a way of ‘passing the buck’ and evading personal responsibility for ‘doing good’. This is the flip side of blaming corporations for everything from obesity to scalding from spilled coffee – both have been the subjects of lawsuits in recent years. As Chandler (2010) states:
Personal social responsibility (PSR)
The continuing individual commitment to behave ethically and contribute to responsible economic, environmental and social development.
Let’s get beyond the idea that firms are inherently evil. Such a perspective does not absolve firms of responsibility, but recognises that for-profit organizations add considerable social value in producing products and services that are in demand. It also recognizes that the relationship between firms and society is symbiotic and, as a result, the responsibility to ensure social responsible outcomes is shared. In the same way that we deserve the politicians we vote for, we also deserve the companies we purchase from.
While this is all pretty obvious, how many of us actually embed PSR considerations in a meaningful way in the various decisions we make? Further, how do accounting and business lecturers embed considerations of PSR within the courses they teach? Arguably, because business educators have an audience of future business leaders, it is even more important that they try to increase consciousness about the role of individual choice in addressing social and environmental issues and problems. But, do they? In a related point, lecturers within economics departments typically continue to teach models of economics that have at their core the ‘rational economic person’ driven by self-interest which is focused towards the goal of maximising wealth. This model is inconsistent with a view that people should embrace PSR. Nothing could be more antipathetical to the goal of sustainable development than the notion of the ‘rational economic person’. Teaching students that selfinterest is the basis upon which most people act can make it a self-fulfilling prophecy that they will also behave like this when choices confront them. So, how many of us have challenged economics lecturers on this? Should we? We can see that there are many interesting issues when it comes to both CSR and PSR!
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STUDY TOOLS CHAPTER SUMMARY This chapter has reviewed various issues associated with corporate social and environmental reporting and sustainability reporting. Since the early 1990s, many organisations throughout the world have been providing an increasing amount of information about their social and environmental performance in a variety of reports. Concerns associated with sustainability (which relates to economic, social and environmental performance issues) have increased since that time, and the evolution of corporate social and environmental performance reporting appears to be related to these concerns, as developments in reporting are arguably a reflection of changing community expectations about the performance and responsibilities of business. In examining various theoretical issues associated with social and environmental reporting, the discussion was structured to follow the why–who –for what– how stages of the sustainability reporting process. In the why stage, various aspects of the motivations for organisations to engage in CSR and social and environmental reporting were explored, including motivations linked to gaining, retaining or repairing organisational legitimacy; managing or manipulating powerful stakeholders; increasing the value of an organisation; or doing the ‘right thing’ in terms of demonstrating accountability in relation to significant social and environmental impacts. When an organisation voluntarily discloses information publicly about its social and environmental performance, this may imply the managers are acknowledging that they are accountable to a broad group of stakeholders in relation to not only their financial performance but also their social and environmental performance. However, as this chapter indicates, not all people consider that managers have social responsibilities to a broad group of stakeholders. Some researchers believe that the prime responsibility of managers is to shareholders alone and, within these confines, to maximising shareholder (financial) value. However, this narrow perspective of corporate responsibility seems to be becoming less widely accepted, as an interrelated understanding of social, environmental and economic sustainability becomes more widely accepted. For the who (or to whom) stage, the chapter examined the range of stakeholders that different organisations are likely to wish to address in their social and environmental (or sustainability) reporting strategies. This range of stakeholders is likely to be directly related to an organisation’s motives for engaging in social and environmental reporting. It will be very broad for organisations that operate in a manner consistent with the ethical branch of Stakeholder Theory. Conversely, organisations following the managerial branch of Stakeholder Theory will tend to focus on the demands and expectations of a narrower range of stakeholders – those with the most power over the organisation. The chapter then explored some theoretical perspectives regarding the mechanisms that organisations may use to identify what information these stakeholders need, or for what issues these stakeholders believe the organisation is socially and environmentally responsible and accountable. It first drew on several studies that demonstrated that stakeholders do appear to make use of information about the social and environmental performance of organisations, and thus it can be concluded that stakeholders do want some social and environmental performance information. An analysis was undertaken of theoretical perspectives on processes of stakeholder dialogue, which can be used by organisations to develop an understanding of what social and environmental information is likely to be demanded by their stakeholders. Finally, in the how stage, theoretical perspectives on some of the processes involved in the production of social and environmental reports were reviewed, including the limitations of conventional financial reporting for capturing and reflecting the social and environmental impact of an organisation’s policies and practices. We discussed various reporting frameworks, including those developed by GRI, IIRC, ISSB and TCFD, and we considered some strengths and limitations associated with various frameworks. We also considered the nature of externalities, why they are not reflected in various measures of financial performance, and some novel approaches to accounting for externalities, including ‘full cost accounting’. We also considered how to account for the important issues of climate change and modern slavery, as well as discussing the benefits of producing ‘counter accounts’. It is worth emphasising that this chapter has provided only an overview of various issues associated with social and environmental reporting. It represents a very rich area of practice and research. However, 582
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the chapter has demonstrated the evolution in reporting and the many interesting issues to address when it comes to reporting issues pertaining to sustainability. What should be clear is that the reliance on measures of financial performance, such as ‘profits’, needs to be reduced and more priority needs to be given to assessing performance from a more holistic perspective. In concluding this summary, the following Native American saying seems very pertinent:
When the last tree is cut down,
the last fish eaten,
and the last stream poisoned,
you will realise that you cannot eat money. Source: Oxford Dictionary of Proverbs (2009).
ANSWERS TO OPENING QUESTIONS At the beginning of the chapter, we asked the following five questions. As a result of reading this chapter, you should be able to provide informed answers to these questions – ours are Module 1 Questions / shown below. Answers
Many companies throughout the world publish reports that discuss their sustainability-related performance. A report by KPMG entitled ‘Big shifts, small steps’ (KPMG, 2022) notes that in 2022, 79 per cent of the top 100 companies by market capitalisation from 58 countries, and 96 per cent of the top 250 global companies, report on sustainability. This contrasts with KPMG’s first survey in 1993 when only 12 per cent of the top companies reported on sustainability.
1 Producing sustainability-related information requires organisations explicitly to consider various facets of their economic, social and environmental performance. But why would companies embrace sustainability as a corporate goal rather than simply aiming for increased and continued economic growth and profitability? There could be many reasons for this. Community expectations have changed and knowledge of various impacts, including those related to climate change, has improved. Managers could be reacting to this. They could be embracing sustainability as a corporate goal because it is the ’right thing to do’ or because powerful stakeholders are expecting the organisation to address sustainability-related issues. Managing and reducing social and environmental impacts also decreases the risks that organisations face. 2 Why might there have been such an increase in reporting between 1993 and 2020? It is often argued that organisational reporting practices respond to community and stakeholder expectations. Since the early 1990s, there has been a significant increase in community concerns about organisational social and environmental impacts, particularly in relation to issues such as climate change and modern slavery. Managers would likely be responding to this increasing concern and accepting a responsibility, and an associated accountability, for their social and environmental impacts. 3 If an entity embraces ‘sustainability reporting’, then what does this imply about the perceived accountability of business? In Chapter 2, we discussed the relationship between managers’ perceptions of organisational responsibility, accountability and ‘accounting’. If managers are reporting information about ‘sustainability’ then this implies they believe they have a responsibility and associated accountability in relation to sustainability. 4 Many professional accounting bodies throughout the world have sponsored research that investigates various social and environmental reporting and accountability issues. But should sustainability reporting issues be within the domain of professional accounting bodies? Absolutely! ‘Accounting’ is a very rich discipline and links to the notion of ‘accountability’. As perceptions of organisational responsibilities broaden to include various social, environmental and economic impact-related responsibilities, this leads to an increase in the required
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‘accountability’ of managers. This in turn broadens the nature of the ‘accounting practices’ embraced by managers and extends the nature and amount of ‘accounts’ being produced by an organisation. Professional accounting bodies are required to respond to changing perceptions of ‘accountability’ and to move away from a traditional fixation on reporting information about financial performance and position. This evolution towards other forms of ‘accounting’ has been evident in the accounting profession for a number of years. 5 What sort of sustainability-related information should organisations disclose (a normative question), and to whom should they make the disclosures (that is, who are the relevant stakeholders)? Do you think your views about organisations’ accountabilities would be the same as those of your fellow readers? What is disclosed needs to be linked to judgements made about an organisation’s responsibilities and associated accountability. One important way to determine this is through some form of engagement with stakeholders. Determining which stakeholders to engage, and to whom to provide required or demanded information, will depend upon how managers define their ‘stakeholders’, which might be based upon a mixture of managerial and ethical reasoning. We all tend to have somewhat different views about organisational accountabilities because we tend to have different views about to whom an organisation is accountable and for what aspects of performance the organisation is accountable.
QUESTIONS 10.1 What has the environment got to do with accounting? LO10.5 10.2 What is accountability and what is its relationship to: a accounting? b an organisation’s responsibilities? LO10.4 10.3 Do you think it would make sense for a student of accounting to undertake an education in accounting without being thoroughly exposed to the idea of accountability? Explain your view. LO10.5 10.4 What is sustainable development? LO10.9 10.5 Do conventional financial accounting practices, principles and definitions encourage or assist corporations to adopt sustainable business practices? Explain your answer. LO10.11 10.6 Why would a company produce a sustainability report? LO10.7 10.7 Are ‘economic rationality’ (as defined by economists) and ‘sustainability’ mutually inconsistent? LO10.9 10.8 Would advocates of Positive Accounting Theory (as explained in Chapter 8) believe that organisations will embrace sustainable development in the way described by the Brundtland Report? Explain your view. LO10.7 10.9 What is an externality, and why do financial accounting practices typically ignore externalities? LO10.14 10.10 What is stakeholder engagement and why might it be important to the success of an organisation? LO10.15 10.11 Think about an organisation that you know and then: a Identify at least one positive and one negative externality generated by the organisation as well as the stakeholders affected. b Would these externalities directly impact on the income or expenses (and therefore profit) of the organisation? c In your opinion, is the failure to recognise externalities a fundamental limitation of our current financial reporting requirements? LO10.14 10.12 Explain how any assessment undertaken by management about why they are reporting will have an effect on the audience for the reports (i.e. to whom they are reporting). LO10.6 10.13 a From your own perspective, and in broad terms, what are the social responsibilities of business organisations? Further, do you believe that the responsibility of business organisations is restricted to current generations or should the implications for future generations be factored into current management decisions?
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b Do you think that business organisations actually operate in accordance with your expectations identified in (a) above, and if not, why not? LO10.3 10.14 What is a social audit and why would a profit-seeking entity bother with one? LO10.15 10.15 Why do you think the European Union called for a: redefinition of accounting concepts, rules, conventions and methodology so as to ensure that the consumption and use of environmental resources are accounted for as part of the full cost of production and reflected in market prices? (European Commission, 1992) LO10.11
10.16 What is triple bottom line reporting? What has it to do with sustainable development? LO10.2 10.17 What is personal social responsibility? What role does it play in relation to the goal of sustainable development? LO10.18 10.18 Evaluate the following statement by Chandler (2010): Let’s get beyond the idea that firms are inherently evil. Such a perspective does not absolve firms of responsibility, but recognises that for-profit organizations add considerable social value in producing products and services that are in demand. It also recognizes that the relationship between firms and society is symbiotic and, as a result, the responsibility to ensure social responsible outcomes is shared. In the same way that we deserve the politicians we vote for, we also deserve the companies we purchase from. LO10.18
10.19 Do you think that triple bottom line reporting can actually lead to separate ‘bottom lines’ for the social, environmental and economic performance of an entity? Explain your view. LO10.2 10.20 Explain what is meant by the following statement: in the long term, environmental sustainability is necessary for both social and economic sustainability, so attention to minimising impacts in respect of the environment is necessary to ensure a sustainable social and economic future. LO10.9
10.21 Of what relevance to the accounting profession is sustainable development? LO10.4 10.22 Why do you think that the accounting profession has generally not released any accounting standards pertaining to the disclosure of social and environmental information from a nonfinancial perspective? LO10.5 10.23 If corporate managers adopted views consistent with those of Milton Friedman, do you think that any quest towards sustainable development would be realistic? LO10.3 10.24 Evidence shows that business entities and business associations typically make submissions to government which argue in favour of maintaining the voluntary status of social and environmental performance reporting. That is, they typically oppose the introduction of legislation to require them to report information about their social and environmental performance. Why do you think this is the case? LO10.7 10.25 Collison (2003, p. 861) states: Attention to the interests of shareholders above all other groups is implicit in much of what is taught to accounting and finance students. The very construction of a profit and loss account … is a continual, and usually unstated, reminder that the interests of only one group of stakeholders should be maximised. Indeed it may be very difficult for accounting and finance students to even conceive of another way in which affairs could be ordered … even at the algebraic level, let alone the moral.
a Do you agree or disagree with Collison, and why? b If ‘profit’ maximisation is biased towards maximising the interests of only one stakeholder group, would you expect that over time there will be less emphasis on profits and more emphasis on other performance indicators? Why? What might be some of the alternative measures of performance? c Would Collison’s comments provide a justification for moves towards profit measures that incorporate ‘full costs’ (that is, that consider the externalities of business)? LO10.3 LO10.11 10.26 If a particular social or environmental incident occurs that involves an organisation and generates negative media attention, how would you expect the organisation to react from a disclosure perspective? LO10.7 10.27 Evaluate the following statement: While discounting liabilities to their present value makes good economic sense (indeed it is not questionable that a dollar in the future is worth less than a dollar now), it does not necessarily make good ecological sense because it effectively downplays the importance of the future clean-up.
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10.28 How would the following theories (addressed in Chapters 8 and 9) explain CSR reporting? a Positive Accounting Theory b Legitimacy Theory c Stakeholder Theory d Institutional Theory. LO10.7 10.29 In publicly released reports, many organisations refer to their ‘licence to operate’. What do you think they mean by this, and is there a theoretical perspective that can explain what this term means? LO10.7 10.30 What is ‘enlightened self-interest’? LO10.3 LO10.4 LO10.7 10.31 Some people argue that fixating on maximising corporate profits and increasing shareholder value will ultimately lead to benefits for all people within society (perhaps through a ‘trickle-down effect’). Evaluate this view. LO10.7 10.32 a How do you think that information, such as CSR-related information, could be used to manage an organisation’s relationships with its powerful stakeholders? b Do you think that this is an ‘appropriate’ rationale for producing CSR reports? LO10.7 10.33 Read the following statement from the Business Council of Australia (2005) and then explain whether such a perspective ties in well with the very real need for corporations to embrace sustainable development for the good of the planet. On the basis of such a statement, to which stakeholder groups would corporations be primarily accountable according to the Business Council? LO10.3 The litmus test for any activity or responsibility is whether the performance of that activity or responsibility can reasonably be seen to be contributing to the growth of shareholder value.
10.34 Consider how the concept of sustainable development, as it applies to business entities, compares with the accountant’s notion of a ‘going concern’. Do you believe that they are similar, or are they quite different? LO10.9 10.35 Do the majority of large companies actually disclose information about their social and environmental performance? What would be the implications for a large company that does not report such information? LO10.1 10.36 Is GDP a ‘good measure’ of national performance? Explain your views. LO10.11 10.37 If a large mining company reports record profits, is this profit figure misleading if the same company has polluted various river systems and has emitted various toxic substances into the air, but has not recognised an expense in relation to these externalities? LO10.11 10.38 From the perspective of sustainable development, why is it important to consider both intergenerational and intragenerational equity? LO10.1 10.39 In 1995, the Institute of Chartered Accountants in Australia (ICAA) established an Environmental Accounting Task Force with the Chairperson being the author of this book (which subsequently became the Triple Bottom Line Issues Group). The task force released a number of documents, one being The Impact of Environmental Matters on the Accountancy Profession (released in January 1998). Within this document, the ICAA Environmental Accounting Task Force raised a number of environmental reporting issues that it believed require consideration. These included: a Are standards or guidelines needed to assist companies to meet the information needs of stakeholders in respect of the disclosure of environmental information? b Do environmental impacts, whether quantifiable in monetary terms or not, warrant some form of disclosure to the extent the environmental implications are deemed ‘significant’ rather than material within the meaning of accounting standards? c Does the provision of environmental performance information and advising on control aspects of environmental management systems fall within the core skills of accountants? d Are the definitions of ‘assets’ and ‘liabilities’ in the IASB Conceptual Framework appropriate to environmental accounting. If not, how should they be expanded? Specifically: should the definition of an asset based on ‘control’ apply? Should it be amended to recognise specifically the environment as an entity, thereby allowing liabilities to be recognised without the intervention of a third party? e Is the concept of materiality relevant to environmental reports?
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f Should reporting of environmental issues according to traditional accounting concepts be progressed while the difficulties of monetary measurement are researched further? g Should general or industry-specific approaches be adopted to advance issues associated with environmental performance evaluation, reporting and auditing? Attempt to provide your own views on these issues. LO10.5 LO10.11 10.40 We now know that tobacco-based products cause severe health impacts for users of the products. For many years, tobacco companies challenged the alleged health impacts of their products but, ultimately, they accepted that their products were unsafe. The products generate various externalities. What would be the implications for tobacco companies’ reported results if: a conventional financial accounting practices were employed? b some form of ‘full cost’ accounting, which took account of externalities, was adopted? LO10.11
LO10.14
10.41 In recent decades, a number of large banks internationally have drastically reduced their workforce as part of ‘cost cutting’ exercises. Do you think that it is a limitation of financial accounting that organisations can show an increase in profits when such an increase is as a result of negatively impacting on a particular group of stakeholders? Explain your view. LO10.11 10.42 Explain the apparent rationale motivating some governments internationally to develop disclosure requirements in relation to modern slavery. LO10.17 10.43 Internationally, large casinos often report very large profits. While casinos provide entertainment for many people, the reality is that they also negatively impact the lives of problem gamblers and their families. a How would a casino account for the social costs created for problem gamblers? b Should a casino account for the social costs created for problem gamblers? c Would GDP be positively or negatively affected by the social costs that arise from problem gambling? LO10.5 LO10.11 10.44 In the early 2000s, the news media internationally ran many stories about the poor working conditions imposed upon workers in factories producing clothes for various clothing and sportswear companies. It was common for these factories to be referred to as ‘sweatshops’. Companies like Nike and GAP were often the subject of sustained media attention. In response, many of these organisations put in place various mechanisms to help ensure improvement in the conditions of factory workers. a Why do you think that companies like Nike and GAP responded to the community concerns? b Would the responses by companies to the news of ‘sweatshop abuse’ be reflective of responses driven by ‘enlightened self-interest’ or a case of a company embracing a form of responsibility to the stakeholders affected by its operations? LO10.11 LO10.15 10.45 Do you think that managers have an accountability for explaining what they are doing to address the risks that modern slavery exists within their supply chains? Why? LO10.17 10.46 What do ‘counter accounts’ represent, and would the incorporation of ‘counter accounts’ within corporate reports enhance the usefulness of corporate reports? LO10.18 10.47 What are some of the risks and opportunities that climate change poses for business organisations? Should such risks and opportunities be disclosed by an organisation? Why? LO10.10 10.48 Organisations create a multitude of social and environmental impacts on various stakeholders. Realistically, not all impacts can be reported. A good CSR report will describe the processes an organisation undertook to determine what information will be reported and what will not be reported. This can be referred to as the ‘materiality determination process’. Why should an organisation clearly describe this process, and why would this description be useful for report readers? LO10.6 10.49 Assume that you are the manager of a large organisation that has never produced a CSR report. It has been decided that the organisation will produce its first report and you have been placed in charge of outlining the steps that need to be undertaken to do so. In this regard, what are some initial factors that need to be considered in determining what aspects of social and environmental performance will be addressed within the CSR report? LO10.4 LO10.5 LO10.6
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10.50 In a newspaper article entitled ‘NAB slashes to brace for digital threat’ (Yeates, 2017, p. 20), it was reported that: National Australia Bank chief executive Andrew Thorburn is unleashing a $1 billion cost-cutting drive he says is needed to prepare the bank for a world of tougher competition and economic conditions. Mr Thorburn said up to 6000 jobs would be lost over the next three years as part of a plan to slash expenses while investing in new technology, including by using automation to replace work done by people.
Required: The slashing of so many jobs will likely cause various social impacts. Referring to the definitions of the elements of financial accounting, why are such social costs not considered to represent ‘expenses’? LO10.11 10.51 In a newspaper article entitled ‘Huawei exec grilled by hostile MPs’ (Bourke, 2019, p. 14), it was reported that John Suffolk, Huawei’s vice-president and global cyber security and privacy officer, appeared before a UK parliamentary committee. He was asked about a report published by the Australian Policy and Strategic Institute that highlighted the organisation’s potential role in enabling China’s surveillance, repression and persecution of Uighurs and other Muslim ethnic minority communities in Xinjiang province. It was reported that he was specifically asked whether the United Kingdom should do business with a company that is complicit in such human rights abuses. It was reported that: Suffolk said: ‘I think you should do business with all companies that stick to the law.’ Earlier, Suffolk said it was Huawei’s job to work within the law of the 170 countries in which it operates, regardless of the sort of government that set the laws. ‘It is the government’s role to set the law whether it is in the east or the west. It is our job as a supplier to work within that law, so it doesn’t matter to us what is the name of the country – it is whether it is lawful,’ Suffolk said. ‘We don’t make judgments whether laws are right or wrong, that’s for others to make those judgments.’
Required: Is this response consistent with our definition of corporate social responsibility provided within this chapter? Further, do you think such a statement would impact the perceived ‘legitimacy’ of the organisation? LO10.3 LO10.7 10.52 In this chapter it was noted that in relation to efforts to restrict accountability, Gray, Adams and Owen (2014, p. 325) were of the opinion that: Powerful people the world over appear to know just how transformative a full accountability and transparency would be – and work very hard to prevent it coming to fruition. It seems difficult to avoid this conclusion – however unsettling it might be.
Required: Explain the reasoning behind the above statement.
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10.53 As indicated in this chapter, Gray and Bebbington (1992, p. 6) provide the following opinion in relation to traditional financial accounting: there is something profoundly wrong about a system of measurement, a system that makes things visible and which guides corporate and national decisions, that can signal success in the midst of desecration and destruction.
Required: Critically evaluate Gray and Bebbington’s statement.
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10.54 What could motivate managers to report counter accounts? LO10.18 10.55 Within this chapter, a quote from Brown (2009, p. 318) is provided, which states: Given the essentially contestable nature of sustainability, new accountings should not be aimed at producing incontrovertible accounts. Societal worth should be judged not in terms of the expert production of the ‘right answer’ but in the facilitation and broadening of debate … Accountants need to develop systems that prevent premature closure and which infuse debate and dialogue, facilitating genuine and informed citizen participation in decision making processes … A framework of a dialogical approach would: recognise ideological assumptions; avoid monetary reductionism; be open about the objective and contestable nature of calculations; enable accessibility of nonexperts; ensure effective participatory processes; be attentive to power relations; and recognise the transformative potential of dialogic accounting.
Required: Explain and evaluate what Brown is saying in the above quote.
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Deegan, C. (1996), ‘A review of mandated environmental reporting requirements for Australian corporations together with an analysis of contemporary Australian and overseas environmental reporting practices’, Environmental and Planning Law Journal, 13(2), pp. 120–32. Deegan, C. (2013), ‘The accountant will have a central role in saving the planet … really? A reflection on “Green accounting and green eyeshades twenty years later”’, Critical Perspectives on Accounting, 24(6), pp. 448–58. Deegan, C. (2019), ‘Legitimacy theory: despite its enduring popularity and contribution, time is right for a necessary makeover’, Accounting, Auditing and Accountability Journal, 32(8), pp. 2307–29. Deegan, C. (2020), Financial Accounting, 9th edn, Sydney: McGraw-Hill. Deegan, C. & Blomquist, C. (2006), ‘Stakeholder influence on corporate reporting: an exploration of the interaction between the World Wide Fund for Nature and the Australian minerals industry’, Accounting, Organizations and Society, 31(4/5), pp. 343–72. Deegan, C. & Gordon, B. (1996), ‘A study of the environmental disclosure policies of Australian corporations’, Accounting and Business Research, 26(3), pp. 187–99. Deegan, C. & Rankin, M. (1997), ‘The materiality of environmental information to users of accounting reports’, Accounting, Auditing and Accountability Journal, 10(4), pp. 562–83. Deegan, C., Rankin, M. & Tobin, J. (2002). ‘An examination of the corporate social and environmental disclosures of BHP from 1983–1997: a test of legitimacy theory. Accounting, Auditing & Accountability Journal, 15(3), pp. 312–43. Deegan, C. & Shelly, M. (2014), ‘Corporate social responsibilities: alternative perspectives about the need to legislate’, Journal of Business Ethics, 121, pp. 499–526. Deegan, C. (2020), Financial Accounting, 9th edition, McGraw Hill Education, Sydney, p. 793. Dillard, J. F., Brown, D. & Marshall, R. S. (2005), ‘An environmentally enlightened accounting’, Accounting Forum, 29(1), pp. 77–101. Elkington, J. (1997), Cannibals with Forks: The Triple Bottom Line of 21st Century Business, Oxford: Capstone. European Commission (1992), Towards Sustainability: A Community Programme of Policy and Action in Relation to the Environment and Sustainable Development, Brussels: European Commission. Eyers, J. & de Kretser, A. (2022), ‘Westpac cuts head office staff and shakes up top ranks’, Australian Financial Review, 3 February. Freeman, R. (1984), Strategic Management: A Stakeholder Approach, Marshall, MA: Pitman. Freeman, R. E. & Reed, D. L. (1983), ‘Stockholders and stakeholders: a new perspective on corporate governance’, California Management Review, 25(3), pp. 88–106. Friedman, M. (1962), Capitalism and Freedom, Chicago, IL: University of Chicago Press. Garcia-Torea, N., Fernandez-Feijoo, B. & De La Cuesta, M. (2020), ‘CSR reporting communication: defective reporting models or misapplication?’, Corporate Social Responsibility and Environmental Management, 27(2), pp. 952–68. Gibassier, D., Rodrigue, M. & Arjalies, D. (2018), ‘Integrated reporting is like God: no one has met Him, but everybody
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Extending corporate accountability: the practice of social and environmental reporting CHAPTER 10
Gray, R., Owen, D. & Maunders, K. T. (1991), ‘Accountability, corporate social reporting and the external social audits’, Advances in Public Interest Accounting, 4, pp. 1–21. Greenhouse Gas Protocol (2022), ‘Corporate standard’, https://ghgprotocol.org/corporate-standard Grieve, C. (2021), ‘CBA to send 100 technology and compliance roles to India’, Sydney Morning Herald, 16 August. Griffin, P., Lont, D. & Sun, Y. (2017), ‘The relevance to investors of greenhouse gas emission disclosures’, Contemporary Accounting Research, 34(2), pp. 1265–97. Griffin, P. & Sun, Y. (2012), ‘Going green: market reaction to CSR Newswire releases, capital markets: market efficiency’, eJournal, University of California, Davis, Graduate School of Management. Guthrie, J. & Parker, L. D. (1989), ‘Corporate social reporting: a rebuttal of legitimacy theory’, Accounting and Business Research, 19(76), pp. 343–52. Haque, F. & Jones, M. (2020), ‘European firms’ corporate biodiversity disclosure and board gender diversity from 2002 to 2016’, The British Accounting Review, 52(2), pp. 1–18. Harvey, C. (2015), ‘We are killing the environment one hamburger at a time’, Business Insider Australia, 6 March, https://www.businessinsider.com.au/onehamburger-environmentresources-2015-2 Hatch, P. (2022), ‘Qantas set for half-empty profit’, The Age, 28 January, p. 28. Hicks, J. R. (1946), Value and Capital: An Inquiry into Some Fundamental Principles of Economic Theory, Oxford: Clarendon Press. Hogner, R. H. (1982), ‘Corporate social reporting: eight decades of development at US Steel’, Research in Corporate Performance and Policy, 4, pp. 243–50. Hutchings, G. & Deegan, C. (2022), ‘The development and application of a decision-useful measure of environmental best practice for the mining industry’, Accounting, Auditing and Accountability Journal, 35(2), pp. 1154–81. IFRS Foundation (2022), IAS 37 Provisions, Contingent Liabilities and Contingent Assets, https://www.ifrs.org/ issued-standards/list-of-standards/ias-37-provisionscontingent-liabilities-and-contingent-assets Ingram, R. W. (1978), ‘Investigation of the information content of certain social responsibility disclosures’, Journal of Accounting Research, 16(2), pp. 270–85. Institute of Chartered Accountants in England and Wales (1975), The Corporate Report, London: ICAEW. Institute of Chartered Accountants in England and Wales (2004), Sustainability: The Role of Accountants, London: ICAEW. Intergovernmental Panel on Climate Change (2022), Sixth Assessment Report of the Intergovernmental Panel on Climate Change (IPCC), https://www.ipcc.ch/assessmentreport/ar6 International Accounting Standards Board (2022), Conceptual Framework for Financial Reporting, London: IASB. International Integrated Reporting Committee (2013), Consultation Draft of the International Integrated Reporting Framework, London: IIRC. Copyright © December 2013 by the International Integrated Reporting Council (‘the IIRC’). International Integrated Reporting Council (2021), The International Framework, January 2021, IIRC. London: IIRC, now part of IFRS.
International Sustainability Standards Board (2022), Exposure Draft: IFRS Sustainability Disclosure Standard – [Draft] S1 General Requirements for Disclosure of Sustainability-related Financial Information, London: ISSB, March. Islam, M. A., Deegan, C. & Gray, R. (2018), ‘Social compliance audits and multinational corporation supply chains: evidence from a study of rituals of social audits’, Accounting and Business Research, 48(2), pp. 190–224. Jaggi, B. & Freedman, M. (1982), ‘An analysis of the information content of pollution disclosures’, Financial Review, 19(5), pp. 142–52. Ji, S. & Deegan, C. (2011), ‘Accounting for contaminated sites: how transparent are Australian companies?, Australian Accounting Review, 21(2), pp. 131–53. Kering (2015), ‘Kering Environmental Profit & Loss’, Paris: Kering, https://www.kering.com/en/news/open-sourcesenvironmental-profit-loss-account-methodologycatalyse-corporate-natural-capital-accounting KPMG (2017), KPMG Survey of Corporate Responsibility Reporting, Amsterdam. KPMG (2020), The Time Has Come: The KPMG Survey of Corporate Responsibility Reporting 2020, https://assets. kpmg/content/dam/kpmg/xx/pdf/2020/11/the-time-hascome.pdf KPMG (2022), Big shifts, small steps: Survey of Sustainability Reporting 2022, https://assets.kpmg/content/dam/kpmg/ xx/pdf/2022/10/ssr-small-steps-big-shifts.pdf La Torre, M., Dumay, J., Rea, M. & Abhayawansa, S. (2020), ‘A journey towards a safe harbour: the rhetorical process of the International Integrated Reporting Council’, The British Accounting Review, 52(2), pp. 1–22. Morand, S. & Lajaunie, C. (2021), ‘Biodiversity and COVID-19: a report and a long road ahead to avoid another pandemic’, One Earth, 4(7), pp. 920–23. Neimark, M. K. (1992), The Hidden Dimensions of Annual Reports: Sixty Years of Social Conflict at General Motors, New York: Markus Wiener Publishing. O’Dwyer, B. (2003), ‘Conceptions of CSR: the nature of managerial capture’, Accounting, Auditing and Accountability Journal, 16(4), pp. 523–57. O’Dwyer, B. (2005), ‘The construction of a social account: a case study in an overseas aid agency’, Accounting, Organizations and Society, 30(3), pp. 279–96. O’Dwyer, B. & Unerman, J. (2020), ‘Shifting the focus of sustainability accounting from impacts to risks and dependencies: researching the transformative potential of TCFD reporting’, Accounting, Auditing and Accountability Journal, 33(5), pp. 1113–41. Owen, D. (2014), ‘The evolution of social reporting: the “early days”’, Social and Environmental Accountability Journal, 34(2), pp. 75–80. Owen, D., Shaw, K. & Cooper, S. (2005), The Operating and Financial Review: A Catalyst for Improved Corporate Social and Environmental Disclosure?, London: ACCA. Oxford University Press (2009), Oxford Dictionary of Proverbs, 5th edn, John Simpson and Jennifer Speake (eds), London: Oxford University Press. Paulson, H. (2015), ‘Short-termism and the threat from climate change’, McKinsey & Company, October, https:// www.mckinsey.com/business-functions/strategy-andcorporate-finance/our-insights/short-termism-and-thethreat-from-climate-change Perks, R. W. (1993), Accounting and Society, London: Chapman & Hall.
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PwC (2021), ‘ESG reporting in Australia – the full story, or just the good story?’, https://www.pwc.com.au/assurance/ esg-reporting-australia-2021.pdf Rinaldi, L. & Unerman, J. (2009), ‘Stakeholder engagement and dialogue initiatives of UK FTSE100 companies over the Internet: an empirical analysis’, Interdisciplinary Perspectives on Accounting Conference, Innsbruck. Rowbottom, N. & Locke, J. (2016), ‘The emergence of ’, Accounting and Business Research, 46(1), pp. 83–115. Sustainability Accounting Standards Board (2018), Automobiles: Sustainability Accounting Standard, https://www.sasb.org/wp-content/uploads/2018/11/ Automobiles_Standard_2018.pdf, now part of IFRS. Talbot, D. & Boiral, O. (2018), ‘GHG reporting and impression management: an assessment of sustainability reports from the energy sector’, Journal of Business Ethics, 147(2), pp. 367–83. Task Force on Climate-related Financial Disclosures (2017), CEO Guide to Climate-related Financial Disclosures, World Business Council for Sustainable Development https:// docs.wbcsd.org/2017/12/CEO_Guide_to_climate-related_ financial_disclosure.pdf Tinker, A. & Neimark, M. (1987), ‘The role of annual reports in gender and class contradictions at General Motors: 1917–1976’, Accounting, Organizations and Society, 12(1), pp. 71–88. Tinker, A. & Neimark, M. (1988), ‘The struggle over meaning in accounting and corporate research: a comparative evaluation of conservative and critical historiography’, Accounting, Auditing and Accountability Journal, 1(1), pp. 55–74. Ullmann, A. (1985), ‘Data in search of a theory: a critical examination of the relationships among social performance, social disclosure, and economic performance of US firms’, Academy of Management Review, 10(3), pp. 540–57. Unerman, J. (2000a), ‘An investigation into the development of accounting for social, environmental and ethical accountability: a century of corporate social disclosures at Shell’, unpublished PhD thesis, Sheffield University Management School, University of Sheffield.
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Unerman, J. (2000b), ‘Reflections on quantification in corporate social reporting content analysis’, Accounting, Auditing and Accountability Journal, 13(5), pp. 667–80. Unerman, J. (2007), ‘Stakeholder engagement and dialogue’, in J. Unerman, J. Bebbington & B. ODwyer (eds), Sustainability Accounting and Accountability, Abingdon: Routledge, pp. 86–103. Unerman, J., Bebbington, J. & O'Dwyer, B. (2018), ‘Corporate reporting and accounting for externalities’, Accounting and Business Research, 48(5), pp. 497–522. Unerman, J. & Bennett, M. (2004), ‘Increased stakeholder dialogue and the internet: towards greater corporate accountability or reinforcing capitalist hegemony?’, Accounting, Organizations and Society, 29(7), pp. 685–707. Unerman, J. & O’Dwyer, B. (2010), ‘Evolution of risk, opportunity and the business case in embedding connected reporting at BT’, in A. G. Hopwood, J. Unerman & J. Fries (eds), Accounting for Sustainability: Practical Insights, London: Earthscan, pp. 149–72. United Nations (2016), White Paper: The UN Global Compact Ten Principles and the Sustainable Development Goals: Connecting, Crucially, https://d306pr3pise04h.cloudfront. net/docs/about_the_gc%2FWhite_Paper_Principles_ SDGs.pdf United Nations (2020), The Global Biodiversity Outlook, https://www.unep.org/resources/report/globalbiodiversity-outlook-5-gbo-5 United Nations Global Compact, The (2022), ‘The ten principles of the UN Global Compact’, https://www. unglobalcompact.org/what-is-gc/mission/principles World Commission on Environment and Development (1987), Our Common Future (The Brundtland Report), Oxford: Oxford University Press. WWF (2020), Living Planet Report 2020, https://livingplanet. panda.org/en-us Yankelovich, D. (1972), Corporate Priorities: A Continuing Study of the New Demands on Business, Stamford, CT: Daniel Yankelovich Inc. Yeates, C. (2017), ‘NAB slashes to brace for digital threat’, The Age, 3 November, p. 20.
CHAPTER
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REACTIONS OF CAPITAL MARKETS TO FINANCIAL REPORTING LEARNING OBJECTIVES On completing this chapter, readers should: LO11.1
understand the role of capital markets research in assessing the apparent information content of accounting disclosures
LO11.2 understand the difference between capital markets research (which explores the response of ‘the market’ in aggregate) and behavioural research (which explores the actions of individuals) LO11.3 understand the assumptions of market efficiency typically adopted in capital markets research LO11.4 understand the basics of the ‘market model’ as derived from the capital assets pricing model
LO11.6 understand how, and why, some researchers use market-based data (such as share prices and share returns) to evaluate the ‘value relevance’ of accounting-based information LO11.7
be able to explain why unexpected accounting earnings and abnormal share price returns are expected to be related
LO11.8 be able to outline the major results of capital markets research into financial accounting and disclosure LO11.9
be aware of debates that challenge long-held beliefs about ‘market efficiency’.
LO11.5 understand the difference between capital markets research that looks at the information content of accounting disclosures, and capital markets research that uses share price data as a benchmark for evaluating accounting disclosures
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OPENING QUESTIONS Before reading this chapter, please consider how you would answer the following four questions. We will return to these questions at the end of the chapter, where we suggest some answers. Assume that there are five companies from the same industry with the same reporting date, this being 31 December. All five companies are to make earnings announcements for the financial year (the announcements being made in February), but the earnings announcements are spread over two weeks, with no two companies announcing their earnings on the same date. 1 Would you expect the earnings announcements made by each company to impact its share price and, if so, why? 2 If it is found that the share prices of some entities change more around the date of the earnings announcement than others, what might have caused this price–effect differential? 3 Would you expect the share prices of larger companies or smaller companies to be relatively more affected by an earnings announcement? 4 Once the first company in the sample of five makes its earnings announcement, would you expect this announcement to impact the prices of shares in the other four companies? Why?
Introduction Some of the previous chapters have considered various normative prescriptions pertaining to how accounting should be practised. For example, Chapter 6 discussed theories that had been developed to prescribe how financial accounting should be practised in times of rising prices (for example, by applying general price level accounting, current cost accounting or Continuously Contemporary Accounting). Chapter 7 considered the role of conceptual frameworks for financial reporting in providing prescription (such frameworks can tell us what the objective of accounting is; what qualitative characteristics accounting information should possess; how elements of financial accounting should be defined and recognised; and how assets and liabilities should be measured). Chapter 10 provided an insight into various approaches for disclosing information about an organisation’s social and environmental performance (which has indeed become a rapidly growing area of accounting practice and research). While the above-mentioned chapters provided a great deal of prescription, they tended not to provide any theoretical arguments as to the motivations for managers to make the disclosures. This void was filled by Chapters 8 and 9, which provided different theoretical perspectives about what drives management to make public disclosures of information. Chapter 8 discussed Positive Accounting Theory and indicated that, where management had a choice in selecting a particular method of financial accounting, both efficiency arguments and opportunistic arguments could be advanced to explain and predict management’s accounting choices. Chapter 9 provided alternative explanations of management’s behaviour. It showed that the choice of a particular accounting method might be made to restore the legitimacy of an organisation (from Legitimacy Theory), or because such disclosure was necessary to retain the support of powerful stakeholders (from Stakeholder Theory), or because the accounting method had been adopted by other organisations and had effectively become an institutionalised practice (from Institutional Theory).
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While this material provided a perspective on what motivates managers to disclose particular accounting information, it did not consider the further issue of how individuals, or groups of individuals in aggregate, react to accounting disclosures. This chapter, and Chapter 12 which follows, provide material that addresses this issue. That is, the focus has changed to research and theories that describe how individuals, or groups of individuals, react to accounting disclosures (rather than what motivated preparers to make the disclosures). This chapter and Chapter 12 examine the impact of financial accounting and disclosure decisions on the users of financial reports. Specifically, the chapters look at research that focuses on the impact of alternative accounting and disclosure choices on the investment decisions of financial statement users, such as share market investors, financial analysts, bank lending officers and auditors. Reported profit is influenced by many financial accounting decisions. Managers have much scope in selecting between alternative accounting methods and accounting assumptions. For example, they will choose between expensing particular costs and capitalising them; they will choose between straight-line depreciation and reducing-balance depreciation; they will exercise discretion in relation to accounting estimates such as the useful life of assets to be depreciated, or the amount that should be recognised to pay a future uncertain liability, such as a provision to clean up a contaminated site; and so on. Further, decisions must be made in relation to how much information to disclose, the medium for disclosure and, in some circumstances, whether to recognise particular items in the financial statements or merely disclose them in the notes to the financial statements. Financial reporting decisions impact the information subsequently provided to users of financial statements. This, in turn, may have implications for the decisions that users make. There are alternative ways to assess reactions to financial reporting information, including: (1) determine the impact of the information on the decisions of individual information users (behavioural research), and (2) determine what impact the release of information has on share price (capital markets research). This chapter looks at capital markets research (which considers reactions at an aggregate or market level). Chapter 12 reviews behavioural research undertaken at the individual level.
Why do I need to know about research that investigates users’ reactions to accounting disclosures? Why
There would be little point in knowing about various ways in which accounting information can be produced, or the various potential types of accounting information, if we did not also have some understanding or insights about whether potential users of the information believe the particular information could be relevant to their various decisions. As accounting practitioners and researchers, we need to have some understanding of the information needs or wants of
LO11.1
LO11.2
LO11.3
different stakeholders. The production of all information should be based upon some form of cost-versus-benefit considerations, and this requires insights into stakeholder information needs and, hence, insights into the benefits that might flow from the disclosure. To this end, this chapter considers some research that explores how investors react to disclosures and, in particular, whether and how they react to various financial disclosures.
An overview of capital markets research
Capital markets research explores the role of accounting and other financial information in equity
markets. That is, it investigates how the disclosure of particular information influences the aggregate trading activities taken by individuals participating within capital markets. A large proportion of published research in academic accounting journals examines the relation between financial statement information and capital markets, referred to as capital markets research.
Capital markets research Investigates how the disclosure of particular information influences the aggregate trading activities taken by individuals participating within capital markets.
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As we know from Chapter 7, the underlying objective of general purpose financial reporting, according to the IASB Conceptual Framework for Financial Reporting (IASB, 2022, paragraph 1.2) 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 decisions about: (a) buying, selling or holding equity and debt instruments (b) providing or settling loans and other forms of credit (c) exercising rights to vote on, or otherwise influence, management’s actions that affect the use of the entity’s economic resources.
The use of financial reporting information by investors is therefore of central importance to the accounting profession and, in particular, the issue of whether particular financial reporting information is used by investors in their decision-making processes. Capital markets research explores the market’s (investors in aggregate) reaction to various releases of information, including financial accounting information, and therefore capital markets research should be of interest to the accounting profession. Capital markets research often involves examining statistical relations between financial information and share prices or returns. Reactions of investors are evidenced by their capital market transactions. Favourable reactions to information are presumed to be evidenced by a price increase in the particular security, whereas unfavourable reactions to information are evidenced by a price decrease. No price change around the time of the release of information implies no reaction to the information (the information release does not provide anything that is new). Conclusions about the market’s reaction to particular information releases or events are generally based on evidence from a large number of companies, with data sometimes spanning several years. This type of research is often used to examine equity market reactions to announcements of company information and to assess the relevance of alternative accounting and disclosure choices for investors. If security prices change around the time of the release of particular information, and assuming that the information and not some other (confounding) event caused the price change, it is considered that the information was relevant and useful for investment decision making. That is, investors reacted to the information. In contrast to behavioural research (considered in Chapter 12), which analyses individual responses to information, capital markets research assesses the aggregate effect of information – typically, financial information (particularly the reporting of accounting earnings) – on investors.1 As we discussed in Chapter 1, different researchers will embrace different ontological and epistemological assumptions, and this influences the research they do, the types of research questions they seek to answer and the theories they choose to apply. Ontological assumptions are those assumptions that we make in relation to how we ‘see the world’ and whether we believe that we all individually attribute the same meanings to phenomena. Epistemological assumptions relate to how, or whether, we determine whether certain things are ‘true’ or not, and whether data collected is believed to have a generalised meaning beyond the point of data capture or, by contrast, must be considered relative to its situational context. Epistemological assumptions are typically linked to ontological assumptions. Researchers undertaking capital markets research typically use large data bases and sophisticated statistical techniques with the intention of generating insights and ‘universal truths’ that the researchers believe are generalisable beyond the samples and settings
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Capital markets research is also used to investigate the response of investors to other types of information besides financial accounting information. For example, capital markets research could be used to investigate how share prices react to particular government announcements, the release of particular sustainability-related information, or how share prices react to companies winning particular awards. Nevertheless, a great deal of capital markets research focuses on share price reaction to the disclosure of financial information and this will be the main focus of this chapter.
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used (their epistemological assumption). Such researchers also generally assume that all capital market participants (investors) have similar motivations typically linked to self-interest and wealth maximisation; that the world is ‘objective’ and external to the researcher; and, that all observers would see that ‘world’ similarly (their ontological assumptions). Therefore, capital markets researchers are often comfortable in gathering large amounts of data from different organisations and then making generalisable predictions that are assumed to apply to investors across various institutional settings (although some capital markets researchers – who are in the minority – do consider the impacts of culture and institutional setting on share price movements). These ontological and epistemological assumptions can be contrasted with other researchers, who might believe that individual human behaviour is influenced by factors such as culture, education, religion, professional memberships, gender and so forth, and who believe that larger-scale generalisation is inappropriate.
Why do I need to know about the ontological and epistemological assumptions underlying particular research, such as capital markets research? Why
As we have emphasised throughout this book, before we consider whether we will embrace the insights generated by particular researchers, we need to consider whether our own ‘world views’ are consistent with those of the researchers who have generated the results. If we, for example, do not believe in ‘universal truths’, do not believe that simplifying assumptions
about ‘market efficiencies’ are appropriate or do not believe the assumption that share prices will always somehow reflect expectations about future cash flows (all of which are accepted by capital market researchers), then we might be disinclined to consider capital market researchers’ results as useful.
When capital markets researchers analyse share price reactions to financial information releases, the sum of the individual investors’ decisions are captured in aggregate. In considering such research, a possible question that comes to mind is: why have so many research studies been undertaken that focus on the market’s response to accounting earnings announcements? Brown (1994, p. 24) provides an answer: Four reasons are that, according to the Financial Accounting Standards Board, information about earnings and its components is the primary purpose of financial reporting; earnings are oriented towards the interests of shareholders who are an important group of financial statement users; earnings is the number most analysed and forecast by security analysts; and reliable data on earnings are readily available.
Another important difference between capital market and behavioural research is that capital markets research considers only investors, while behavioural research is often used to examine decision making by other types of financial statement users, such as bank managers, loan officers or auditors. Further, as capital markets researchers seek to report the presence or absence of a share price effect, they are effectively ignoring how other stakeholders (noninvestors or non-financial stakeholders) might demand or use information. Therefore, just because there is no capital market reaction to information (indicating that investors did not find the information useful and therefore did not revise the amount they would pay for the shares of an organisation), this should not be deemed to mean that other stakeholders do not expect an organisation to be ‘accountable’ in respect of the information being disclosed. Capital markets research relies on the underlying assumption that equity markets are efficient. Market efficiency is defined in accordance with the Efficient Markets Hypothesis (EMH) as a market that adjusts rapidly to fully impound information into share prices when the information is released (Fama et al., 1969). Embracing assumptions about market efficiency, in which markets react to information from various sources, perceives accounting information as being effectively in competition with other sources of information, such as that provided through the news media
Market efficiency A measure of how rapidly a market adjusts to fully impound information into share prices when the information is released.
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or from investment analysts. Embracing such a perspective means that accounting, in the form of financial reporting, only survives to the extent that it provides relevant information that is not otherwise available from alternative sources. Capital markets research in accounting typically assumes that equity markets are semi-strongform efficient. That is, that all publicly available information, including that available in financial statements and other financial disclosures, is rapidly and fully impounded into share prices in an unbiased manner as it is released. Relevant information is not ignored by the market. But why does the capital market react so quickly to information? According to Lee (2001, p. 236): Why do we believe markets are efficient? The answer boils down to a visceral faith in the mechanism of arbitrage. We believe markets are efficient because we believe arbitrage forces are constantly at work. If a particular piece of value-relevant information is not incorporated in price, there will be powerful economic incentives to uncover it, and to trade on it. As a result of these arbitrage forces, price will adjust until it fully reflects the information. Individual agents within the economy may behave irrationally, but we expect arbitrage forces to keep prices in line. Faith in the efficacy of this mechanism is a cornerstone of modern financial economics.2
Semi-strong-form efficiency is the most relevant assumption for capital markets research in accounting since it relates to the use of publicly available information. Again, predictions based on the assumption that markets are ‘semi-strong form’ efficient are based on the view that markets respond rapidly to publicly available information. Other hypotheses about market efficiency are the weak-form efficiency perspective and the strong-form efficiency perspective. The weak form of market efficiency assumes that existing security prices simply reflect information about past prices and trading volumes. The strong form of market efficiency assumes that security prices, on average, reflect all information known to anyone at that point in time (including information not publicly available). According to Watts and Zimmerman (1986, p. 19) the available evidence is generally consistent with the semi-strong form of the EMH.3 That is, the share market reacts rapidly to impound within the share prices publicly available information that is considered to be relevant for determining the value of such shares. Nevertheless, any assumptions about market efficiency are simply that – assumptions that are used within a model – and, as we have emphasised throughout this book, theories and related models will not always fully reflect what actually happens in the ‘real world’. Indeed, there are many researchers who have rejected claims that securities markets are efficient. The view held by many (but not all) researchers that markets are efficient does not imply that share prices will always provide an accurate prediction of the value of future cash flows. Market predictions are sometimes proved in hindsight to be wrong, thus necessitating subsequent adjustments. As Hendriksen and Van Breda (1992, p. 177) state: It needs to be stressed that market efficiency does not imply clairvoyance on the part of the market. All it implies is that the market reflects the best guesses of all its participants, based on the knowledge available at the time. New information appears all the time that proves the market was incorrect. In fact, by definition, the market will not react until it learns something that it did not know the day before. One cannot prove the market inefficient, therefore, by looking back, using the benefits of hindsight and pointing to places where the market was incorrect. Market efficiency simply asserts that prices are appropriately set based on current knowledge; practical evidence shows that with hindsight the market is always incorrect. 2
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The Macquarie Dictionary defines arbitrage as ‘the simultaneous purchase and sale of the same securities, commodities or moneys in different markets to profit from unequal prices’. Brown (1994, p. 14) notes that ‘few if any investors would seriously accept the strong form, although many would accept the semi-strong form as their working hypothesis’.
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The assumption of market efficiency is central to capital markets research.4 But why is the assumption of information efficiency so important for capital markets research in accounting? Simply put, unless such an assumption of efficiency is accepted, it is hard to justify efforts to link security price movements to information releases. A great deal of capital markets research considers the relationship between share prices and information releases. The reason for looking at this relationship is that share prices in an efficient market are deemed to be based on expectations about future earnings. If information leads to a price change, the assumption is that the information was useful and caused investors to revise their expectations about the future earnings of the organisation in question. That is, share prices and returns are used as benchmarks against which the usefulness of financial information is assessed. If we do not assume market efficiency, there is an inability to explain how or why share prices change around the date of information releases. If share markets are not semi-strong-form efficient, they do not provide accurate benchmarks against which to assess alternative financial reporting choices. Overall, market inefficiency would render capital market research results to be at best less convincing, and at worst extremely unreliable, depending on the extent of inefficiency present.
REFLECTION QUESTION 11.1 Market efficiency Question Does a belief in market efficiency mean a belief that the market always ‘gets it right’? Solution As is hopefully clear by now, the way ‘efficiency’ is interpreted by capital markets researchers is generally related to the speed
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with which the market in aggregate responds to information that signals likely future changes in the cash flows, and hence financial value, of an organisation. Efficient markets are expected to respond to current knowledge.This does not mean the market has some form of power to perfectly predict whether information will subsequently be shown to be ‘correct’.
Assumptions about market efficiency also have implications for financial accounting and financial reporting. If markets are efficient, they will use information from various sources when predicting future earnings, and hence when determining current share prices. If financial accounting information does not impact on share prices, then, assuming semi-strong-form efficiency, it would be deemed not necessary to provide any information over and above that currently available. At the extreme, financial accounting’s survival would be threatened.5,6 While the acceptance of market efficiencies is central to much capital markets research, there is some research that suggests that markets might not impound information as quickly as many researchers have assumed (see Frankel and Lee, 1998). Nevertheless, most researchers working within the capital markets research area still assume that relevant information is
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Given this is a central assumption of the research, if particular researchers did not accept this central assumption about market efficiency then they would be inclined to disregard many of the results being generated by capital markets research. As emphasised throughout this book, and from a logical perspective, before we are prepared to accept particular theories or particular research we must consider and evaluate the assumptions being made within the research. Once we relax notions of efficiency, and once we consider broader issues about corporate accountability to stakeholders other than investors, threats to accounting’s survival tend to dissipate. Organisations arguably have a responsibility to be accountable for various aspects of performance regardless of whether capital markets believe the information to be relevant. Of course, there would be various researchers who would want financial accounting’s survival to be ‘threatened’ and for the way that financial accounting is practised to be overthrown. As is discussed in Chapter 10, financial accounting as it is currently practised, can signal success (profitability) at the same time that an organisation is generating various negative (and unrecognised) social and environmental impacts.
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impounded very quickly into share prices.7 Issues related to potential market inefficiencies will be discussed towards the end of the chapter. Within an ‘efficient market’, share prices are assumed to react to new information to the extent that the information has implications for reassessing the future cash flows of an organisation. While the focus here is on the market’s reaction to financial accounting information, information of a non-financial nature can also be of relevance to capital markets if that information has implications for revisions in expectations about a company’s future cash flows (upon which share prices are assumed to be based). For example, we sometimes read in news media articles that the resignation of a senior executive created a negative impact in a company’s share price around the time of the departure. As an example, following the unexpected departure of the chief executive officer of the Australian-listed company, Core Lithium, in March 2022, several newspapers within Australia reported a significant drop in the price of the organisation’s shares. More famously, when the death of Steve Jobs was announced in 2011, Apple’s share price fell by more than 5 per cent. Interestingly, when his death was wrongly reported in 2008, share prices also fell. If share prices decrease when an executive’s resignation or death is announced then, according to capital markets researchers, this would imply that investors in aggregate have made a downward assessment of the organisation’s expected future cash flows. Of course, whether a share price decrease is caused by news of the resignation of the chief executive, to profit announcements made at the same time or to some other (contemporaneous) event will not always be clear. As indicated above, share prices are predicted to react to various types of information, some of which will be of an accounting nature, while some will relate to other corporate matters. Various capital market researchers investigate how the capital market reacts to different events and different types of information. Again, an efficient capital market is predicted to respond to all types of information to the extent that it is of relevance in predicting future cash flows associated with a company’s securities. As one such example, Clarkson, Joyce and Tutticci (2006) investigated whether takeover rumours on a particular internet discussion site created a share price reaction within the Australian context. The authors identified the time when takeover rumours were posted to the HotCopper internet discussion site (a site which, according to the authors, was one of the most visited Australian ‘business and finance’ websites), and they then investigated whether there appeared to be an associated share price change. In looking for a market reaction, they viewed intraday return and trading volume data (‘intraday’ data is data that is collected at various points of time within a particular day). The authors reviewed 10-minute trading intervals surrounding the time of the posting of the rumours. In justifying the use of the narrow (10-minute) observation periods, the authors state: By examining intraday return and trading volume data, we are better able to isolate the effects of the rumour posting, if any. Although an analysis of daily return and trading volume data surrounding the rumour posting day has the potential to provide insights into the market reaction to the posting, competing explanations also exist. For example, the market reaction might simply be to information released through other media that could not reasonably be screened during the sample construction process. Alternatively, if posters are merely reacting to increases in share price and/or trading volume, the observed market activity, although correlated with the IDS rumour, would not be in response to its posting. It is far less likely that reactions observed in the 10 min posting interval would be vulnerable to these or other competing explanations.
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According to Kothari (2001, p. 109), the view that markets do not react rapidly has had the effect of ‘spurring research on fundamental analysis’. According to Kothari, ‘fundamental analysis entails the use of information in current and past financial statements, in conjunction with industry and macroeconomic data, to arrive at a firm’s intrinsic value. A difference between the current price and the intrinsic value is an indication of the expected rewards for investing in the security’. Rewards from fundamental analysis would diminish in an efficient market.
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According to Clarkson, Joyce and Tutticci (2006), their results indicated a price increase and an increased trading volume around the time the takeover rumours were posted. This is deemed to indicate that such information is of relevance to investors and is being used despite the fact that it is based on rumour. As already indicated, the basis of capital markets research is that the market is expected to quickly respond to relevant information from various sources. In discussing the implications of their finding, Clarkson, Joyce and Tutticci refer to concerns held by regulators that some individuals (‘posters’) have been posting information to Internet sites to ‘pump up’ share prices before they subsequently sell the shares at a profit. The authors state (p. 33): Litigation by the Australian Securities and Investments Commission (ASIC) and the US Securities and Exchange Commission (SEC) of posters deemed to have inappropriately used Internet Discussion Sites, including ‘pump and dump’ strategies, indicates a belief by regulatory bodies that rumours posted on these sites affects firm value. Our findings provide formal support for the regulators’ view of Internet Discussion Sites as a source of information for the market.
Also reflective of the concerns of regulators in relation to rumours, and in particular to the spreading of ‘false rumours’, the SEC released an ‘Investor alert’ in November 2015 in which it warned investors about fraudsters who may attempt to manipulate share prices using social media to spread false or misleading information about particular shares. The SEC acknowledged that social media can represent an important source of information for investors, but the information needs to be used cautiously. The SEC stated that fraudsters can use social media posts to spread false and misleading information about a particular company or industry and they can do this at relatively low cost, and anonymously or through impersonating reputable sources of market information. The false or misleading information may be positive or negative. For example, in a ‘pump-anddump’ scheme, fraudsters can inflate share prices by spreading positive rumours that encourage people to buy shares and pump up the price, after which time the fraudsters quickly dump (sell) the shares before it becomes known that the information was false. The share prices then fall, thereby creating losses for those investors that were misled. Alternatively, fraudsters might start some negative rumours that drive down share prices, at which time the fraudsters buy the shares at deflated prices. When the rumours are exposed as untrue, and when prices rise, the fraudsters sell their shares. As examples of where the SEC acted against individuals for committing fraud through social media, the SEC took action against an individual who allegedly tweeted rumours that federal law enforcement was investigating a technology company for fraud, and against an individual who tweeted that a biopharmaceutical company had tainted drug trial results and a federal government agency seized its research results. The SEC asserted that these deceptive tweets were made from Twitter accounts mimicking established securities research companies. Another interesting example of how share prices can react to information was provided in an Australian Financial Review article entitled ‘Watchdogs issue warning on Twitter’ (Hutchinson and Shapiro, 2013), which referred to market reactions to false rumours that the White House had been bombed and President Obama had been injured. The fact that the market reacted to false rumours does not of itself provide information that the market is inefficient. As we have discussed, efficiency relates to how quickly the market reacts to new and potentially relevant information. In the newspaper article and using the hoax tweet in the United States as an example, Australian-listed companies and traders were warned against using social media to distribute or gather market-sensitive information. According to the article: The renewed caution comes after the Associated Press’s official Twitter account last week reported bombings at the White House and injuries to US President Barack Obama. Although quickly reported as fake, the news spread widely among the Twitter account’s 1.9 million followers and beyond, wiping $US136.5 billion off US equity markets in three minutes. 601
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According to the article, the hoax tweet from the Associated Press exposed the number of traders and hedge funds that buy and sell securities based on social media. The article stated: ‘Given the scope of the fall, it shows how many funds are trading on news delivered via Twitter, and also, how fragile the markets are now,’ said Michael Giles, founder and chief executive of New York-based online brokerage firm PennTrade. ‘It shows the speed at which news can travel.’
The article also quoted a spokesperson from ASIC, who stressed that investors should exercise ‘common sense and scepticism’ when trading based on information from social media.
Why do I need to know the available evidence about market efficiency? A central foundation of capital markets research is a belief in market efficiency. Therefore, we need to know, and perhaps evaluate, the evidence about market efficiency before we will be prepared to accept the results being generated by capital markets researchers. Financial reporting standard-setters often use the information produced from capital markets research to justify the introduction or removal of particular disclosure
requirements. Hopefully, these standard-setters Why fully understand the basis of researchers’ beliefs in market efficiency and evaluate the related assumptions and evidence carefully. If we reject the assumptions pertaining to market efficiency and/or the supporting evidence, then we would be inclined to reject the results emanating from capital markets research.
Following the theme that an efficient market will react to various types of relevant information, it might also be anticipated that any concerns raised by external auditors as a result of undertaking their audit work would also have the potential to create share price changes. This would particularly be the case if the audit opinion signalled to investors that there were uncertainties about the future profitability and, hence, about the future cash flows of an organisation. In this regard, Herbohn, Ragunathan and Garsden (2007) considered the share price reaction of a number of Australian companies around the time the companies received a going concern modification (GCM) of their audit report. A GCM in the form of a qualification is issued when the auditor is satisfied that it is highly improbable that the entity will continue as a going concern. According to the authors, a GCM of an audit report is a significantly unambiguous ‘bad news’ event for stock-market participants and an adverse stock-market reaction is to be expected (p. 465). The authors studied share price movements in the 12 months leading to, and the 12 months following, a company receiving its first GCM. They also studied share price reactions around the event date, which is defined as the day of the release of the annual report that includes the audit qualification. The authors found no evidence of a market reaction to a first-time GCM announcement around the event date. The lack of a share price reaction to the audit report is explained by the authors on the basis that, in an efficient market, investors would have been preconditioned to expect that the organisations to receive the GCMs were suffering financial difficulties. The audit report would act to confirm market expectations, rather than to cause a revision to expectations (a revision to market expectations about future cash flows would have caused a price change). In explaining their results, the authors stated (p. 489): The underlying research question of this paper is what is the value added from the audit report. Prima facie, our results that show a significant negative market reaction in the pre-event period rather than the post-event period are consistent with the audit report fulfilling an attestation function rather than signalling additional information to the market. Additionally, in the 12 months prior to the GCM announcement, the sample of GCM firms underperforms a matched sample of firms in similar financial distress that have unmodified audit opinions for the same period. We contend that these results 602
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are consistent with investors viewing a GCM as having information content because it confirms a deteriorating financial condition. That is, a GCM is an independent confirmation by an auditor that, at the very least, there is significant uncertainty that a firm is able to pay its debts as and when they fall due. Furthermore, once issued a GCM increases the financial pressures on a firm through bank credit freezes, possible debt defaults and worsening relations with suppliers. Therefore, receipt of a GCM confirms the likelihood of tightening of debt constraints for the firm. A question raised by our results is why does the negative market reaction for GCM firms occur in the 12 months prior to the GCM announcement and not persist in the 12 months post-announcement as documented on the LSE by Taffler et al. (2004)? One explanation is that the Australian market is well informed because of the continuous disclosure regime in place. The announcement of a GCM is not an isolated or sudden event. Rather, it is a culmination of multiple events over time. The majority of these events are likely to be price-sensitive and, therefore, are required to be disclosed immediately to the market under the continuous disclosure regime of the Australian Stock Exchange. Therefore, it seems likely that the underperformance of our sample firms in the 12 months pre-GCM announcement is a result of a conditioning of market expectations from the price-sensitive disclosures made to the ASX. Because the market is fully informed at the time of the GCM announcement, there is no significant adverse market reaction that persists in the 12 months post-GCM.
Hence, Herbohn, Ragunathan and Garsden (2007) were able to use assumptions about the efficiency of the market to explain how the market would have anticipated the news provided by the auditor (as a result of the ‘continuous disclosure regime’ in Australia), and hence, as the audit report was in accordance with expectations, no significant share price movement would occur. Some of the above events relate to specific companies (for example, a particular company receiving a particular form of audit report), but share prices will also react to market-wide events. For example, within the United States the introduction of the Sarbanes–Oxley Act of 2002 had potential cash-flow implications for a very large number of organisations.8 Zhang (2007) used capital markets research to investigate reactions to the introduction of the Act. In considering the implications of the Act, Zhang (p. 75) stated: By requiring more oversight, imposing greater penalties for managerial misconduct, and dealing with potential conflicts of interest, the Act aims to prevent deceptive accounting and management misbehaviour. However, despite the claimed benefits of this Act, the business community has expressed substantial concerns about its costs. Whereas the out-of-pocket compliance costs are generally considered significant (Solomon and Bryan-Low, 2004), they are likely swamped by the opportunity costs SOX imposed on business. Executives complain that complying with the rules diverts their attention from doing business (Solomon and Bryan-Low, 2004). Furthermore, the Act exposes managers and directors to greater litigation risks and stiffer penalties. CEOs allegedly will take less risky actions, consequently changing their business strategies and potentially reducing firm value (Ribstein, 2002).
Whereas US corporations had to comply with the Act, non-US companies that traded their securities within the United States did not have to comply with the Act. Zhang (2007) examined 8
US Congress passed the Sarbanes–Oxley Act in July 2002 in response to a number of high-profile corporate scandals that came to light in 2001, most notably scandals associated with the major US company Enron. The Act was named after two people who were largely involved in its development, Senator Paul Sarbanes and Congressman Michael Oxley. The Act imposed additional disclosure requirements as well as requiring significant changes in corporate governance policies.
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the abnormal returns earned on the shares of US companies around the time of significant Sarbanes–Oxley (SOX) legislative events relative to returns earned on the shares of foreign companies listed in the United States. Zhang found that the introduction of the Act appeared to be associated with negative share price reactions for US companies relative to foreign companies that did not have to comply with the Act. While the negative share price reaction could be interpreted as a negative consequence of introducing the Act, Zhang does note (p. 77) that focusing on share price reactions alone does not take into consideration various social benefits that might arise as a result of introducing the Act – benefits that would be shared by individuals (stakeholders) who are not investors: This study does not explore the social welfare implication of the Act. An investigation of changes in security prices provides evidence for the private benefits and costs of regulations, but social benefits and costs may not be fully reflected in stock prices.
The preceding discussion has highlighted the variety of events that can influence share prices. It also reflects the variety of issues or events that capital markets researchers explore as part of their research. As emphasised, a share price reaction to the release of financial information or other information is taken to indicate that the announcement has ‘information content’ (and the information might later prove to be either correct or incorrect). The absence of a share price movement indicates either that the information is considered by the capital market as irrelevant or that it confirms market expectations. While capital markets researchers often explore how particular events affect share prices, some researchers have investigated whether share prices seem to change/adjust more on particular days of the week relative to other days. Birru (2018), for example, shows that there seems to be a ‘Monday effect’ as well as a ‘Friday effect’, which he relates to ‘mood’. He states (p. 209): This study shows strong, predictable variation in the cross-section of returns (changes in share prices) across day of the week. Relative to non-speculative stocks, speculative stocks earn low returns on Mondays and high returns on Fridays. The results are robust to different subsample periods and are not explained by macroeconomic news releases, firm-specific news releases, institutional trading, or changes in market liquidity. Psychological research finds predictable variation in mood across day of the week, with decreases in mood occurring on Mondays and increases in mood occurring on Fridays. The cross-sectional return patterns are consistent with an explanation in which decreasing mood on Monday leads to relatively low returns for speculative stocks and increasing mood on Friday leads to relatively high returns for speculative stocks.
In related research, international share prices have been found to also be impacted by changes in daylight hours (Kamstra, Kramer and Levi, 2003), rainy days (Hirshleifer and Shumway, 2003) and national sporting events (Edmans, Garcia and Norli, 2007). Given the evidence suggesting that share prices are potentially influenced by mood, daylight hours, rainy days or the occurrence of sporting events, can we really argue that capital markets are efficient in disseminating information? It depends on our view about what ‘efficiency’ actually represents. If we believe some of this evidence, then it suggests that share price adjustments are influenced not only by the information but by the mood of the market or the day on which the disclosure was made, all of which could be seen by some people to bring doubt to claims about market ‘efficiency’. In relation to financial accounting information, a high association between financial information and share prices or returns over an extended period of time indicates that the information provided by the financial accounting system reflects information being used by the capital market (and this information will come from a multitude of sources). Each of these roles for accounting information in equity markets is explored in the following sections. While 604
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the ‘information content’ of many types of financial information can be assessed using capital markets research, the bulk of this work has focused on financial accounting earnings (profits) as the primary measure of the financial accounting system. For example, one issue that has been the subject of many research papers is whether corporate earnings/profit announcements cause a movement in share price. This focus is reflected in the following discussion.
REFLECTION QUESTION 11.2 The relevance of information Question Comment on this statement: if there is no share price reaction to information, then there is no point disclosing it. Solution Such a statement first assumes that the capital markets research was of a quality that would have detected a price change. Perhaps there were other factors that the researchers failed to control for (such as other events that were not considered which might have impacted share prices in the opposite direction – we can call these confounding events). Also, perhaps the market anticipated the information, but
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this does not necessarily mean the market would always anticipate such information. More broadly, when capital markets researchers consider ‘relevance’, they are restricting their view of relevance to information that is potentially useful for adjusting assessments about an organisation’s future cash flows. Other stakeholders will have different perceptions of ‘relevance’. From a ‘right-to-know’ perspective, just because investors do not appear to use information does not mean that other stakeholders might not use it. We always need to remember arguments about organisational responsibilities and accountabilities, as discussed in Chapter 2.
The information content of earnings
Many research papers have investigated capital market reactions to corporate earnings announcements. That is, when a company announces its earnings for the year (or half-year), what is the impact, if any, on its share price? These studies, which look at the changes in share prices around a particular event, such as the release of financial accounting information, are often referred to as ‘events studies’.9 According to Kothari (2001, p. 116): In an event study, one infers whether an event, such as an earnings announcement, conveys new information to market participants as reflected in changes in the level or variability of security prices or trading volume over a short time period around the event (see Collins and Kothari, 1989, p. 144; Watts and Zimmerman, 1986, Chapter 3). If the level or variability of prices changes around the event date, then the conclusion is that the accounting event conveys new information about the amount, timing, and/or uncertainty of future cash flows that revised the market’s previous expectations. The degree of confidence in this conclusion critically hinges on whether the events are dispersed in calendar time and whether there are any confounding events (e.g., a simultaneous dividend and earnings announcement which in themselves could have been responsible for causing revised estimates about the firm’s future cash flows thereby creating revisions in share prices) co-occurring with the event of interest to the researcher. As noted earlier, the maintained hypothesis in an event study is that capital markets are informationally efficient in the sense 9
Events studies Studies that examine the changes of share prices or trading volume over a short time around the occurrence of a particular event, or around the time of release of particular information, such as earnings announcements.
The studies considered earlier, such as the study by Clarkson, Joyce and Tutticci (2006) (on internet discussion sites) and by Zhang (2007) (on the Sarbanes–Oxley Act), would also be considered to be ‘event studies’ because they investigated share price reactions around particular events.
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that security prices are quick to reflect the newly arrived information. Because event studies test for the arrival of information through an accounting event, they are also referred to as tests of information content in the capital markets literature in accounting. Besides Ball and Brown (1968) and Beaver (1968), other examples of event studies include Foster (1977), Wilson (1986), Ball and Kothari (1991), Amir and Lev (1996), Vincent (1999), and many more.
The above quote refers to possibly ‘confounding events’. It should be noted that across time there will be many events that will affect share prices and trading volumes. One of the difficult tasks in undertaking event studies that review share price reactions to particular announcements is to try to ensure there have been no other (confounding) events around the same time which might also have influenced share prices. For example, if accounting profits are announced on the same day that the chief executive officer has resigned then it would be difficult to determine what caused any possible share price reaction – was it the profits or the resignation? Assuming that capital markets are semi-strong-form efficient (they react swiftly and in an unbiased manner to publicly available information), a movement in share price is considered to indicate that the new information in the public earnings announcement has been incorporated into the security’s price through the activities of investors in the market. The information was useful in reassessing the future cash flows of the entity.
Why do I need to know about the nature of confounding events? As investors, managers or capital markets researchers, we need to understand that many events can impact the market assessments of the value of an organisation. Without knowledge of other events – confounding events – that might be organisational-specific, industry-specific or-market specific,
it would be naïve to believe that the release of Why information about a particular event will always generate a particular form or direction of share price reaction. Any efforts to predict how the market will react to information needs to consider what else might be happening at the same time.
A number of studies have shown information about earnings to be linked to changes in the price of securities. But, why would we expect accounting earnings and share prices to be related? Modern finance theory proposes that a share price can be determined as the sum of expected future cash flows from dividends, discounted to their present value using a rate of return commensurate with the company’s level of risk. Further, dividends are a function of accounting earnings (profits), since they can generally only be paid out of past and current earnings. It follows therefore that, if cash flows are related to (a function of) financial accounting earnings, the price of a share in company i, which we can denote as Pi, can be viewed as the sum of expected future earnings per share (Ē), discounted to their present value using a risk-adjusted discount rate (ki).10 That is, for company i today: ∞
t Pi = ∑ E t /(1 + ki )
(Equation 1)
t =1
Equation 1 shows that a relation exists between share price and expected future earnings. In general, after adjusting for risk, companies with higher expected future earnings will have higher share prices. These expectations are formed, at least in part, on the basis of historical earnings for
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The risk-adjusted discount rate chosen should be commensurate with the level of uncertainty associated with the expected earnings stream.
Reactions of capital markets to financial reporting
the company. However, all currently available information (for example, media releases, analysts’ reports, production statistics, market surveys, market rumours and impending legislation) is considered when predicting future earnings. Any revisions to expectations about future earnings per share, including those resulting from new information contained in announcements of current earnings, will – it is assumed – be reflected in a change in share price. Revisions to expectations about future earnings per share will result only from new information, since under the maintained assumption of a semi-strong-form-efficient market, price is assumed to reflect already all publicly known information, including expectations about current earnings. Therefore, only the unexpected component of current earnings announcements constitutes new information. That is, unexpected earnings, rather than total earnings, are expected to be associated with a change in share price. For example, if CMR Company announces annual earnings of $11 billion when $10.5 billion had been expected, unexpected earnings are equal to $0.5 billion. Any share price reaction will be to these unexpected earnings rather than to the total annual earnings of $11 billion, since investors had already anticipated most of this. As an example of market reactions to profit announcements, we can consider the contents of an Australian Financial Review article entitled ‘Macquarie profits from a perfect storm’ (Chanticleer, 2022), in which it was reported that despite reporting record profits, the Macquarie Group’s share price fell. It was reported that the market had already anticipated the size of Macquarie Group’s profit (as represented in various analysts’ forecasts); however, the market expected a higher dividend payment than was announced, and this led to the price decline. By contrast, in an article in The Age entitled ‘Newcrest doubles dividend after blockbuster results’ (Kruger, 2021), it was reported that Newcrest Mining had reported a record profit that was ‘well ahead of market expectations’, with the result that the share price increased at the time of the profit announcement. A change in share price results in a return to investors (Rit), since returns are a function of capital gains or losses, in addition to dividends received (Dit). Thus, for an investment in company i for one holding period (t – 1 to t), the return would be:11
R = it
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Unexpected earnings The difference between reported earnings and expected earnings per share.
(Equation 2)
Pit − 1
The length of time over which returns are calculated (the return period) depends on the particular research focus, but it is generally not less than one day (although shorter intraday returns could be used) or longer than one year. In return periods where no dividend is paid, returns can simply be calculated as a percentage change in share price. This is generally the case when returns are calculated on a daily (or shorter) basis. For example, if CMR Company’s share price moved from $5.42 to $5.56 during the day when earnings were announced, the daily return (RCMR) is equal to ($5.56 − $5.42)/$5.42, or 2.6 per cent. Given that returns are a function of changes in share prices (from Equation 2) and share price can be expressed as a function of expected future earnings (from Equation 1), returns are related to changes in expected future earnings. This relation is often referred to as the earnings/ return relation. For CMR Company, the unexpected announcement of an additional $0.5 billion of earnings has resulted in a return to investors. While the total daily return to investors is 2.6 per cent, not all of this might be due to the unexpected earnings announcement. Some of the 2.6 per cent might be due to market-wide share price movements or to other possibly contemporaneous (confounding) events.
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Where price at the end of the holding period (Pit) is adjusted for any capitalisation changes such as rights issues or bonus issues.
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As already indicated, not all share returns are due to investors trading on information about individual companies. Share prices tend to change on a daily basis due to things that affect the whole market or sectors of it. These can be called ‘systematic changes’. For example, the publication of new (and unexpected) statistics about factors likely to affect the whole economy to some extent – such as rates of inflation, new legislation that will impact on the activities of investors or companies, levels of unemployment, the global catastrophe associated with the COVID-19 pandemic, the declaration of war by Russia within Ukraine, or the general level of consumer or business confidence – and daily returns for individual companies largely reflect this. The market model (see Fama [1976] for details about its early development), which is derived from the capital asset pricing model (CAPM), is used to separate out company-specific share price movements from market-wide movements.12 The CAPM explains how a market should decide the appropriate return on a share, given its riskiness. It predicts a linear relationship between expected market returns and systematic risk, where systematic risk is the riskiness of an asset when it is held as part of a thoroughly diversified portfolio. Systematic risk is the nondiversifiable or unavoidable risk that investors are compensated for through increased returns. The market model is expressed as:
Rit = α it + βit Rmt + µit
(Equation 3)
where Rit is the return for company i during period t, calculated in accordance with Equation 2; Rmt is the return for the entire market during period t (as would be approximated by the average return generated from a very large diversified portfolio of securities); and βit is company i’s level of systematic risk, which indicates how sensitive the returns of company i’s securities are relative to market-wide (systematic) movements – this is often referred to as the company’s ‘beta estimate’.13 Again, market-wide movements will potentially account for a significant proportion of the change in a company’s share prices. αit is a constant specific to company i, and reflects a constant average return on company i’s shares regardless of returns being earned by the market, while µit is an error term that provides an indication of how the return on a security relates, or moves, with respect to specific events, such as the release of new accounting information. It is µit that capital markets researchers are typically interested in identifying, as it is considered to reflect the reaction of the company’s shares to the new information being disclosed. It reflects the difference between what the market return on that organisation’s shares was expected to be (based on the model) and what it actually was following a particular event, such as the release of accounting earnings data. Estimates of αi and βi are typically calculated using ordinary least-squares regression (or the generalised least-squares approach), which utilises historical data and many observations about a company’s returns and the market’s returns. For the market model, it is assumed that the market model parameters are consistent throughout the period of analysis and that the variations in returns on individual securities are largely due to market-wide factors. As a portfolio of investments increases in diversity, the non-systematic risk of the diversified portfolio (measured by α it + µit) tends to disappear, thereby leaving only returns that are due to market-wide movements (that is, βitRmt). The market model makes a number of assumptions, including that investors are risk averse and that investors have homogeneous expectations (that For further information on the development of the CAPM, reference can be made to Sharpe (1964) or Lintner (1965). 13 For example, if the returns of company i’s securities are expected to fluctuate in period t at the same rate as a very large diversified portfolio of securities, then beta (βit) would be approximately 1. If the returns of the individual company are twice as sensitive or volatile as general market movements (indicating that the returns on the undiversified security are more risky than the returns on a very large diversified portfolio), then the beta would be approximately 2, and so on. 12
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is, investors are all assumed to think alike), which, as we discussed earlier, represents a central assumption of capital markets research. Equation 3 shows that total, or actual, returns can be divided into normal (or expected) returns, given market-wide price movements (αit + βitRmt), and abnormal (or unexpected) returns due to company-specific share price movements (µit).14 Normal returns are expected to vary from company to company, depending on their level of systematic risk in relation to the market, while abnormal returns are expected to vary from company to company, depending on whether there is new information about the company that causes investors to revise expectations about future earnings. The abnormal rate of return for company i in period t (µit) is equal to the realised rate of return (Rit) less the expected rate of return. According to Kothari (2001, p. 115): The risk-related variation in returns is generally not of interest to researchers who focus on firm-specific accounting information and its relation to the firm-specific component of the stock return. Therefore, the Capital Asset Pricing Model (CAPM), along with the efficient market hypothesis, greatly facilitated the estimation of the firmspecific return component. The use of the firm-specific component alone enhances the power of the tests of information content of accounting reports (Brown and Warner, 1980, 1985).
The market model is used to control for share price movements due to market-wide events, allowing the researcher to focus on share price movements due to company-specific news. For example, part of the 2.6 per cent return earned by CMR Company on announcing its annual earnings may be due to an overall rise in the market on the announcement day. A researcher analysing the impact of the earnings announcement would control for the impact of this rise in the market by deducting it from CMR Company’s return. Assuming αCMR = 0.02%, βCMR = 0.8 and Rm = 1%, this calculation would leave an abnormal return (µCMR) of 1.78 per cent. It is abnormal returns, or company-specific share price movements, that are analysed by researchers to determine the information effects of company announcements. The returns on CMR are diagrammatically represented in Figure 11.1. In Figure 11.1, the slope of the line representing the model is the same as βit, which is 0.8. It is assumed that ‘beta’ remains fixed over the period of the analysis. Obviously, if it has changed during the period then this has implications for the measurement of abnormal returns and for any results generated from the research. The intercept with the vertical access is the constant average return expected on CMR’s shares (αCMR) for the period of analysis, this being 0.02 per cent. Given an assumption that the return on the market in this period is 1.0 per cent then the expected return on CMR shares can be calculated as equalling 0.02 + 0.8(1.0) = 0.82. The unexpected return on CMR shares (µCMR) therefore is 1.78 per cent. Capital markets research into the earnings/return relation analyses company-specific price movements (abnormal returns) at the time of earnings announcements. These abnormal returns are used as an indicator of the information content of the announcement. That is, how much, if any, new information has been released to the capital markets. If there is no share price reaction, it is assumed that the announcement contained no new information. That is, the information was already known or anticipated by market participants or, alternatively, was deemed to be irrelevant by capital market participants.
14
Normal returns can also be thought of as the level of return to investors that is expected simply as a reward for investing and bearing risk. Abnormal returns are the realised rate of return, less the expected normal rate of return (calculated by reference to the market model).
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FIGURE 11.1 Diagrammatic representation of the market model RCMR Actual return 2.6
Expected return of CMR = 0.02 + 0.8 (Rmt)
Abnormal return μCMR = 1.78 Expected return 0.82
Intercept = ∞CMR 0.02 1.0
RM
Results of capital markets research into financial reporting LO11.8
Capital markets research has been a major focus of financial accounting research over the past 50 years. The research has investigated the information content of corporate earnings announcements as well as many other accounting and disclosure items. Results of this research are considered useful for both practising accountants and finance professionals such as security analysts. Knowledge of these results is considered to be particularly useful in relation to making financial reporting decisions. It is often argued that more informed choices between financial accounting and disclosure alternatives can be made if the expected impacts on share prices are anticipated when making financial reporting decisions. A summary comprising some of the more important capital markets research results follows. These key findings include: • historical cost income is used by investors • prior to an earnings release, investors obtain much of the information they need from other sources • the information content of earnings announcements depends on the extent of alternative sources of information • the capital market impact of unexpected changes in earnings depends on whether the change is expected to be permanent or temporary • earnings persistence depends on the relative magnitudes of cash and accruals components of current earnings • the earnings announcements of other organisations in the same industry have information content • earnings forecasts have information content • there are benefits associated with the voluntary disclosure of information • recognition is perceived differently to mere footnote disclosure • size of a company affects whether the capital market will react to a company’s release of information, such as earnings announcements • unexpected changes in accounting earnings created by unexpected increases in revenues rather than unexpected reductions in expenses. We consider each of the above dot points in the material that follow. 610
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Historical cost income is used by investors Ball and Brown (1968), in the first major capital markets research publication in accounting, investigated the usefulness of accounting earnings under a historical cost model. Prior to their research, there was a widely held view that historical cost accounting methods resulted in ‘meaningless’ information that was not useful for investors and other users of financial statements.15 When Ball and Brown undertook their research, it was at a time when the use of fair values was relatively absent within financial accounting and there was much greater reliance on historical cost relative to the situation today wherein various assets, and liabilities are, or can be, measured at fair value. Ball and Brown saw the need for empirical evidence about whether accounting earnings/profits, calculated using historical cost accounting principles, provide useful information to investors. They stated (p. 159): If, as the evidence indicates, security prices do in fact adjust rapidly to new information as it becomes available, then changes in security prices will reflect the flow of information to the market. An observed revision of stock prices associated with the release of the income report would thus provide evidence that the information reflected in income numbers is useful.16
Using data for 261 US companies, Ball and Brown tested whether companies with unexpected increases in financial accounting earnings had positive abnormal returns, and companies with unexpected decreases in accounting earnings had negative abnormal returns (on average). Unexpected earnings were calculated (quite simplistically) as the difference between current earnings and the previous year’s earnings. That is, Ball and Brown assumed that this year’s earnings were expected to be the same as last year’s earnings. Monthly share price data were used, with the market model being used to calculate abnormal returns for each company. Cumulative abnormal returns (CARs) were then calculated for each of (1) the full sample of companies, (2) companies with unexpected increases in earnings (favourable announcements), and (3) companies with unexpected decreases in earnings (unfavourable announcements), by summing the average abnormal returns for each of these groups over time. Ball and Brown found evidence to suggest that the financial information contained in the annual report is used in investment decision making, despite the limitations of the historical cost accounting system. This result is evidenced by the CARs during the month of the earnings announcements (month 0). As can be seen from Figure 11.2, companies with unexpected increases in earnings (favourable announcements), represented by the top line in the chart, had positive abnormal returns during the announcement month (on average), while companies with unexpected decreases in earnings (unfavourable announcements), represented by the bottom line in the chart, had negative abnormal returns. Since Ball and Brown’s early study, this research has been replicated many times using more sophisticated data and research methods. The results generally appear to confirm the usefulness of historical cost income to investors. This is not to say that the historical cost accounting system is the ‘most useful’, since a present value, fair value or current cost accounting system may be more useful, but it gives some credence to the continued use of historical costs for some assets and liabilities.
15 16
For example, see Chambers (1965) and Sterling (1975). We discussed their views within Chapter 6. However, just because the market reacts to information, which might reflect that the information was used to revise expectations about future cash flows (that is, the information was useful and led to changes in share prices), this does not necessarily mean that other forms of accounting not based on historical costs might not have been more useful for revising expectations about future cash flows.
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FIGURE 11.2 Movements in cumulative abnormal returns before and after the announcement of earnings 1.12 1.10 1.08
Cumulative abnormal returns for favourable announcements
Abnormal performance index
1.06 1.04 1.02 1.00 0.98
Total sample
0.96 0.94 0.92
Cumulative abnormal returns for unfavourable announcements
0.90 0.88
-12
-10
-8
-6
-4
-2
0
2
4
6
Month relative to annual report announcement date Source: R. Ball & P. Brown (1968), ‘An empirical evaluation of accounting income numbers’, Journal of Accounting Research, 6(2), pp. 159–78.
Prior to an earnings release, investors obtain much of the information they need from other sources In addition to confirming the usefulness of the historical cost accounting model, Ball and Brown (1968) found that most of the information contained in earnings announcements (85–90 per cent) is anticipated by investors. The gradual slope in the lines (which represent the cumulative abnormal returns) prior to the earnings announcements (which were made at time 0) in Figure 11.2 provide evidence of this. Anticipation of earnings changes by investors indicates that investors obtain much of the information useful for investment decision making from sources other than annual earnings announcements (perhaps from media releases, analysts’ releases, information about the industry’s production and sales trends, and so on). This is not surprising, given that alternative sources of information, such as conference calls to analysts and press releases, are generally timelier than the annual report, which tends to be issued several weeks after year end (the reporting date) and less frequently than many alternative sources of information. Therefore, we can never expect to produce accounting statements that will tell investors everything they may want to know. That is, the provision of all relevant information to investors is not a good basis for regulation or practice. When making financial reporting decisions, it is important to
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remember that, while financial accounting appears to be an important source of information for the share market, it is not the only source of information.17 In finishing this brief discussion of Ball and Brown (1968), it is worth noting that this paper is generally accepted as the most highly cited academic accounting paper. It certainly represented quite a change from previous accounting research, which was predominantly normative. Reflecting on the significance of the work, Brown (1994, p. 24) states: A number of reasons have been given to explain the paper’s major impact on the accounting literature since 1968: • It was cast in the mould of a traditional experiment: hypothesis, data collection, data analysis, conclusion. • It expressed a view that ran counter to the critics of GAAP (these critics arguing that historical cost accounting information was meaningless and useless). • It was an early plea for ‘empirical research’. • It emphasised the use of data to test a belief. • It adopted an information perspective. • It contained the basic elements of a research design that became a model for future research: the semi-strong form of the EMH was a maintained hypothesis, so the focus was on market behaviour around an announcement date; earnings predictions were modelled to identify the news in, or what was new about, the earnings report; GAAP earnings were compared with a primary version of operating cash flows; and abnormal returns were measured by the Market Model and the CAPM. • It was a particularly robust experiment, in the sense that it has been replicated for firms with different fiscal years, in different countries, and at different times. • It gave rise to many papers in related areas.
As Chapter 8 indicates, Watts and Zimmerman (1986) credit the development of Positive Accounting Theory, at least in part, to the early experimental approach adopted by Ball and Brown. Studies of markets’ reactions to particular accounting disclosures, such as Ball and Brown’s, have been used to make recommendations to financial reporting standard-setters. Relying on the maintained assumption that capital markets are efficient, researchers have been known to argue against standard-setters requiring particular information if research has shown that share prices did not react when the particular information was disclosed. As Kothari (2001, p. 119) states: The early evidence of earnings’ association with security returns and evidence of capital market efficiency in finance and economics led some accounting researchers to draw standard-setting implications. For example, Beaver (1972) in the Report of the American Accounting Association Committee on Research Methodology in Accounting, suggests that the association of accounting numbers with security returns can be used to rank order alternative accounting methods as a means of determining the accounting method that should become a standard. The report states that the ‘method which is more highly associated with security prices ought to be the method reported in the financial statements’ (p. 428), subject to considerations of competing sources of information and costs. 17
And as we have expressed elsewhere in this book, there is a growing trend for various stakeholders to use social and environmental information when making their various decisions.
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In understanding why investors often use information from sources other than the financial accounting information released by the organisation, we need to remember that the application of generally accepted accounting principles can act to restrict, or eliminate, the disclosure of particular information that would otherwise be of relevance to investors. For example, many intangible assets – particularly those that have been internally generated – are not allowed to be recognised for financial reporting purposes despite their very real value to an organisation. Also, financial accounting methods might be chosen because they restrict the potential for managers to act opportunistically (and therefore to reduce agency costs, as explained in Chapter 8) and to reduce the threat of litigation for overstating company financial results and position. While the use of historical costs for some assets (for example, inventory) or the requirement to expense many expenditures (for example, amounts expended on internally generated intangible assets are generally required to be expensed regardless of any likely future economic benefits) might act to limit the ability of managers to use accounting method selection in an opportunistic manner, it also means that investors will seek out other sources of information to enable them to determine the value of an organisation.
The information content of earnings announcements depends on the extent of alternative sources of information Research indicates that the information content of earnings varies between countries and between companies within a country. For example, Brown (1970) found that, when compared with US markets, the Australian market had slower share price adjustments during the year, with larger adjustments at the earnings announcement date. This result implied that annual reports were a more important source of information for the Australian capital market than they were for US capital markets because there were fewer alternative sources of information for Australian companies. The difference in the extent of alternative sources of information was partly due to Australian regulations that required only semi-annual rather than quarterly reporting, and partly also a function of differences in average company sizes between the two countries. Small companies tend to have fewer alternative sources of information than larger companies, and are less likely to be followed by security analysts. This difference causes differences in the usefulness of earnings announcements, with these being more useful for smaller Australian companies than larger Australian companies. Therefore, the extent of alternative sources of information should be considered when making financial reporting decisions. (The issue of size is returned to later in the chapter.)
REFLECTION QUESTION 11.3 Does size matter? Question Would information disclosed within financial reports likely be more ‘relevant’ to investors in smaller capital markets or in larger capital markets? Solution We would expect that some information in financial reports would be relevant to investors in all capital markets, regardless of the size of that market. However, evidence does seem to suggest that investors in smaller capital markets are relatively
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more reliant on the financial reports issued by a company when assessing the likely future cash flows of that company. In larger markets there are more analysts and more information sources about organisations, and hence with greater information from a variety of sources, there is relatively less reliance on financial reports. Nevertheless, there are still many important roles for financial reports other than just for the use of capital markets. Also, it is highly unlikely that there would be no ‘news content’ in the released financial reports.
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The capital market impact of unexpected changes in earnings depends on whether the change is expected to be permanent or temporary Following Ball and Brown’s finding that the direction of unexpected earnings changes is positively related to the direction of abnormal share price returns, further research was conducted into the relation between the magnitude of the unexpected change in earnings, or earnings per share, and the magnitude of the abnormal returns. This relationship is often referred to as the earnings response coefficient. The results show that this is not a one-to-one relationship. Indeed, some research has shown that the average abnormal return associated with a 1 per cent unexpected change in earnings is only 0.1 to 0.15 per cent (Beaver, Lambert and Morse, 1980). This relationship varies, depending on whether the change in earnings is expected to be permanent or temporary. Permanent increases are expected to result in increased dividends, and therefore increased future cash flows, and this implies a change in the value of the company. On the other hand, temporary increases are discounted or ignored, since they are not expected to have the same impact on expected future dividends (Easton and Zmijewski, 1989). While some earnings changes, such as those due to one-off restructuring charges, are obviously temporary, it is more difficult to determine whether other earnings changes are likely to persist.
Earnings persistence depends on the relative magnitudes of cash and accruals components of current earnings The accrual system of accounting differs from the cash basis of accounting owing to differences between the timing of cash flows and the timing of when income and expenses are incurred. Under the accrual system, transactions and events are often recognised before the cash flows are received or paid (for example, credit sales and purchases), while some expenses are recognised on a periodic basis without a corresponding cash flow (for example, the cost of a non-current asset is recognised over its useful life through periodic depreciation charges). Therefore, the accrual process involves recognising transactions and events at times that are different to when the related cash inflows and outflows are expected to occur. Earnings/profits, the summary performance measure of the accrual system, is considered to represent a better measure of financial performance relative to measures of cash flows, such as ‘cash flows from operating activities’. However, application of the accrual system can be a subjective rather than an objective process and, depending on the choices made, many different earnings figures can be achieved. For example, if the reducing-balance method of depreciation is chosen over the straight-line method, reported profits will initially be lower, owing to a greater depreciation expense. However, reported earnings will be higher in the later years of the asset’s life due to lower depreciation expense. Sloan (1996) undertook a study to see if share prices behave as if investors simply ‘fixate’ on reported earnings without considering how those numbers have actually been determined (that is, without considering the methods of accounting that have been employed). According to Sloan (1996, p. 291): A meaningful test of whether stock prices fully reflect available information requires the specification of an alternative ‘naive’ expectation model, against which to test the null of market efficiency. The naive model employed in this study is that investors ‘fixate’ on earnings and fail to distinguish between the accrual and cash flow component of current earnings. This naive earnings expectation model is consistent with the functional fixation hypothesis, which has received empirical support in capital market, behavioral and experimental research.18 18
According to Watts and Zimmerman (1986, p. 160), ‘the hypothesis of functional fixation maintains that individual investors interpret earnings numbers in the same way, regardless of the accounting procedures used to calculate them. If all investors acted in this way, there would be a mechanical relation between earnings and stock prices, and the stock market would not discriminate between efficient and less efficient firms’.
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Sloan provides evidence that companies with large accruals relative to their actual cash flows are unlikely to have persistently high earnings, since the accruals reverse over time, reducing future earnings. However, share prices are found to act as if investors simply ‘fixate’ on reported earnings, thereby failing to take account of the relative magnitudes of the cash and accrual components of current earnings (fixation implying a degree of market inefficiency). In concluding his paper, Sloan (p. 314) states: This paper investigates whether stock prices reflect information about future earnings contained in the accrual and cash flow components of current earnings. The persistence of earnings performance is shown to depend on the relative magnitudes of the cash and accrual components of earnings. However, stock prices act as if investors fail to identify correctly the different properties of these two components of earnings.
Hence, while earnings/profits can be increased – perhaps, opportunistically – through various discretionary accruals, this cannot be done indefinitely, and earnings will eventually be lower as the accruals subsequently reverse. Likewise, while it may be possible to increase share price through reporting higher earnings, this effect will be reversed when lower earnings are reported in the future. Although the lower earnings are due to the reversal of accruals, evidence indicates that the market fixates on the lower reported earnings, and share prices therefore fall as the accruals subsequently reverse. Notions questioning market efficiency, such as the ‘functional fixation perspective’, have been hotly contested in the accounting literature.
The earnings announcements of other organisations in the same industry have information content When a company announces its annual earnings/profits, this can result in abnormal returns not only for the company concerned, but also for other companies in the same industry (Foster, 1981). That is, there is information content for similar organisations as well as for the announcing organisation. This phenomenon, known as ‘information transfer’, reduces the surprise (unknown) element in earnings announcements of other companies in the industry that choose to announce their earnings later. The direction of the capital market reaction is related to whether the news contained in the announcement reflects a change in conditions for the entire industry or changes in relative market share within the industry. Because information is gained from the announcements of similar organisations, information releases about sales and earnings changes result in price reactions for other companies in an industry, as well as the company making the announcement (Freeman and Tse, 1992). Therefore, in forming expectations about how information releases, such as earnings announcements, might affect share prices, it is important to consider the timing of information releases relative to those of similar companies, since information about a company can be gained from the information releases of similar companies. Firth (1976) investigated the ‘information transfer’ issue. He sought to ‘investigate the impact of a company’s results being publicly announced on the share price behaviour of competing firms’ (p. 298). His results indicated that when ‘good news’ was released about accounting earnings, the share prices of the non-announcing companies in the same industry reacted quickly (the same day) by showing a statistically significant increase. Interestingly, there seemed to be no abnormal returns in the days before the announcement (limited anticipation) or the days after the announcement. That is, most of the adjustment appeared to occur fairly immediately. Similar results were found with respect to ‘bad news’ earnings announcements. The share prices of non-disclosing companies in the industry tended to fall on the day of the ‘bad news’ earnings announcement. If the announcement of earnings by one company impacts on the share prices of other companies in the same industry, there would be an expectation that if a number of companies 616
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are about to release earnings information then, all other things being equal, the largest share price reactions might be generated by the entity that makes the first release. By the time the last entity releases its earnings announcements for a particular year end, it could be expected that a great deal of this information would already have been impounded in share prices and hence the last announcement would have relatively little impact on share prices. This expectation was confirmed by Clinch and Sinclair (1987). In summarising their findings, they stated (p. 105): The directional association between daily price changes for announcing and nonannouncing firms and the magnitude of the price change diminishes for subsequent announcing firms in the same industry over the reporting period.
While the above discussion has considered the industry implications of corporate earnings or profit announcements, other studies have also shown that there can be industry share price implications that flow from other events that impact on specific organisations within the industry. Blacconiere and Patten (1994) examined the market reaction to Union Carbide’s chemical leak in India in 1984. In December 1984, methyl isocyanate (MIC) gas leaked from the Union Carbide India Limited (UCIL) plant in Bhopal, killing approximately 3800 people and causing several thousand other individuals to experience permanent or partial disabilities. Using a sample of 47 US companies, Blacconiere and Patten observed a significant impact on the share prices of Union Carbide directly following the disaster (as might be expected). They also found a significant intra-industry market reaction to the event. However, companies with more extensive environmental disclosures in their annual reports before the disaster (with the disclosures covering such issues as emergency response policies) experienced a smaller negative share price reaction than those with less extensive disclosures.
Earnings forecasts have information content Announcements of earnings forecasts by both management and security analysts are associated with share returns. That is, not only do announcements of actual earnings appear to cause share prices to change, but announcements of expected earnings also appear to cause price changes. Similar to earnings announcements, earnings forecasts are associated with market returns in terms of both direction and magnitude (Imhoff and Lobo, 1984; Penman, 1980). These results are not surprising, since earnings forecasts are expected to contain new information that can be used in the prediction of future earnings. Forecasts of expected future earnings appear to be an effective way of communicating information to the share market. Also, bad news forecasts about lower than anticipated future earnings may be useful for avoiding potential shareholder lawsuits (Skinner, 1997). As an example of how share prices might respond to profit forecasts, in an article in The Age entitled ‘Testing a boost for pathology shares boom’ (Koehn, 2021) it was reported how new requirements pertaining to COVID-19 testing for travellers meant that a company known as Australian Clinical Labs updated its profit forecasts, with the result that the share price of the company increased by 25.31 per cent following the announcement. It would appear that given the amount of the share price adjustment, the revision to expected profits exceeded the profit upgrade expectations held by the market. Earnings forecasts have also been explored in terms of the ‘information transfer’ phenomenon discussed earlier. Baginski (1987) generated results that showed that the share prices of companies within the same industry that did not provide an earnings forecast were positively correlated with the change in earnings expectation indicated by earnings forecasts released by managers of other companies within the same industry. However, what must be remembered in research that looks at market reactions around particular events is that share prices might actually be reacting to other unknown (by the researcher) contemporaneous events.
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There are benefits associated with the voluntary disclosure of information The disclosure of additional information, over and above that required by accounting regulations, has benefits in the capital markets. Voluntary disclosures include those contained within the annual report, as well as those made via other media, such as press releases and conference calls to security analysts, as well as various voluntary disclosures made on corporate websites. For example, Lang and Lundholm (1996) show that companies with more informative disclosure policies have a larger analyst following and more accurate analyst earnings forecasts. They suggest that potential benefits to disclosure include increased investor following and reduced information asymmetry. Further, Botosan (1997) shows that increased voluntary disclosure within the annual report is associated with reduced costs of equity capital, particularly for companies with low analyst following. For these low-analyst companies, disclosure of forecast information and key non-financial statistics is particularly important, while for companies with a high analyst following, disclosure of historical summary information is beneficial. Therefore, the potential benefits of increased disclosure should perhaps not be ignored when deciding the extent of voluntary disclosure.
Recognition is perceived differently to mere footnote disclosure Recognising an item by recording it in the financial statements and including its numerical amount in the financial statement’s totals is perceived differently to merely disclosing the amount in footnotes to the financial statements. For example, Aboody (1996) found that where companies in the US oil and gas industry recognised a write-down in their financial statements, the negative pricing effect was significant, whereas when companies in the same industry merely disclosed such a write-down in footnotes, the pricing effect was not significant. In other words, the market perceives recognised write-downs to be more indicative of a value decrement than disclosed write-downs. Further, Cotter and Zimmer (1999) show that mere disclosure of current values of land and buildings in the notes to the financial statements indicates that the amount is less certain when compared with current values that are recognised in the statement of financial position (balance sheet) via an asset revaluation. These results indicate that investors place greater reliance on recognised amounts than on disclosed amounts. Therefore, while it is not necessary to recognise information in the statement of financial position for it to be useful, since merely disclosing the information in the footnotes conveys the information to investors, disclosed information is perceived to be less reliable than recognised information.
Size of a company affects whether the capital market will react to a company’s release of information There is evidence that the relationship between earnings announcements and share price movements is inversely related to the size of an entity. That is, earnings announcements have been found generally to have a greater impact on the share prices of smaller companies relative to larger companies. This is explained on the basis that with larger companies there is generally more information available in the marketplace and therefore greater likelihood that projections about earnings have already been impounded in the share price. The earnings announcement for larger companies would have a relatively limited unexpected component. For example, research has shown that the relationship between the information content in earnings announcements and changes in share prices tends to be more significant for smaller companies. That is, in general, larger companies’ earnings announcements have relatively less information content (for example, Collins, Kothari and Rayburn, 1987; Freeman, 1987). This is consistent with the EMH and is explained by the fact that larger companies tend to have more information 618
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being circulated about them, as well as attracting more attention from such parties as security analysts. Hence, on average, earnings announcements for larger companies tend to be more anticipated, provide less surprise and are already impounded in the share price prior to the earnings announcement. Grant (1980) also explored this issue. He investigated the information content of earnings announcements of securities traded on the New York Stock Exchange (NYSE), as well as securities traded on what is known as the ‘over-the-counter’ (OTC) market. Companies traded on the OTC market are typically smaller than those traded on the NYSE. Consistent with the perceived size effect, the prices of securities traded on the OTC market were more responsive to earnings announcements than were the prices of securities traded on the NYSE.
REFLECTION QUESTION 11.4 Less regulation for larger organisations? Question Evaluate this statement: because there is more information about larger organisations, and because of the so-called ‘size effect’ discussed above, there is relatively less need for financial reporting regulation for larger organisations. Solution Financial reporting regulators throughout the world usually require larger organisations to provide more financial disclosures than smaller organisations. This is because larger organisations generally impact the lives of more stakeholders and also because as organisations get larger, there is generally a greater separation between ownership and control. The greater the separation between ownership and control means that the owners of larger organisations typically have limited or no direct knowledge of the internal functioning of the organisation, thereby increasing their reliance on relevant and reliable general purpose financial information. For example, within Australia, small proprietary companies are generally not required to comply with financial reporting
Reflection
standards, whereas large proprietary companies and public companies are required to comply. This is perhaps opposite to what some capital market researchers might prescribe. There are also many Positive Accounting Theorists (see Chapter 8) who argue against the extent of disclosure regulation imposed upon larger organisations, saying that such regulation tends to introduce various inefficiencies with respect to the ability of managers to report information about their financial performance and position. We need to remember that capital markets research explores aggregate market movements in share prices and does not consider the gains and losses made at the individual investor level. To protect the interests of individual investors (who tend to be ignored by capital markets researchers), who might have large proportions of their wealth invested in companies, it is arguably important that companies be required to provide relevant and reliable information to enable such investors to assess the performance and risks of their investments.
Unexpected changes in accounting earnings created by unexpected increases in revenues Where there is an unexpected increase in earnings (profits), this could be due to an increase in income (revenues), a reduction in expenses or a combination of both. In this regard, would it make a difference to the share price reaction if an unexpected increase in earnings (profits) was due to an income (revenue) increase rather than a reduction in expenses, or vice versa? Jegadeesh and Livnat (2006) explored this issue. They state (p. 148): We examine the incremental information conveyed by revenues reported during preliminary earnings announcements. Several factors motivate our analysis of the information content of revenues. Earnings, by definition, is revenues minus aggregate expenses. If earnings surprises are accompanied by revenue surprises of similar magnitude in the same direction, then the earnings surprises are driven by revenue
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growth rather than by a reduction in expenses. We expect earnings growth driven by revenue growth to exhibit a different level of persistence compared with earnings growth driven by expense reduction.
Jegadeesh and Livnat’s results indicate that the market does tend to react more to unexpected earnings when these ‘surprises’ are due to increases in revenues. These results are generally consistent with those provided by Ertimur, Livnat and Martikainen (2003), who found that market prices react significantly to unexpected revenue increases on earnings announcement dates after controlling for unexpected earnings announcements.
Do current share prices anticipate future accounting earnings announcements? LO11.5
LO11.6
The previous discussion has provided evidence that financial accounting earnings announcements, because of their potential information content, can impact share prices. That is, share prices change in relation to information as it becomes available. However, the impact of ‘new’ information seems to be more significant for smaller companies. As we saw, this is explained on the basis that there tends to be more information available for larger companies (for example, through more analysts paying particular attention to the larger companies). Hence, as company size increases, the general perspective taken is that share prices incorporate information from a wider number of sources (including, perhaps, numerous analysts’ forecasts of the larger entity’s earnings, newspaper articles about the organisation’s sales, workplace disputes, executive appointments and so forth) and therefore there is relatively less unexpected information when earnings are ultimately announced. For large companies, we might actually be able to argue that share prices anticipate future accounting earnings announcements with some degree of accuracy. As Brown (1994, p. 105) states, if we take the perspective that share prices anticipate earnings announcements, we are effectively ‘looking back the other way’ from traditional perspectives that assume that accounting earnings or profit announcements actually drive share price changes. A more recent focus taken by some capital markets researchers is on how well accounting information, such as annual profits, captures information that is relevant to investors. This is a different focus from research considered previously in the chapter. Rather than determining whether earnings/profit announcements provide information to investors, this alternative form of research seeks to determine whether earnings/profit announcements reflect information that has already been used by investors in decision making. This research views market prices, and hence returns, as leading/anticipating accounting earnings (but not driving accounting earnings), while ‘information content’ research (the previous focus of the chapter) views earnings as leading (or driving) market returns. That is, ‘event study’ type research, which we have explored already in this chapter, investigates how financial accounting information influences or drives share prices, whereas the other branch of research we are now discussing explores an association between financial accounting measures, such as profits, and share prices without assuming a causal association. Both perspectives have merit, since the earnings announcement is likely to contain some information about a company’s activities that was not previously known to investors, as well as information that investors have already determined (or anticipated) from alternative sources. In considering why share prices convey information about future accounting earnings, Brown (1994, p. 106) argues: In a world of rational expectations, events that affect future distributions to shareholders will be reflected in today’s share price, whereas accounting standards often require that the recognition of those events be deferred until some future accounting period. 620
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Share prices and returns (‘returns’ being changes in share prices plus dividends) are considered by some researchers to provide useful benchmarks for determining whether accounting information is relevant for investor decision making. Share prices are deemed to represent a benchmark measure of company value (per share), which can be compared against the value of a company as represented in the organisation’s balance sheet. Also, share returns represent a benchmark measure of company performance (per share), which can then be compared to another measure of company performance – accounting earnings (or profits) as reported in the organisation’s statement of profit or loss and other comprehensive income. These market-based benchmarks (share prices and returns) are, in turn, used to compare the usefulness of alternative financial accounting and disclosure methods. For example, this methodology is used to answer questions such as: are cash flows from operations a better measure of a company’s performance than earnings calculated using the accruals system? Each of these accounting measures of performance is compared with the market benchmark measure of performance (share returns) to determine which accounting measure best reflects the market’s assessment of company performance. This type of capital markets research, which is often referred to as ‘value-relevance research’– and particular information, including financial accounting information, is deemed to be ‘value-relevant’ if there is a significant statistical relationship between the information (for example, a financial accounting number) and the market value of the company’s equity – also assumes that the market is efficient, and acknowledges that financial statements are not the only source of information available to the markets, such that security prices reflect information that is generally available from a multitude of sources. In particular, it assumes that investors and financial analysts actively seek out relevant information when making investment decisions or recommendations, rather than awaiting the release of annual reports that include all the financial statements and supporting notes. Further, this focus of research allows researchers to consider questions about balance sheet (statement of financial position) measures. For example, are disclosures about current or fair values of assets value-relevant? That is, are the asset measures associated with, or linked to, the current market value of the company? Again, there is an assumption that market values reflect all publicly available information (consistent with assumptions about market efficiency), including, but not limited to, information contained in financial statements and accompanying notes. This area of research is based on a theoretical framework that is derived from the premise that market values and book values (carrying amounts) are both measures of a company’s value (stock of wealth), even though book value measures wealth with some error. That is, at any point in time, the market value of a company’s equity (MVit) is equal to the book (carrying) value of shareholders’ equity (BVit) plus some error (eit):
MVit = BVit + ε it
(Equation 4)
This error is due to the conservative nature of the financial accounting system. The carrying amount (book value), as determined by the application of generally accepted accounting principles, is generally expected to be lower than market value for a number of reasons. First, not all assets and liabilities are recognised in the financial statements. For example, human resources, customer satisfaction levels and internally generated intangible assets, including internally developed goodwill, internally developed brand names, internally developed patents and copyrights and so forth, are not recognised in the statement of financial position (balance sheet), nor are their values amortised to the income statement (or as it has become known in recent years, the statement of profit or loss and other comprehensive income). Nevertheless, while such assets are not recognised for financial accounting purposes, the expectation is that an efficient market will consider such assets when determining the appropriate market price
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for the company’s securities.19 Second, some assets are recognised at less than their full value. For example, non-current assets that have not been revalued to fair value, and inventory, are generally recorded at less than their expected net sale prices. If markets are assumed to be efficient, the market value of the company’s shares provides a benchmark measure against which alternative measures of ‘book value’ (or ‘carrying amount’) can be assessed. As will be seen shortly, there is a great deal of research that evaluates the output of the financial accounting system on the basis of how the financial accounting information relates to or compares with current market prices of the company’s securities.20 If the market value of an organisation (based on the number of securities issued and their respective market values) and the book value of a company (represented by total assets less total liabilities, which equals equity) are considered as ‘stocks’ of wealth, then changes in each of these measures of wealth between two points in time can be considered as ‘flows’ of wealth. Just as market and book measures of stocks of wealth equate, so too can market and book measures of flows of wealth (changes in value) be equated, albeit with some degree of error (with ε being the symbol used to refer to the error):
∆MVit = ∆BVit + ε it′
(Equation 5)
Change in market value (∆MVit) is simply the difference in the market capitalisation of a company between two points in time (t − 1 to t). On a ‘per share’ basis, it can be expressed as the change in the price of one share.
∆MVit/no. of shares = Pit − Pit-1
(Equation 6)
Change in accounting ‘book value’ (∆BVit) is the difference between opening and closing total shareholders’ equity as reported in the balance sheet. However, if we assume that there have been no additional capital contributions during the period, ∆BVit can also be measured by considering the change in retained earnings for the period. On a per share basis, this is measured as earnings per share (Eit) less dividends paid per share (Dit):
∆BVit/no. of shares = Eit − Dit
(Equation 7)
This formula is based on the concept of ‘clean surplus’ earnings, which assumes that all increases in book value (assets less liabilities) pass through the organisation’s profit or loss. Clean surplus earnings does not always hold in practice, since items such as asset revaluation increments are credited directly to owners’ equity (through a credit to revaluation surplus which would be reflected within ‘other comprehensive income’). However, the assumption of clean surplus is useful for simplifying our analysis. Substituting Equations 6 and 7 into Equation 5 gives:
Pit − Pit −1 = E it − Dit + ε it′
(Equation 8)
As another example, the appointment of a very reputable managing director would be value-relevant because it is an action that could be expected to lead to improved company performance, cash flows and hence share value. However, such an appointment would not generally be reflected in the financial statements themselves. The disparity between the value of net assets as represented in the statement of financial position (balance sheet) and the market value of the company’s securities will tend to be greater for those organisations with operations that are more dependent on intangible assets (such as human capital) relative to those organisations that rely more heavily on tangible assets (such as property and equipment, which are recognised for financial statement purposes). 20 This research assumes, perhaps somewhat simplistically, that the market has it ‘right’ in its determination of the company’s value. Thereafter, financial accounting numbers are compared with the market’s ‘benchmark’ of share price (or share returns). Clearly, the benchmark figure of valuation might overvalue or undervalue the entity relative to the value that would be placed on it if all private and public information was known and ‘appropriately’ used. As noted earlier in the chapter, market predictions are sometimes, in hindsight, proved to be wrong, thus necessitating subsequent adjustments. 19
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That is, there is a theoretical relationship between change in share price and change in retained earnings for the period. With a small amount of manipulation, this equation can be expressed to relate returns to earnings (the return/earnings relation). First, adding dividends to both sides of the equation, and dividing through by beginning of period share price, gives:
(Pit − Pit −1 ) + Dit
Pit −1
= E it /Pit − 1 + ε it′′
(Equation 9)
Since the left-hand side of the equation, ((Pit − Pit–1) + Dit)/Pit–1, is equal to returns (Equation 2), we are left with an equation relating returns to earnings:
Rit = E it /Pit −1 + ε it′′
(Equation 10)
Equation 10 shows that we should expect capital market returns (Rit) and accounting earnings per share divided by beginning of period share price (Eit/Pit–1) to be related. In short, this perspective says that if market value is related to accounting book (carrying) value, share returns should also be related to accounting earnings per share, divided by price at the beginning of the accounting period. This analysis provides an underlying reason why we should expect capital market returns to be related to financial accounting earnings/profits over time. However, it is interesting to note that it is total earnings per share rather than unexpected earnings per share that this theoretical framework proposes should be associated with returns. This is in contrast to research that assesses the ‘information content’ of earnings announcements by analysing the association between unexpected earnings per share and abnormal returns at the time of the announcement. It will be seen that there have been a number of studies that evaluate reported earnings (which is a financial accounting number) on the basis of how closely the movements in reported earnings (or earnings per share) relate to changes in share prices.21 Beaver, Lambert and Morse (1980) were the authors of an early paper that sought to investigate how efficiently data about share prices enable a researcher to estimate future accounting earnings. Accepting that share price is the capitalised value of future earnings (which ultimately lead to dividend payments), they regressed the annual percentage change in share price on the percentage change in annual accounting earnings per share. Consistent with Equation 10, they found that share prices and related returns were related to accounting earnings, but they also found that share prices in year t were positively associated with accounting earnings in year t + 1 (share prices led accounting earnings). It was accepted that share price movements provided an indication of future movements in accounting earnings/profits. Because of various information sources, share prices appeared to anticipate future accounting earnings – that is, share prices lead accounting earnings. These findings were also supported in a later study by Beaver, Lambert and Ryan (1987), who regressed changes in security prices on the percentage changes in earnings. Earlier discussion in this chapter explained that research indicates that share prices of larger companies do not adjust as much to accounting earnings announcements as do the share prices of smaller companies. This was explained on the basis that there is more information available and analysed in relation to larger companies, and hence information about accounting earnings is already impounded in the share price before the profit announcements are made. That is, ‘for larger firms, there is a broader and richer information set, and there are more market traders and more analysts seeking information’ (Brown, 1994, p. 110).
21
Again, this research assumes, perhaps somewhat simplistically, that the market has determined the ‘right’ valuation of the organisation and financial accounting numbers are then to be evaluated against this marketbased benchmark.
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If we adopt the position taken here, that share prices can actually anticipate accounting earnings announcements (‘looking back the other way’), as indicated in Beaver, Lambert and Morse (1980) and Beaver, Lambert and Ryan (1987), then perhaps share prices anticipate accounting earnings more efficiently in the case of larger organisations. Collins, Kothari and Rayburn (1987) found evidence to support the view that size does matter, with the share prices being a better indicator of future earnings in large companies. As noted above, a number of studies have used share market valuations as a basis for evaluating financial accounting information. In Equation 10 we indicated that, theoretically, market returns should be related to earnings. Dechow (1994) investigates how well accounting earnings reflect market returns. She also considers whether another measure of performance, based on cash flows, relates better to market returns than accounting earnings based on the accrual accounting system, and states (p. 12): This paper assumes that stock markets are efficient in the sense that stock prices unbiasedly reflect all publicly available information concerning firms’ expected future cash flows. Therefore, stock price performance is used as a benchmark to assess whether accounting earnings or realised cash flows better summarise this information.
According to Dechow, accounting earnings are predicted to be a more useful measure of firm performance than cash flows because they are predicted to have fewer timing and matching problems. In her conclusions, she states (p. 35): This paper hypothesizes that one role of accounting accruals is to provide a measure of short-term performance that more closely reflects expected cash flows than do realized cash flows. The results are consistent with this prediction. First, over short measurement intervals earnings are more strongly associated with stock returns than realized cash flows. In addition, the ability of realized cash flows to measure firm performance improves relative to earnings as the measurement interval is lengthened. Second, earnings have a higher association with stock returns than do realized cash flows in firms experiencing large changes in their working capital requirements and their investment and financing activities. Under these conditions, realized cash flows have more severe timing and matching problems and are less able to reflect firm performance.
Using the market value of a company’s securities as a benchmark, a number of studies have also attempted to determine which asset measurement approaches provide accounting figures that best reflect the valuation the market places on the company. The perspective taken is that book values (carrying amounts) that relate more closely to market values provide more relevant information than other accounting measurement approaches. Barth, Beaver and Landsman (1996) undertook a study that investigated whether fair value measurements of a bank’s financial instruments (as required in the United States at the time) seem to provide a better explanation of bank share prices relative to values determined on the basis of historical cost accounting. Their findings indicate that the disclosures required by the US accounting standard SFAS No. 107 ‘provide significant explanatory power for bank share prices beyond that provided by book values’ (p. 535), thereby providing evidence that such values are the values that are relevant to investors. Easton, Eddey and Harris (1993) investigate whether revaluations of assets result in an alignment between information reflected in annual reports and information implicit in share prices and returns. Again, share price data are used as the ‘benchmark’ against which financial accounting data are assessed. According to Easton, Eddey and Harris (p. 16): Prices are used to assess the extent to which the financial statements, including asset revaluations, reflect the state of the firm at a point in time, while returns are used to assess the summary of change in financial state that is provided in the financial statements. 624
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They found that the revaluation of assets generally resulted in better alignment of market and book values. In concluding their paper, they state (p. 36): Our analyses support the conclusion that book values including asset revaluation reserves are more aligned with the market value of the firm than book values excluding asset revaluation. That is, asset revaluation reserves as reported under Australian GAAP help to provide a better summary of the current state of the firm. Thus, allowing or requiring firms to revalue assets upward should be carefully considered by organizations such as the UK Accounting Standards Board, the Japanese Ministry of Finance, and the International Accounting Standards Committee as they debate the merits of various proposed changes in asset revaluation practice.
In a test of the ‘value relevance’ of a particular financial reporting standard, Dargenidou et al. (2021) used a sample of UK companies to investigate the relevance of the information required by the International Financial Reporting Standard (IFRS) relating to research and development, which is IAS 38 Intangible Assets, relative to the former UK requirement detailed within SSAP 13 Accounting for Research and Development. The authors developed an argument that the requirements to capitalise ‘development expenses’ were more stringent under the former accounting standard, SSAP 13, relative to IAS 38 and that because it was more difficult to pass the test for deferral and to therefore recognise an intangible asset under the former accounting standard, the amount reported for development expenditure (an intangible asset) tended to be more ‘reliable’ than the measures reported for the asset under the more recent accounting standard. Consequently, the propensity for capitalisation was relatively higher under the newer accounting standard, but because it is ‘easier’ to capitalise, the information is not as informative. Dargenidou et al. (2021, p. 5) state: Overall, optional capitalisation of development costs relative to expensing, under SSAP 13 helped analysts and investors to form future earnings expectations. We examine whether the market’s ability to anticipate earnings for UK companies capitalising development costs changes after IFRS implementation, given the lower threshold of asset recognition in IAS 38 ... SSAP 13 promoted an implicit high asset recognition threshold whereby only a small proportion of firms exercised their discretion to capitalise R&D. This is consistent with the notion that under SSAP 13 managers were inclined to capitalise only the R&D expenditure with a high probability of successful outturn. By comparison to SSAP 13, IAS 38 introduces a lower threshold for recognition with regards to internally generated intangible assets by leaving too limited choice (or, no choice) with respect to the capitalisation of development costs when the IAS 38 criteria are met.
The authors predict that the capital market’s ability to better anticipate future earnings for companies that capitalise R&D relative to those expensing in the pre-IFRS period would be weaker in the post-IFRS period, In relation to their finding, the authors report (p. 18): Focusing on the UK market, we examine whether requiring versus allowing conditional capitalisation of development expenditure affects the extent to which capitalisation conveys more information about future earnings, relative to expensing. We find that capitalisation under UK GAAP improves the stock market’s ability to anticipate future earnings relative to expensing. By contrast, we do not find similar evidence in the postIFRS period. Specifically, our results show that capitalisation under the more recent IFRS does not result in current returns incorporating more future earnings information than expensing. Moreover, share prices of capitalisers become less information-efficient in the post-IFRS period compared to the pre-IFRS period, as they reflect less forwardlooking information. Our conclusions for the post-IFRS period are independent of firms’ strength of corporate governance and earnings management incentives 625
Financial Accounting Theory
Again, the logic underlying this research is that it is assumed that market-determined returns (based upon movements in share prices) are somehow ‘correct’ and that the higher the association with accounting-based earnings/profits, then the better – or more informative – is the financial accounting measure. In finding that following the application of the more recently released accounting standard, share market returns of those organisations capitalising research and development no longer seem to show a strong association with accounting earnings in the same way as those organisations formerly expensing research and development (which was in contrast to the situation under the previous accounting standard), the ‘value relevance’ of the financial accounting disclosures seemed to have declined. In terms of the implications of the results, the authors state (p. 18): Our findings should inform future developments in accounting standard setting, particularly the recognition of development costs. We find that the transition from SSAP 13 to IAS 38 in relation to accounting for R&D expenditure was a retrograde step.
In more recent years, an increasing amount of research has also addressed the value-relevance of non-financial accounting information. For example, Choi and Luo (2021) explore whether carbon emissions information voluntarily disclosed by organisations is linked to the market value of the organisation’s shares; specifically, they test whether the level of an organisation’s carbon emissions is negatively associated with the market value of its shares. The authors argue that carbon emissions can affect expected future earnings or cash flows (which therefore impacts share prices) because organisations with higher emissions might need to change their production processes to reduce their emissions, or they could be subject to extra taxes and penalties to be introduced by government at some time in the future. By using an international sample of organisations, the authors also investigated whether the negative impact on share prices is relatively greater in countries with costly emissions trading schemes (which would impose financial costs on the emissions) and whether the existence of good corporate governance systems reduces the negative relationship between emissions and share price. They also considered how ‘national culture’ impacts the negative relationship between carbon emissions and share value.22 Specifically, they considered whether the negative relationship between carbon emissions and market values of organisations’ shares is weaker in countries with relatively higher ‘uncertainty avoidance’ and relatively higher ‘long-term orientation’.23 Therefore, unlike many other capital markets studies, the authors considered the potential influence of ‘culture’ on the relationship they were investigating. Choi and Luo state (p. 5): Through its norming process, the cultural context that is more compatible with sustainability principles can generate more sustainability-relevant institutions. That is, the norms and values regarding sustainability that are reflected in a culture are formalized by local and national institutions (for example, in policies and regulatory bodies). In response to such institutional pressures, individual organizations may decide to resist or conform. National culture can then facilitate or impede such conforming acts of firms. In particular, the impact of institutional pressure will be greater in tight cultural contexts than in loose ones. National culture also determines the degree of constraint in terms of the scope of actions and decisions of senior corporate executives (Crossland & Hambrick, 2007). In other words, culture can affect corporate policies and decisions made by individual managers.
Consistent with the discussion of culture provided within Chapter 5, culture is defined as the ‘collective programming of the mind which distinguishes the members of one group or category of people from another’ (Hofstede, Hofstede and Minkov, 2010, p. 6). 23 We considered both of these cultural attributes in Chapter 5. 22
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In relation to the cultural attribute of uncertainty avoidance, the authors state (p. 5): Uncertainty avoidance is the level of acceptance of uncertainty in a society. In cultures high in uncertainty avoidance, stakeholders have less tolerance for unexpected, unconventional, or risky executive actions. In relation to environmental sustainability practices, companies in cultures high in uncertainty avoidance are more likely to put systems and procedures in place to avoid ambiguity and threats caused by environmental disasters such as pollution and climate change (Parboteeah, Addae, & Cullen, 2012). Miska, Szocs, and Schiffinger (2018) find that a country’s level of uncertainty avoidance positively predicts corporate sustainability practices.
In relation to the cultural attribute of ‘long-term orientation’, the authors state (p. 5): Stakeholders in forward-looking cultures are more likely to place a higher priority on long-term success and to focus on the long-term strategic orientation of a firm (Miska et al., 2018). Corporate social practices are considered to emphasize long-term decision making (Trotman & Bradley, 1981). This indicates that national cultures with a future orientation can be positively related to sustainability practices in business.
In terms of their results, the authors report (p. 19): Using multi-country firm data, we find that firms’ carbon emissions are value-relevant. In particular, firms are penalized by the stock market based on their level of carbon emissions. The negative effect of carbon emissions on firm value is found in both countries with and without a national ETS, while high carbon emitters operating in a country with a national ETS tend to be penalized more. Furthermore, the country governance index and environmental performance index variables as two additional proxies for stringency of environmental regulations also strengthen the negative valuation effects of carbon emissions. However, the negative impact of carbon emissions on firm value is weakened for firms with good corporate governance, in particular, with higher percentage of independent board directors and increased institutional ownership. Further, we examine whether differences in national culture can help explain cross-country differences in the firm valuation of carbon emissions. The results confirm that the national culture dimensions of ‘uncertainty avoidance’ and ‘long-term orientation’ attenuate the negative effect of carbon emissions on firm value.
The results reported in Choi and Luo (2021) therefore confirm earlier results from researchers such as Chapple, Clarkson and Gold (2013), Clarkson et al. (2015) and Griffin, Lont and Sun (2017), who all reported a negative relationship between share values and carbon emissions in countries such as the United States, Australia and various European countries. In considering the implications of their results, Choi and Luo (2021, p. 19) state: Our results have implications for investors, managers, regulators, and accounting standard setters. The negative impact of carbon emissions on firm value indicates that managers, especially of firms in a country with stringent environmental regulations, need to consider penalties imposed by the market on GHG emissions and conduct a cost-benefit analysis of environmentally controversial projects.
Philosophically, many of us might challenge the above implications. Arguably, when considering production processes that could create high carbon emissions (and therefore contribute to climate change and negatively impact upon the welfare of current and future generations), managers should think beyond ‘penalties imposed by the market’. Stakeholders, other than capital market participants – who are notoriously short-term in their orientation – should be considered and we should not leave it up to ‘penalties potentially imposed by the 627
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capital market’ (in terms of lower share prices) as the determining factor as to whether emission reduction technologies should be employed. We can also consider some of the data the authors used in their study. For example, for their measure of ‘carbon emissions’ the authors use data provided by the CDP (which we discussed within Chapter 10), which obtains much of its data about emissions from organisations that voluntarily complete a questionnaire. Much of this data has not been audited. Also, their measure of ‘corporate governance’ is based upon a score provided for organisations by the ratings agency known as Thomson Reuters ASSET 4. As we explained in Chapter 10, when using such ratings services, researchers need to consider the reliability of such measures, given that unreliable measures of independent variables undermine the credibility of the results being generated.
Why do I need to know that share prices are influenced by news about an organisation’s social and environmental performance? Why
As investors or managers, it is useful to understand the various factors that might influence share prices. The success and continuity of an organisation is influenced, at least in part, by how ‘the market’ perceives an organisation. Evidence is increasingly showing that factors such as climate change or modern slavery create many risks and opportunities for organisations that will potentially impact their financial performance and position, and their share price. As we discussed within Chapter 10, organisations such as the Task Force on Climate-related Financial Disclosures and the newly established International Sustainability Standards Board have acknowledged that investors require information about organisations’ sustainability-related practices to be able to make informed investment (buy or
sell) decisions. If we individually are thinking about making investments, we need to appreciate that social and environmental performance will impact share price, and capital markets research is increasingly demonstrating this linkage. If we are managers, we also need to appreciate that our social and environmental performance will influence company value and perhaps, ultimately, the ability to continue operating. While it is simply morally appropriate for managers to behave responsibly from a social and environmental perspective, investors, lenders and creditors are increasingly factoring in information about organisations’ sustainability-related performance before deciding to support organisations.
REFLECTION QUESTION 11.5 Capital markets’ use of non-financial information As indicated in Chapter 10, there is an increasing global trend for organisations to voluntarily disclose detailed information about their emissions of greenhouse gases. Question If capital markets researchers provide evidence that the capital market did not react to emissions data, then is it appropriate to argue that the information is not ‘relevant’. Further, why might share markets not react to such information? Solution It really depends upon which stakeholders we are focusing and the underlying philosophy that guides our research. There could be various reasons why investors in aggregate might not react to emissions data. Share price reactions are predicated on a belief that the information has relevance for revising expectations about the future cash flows of an organisation. Perhaps the capital
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market already anticipated what the emissions of an organisation were before the organisation made the disclosures (for example, through some modelling or through access to government emissions-related websites). Alternatively, the investors in aggregate might believe that emissions data will have no impact on future cash flows (perhaps a rather naïve perspective?) and hence disregard the information (however, we have indicated above that the capital market does take notice of emissions data). Nevertheless, even if it was shown that the capital market does not react to such sustainability-related information, this does not mean it is irrelevant from a broader accountability perspective. Capital markets research simply investigates how investors as a group react, or not, to information. Just because they do not appear to react does not mean that managers do not have an accountability to other stakeholders in respect of certain aspects of organisational performance.
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In other research that considers the value relevance of information, some capital market researchers examine what is known as ‘stock/share return synchronicity’ or ‘share price synchronicity’ in which they test the degree to which the share prices of individual companies comove with the rest of the capital market and, in doing so, they are testing ‘price informativeness’, which reflects the extent to which organisation-specific ‘value relevant’ information is reflected or impounded within share prices.24 Higher synchronicity is deemed to reflect lower ‘price informativeness’ because a high level of synchronicity implies that there is less organisationspecific information to enable the market to generate different returns for different shares. That is, companies will have higher share price synchronicity because less organisation-specific information is being used to determine share prices. Barth et al. (2021) found that higher-quality integrated reports (we discussed integrated reporting in Chapter 10) are associated with greater ‘price informativeness’, which indicates that higher-quality integrated reports reflect more organisation-specific information, thereby enabling investors to make more informed decisions and, according to the authors, to allocate their investment capital more efficiently. Share prices will reflect organisation-specific, industry and market-wide information. Higher synchronicity means that share prices for an organisation seem to be closely matching whole-of-market, or industry, returns. Where there are lower levels of synchronicity, this indicates that particular information has ‘price informativeness’ because the organisation-specific variations in share prices represent a relatively larger proportion of the total share price variation. The authors use an integrated reporting quality rating provided by Ernst and Young, and they find a significant negative relationship between integrated return quality and synchronicity, which indicates a positive relationship between integrated report quality and ‘price informativeness’. They state: This finding is important because it indicates that higher quality integrated reports reflect more firm-specific information, which enables investors to make more informed decisions and, thus, allocate capital more efficiently ... Our findings provide indirect evidence that investors’ valuation decisions reflect firm-specific non-financial information related to sustainability, which integrated reports include but financial statements do not.
A number of other research studies have also addressed various issues through the approach of examining ‘synchronicity’. For example, Gul, Kim and Qui (2010) found that the level of price informativeness increases as audit quality increases and Kim and Shi (2012) reported higher price informativeness following the voluntary application of IFRS by organisations across 34 countries, also finding that price informativeness is higher for organisations applying IFRS relative to those that did not. It needs to be remembered that while there is research, as discussed above, that evaluates accounting methods on the basis of how the methods generate accounting numbers that relate to market values (and therefore to investors’ aggregated expectations), this research ignores the fact that financial accounting information will be of relevance to people other than just investors (although, as we know, the IASB Conceptual Framework of Financial Reporting prioritises the information needs of investors and also effectively ignores the information demands of nonfinancial stakeholders).
24
Studies that examine ‘share price synchronicity’ often use the R 2 statistic – which is a statistical measure that represents the proportion of the variance for a dependent variable that is explained by an independent variable – to examine the relationship between an organisation’s share price and market and industry returns because it shows the extent to which variations in share prices are explained by market and industry-wide movements. A high R 2 implies a higher level of synchronicity and a lower level of organisation-specific information influencing the organisation’s share price.
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Relaxing assumptions about market efficiency LO11.9
The research discussed so far in this chapter has relied on a fundamental assumption that capital markets are efficient, which basically means that relevant publicly available information is quickly (or instantaneously) impounded within share prices. According to Kothari (2001, p. 114): Building on past theoretical and empirical work, Fama (1965) introduced, and subsequently made major contributions to the conceptual refinement and empirical testing of, the efficient markets hypothesis. Fama (p. 4) notes that ‘In an efficient market, on the average, competition’ among rational, profit maximising participants ‘will cause the full effects of new information on intrinsic values to be reflected “instantaneously” in actual prices’. The maintained hypothesis of market efficiency opened the doors for positive capital markets research in accounting. Ball and Brown (1968, p. 160) assert that capital market efficiency provides ‘justification for selecting the behaviour of security prices as an operational test of usefulness’ of information in financial statements. Beaver (1968) offers a similar argument. Unlike previous normative research on accounting theories and optimal accounting policies, positive capital markets research began using changes in security prices as an objective, external outcome to infer whether information in accounting reports is useful to market participants.
However, in recent years there has been a deal of research that has questioned assumptions of market efficiency. As Kothari (2001, p. 107) states: The mounting evidence of apparent market inefficiency documented in the financial economics and accounting literature has fueled accounting researchers’ interest in fundamental analysis, valuation, and tests of market efficiency. Evidence of market inefficiency has created an entirely new area of research examining long-horizon stockprice performance following accounting events. This is in sharp contrast to the boom in short window event studies and studies of economic consequences of standard setting of the 1970s and 1980s. Future work on tests of market efficiency with respect to accounting information will be fruitful if it recognizes that (i) deficient research design choices can create the false appearance of market inefficiency; and (ii) advocates of market inefficiency should propose robust hypotheses and tests to differentiate their behavioral-finance theories from the efficient market hypothesis that does not rely on irrational behavior.
A deal of the research that challenges market efficiencies does so on the basis that it appears that the capital market’s response to information takes longer than previously believed. As already indicated, much previous research was predicated on the view that capital markets react, through changes in share prices, almost instantaneously to relevant information. According to Kothari (2001, p. 130): If the market fails to correctly appreciate the implications of a current earnings surprise in revising its expectations of future earnings, the price change associated with earnings change will be too small. There is a large body of evidence that suggests that the stock market under-reacts to earnings information and recognizes
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the full impact of the earnings information only gradually over time. Smallerthan-predicted values of earnings response coefficients are consistent with capital market inefficiency.
Where share prices are found to take time to react to particular information, such as a corporate earnings announcement, this is referred to in the literature as ‘drift’, or ‘post-earnings announcement drift’. As Kothari (2001, p. 193) states: Post-earnings-announcement drift is the predictability of abnormal returns following earnings announcements. Since the drift is of the same sign as the earnings change, it suggests the market under-reacts to information in earnings announcements. Ball and Brown (1968) first observed the drift. It has been more precisely documented in many subsequent studies. The drift lasts up to a year and the magnitude is both statistically and economically significant for the extreme good and bad earnings news portfolios. A disproportionate fraction of the drift is concentrated in the three-day periods surrounding future quarterly earnings announcements, as opposed to exhibiting a gradually drifting abnormal return behavior. Because of this characteristic and because almost all of the drift appears within one year, I characterize the drift as a short-window phenomenon, rather than a long-horizon performance anomaly. The profession has subjected the drift anomaly to a battery of tests, but a rational, economic explanation for the drift remains elusive.
If we relax assumptions about the speed with which the capital market reacts to information (that is, if we accept that the market does not react instantaneously and there is ‘drift’), this leads to opportunities for some capital market participants to make gains in periods when share prices do not fully reflect the available information. Lee (2001, p. 238) states: Is it possible for mispricing to exist in equilibrium? Certainly. In fact, it strikes me as self-evident that arbitrage cannot exist in the absence of mispricing. Arbitrageurs are creatures of the very gap created by mispricing. Therefore, either both exist in equilibrium, or neither will. Arbitrage cannot take place without some amount of mispricing. If by some mystical force prices always adjust instantly to the right value, we would have no arbitrageurs. Therefore, if we believe that arbitrage is an equilibrium phenomenon, we must necessarily believe that some amount of mispricing is also an equilibrium phenomenon.
If further evidence continues to surface that capital markets do not always behave in accordance with the EMH, should we reject the research that has embraced the EMH as a fundamental assumption? In this regard, we can return to earlier chapters of this book in which it was emphasised that theories are abstractions of reality. Capital markets are made of individuals and, as such, it would not (or perhaps, should not) be surprising to find that the market does not always act in the same predictable manner. Nevertheless, the EMH has helped provide some useful predictions and no doubt will continue to be relied on by many researchers for a considerable period of time. As Lee (2001, p. 238) states: A common assertion is that even if the EMH is not strictly true, it is sufficient to serve as a starting point for research purposes. Like Newtonian physics, it is more than good enough for everyday usage. Unfortunately, it is becoming increasingly more difficult to accommodate what we know about the behavior of prices and returns within this traditional framework.
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Some researchers who are interested in exploring potential inefficiencies in capital markets have referred to insights provided within the behavioural finance literature. This literature, which has much in common with the behavioural research that we explore in Chapter 12, relies in part on work often done in psychology-based research to explore the apparent phenomenon that individual investors appear to sometimes make decisions that cannot be considered as economically rational. In making their decisions, investors often use various ‘heuristics’, or simplifying shortcuts. For example, investors have been found to be more inclined to hold on to shares for too long in order to avoid finally realising a loss, but at the same time might sell valuable shares too early and miss out on future gains. In the next chapter, we explore various heuristics that investors might adopt, but what the research shows is that individuals often make decisions in ways that are not consistent with ‘economic rationality’, and this research can provide some interesting insights into why there is a certain degree of inefficiency in capital markets. It should be appreciated that the theory used within capital markets research (with its reliance on the EMH) effectively treats decision making by individuals as occurring within a ‘black box’ – that is, no investigation is made of how individuals make their decisions, but rather, the same decision-making abilities and motivations are attributed to all individuals. By contrast, behavioural research focuses on individual decision making and can show that some individuals are not ‘rational’ wealth maximisers in the way that capital markets researchers have traditionally assumed. Therefore, at the present time, it should be acknowledged that there is a deal of research into capital markets that does not rely on market efficiencies. The consideration of ‘other forces’ that shape share prices and returns might eventually lead to a revolution in thought (Kuhn, 1962), but it will arguably take a long time. As stated in Chapter 1, Kuhn (1962) explained how knowledge, or science, develops: scientific progress is not evolutionary; rather, it is revolutionary. His view is that knowledge advances when one theory is replaced by another as particular researchers attack the credibility of an existing paradigm and advance an alternative, promoted as being superior, thereby potentially bringing the existing paradigm into ‘crisis’. As knowledge develops, the new paradigm may be replaced by a further research perspective or a prior paradigm may be resurrected. In discussing the process of how researchers switch from one research perspective (or paradigm) to another, Kuhn likens it to one of ‘religious conversion’.25 Whether the EMH will ever be abandoned in favour of a different perspective is an interesting issue to consider.
25
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Kuhn’s ‘revolutionary’ perspective about the development of knowledge is in itself a theory about how knowledge develops, and, as with financial accounting theories, there are alternative views of how knowledge develops and advances. Although a review of the various perspectives of the development of science is beyond the scope of this book, interested readers are referred to Popper (1959), Lakatos and Musgrove (1974), Feyerabend (1975) and Chalmers (1982).
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STUDY TOOLS CHAPTER SUMMARY Capital markets research has investigated a number of issues. Central to the research are assumptions about the efficiency of the capital market. The chapter looked at ‘information content’ studies, in which researchers investigated share market reactions to the releases of information, often specifically the release of financial accounting information. The view taken was that the financial accounting disclosures often revealed new information, and in a market that was deemed to be informationally efficient with regard to acting on new information, share prices react to this information. The chapter also considered studies that investigated whether accounting disclosures reflected, or perhaps confirmed, information already impounded in share prices. The perspective taken was that in an informationally efficient capital market, market prices of shares will reflect information from a multitude of sources. Some researchers would argue that, if the accounting information does not reflect the information already impounded in share prices, accounting data that do not relate to share prices, and changes therein, are somewhat deficient. The idea is that market prices reflect information from many sources and if the accumulated data provide a particular signal the accounting disclosures should provide similar signals. This approach implies that the market has it ‘right’ when determining share prices and hence returns. In practice, the market cannot be expected always to get it ‘right’. Because much knowledge about the performance of an entity will be gained from sources other than accounting, it is perhaps reasonable to expect that accounting information should relate (not perfectly) to expectations held by capital market participants, as reflected in share prices. However, because there will arguably always be some unexpected information released when accounting results are made public, we might expect that not all accounting disclosures will be of a confirmatory nature. Some information in the financial reporting releases will be new and, in a market that is assumed to be informationally efficient, some share price revisions are to be expected. Many share price studies have investigated the market’s reaction to particular disclosures. Often, if no reaction is found, it is deemed that the information is not useful and therefore entities should not go to the trouble and expense involved in making such disclosures. This form of argument has been used to criticise financial reporting regulators for mandating particular disclosure requirements. What must be recognised, however, is that capital markets research investigates the aggregate reaction of one group of stakeholders, the investors. While the share market is an important user of financial accounting information (and indeed the demands of investors are prioritised within the IASB Conceptual Framework), provision of information to the share market is not the only function of the accounting system. Accounting information is also used for monitoring purposes (Jensen and Meckling, 1976; Watts and Zimmerman, 1990), and hence financial statements play an important role in relation to the contracting process (see Chapter 8). Financial statements provide a relatively low-cost way of measuring managers’ financial performance and monitoring compliance with accounting-based contractual terms, thereby helping to reduce agency costs. Further, financial statement information can be used to satisfy people’s ‘rights to know’, that is, to fulfil the duty of accountability (see Chapter 2 for an overview of the notion of accountability). Therefore, while investors are important users of financial statements, it would be foolish to focus solely on the investor-information role of financial reporting, to the exclusion of considerations about the monitoring/accountability role. Arguably, organisations have an accountability to a broader group of stakeholders other than just shareholders.
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ANSWERS TO OPENING QUESTIONS At the beginning of the chapter, we asked the following four questions. As a result of reading Module 1 this chapter, you should be able to provide informed answers to these questions – ours are Questions / shown below. Answers
Assume that there are five companies from the same industry with the same reporting date, this being 31 December. All five companies are to make earnings announcements for the financial year (the announcements being made in February), but the earnings announcements are spread over two weeks, with no two companies announcing their earnings on the same date.
1 Would you expect the earnings announcements made by each company to impact its share price and, if so, why? As we have learned in this chapter, capital markets researchers would argue that the capital market will react, and therefore share prices will change, when unknown or unexpected information is revealed. Earnings announcements would be expected to impact share price if the magnitude of earnings being announced were not otherwise expected by the capital market. 2 If it is found that the share prices of some entities change more around the date of the earnings announcement than others, what might have caused this price–effect differential? We would expect greater share price movements to occur for those organisations where the earnings announcements differed most from market expectations. 3 Would you expect the share prices of larger companies or smaller companies to be relatively more affected by an earnings announcement? More information is available within the capital market in relation to larger organisations. In part, this is because there is more scrutiny by analysts and investors, and the news media is also likely to publish more information regularly about larger organisations. Because more is known about larger organisations, it would be expected that the capital market will be better able to anticipate future earnings relative to smaller organisations. Therefore, the share prices of smaller companies would be expected to be relatively more affected by an organisation’s earnings announcements. 4 Once the first company in the sample of five makes its earnings announcement, would you expect this announcement to impact the prices of shares in the other four companies? Why? Yes, if the announcement was unexpected and if it provided information that caused analysts and investors to revise their expectations about the future cash flows of other organisations within the industry.
QUESTIONS 11.1 11.2 11.3
11.4 11.5
11.6 11.7 11.8 634
What is the role of capital markets research? LO11.1 What assumptions about market efficiency are typically adopted in capital markets research? What do we mean by ‘market efficiency’? LO11.3 If some research is undertaken that provides evidence that capital markets do not always behave in accordance with the EMH, does this invalidate research that adopts an assumption that capital markets are efficient? LO11.3 LO11.9 What is an event study and why would an event study be of relevance to a financial reporting standard-setter? LO11.1 LO11.6 Contrast an ‘event study’ (which looks at how, or whether, the release of particular information leads to a share price change) with a study that looks at the association between changes in share prices (returns) and accounting earnings (profits). LO11.5 What would be the implications for capital markets research if it was generally accepted that capital markets were not efficient in assimilating information? LO11.9 If an organisation releases its earnings figures for the year and there is no share price reaction, how might capital market researchers explain this finding? LO11.4 LO11.5 How would a researcher undertaking capital markets research typically justify that a particular item of information has ‘value’ to investors? LO11.4 LO11.5
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11.9
11.10
11.11
11.12 11.13 11.14 11.15 11.16
11.17
11.18 11.19 11.20
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If individuals have access to ‘insider information’, and are able to make large gains on a securities market as a result of using information that is not widely known, then is this an indication that the market is inefficient? LO11.3 LO11.9 Evaluate the following statement: if an item of accounting information is released by a corporation and there is no apparent change in the share price of the company, the information is not relevant to the market and therefore there is no point in disclosing such information again. LO11.1 Explain what is meant when we say that the information content associated with unexpected earnings (profits) announcements is expected to be inversely associated with the size of an organisation. LO11.8 What, if any, effect would the size of an entity have on the likelihood that the capital market will react to the disclosure of accounting information? LO11.8 Contrast some of the main differences between capital markets research and behavioural research. LO11.2 What does it mean to say that capital markets researchers treat individual decision making as occurring within a ‘black box’? LO11.2 With respect to capital markets research, explain what a potentially confounding event represents. LO11.7 Evidence shows that share prices might not fully react to financial accounting information immediately and that abnormal returns might persist for a period of time following the release of information (a case of ‘post-announcement drift’). Does this indicate that securities markets are not efficient and that assumptions about market efficiency should be rejected? LO11.8 LO11.9 if an organisation’s operations rely heavily on the specialised expertise of its management team, would you expect there to be a higher or a lower correspondence between the net assets recognised in the statement of financial position (balance sheet), and the total market value of the organisation’s securities, relative to an organisation that relies more on tangible assets (for example, commonly used plant and machinery) to generate its income? LO11.5 LO11.6 Would you expect an earnings announcement by one organisation within an industry to impact the share prices of other organisations in the industry? Why? LO11.8 If evidence suggests that the capital market reacts to rumours, then does this undermine researchers’ claims that the capital market is efficient? LO11.4 LO11.7 In a newspaper article entitled ‘BHP posts bumper profit and hikes dividend’ that appeared in the Sydney Morning Herald (Milne, 2022), it was reported that the global mining company’s profit had increased by 144 per cent from the previous period and that the company was going to increase its dividend payments by 50 per cent. You are to provide a prediction as to whether the news about the record profits and increased dividend payment would have created a change in the company’s share price. What factors would have an impact on the nature of any potential share price reaction? LO11.1 LO11.7
11.21 Researchers such as Chambers and Sterling have made numerous claims that historical cost information is meaningless and useless. Are the results of capital markets research consistent with this perspective? LO11.8 11.22 Accepted assumptions about market efficiency mean that it is the information content of disclosure, and not the form of the disclosure, that is valued by the market. Therefore, it should not matter whether information is disclosed within the notes to the financial statements or in the financial statements themselves. If this is true, then why would managers care if something – such as an obligation for remediating a contaminated site – is disclosed only in the notes or is included within liabilities within the balance sheet? LO11.1 LO11.3 11.23 One branch of capital markets research investigates whether financial accounting information reflects the valuations that have already been made by the market (as reflected in share prices). In a sense, it assumes that the market has it ‘right’ and that a ‘good’ financial accounting approach is one that provides accounting numbers that relate to, or confirm, the market prices/returns. If we assume that the market has it ‘right’, what exactly is the role of financial accounting? LO11.5 LO11.6 11.24 In this chapter, we referred to research that suggested that factors such as mood, rainy days, daylight hours and the holding of sporting events impact share prices across the market. What does such evidence imply about capital market efficiency? LO11.3 LO11.9 635
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11.25 In an article in The Age entitled ‘Mexican standoff cuts off the blood from donors’ (Knight, 2021) it was reported that the large biotechnology company, CSL, lost a US District Court legal challenge to a US ban on certain Mexican visa holders entering the United States to provide needed blood plasma for which they were paid $50 a time. Such people had been a major source of plasma. Around the same time unconfirmed news also suggested that the company was in multi-billion dollar talks to acquire a Swiss medical company that would potentially be funded through a large issue of discounted shares. Following this news, the company’s shares were reported as falling by around 3 per cent. How would capital markets researchers explain this share price decline and how could they determine what caused the decline? 11.26 This chapter has emphasised that the capital market appears to respond to information from many sources, including, but not limited to, financial accounting. We have discussed how news (sometimes incorrect) about the death or resignation of senior corporate executives is often followed by share price declines for the companies in question Why do you think the market reacts in this way to such news, and do you think that this implies market efficiency or inefficiency? LO11.8 LO11.9 11.27 If we assume that an organisation reported information that it will recognise a large impairment loss in relation to its intangible assets and its share price then fell, then how would a capital markets researcher differentiate between the component of the share price change that related to market-wide movements and the component that related to the write-down of the organisation’s intangible assets? LO11.4 LO11.7
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REACTIONS OF INDIVIDUALS TO FINANCIAL REPORTING: AN EXAMINATION OF BEHAVIOURAL RESEARCH IN ACCOUNTING LEARNING OBJECTIVES On completing this chapter, readers should:
LO12.1
have a broad understanding of the nature of behavioural research and its relevance to accounting
LO12.2 understand some of the different approaches to undertaking behavioural research LO12.3 understand that many of the insights in behavioural research have been developed by applying knowledge from the discipline of psychology, and therefore behavioural research in accounting represents a situation where insights from one discipline can usefully be employed in another
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LO12.4
know how behavioural research differs from, as well as complements, capital markets research, and other research, such as that which applies Agency Theory and Positive Accounting Theory
LO12.5 understand how different accountingrelated variables can be manipulated in behavioural research and appreciate the role that the Brunswik Lens Model has played in behavioural research LO12.6 understand the meaning of a ‘heuristic’ and why knowledge of heuristics is important to the accounting profession, standard-setters and users of information LO12.7 be aware of how the results of behavioural research can be of relevance to corporations and the accounting profession for anticipating individual reactions to accounting disclosures LO12.8 know how the results of behavioural research can form the basis for developing ways to use accounting-related data more efficiently LO12.9 understand some of the limitations inherent within behavioural research.
Reactions of individuals to financial reporting: an examination of behavioural research in accounting CHAPTER 12
OPENING QUESTION Before reading this chapter, please consider how you would answer the following question. We will return to this question at the end of the chapter, where we suggest an answer. The accounting profession often considers introducing new standards requiring the disclosure of particular information or specifically requiring information to be disclosed in a standardised format. The information might be financial or non-financial. A concern that often arises is how, or whether, various potential users of the information will react to the new disclosures that might be mandated, particularly given that new disclosure requirements typically impose costs on those entities required to make the disclosures, as well as costs on users who seek to understand the relevance of the information. How can behavioural research be used to address questions or concerns that accounting regulators might have about users’ reactions to the proposed requirements?
Introduction Chapter 11 discussed capital markets research, which considers the aggregate behaviour of investors in the capital market. This aggregated behaviour can be observed by looking at movements in share prices around the time of particular events, such as when earnings announcements are made. Capital markets research does not consider how items of information are processed or used by the market participants; it simply looks for an aggregated share price reaction as evidence of ‘information content’ within the respective announcement. To explain such share price reactions, different theories, such as Agency Theory or Positive Accounting Theory (discussed in Chapter 8), are applied. However, although Agency Theory and Positive Accounting Theory consider what influences people’s decisions, they somewhat simplistically attribute the same motivation to all individuals – this being that all individuals are driven by self-interest with the goal of maximising their own wealth.1 While such an assumption might lead to some useful explanations and predictions, we are left with the same explanation for all people and for all accounting choices. To gain a richer understanding about how accountingrelated decisions might be different in different circumstances, places and times, alternative research, such as that discussed in this chapter, is relevant. This chapter considers decision making at the individual level. The research has traditionally been referred to as behavioural research, although it has also been referred to as human information processing (HIP) research. More recently, many people refer to it as judgement and decision making (JDM) research. Such research involves performing studies to see how, for example, a variety of financial statement user groups (not just investors, as is the case in capital markets research) react to a variety of accounting information, often presented in different forms and in different contexts. According to Birnberg and Shields (1989, p. 24): Behavioural Accounting Research applies theories and methodologies from the behavioural sciences to examine the interface between accounting information and processes and human (including organizational) behaviour.
In previous chapters, theories that seek to explain or predict particular actions, such as the manager’s choice of accounting methods, were discussed. Chapter 8, for example, discussed 1
As we noted in Chapter 11, researchers undertaking capital markets research or embracing Positive Accounting Theory typically seek to generate insights and a ‘universal truth’ (an epistemological assumption) that are generalisable. These researchers also typically assume that all capital market participants (investors) have similar motivations. Such researchers assume that the world is ‘objective’ and external to the researcher; and, that all observers would see that ‘world’ similarly (their ontological assumptions).
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Positive Accounting Theory and Agency Theory. As noted earlier, economics-based theories such as these make assumptions about what motivates human actions (for example, a quest to maximise personal wealth), and such motivations are attributed to all individuals. By contrast, behavioural research studies individuals’ actions and choices and typically does not make broadbased assumptions about how all individuals behave, or about what motivates them to behave in a particular way (although there could be an acceptance that many individuals will tend to adopt specific strategies or biases when making decisions). Further, behavioural research is typically grounded in organisational theory, and theories from psychology and sociology rather than from economics. However, like theories such as Positive Accounting Theory, Legitimacy Theory and Institutional Theory (discussed in Chapters 8 and 9), behavioural research can be thought of as ‘positive research’, because it seeks to explain particular actions or behaviours (in contrast to ‘normative research’, which prescribes how certain activities should be undertaken). However, unlike some theories that strictly limit their attention to explaining and predicting behaviour at an individual level, behavioural research typically also concerns itself with improving the quality of decision making – hence, there can ultimately be a normative component to behavioural research. As noted above, behavioural research, including that undertaken with a focus on accounting, borrows many insights from the psychology literature. Many accounting researchers who undertake this form of research have undertaken education that incorporates studies in psychology. This provides an example of how research insights developed in particular disciplines can then be ‘borrowed’ by researchers working in other disciplines. By generating knowledge about how different categories of financial statement users (investors, research analysts, auditors, bankers, loan officers and so on) react to particular accounting disclosures, corporations, the accounting profession, regulators and standardsetters (such as the International Accounting Standards Board [IASB], Securities and Exchange Commission [SEC] in the United States, the Australian Securities and Investments Commission [ASIC] in Australia, the Global Reporting Initiative [GRI], the International Sustainability Standards Board [ISSB] and so forth) will be better placed to anticipate how different individuals will react to particular information. Because behavioural research is undertaken by typically exposing individuals to experiments, this body of research is particularly relevant to the accounting standard-setting process. That is, before disclosure requirements are mandated, it would be advisable for standard-setters to identify stakeholder groups (such as investors) and then test within a controlled setting how they react, if at all, to particular disclosures or accounting methods. Such testing can be done before an accounting standard is finalised and as a key part of the development of the accounting standard. By contrast, capital markets research would typically test how ‘the market’ in aggregate reacts to the finalised accounting standard. As Trotman, Tan and Ang (2011, p. 339) state: Experiments can be most useful when we want to test something that does not yet exist in practice. In accounting, regardless of the specialisation, new possibilities need to be tested (accounting and auditing standards, presentation alternatives, performance measurement systems, etc.) and experiments are an ideal way of doing this. In experiments, individuals or groups are randomly allocated to a small number of treatments, and other factors are controlled or measured.
We have discussed ‘experiments’ above. In defining what an ‘experiment’ represents, Simnett and Trotman (2018, p. 57) note: ‘Experiment’ is defined as a scientific investigation in which an investigator manipulates and controls one or more independent variables and observes the dependent variable or variables for variation concomitant to the manipulation of the independent variables. An experimental design then is one in which the investigator manipulates at least one independent variable. 640
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Relatedly, Lipe (2018, p. 15) also states: Experimental researchers, with their ability to create and control all aspects of their disclosure stimuli, have the opportunity to unpack the disclosure ‘package of information’ to investigate the effect of specific parts or aspects of this disclosure.
Apart from the anticipatory implications associated with behavioural research, the results of analysis of the decision-making processes of individuals can also provide the basis for developing procedures to improve future decision making. The field of behavioural research can be subdivided into a number of different ‘schools’. According to Birnberg and Shields (1989), behavioural research in accounting can be classified into five main branches (or ‘schools’): 1 Managerial control. This research considers such issues as the role of budgets in affecting the level of managerial performance and behaviour, the impact of leadership style on managerial performance, the role of feedback on managerial performance, and the impact of different incentives on managerial performance. 2 Accounting information processing. This research considers how users of financial reports process accounting information, often referred to as the human information processing (HIP) branch of behavioural research. This research frequently involves the use of the ‘lens model’, something that is discussed in this chapter. The lens model allows the researcher to assess the effects of multiple cues (items of information, for example) on decisions without the need for a prohibitively large number of subjects in a between subjects design (a between subjects design is an experimental design in which each subject is randomly assigned to only one of the treatment conditions). 3 Accounting information system design. This branch of research relates behavioural issues to the design of information systems. 4 Auditing process research. This branch of research often uses the lens model. It delves into the decision-making processes of auditors and covers such issues as what cues an auditor would use in formulating an opinion about financial statements. 5 Organisational sociology. This branch of research investigates changes that may occur in an organisation’s accounting system over time, and links changes in accounting systems to particular events. Not all of these branches of behavioural accounting research are discussed in this chapter. Rather, the chapter concentrates on those areas that are related to individual behaviour with respect to financial accounting (not managerial accounting) information. Thus, the focus is on accounting information processing (human information processing) and auditing judgement research.
research LO12.1
LO12.2
LO12.3
LO12.4
LO12.7
An overview of behavioural
Behavioural accounting research Applies theories and methodologies from the behavioural sciences to examine the interface between accounting information and processes and human behaviour.
Chapter 11 considered research that investigated the aggregate reaction of the capital market to various accounting disclosures. This chapter turns to a different approach to research, which considers how individuals react to various accounting disclosures. Research that considers how individuals react or behave when provided with particular items of information can be classified as behavioural research.2 According to Libby (1975, p. 2), research that attempts to describe
2
For those readers of this book who are interested in its history, Trotman, Tan and Ang (2011) provide a comprehensive 50-year overview of behavioural research in accounting, or as they refer to it, judgement and decision making research. Simnett and Trotman (2018) provide a 25-year overview of experimental auditing research.
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individual behaviour is often grounded in a branch of psychology called behavioural decision theory, which has its roots in cognitive psychology, economics and statistics. According to Libby (1975, p. 151): The goal of much of this work is to describe actual decision behavior, evaluate its quality, and develop and test theories of the underlying psychological processes which produce the behavior. In addition, these descriptions reveal flaws in the behavior and often suggest remedies for these deficiencies.
In considering the role of judgement and decision-making research in the area of auditing, Simnett and Trotman (2018, p. 55) note: The aims of the judgement and decision-making audit research are primarily to evaluate the quality of judgements of auditors (or those interacting with auditors), to describe how the judgements are made, to examine the factors that affect those judgements, and to develop and test theories of the underlying cognitive process by which judgements are made. The output of this research allows researchers to suggest and test potential remedies for any deficiencies found.
Behavioural research was first embraced by accounting researchers in the 1960s (Maines, 1995) but became particularly popular in the 1970s when embraced by researchers such as Ashton and Libby. In reflecting on the evolution of behavioural research, Dyckman (1998, p. 1) states: While research in behavior is anything but new, it was not until the twentieth century that researchers investigated the behavior of individuals in business organizations. Research into the behavioral impact of what occurs in accounting is an even more recent phenomenon, traceable perhaps back to the early sixties although the groundwork for much of the early efforts had been laid earlier.
Behavioural research has been used to investigate a variety of decision-making processes in the accounting and auditing area, such as the valuation of market shares by individual analysts, the lending decisions of loan officers, the assessment of bankruptcy or financial distress by bankers or auditors, and the assessment of risk by auditors. According to Birnberg and Shields (1989, p. 25): The method of systematic observation in behavioural accounting research usually involves the systematic observation of people either in the laboratory or field as opposed to archival data on human behaviour or computer simulation of behaviour.3 The theories which are used to identify important variables for a study or to explain the behaviours observed are drawn from the behavioural sciences. Thus, behavioural studies can be differentiated from Efficient Markets Research because the latter relies exclusively on archival data and focuses on market forces not individual or group behaviour.
Trotman, Tan and Ang (2011, p. 279) provide a useful overview of behavioural research, which they refer to as judgement and decision-making research (JDM), in accounting: Judgment and decision-making research is undertaken to understand individual and group judgments and decisions. So, who makes these judgments in accounting? First, auditors, given that the whole process of auditing is permeated by professional
3
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Where data are generated by the researcher, perhaps through an experiment, the data are often labelled ‘primary data’. Data that are already available independent of the researcher, from sources such as publicly assessable archives, are referred to as ‘secondary data’. Share price data, the subject of Chapter 11, are secondary data.
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judgments as evidenced by the very common references to the need for judgments in International Auditing Standards. Second, preparers of both financial statements and management accounting reports make judgments about what to include in the report, what accounting treatments to use (e.g. consolidated or not), dollar estimates to include (provision for warranty) and the likelihood of future events (e.g. whether ‘it is more likely than not’ that a company will earn enough taxable income in the future to include deferred tax assets in the balance sheet). Management accountants also face measurement issues and judgments about what to include in the report. Third, users of financial statements, including investors, analysts and bankers who make judgments about future earnings and future cash flows and decisions concerning investments and lending. Fourth, managers who use management accounting reports for such purposes as planning decisions, performance evaluation and resource allocation. Of interest is the impact of the design and content of these management accounting reports on managers’ judgments. The aims of JDM research in accounting include evaluating the quality of the judgments of auditors, preparers and users of accounting reports; describing how the judgments are made; determining which factors impact these judgments and why; developing and testing theories of the underlying cognitive processes by which judgments are made; and improving the judgments of auditors, preparers and users of accounting information (Libby, 1981; Trotman, 1996). Answering these questions provides insights for suggesting remedies for any discovered deficiencies, as it is necessary to understand a decision process to improve it. Possible methods of improving decision-making that have been addressed include providing feedback, using groups, changing group structures, providing decision aids, changing the format of the information provided, changing how the question is framed, decomposing the judgments made, etc.
Much of the behavioural accounting research studies have been undertaken in a laboratory setting, where a group of individuals are assigned a number of simple or complex tasks (which may or may not be reflective of ‘real-life’ tasks), while other behavioural accounting research has been conducted in the individual’s own workplace.4 This can be contrasted with capital markets research (discussed in Chapter 11), which uses archival data and frequently does not require the researcher leaving their own office. In providing an overview of experimental research in behavioural research, Trotman, Tan and Ang (2011, p. 280) state: While some JDM research is based in the field (see Hunton and Gold, 2010), JDM research generally involves an experiment. The key questions addressed by an experiment are as follows: whether there is an effect; when there is an effect (i.e. under what circumstances); how and why there is an effect (e.g. cognitive processes). A major benefit of experiments is that the researcher creates the setting in which the experiment is carried out. The researcher manipulates the independent variables of their choice and examines the effect on the dependent variable while at the same time controlling for any potential confounding factors. The researcher can also measure intervening variables (including information search and cue usage) and the
4
A laboratory setting would constitute a setting different from where the subjects would normally undertake their work and where the researcher is relatively more able to control certain variables relating to the decisionmaking task than would otherwise be possible. Using an artificial setting does create some issues relating to the external validity of the results being generated.
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knowledge of participants. Experiments have the advantage of testing the effects of conditions that do not presently exist in practice (e.g. proposed new standards, new audit methods), as well as conditions that already exist but not in sufficient volume to examine archivally. Experiments can also be used to disentangle inter-related factors that co-exist in the natural environment to examine which of a number of factors cause a change in the dependent variable (Joe, 2003; Ng and Tan, 2007). A key strength of experiments is that they allow strong causal inferences to be made. That is, we should be thinking of experiments as a complement to archival research, not as an alternative.
As the above material emphasises, behavioural research can have several aims. Some research has been undertaken to understand underlying decision-making processes, while other research has been conducted to improve decision making. Some research manipulates the amount and types of information provided to subjects to assess how such differences impact on any final decisions, while other research provides all subjects with the same information and attempts to derive a model to explain how decisions by a particular category of decision makers appear to be made (for example, decisions by auditors, stockbrokers, bankers or lending officers). Behavioural research can also be used to address issues that might be unresolved by researchers who embrace other research paradigms, such as those used in capital markets research. For example, certain indicators of market inefficiency have been advanced by some capital market researchers. Behavioural research might provide some relevant insights to explain the perceived market inefficiency. As Trotman, Tan and Ang (2011, p. 315) state: As noted earlier, the availability of financial databases during this period (1980s and 1990s) greatly facilitated the use of econometric techniques to investigate financial accounting issues. Several market inefficiencies, including the postannouncement earnings drift, were uncovered using this approach. The prevalence of these inefficiencies challenged the widely held belief that capital markets were semi strong-form efficient. The difficulty of controlling for all confounding factors in a natural setting made it difficult for archival researchers to identify the causes of these inefficiencies. In contrast, experiments were eminently suited to this form of investigation. The experimental researcher could manipulate variables of interest and could use randomisation to control for potentially influential variables. Specifically, JDM researchers were motivated to investigate whether the cognitive limitations and bias of individual investors contributed to these observed inefficiencies.
When discussing experiments, we should also note that experiments can be conducted in either a supervised environment in the presence of the researchers – which we might refer to as a ‘controlled environment’ – or experiment-related material (such as questionnaires) can be distributed to the participants of the experiment for them to complete in an unsupervised (non-controlled) environment. With the increase in the availability of online platforms, there has been a relative increase in the use of non-controlled environments. As Simnett and Trotman (2018, p. 70) note: Traditionally, controlled experiments were most common and were particularly useful in studies involving group processes where teams interact, in memory recognition and recall studies to avoid participants referring back to earlier materials, and studies where the order of reading the material and/or time allocation for sub-tasks are important. These controlled experiments often involve the researcher using different envelopes to control the distribution of materials. 644
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Simnett and Trotman (2018, p. 70) identify a range of problems associated with conducting non-controlled experiments: First, participants may consult additional information beyond what is in the research instrument. This is more of a problem in studies examining cue usage but, in general, it does take away one of the advantages of an experiment, which is the ability to manipulate particular variables and hold constant all other information. Second, it is much more difficult to ensure all participants work independently … Third, it is difficult to control who completes the research instrument. This is more likely to be a concern for many online platforms … Fourth, in hard copy non-controlled settings, manipulation checks can be difficult to include because of the possibility of making the manipulation salient or allowing the participants to refer back to earlier parts of the task. This can be controlled for in online settings. Fifth, in non-controlled settings, whether hard copy or online, it is more difficult to control extraneous factors such as time to complete the task, interruptions, multi-tasking, etc.
Therefore, while it is commonly considered that conducting non-controlled experiments is easier, we must consider whether this advantage exceeds the loss of ‘control’ imposed upon the researcher. Simnett and Trotman (2018) undertook a review of the literature and note that, across the previous 25 years, there has been a declining number of experiments using controlled settings. Any potential loss of control in an experiment can have clear implications for internal validity. Internal validity represents the extent to which a researcher can be confident that a change in a dependent variable was caused by identified independent variables and not by some other variables that were not identified or measured. That is, an experiment with high internal validity would be one wherein the researchers are confident that they can rule out other alternative explanations for why a dependent variable changed. By contrast to internal validity, external validity refers to the extent that results can be generalised to settings or contexts other than the particular setting or context in which the research was undertaken. Because controlled settings are sometimes quite different to the workplace, the external validity of controlled settings is often questioned. That is, when a causal relationship between a dependent and an independent variable is tested in a controlled laboratory setting, this will tend to lead to higher internal validity due to external influences being minimised. However, external validity would often be considered lower because the environment in which the experiment is conducted is different to the ‘outside word’. It tends to be ‘artificial’.
REFLECTION QUESTION 12.1 The relevance of behavioural research to auditors Question Why would, or should, auditors find the results of behavioural research relevant?
Solution One of the key roles of an auditor is to provide an opinion about the reliability of particular information,or about the appropriateness of particular controls. It would be useful for auditors to possess
Reflection
greater insights into how their decisions – individually and as a group – are made and how particular items of information (cues) are weighted. Research could highlight biases that otherwise might not be apparent to the auditors and this could signal the need for some form of training to undo such biases. The research could also identify differences between the decision-making processes of senior and junior auditors, and this could also be used in terms of training inexperienced auditors.
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LO12.5
Brunswik Lens Model Depicts the processes involved in making decisions. It represents the processes involved when people use information cues in a variety of ways to come to a decision about future events. The Brunswik Lens Model also suggests that some of the cues might be interrelated. No individual cue is expected to provide a perfect predictor of the future event.
The Brunswik Lens Model
In explaining behavioural research, a number of researchers, particularly in the 1970s and 1980s, found it useful to relate their work to a model developed by Brunswik (1952) – the Brunswik Lens Model. Libby (1981, p. 6) provides a simplistic representation of the Lens Model (see Figure 12.1). According to Birnberg and Shields (1989, p. 45): The suggestion that the lens model be adapted to behavioural accounting research from the psychological literature was outlined in the report of the Committee on Accounting Valuation Basis (1972) in a section initially authored by Nick Gonedes. Ashton (1974) discussed the lens model and asked what kinds of phenomena could be examined by the lens model. Libby (1975) was the first to utilise the lens model to look at a useroriented issue, the prediction of corporate failure by loan officers. He developed a model of loan officers’ behaviour and examined both the predictability and the stability of their judgements. Libby (1975) served to demonstrate the richness of the lens model and to demonstrate the greater insight into user behaviour available using the lens model compared to the earlier stimulus-response studies. As one might expect, Libby’s study led to a series of subsequent studies using the lens model to examine the use of accounting data. The lens model made it possible for the experimenter to examine the patterns of cue utilization by the subjects and in that way begin to investigate what previously had been viewed as a ‘black box’. FIGURE 12.1 A simple diagrammatic representation of the Brunswik Lens Model ENVIRONMENT
GMAT score
DECISION MAKER
Grade point
$ Event (success)
School quality
Recommendations
etc.
Judgement (most likely estimate of success)
Achievement Source: Adapted from R. Libby (1975), ‘Accounting ratios and the prediction of failure: some behavioral evidence’, Journal of Accounting Research, 13(1), pp. 150–61.
Libby (1981, p. 5) illustrates the application of the Brunswik Lens Model to the decision by graduate schools to admit students. As indicated in Figure 12.1, the criterion event is the students’ future success, denoted by ‘$’ (on the left-hand side of the model). Given that this event will take place in the future, the decisions made by admissions officers within schools must be based on a number of factors or environmental ‘cues’ (pieces of information), which can be probabilistically related to the particular event under consideration (in this case, student success). A number of cues (in this case, items of information) can be used – for example, GMAT scores, grade point 646
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averages in prior studies, quality of the undergraduate school attended, recommendations or references from various people, whether the individual participates in extracurricular activities and answers to particular subjective questions.5 As Libby indicates, none of these individual cues, or combinations of cues, can be expected to provide a perfect indication of the future success of the student, but some may be linked, with some degree of probability, to success. In effect, perspectives about the environment (the issue in question in this case being student success) are generated (observed) through a ‘lens’ of imperfect cues. The relationships between these imperfect cues and the judgement about success are represented by broken lines.6 There would also be an expectation that some of the cues will be interrelated. For example, the GMAT score might be expected to be correlated with grade point averages, as well as quality of school attended. Such interrelationships are represented by the broken lines linking the various cues, as indicated in Figure 12.1. To determine the weighting (or importance) of the various cues (independent variables) to the criterion event of success (the dependent variable which could simplistically be categorised as either success or failure in this case), as well as the correlations between the cues, various advanced statistical modelling approaches are applied. One model might be developed that provides a linear representation of the assessors’ weightings of the various cues. This then provides a model of how the assessors went about their job of assessing applications. Knowledge of this model may be useful to several parties. For example, intending students would know what factors (cues) are particularly important to the assessors and hence the students may then know what factors to concentrate on. From the assessors’ perspective, it might be interesting for them to see how, as a group, they appear to be making their judgements. This might not be obvious until such a model is developed. A model could also be developed that looks at the relationship between the actual outcome (student success or failure) and the various items of information available. That is, a model could be developed by looking in the reverse direction from the event (the left-hand side) back to the cues (that is, not involving individuals making judgements). Obviously, such analysis could only be undertaken when a measure of actual success or failure can be obtained. Libby (1981) provides an insight into the general applicability of the Lens Model to various decision-making scenarios. As he states (p. 6): This structure is very general and can be applied to almost any decision-making scheme. Again, consider a simplified commercial lending decision in which the principal task of the loan officer is to predict loan default. Loan default–non default is mainly a function of the future cash flows which will be available to the customer to service the debt. The customer provides a number of cues, some of which are probabilistically related to future cash flows. These include indicators of liquidity, leverage, and profitability drawn from financial statements, management evaluations resulting from interviews, plant visits, discussions with other knowledgeable parties, and outside credit ratings. No individual cue or combinations of cues is a perfect predictor of future cash flows, and there is overlap in the information (e.g., credit ratings are closely associated with profitability and liquidity measures). In making this judgement, the loan officer combines these cues into a prediction of future cash flows. Even if the banker’s judgemental policy is highly stable over time, some inconsistencies are likely to arise, which will result in a probabilistic relationship between the cues and the final judgement. At the end of the term of each loan, the officer’s prediction of cash flows can be compared with the actual event, and any resulting losses can be computed to measure achievement. 5
6
As we show later, in an accounting study, such as the prediction of bankruptcy, the ‘cues’ might be information about various accounting ratios. Libby (1981, p. 5) notes also that relative reliance on various cues is likely to change over time as a result of fatigue, special circumstances, learning and so on.
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While this example is highly simplified, it illustrates the generality of the framework and its importance for accountants. The model’s principal concern with informationprocessing achievements in an uncertain world coincides with accountants’ interest in improving the decisions made by users of accounting information and their more recent attention to the quality of their own decisions.
In applying the Lens Model, it is common for researchers to model mathematically both the left-hand and right-hand sides of the lens. For example, on the right-hand side of the model we are interested in providing a model (typically linear) of how the individual uses the respective cues to make an ultimate decision about the issue under investigation. This is often the major goal of much behavioural research. This can be undertaken by considering how each cue individually relates to the ultimate decision (univariate analysis) or how the entire set of cues relates to the ultimate decision or judgement (multivariate analysis). If statistical regression is undertaken as part of the multivariate analysis, the decision maker’s response might be summarised or modelled as follows:7
Yˆs = as + B1 s X 1 + B2 s X 2 + Bks X k
(Equation 1)
where: Yˆs is the model’s prediction of the judgement (for example, that the student succeeds or fails) based on the individual’s judgements or predictions; X1, X2, … Xk represent the set of cues (for example, the GMAT score, grade point average) for cue number 1 through to cue number k; B1, B2, … Bk represent the weighting in the model given to each of the cues, based on the responses of the subjects. If a cue contributes nothing to the prediction, it will be given a zero weighting. Conversely, if a particular item of information (cue) is relatively important in making a particular decision or judgement, it will have a greater weighting. Because the model will need to be generated from many observations, and because models such as the above assume that individual cues contribute to the decision in a linear manner, the model will not explain or predict with total accuracy the actual judgements made by particular individuals. But as we would appreciate, it is not expected to – it is a model of individual behaviour. As Libby states (1981, p. 22): It is important to note that the algebraic models resulting from these studies simply indicate the functional relationship between the cues and the judgement. These, like all models, are abstractions and do not purport to represent ‘real’ mental processes.
Some researchers also model the left-hand side of the Lens Model (often referred to as the ‘environmental’ side), which looks at the relationship between the actual phenomenon under consideration and the cues provided. Without relying on judgements provided by individuals, this equation can be used to predict a particular environmental event.8 The model can be represented as follows:
Yˆe = ae + B1e X 1 + B2e X 2 + Bke X k
(Equation 2)
where: Yˆe is the model’s prediction of the environmental event under consideration (for example, student succeeds or fails); 7
8
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Only a brief overview of this modelling is provided here. For further insight, interested readers are referred to Libby (1981, pp. 19–21) and Trotman (1996, pp. 33–6). For example, Altman (1968) developed a bankruptcy prediction model by forming equations that related a particular environmental event (bankruptcy) with particular financial variables (derived from financial statements). Representative of modelling the left-hand side of the ‘lens’, no use was made of decisions of individual judges or experts.
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X1, X2, … Xk represent the set of cues (for example, the GMAT score, grade point average) for cue number 1 through to cue number k; B1, B2, … Bk represent the weighting in the model given to each of the cues, based on the modelling of the relationship between the actual event and the available cues. Researchers often compare the results of the model derived from studying the decisionmaking processes of individuals (Equation 1) with the results of the model provided by considering the relationship of the actual environmental event and the various cues (Equation 2). As we will see below, other issues focused on by researchers include how different individuals or groups weight particular cues, the consistency (or stability) of the weighting, what issues associated with the presentation format of the cues might influence factor usage and weighting, and so on. Because the Lens Model generates an explanation that is in the form of an equation (see above), there is an implicit assumption that all relevant factors are considered simultaneously, rather than sequentially. This is often seen as a limitation of this form of research. In reality, individuals might not consider information simultaneously, but would consider particular information cues before moving on to other items of information.9 The Lens Model can be used to categorise a great deal of the behavioural research that has been undertaken in the past. The Lens Model explicitly considers inputs (uses of various cues), the decision process and the outputs (ultimate decisions). Libby (1981, p. 8) provides a summary of the type of issues that can be considered when undertaking research about how individuals process information when making a decision. These issues include: At the input level (that is, issues pertaining to the cues): • scaling characteristics of individual cues (for example, whether the presentation of the cues as nominal, ordinal, discrete, continuous, deterministic or probabilistic influences whether the cues are used in making a decision) • method of presentation (for example, does the presentational format appear to impact on the use of the cue(s)) • context (for example, do perceived rewards, social setting and so on seem to impact on the use of the various cues). At the level of processing the information: • characteristics of the person making the judgement (for example, whether the demographics, attitudes of the judge or the level of prior experience or interest impact on the decision that is made) • characteristics of the decision rule (for example, how the individuals weight the cues, whether the judgements are stable over time, whether the judges use any simplifying heuristics when presented with potentially complex data). At the output or decision level: • qualities of the judgement (whether the response is accurate, quick or reliable, whether it incorporates particular biases, whether the judgements are consistent over time, whether there is consensus between the various judges) • self-insight (whether the judge is aware of how they appear to weight various factors, etc.). The results of the research may provide individuals with insights about their decision-making processes that they were previously unaware of.
9
Later in the chapter, protocol analysis as another form of behavioural research is considered, which requires subjects of an experiment to ‘think aloud’ about how they make decisions. This research method would help to identify the sequence of how individuals process information.
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REFLECTION QUESTION 12.2 The commercial application of behavioural research Question How could an organisation profit from the results of behavioural research?
Solution Behavioural research could use experts as subjects and then ask them to make decisions. The results of the research can then be used to develop models that can be used within the organisation. For example, in the 1980s and the 1990s there was extensive research exploring how financial experts predict
Reflection
organisational financial distress and bankruptcy. Several organisations then used these insights to generate generalisable models that predict financial distress or bankruptcy. These models tended to use different items of financial information as disclosed within organisations’ financial statements. Other research has investigated how senior loan officers make decisions about lending funds to organisations. This research was used by organisations, such as banks, to help junior loan officers screen potential recipients of funding.
Why do I need to know about how different ‘cues’ influence decision making? We make various decisions, some with good outcomes, some not. To improve decision making, we need to understand the factors that might have influenced our decisions, as well as factors that should have been considered, but were not. Behavioural research provides insights into the cues we might be using and the weighting associated with such cues. Behavioural research might
identify biases in our decision making that we were Why not aware of. When behavioural research is undertaken of experts’ decision making, a description of what they do, and the information they use, can help us to make decisions.
The use of particular information items and the implications of different forms of presentation LO12.5
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At the input level, the issue of how and whether particular cues (information items) are used in decision making is particularly relevant to the accounting profession. If it is shown that users of financial statements do not use particular information items (cues), it could be deemed that such information is not material and, hence, does not require disclosure or associated disclosure regulation. Alternatively, it could indicate that users of financial statements do not know how to use particular information, which might indicate a need for education. The accounting profession would also be particularly interested in whether the form of disclosure – for example, whether an item is recognised within the balance sheet (statement of financial position), in a supplementary financial statement or in a note to the financial statements – impacts on users’ decisions. We now look at a limited number of the many papers that have considered such issues.10 In relation to the use of particular items of financial accounting information, Pankoff and Virgil (1970) investigated financial analysts’ predictions of financial returns on particular shares. They found that the analysts acquired earnings and sales information (often through purchasing such information) more often than other types of information. In another study of financial
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The overview of research provided in this chapter is certainly not comprehensive. Rather, the intention is to provide an insight into some of the different research that has been undertaken in the area. For those readers desiring a more comprehensive insight, reference could be made to Ashton (1982), Ashton and Ashton (1995), Libby (1981), Simnett and Trotman (2018), Trotman (1996) and Trotman, Tan and Ang (2011).
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analysts’ information demands (cue usage), Mear and Firth (1987) also found that analysts believed that sales growth and profitability were particularly important for estimating returns on particular securities. From time to time, accounting professions throughout the world consider whether they should require reporting entities to provide additional information as a supplement to existing financial information. One particular instance of this was the accounting profession’s move in the 1980s to require supplementary current cost (inflation-adjusted) financial information to be disclosed in corporate annual reports (which we discussed in Chapter 6). Clearly, research can be useful in providing an insight into how and whether current cost information would be used by readers of annual reports.11 Such research includes that undertaken by Heintz (1973) and McIntyre (1973). These studies examined how three forms of disclosure impacted investment decisions. Subjects were provided with either historical cost information (only), current cost information (only), or both current cost and historical cost information. The results generally questioned the provision of current cost information, as the subjects did not appear to alter their decisions as a result of being provided with current cost information. Such results obviously challenged the accounting profession’s move to require supplementary current cost information.12 Whether an organisation chooses to use conservative accounting methods, such as historical cost, might also have implications for the propensity of particular investors to invest in an organisation. As we discussed in Chapter 8, conservative accounting methods are often considered to reduce the ‘contracting’ costs of an organisation because they tend to provide lower levels of discretion for managers to opportunistically manipulate accounting numbers. Falk and Ophir (1973) undertook research that considered this issue. Reflecting upon their research, Trotman, Tan and Ang (2011, p. 307) state: Falk and Ophir (1973) examined the effect of conservative versus non-conservative accounting policies on investment decisions. In their study, the accounting policy choices that lowered a firm’s net worth were considered more conservative. Eight accounting policies including depreciation, deferred taxes, inventory valuation were examined in their study. They found that participants increased (decreased) their investments in firms with conservative (non-conservative) accounting policies.
We can see here that the above research confirms the views provided by Positive Accounting Researchers (see Iyengar and Zampelli, 2010), who argued that a reduction in the ability of managers to manipulate accounting numbers will in turn lead to an increased propensity for investors to support an organisation (as discussed in Chapter 8). Behavioural research has also been undertaken in human resource accounting, an area that has been typically neglected by the accounting profession. In related research, both Elias (1972) and Hendricks (1976) found that the disclosure of information on costs incurred in relation to recruiting, training and personnel development had an impact on subjects’ decisions
Also, and as already noted elsewhere in this chapter, behavioural research relating to reactions to particular disclosures can be done in advance of an accounting requirement being mandated. On the basis of the behavioural research findings, accounting regulators might determine that there is no point in progressing a particular issue past its initial stages of development. This can be contrasted with capital markets research, which relies on historical share price data – data that capture how the market reacted to the implementation or formal proposal of the particular requirement. 12 Chapter 8 discussed research that investigated the incentives for managers to lobby in support of and/or potentially to adopt general price level accounting (which, like current cost accounting, adjusts historical cost accounting information to take account of rising prices). Specifically, it considered Watts and Zimmerman (1978). This research applied economic-based theory to explain lobbying positions of individuals. It did not directly involve any human subjects in the experimentation. Other research has considered how capital markets react to current cost information by investigating share price changes around the time of the information disclosure (for example, Lobo and Song, 1989). What is being emphasised here is that there is a variety of approaches that can be taken to investigate particular phenomena. 11
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about acquiring shares in particular sample companies. It could be imagined that such results, particularly if replicated across a number of studies, would potentially act as a stimulus for the accounting profession to put such issues on their agenda for consideration. In the absence of this type of research, the accounting profession might be ignorant of the fact that people would use such information if it were provided. In relation to the format of presentation, some studies have found that different presentation formats seem to impact users’ decisions. For example, some researchers have investigated how the presentation of particular graphics, such as the inclusion of bar charts, line graphs, pie charts and tables, impact the decisions of different user groups (Davis, 1989; DeSanctis and Jarvenpaa, 1989). In a famous piece of research, Moriarity (1979) examined whether the accuracy of subjects’ (students and accounting practitioners) judgements pertaining to potential bankruptcy of merchandising companies was affected by whether they were given a number of financial ratios or were provided with a series of schematic faces (referred to as ‘Chernoff’ faces; see Chernoff and Rizvi, 1975), where the faces themselves were constructed on the basis of the various ratios. Depending on the ratios, different facial features were provided (mouth shape, angle of the eyebrow, nose length and so on represented changes in ratios). The findings of the research indicated that the students and accountants using the faces outperformed those using ratios in predicting bankruptcy. Further, the subjects using the faces were able to outperform models of bankruptcy that had been developed by other researchers (for example, Altman, 1968). The potential implications of this research are interesting. On the basis of the results, companies perhaps should provide numerous cartoon-like faces in their annual reports if they want to assist people in their decision-making processes (perhaps the accounting profession might release an accounting standard on drawing faces?). However, to date, the disclosure of faces in annual reports is not an approach that has been adopted by corporate management. Another disclosure issue that has been addressed is whether subjects will make different decisions depending upon whether particular information is incorporated within the financial statements themselves or disclosed within the notes to the financial statements. One study that investigated this issue was by Wilkins and Zimmer (1983). They studied the decisions of bank lending officers and how their decisions were influenced by whether information about leases was incorporated in the financial statements or simply provided in the notes. They found that from the lending officers’ perspective, the format of disclosure did not affect their assessment of the entity’s ability to repay a debt. Again, such evidence should be of potential interest to financial reporting standard-setters when deciding whether to mandate the adoption of particular accounting methods within the financial statements or simply within the notes to those financial statements.13 Research has also investigated whether the disclosure of segmental information will impact on the decisions of individuals. For example, Stallman (1969) found that providing information about industry segments reduced the subjects’ reliance on past share prices when making choices to select securities. Doupnik and Rolfe (1989) found that subjects were more confident in making assessments about future prices of an entity’s shares when they were also provided with information about geographical performance. A further issue often addressed in behavioural research is that of ‘information overload’. It has been found that increasing the amount of information (cues) provided to individuals can 13
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Consistent with a great deal of behavioural research, the results of Wilkins and Zimmer were contradicted by other research. For example, Sami and Schwartz (1992) provided evidence that loan officers’ judgements about an entity’s ability to repay a debt were influenced by whether information about pension liabilities was included in the financial statements or in the accompanying notes. However, because this research relates to pension liabilities, it is not clear whether the results contradict a general notion that users can equate information provided by way of note disclosure with information provided by financial statement disclosure, or whether the differences in the respective studies’ results were due to the fact that one study considered pension liabilities while the other study considered lease liabilities.
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improve the quality of decision making to a point, beyond which the introduction of additional cues can lead to a reduction in the quality of the decisions being made (Snowball, 1980). Chapter 10 addressed an area of reporting that is attracting increasing attention – sustainability (social and environmental) reporting. Because of the growing importance of information about the social and environmental performance of organisations, it could be anticipated that accounting researchers will explore how various information cues, perhaps relating to environmentally and socially related activities, influence investment decisions. In this regard, we can consider research undertaken by Wood and Ross (2006). These authors explored how particular ‘environmental social controls’ can affect managers’ capital investment decisions with respect to investing in less-polluting plant and equipment. The environmental social controls that were examined for their impact on capital investment decisions were: • mandatory disclosure, meaning environmental disclosure required by law and accounting standards • regulatory costs, meaning direct payments on pollutant emissions, clean-up costs and/or regulatory compliance • subsidisation, meaning depreciation allowances that provide higher tax benefits • stakeholder opinion, meaning how the investment will be perceived by various nongovernment stakeholder groups such as shareholders, creditors and customers. In their experiment, which was undertaken using corporate financial managers, the four ‘environmental social controls’ (mandatory disclosure, regulatory costs, depreciation allowances and stakeholder opinion) were varied to gauge their influence on the managers’ capital investment in less-polluting plant and machinery. The results of the study indicated that stakeholder opinion was the most influential factor in management decisions to invest in ‘environmentally friendly’ plant and equipment, followed by subsidisation. Regulatory costs ranked third, while mandatory disclosure was quite lowly rated and was ranked fourth. In discussing the results, Wood and Ross (2006, p. 691) state: Stakeholder opinion is a very important social control, with approximately 40 per cent of the combined weight of the environmental social controls. This suggests that managers are much more responsive to stakeholder opinion than they are to regulatory costs, subsidy or mandatory disclosure.
In considering the implications of their study for government action, Wood and Ross (p. 692) state: Subsidisation, the ‘carrot’ among social controls, was found to be an influential factor, with a weighting of 27 per cent. This was second only to stakeholder opinion. The relatively high-level responsiveness of managers to change in the level of subsidy suggests that managers would be very responsive to increased subsidisation. This finding adds support to the suggestion in the published literature (Lockhart, 1997; EPA (South Australia), 2001) that subsidies can be very effective as an incentive for environmental improvement. The experiment adds support to the conclusion that there is room for increased use of subsidisation. Some (or all) of the cost to government might be offset by increased tax receipts from higher profits made by firms, savings in the cost of ‘policing’ of small firms, and reduction in environmental damage.
Riedl and Smeets (2017) and Martin and Moser (2016) also explored how social factors influence stakeholder decisions – specifically, investors’ decisions – and they found that investors with certain social performance expectations were willing to forgo financial returns if target organisations were able to demonstrate particular social performance attributes. Reimsbach, Hahn and Gurturk (2017) also used an experimental setting to show how the assurance of
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sustainability-related information by independent assurance providers positively impacts investors’ decisions to invest in particular organisations. They state (p. 559): The results from a sample of professional investors underline the important role of assurance in the context of voluntary disclosure and illustrate the relevant interaction with the reporting format. Assurance of sustainability information positively affected professional investors’ evaluation of a firm’s sustainability performance, resulted in a higher weighting of this information, and led to higher investment-related judgments.
Reimsbach and Hahn (2015) used an experiment to explore how negative sustainabilityrelated incidents impacted investors’ decisions. They found that investors’ investment decisions were more negatively impacted if the negative news came from external sources compared to if the news was self-reported by the organisation. Such a result supported the view that organisations are best served by ‘coming clean’ about particular social and environmental events or incidents. While the above examples of behavioural research provide only a small snapshot of the total research that is available, they nevertheless provide an insight into how researchers can manipulate various items (or cues) to see how these impact particular decisions. The results of such research are valuable for understanding and potentially improving decisionmaking processes.
REFLECTION QUESTION 12.3 Standard-setters’ use of behavioural research Question Should accounting standard-setters and regulators have an interest in behavioural research?
Solution Standard-setters and regulators absolutely should have an interest in behavioural research. For example, research could
Reflection
highlight what information is material to particular stakeholders, such as investors, and therefore warrant some consideration in terms of developing associated reporting requirements. Further, before mandating particular disclosures or presentation formats, research might show whether intended users actually use the information that is potentially about to be mandated.
Decision-making processes and the use of heuristics LO12.6
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In relation to research that considers the processes involved in making a judgement (the middle part of the Brunswik Lens Model), a number of studies have considered issues associated with how the various cues (information items) are weighted. Schultz and Gustavson (1978) used actuaries as subjects (who were deemed to be experts) to develop a model to measure the litigation risk of accounting firms. They found that cues deemed to be important (relatively more weighted) were the number of accountants employed within the organisation, the extent to which the work of the accountants was rotated among themselves, the size and financial condition of the clients and the percentage of ‘write-up’ work performed.14
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Another approach to gathering such information would simply be to send out questionnaires asking respondents to rank the importance of various items of information in terms of the various decisions they make. Of course, this would be much simpler than a process involving the actual modelling of decision making, which typically occurs in Lens Model-type research.
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Another issue that has been considered is consistency. For example, do the individuals make the same judgements over time? Ashton (1974) investigated this issue. Ashton used 63 practising auditors in a study that required the auditors to assess the internal control system associated with an organisation’s payroll. In undertaking the assessment, the subjects were required to do the task twice, the second time being between six and 13 weeks after the first time. The findings indicated that the subjects were very consistent in their weightings over time and that the weightings between the various subjects were also quite consistent. Further, the cue that was weighted the most was ‘separation of duties’. When considering how individuals make decisions, researchers have also found evidence that decision makers often appear to employ simplifying heuristics when making a decision. A heuristic can be defined as a simplifying ‘rule of thumb’. That is, rather than fully considering all the potentially relevant factors, a simplifying rule may be employed which takes a lot less time but, nevertheless, might generate a fairly acceptable (and cost-effective) prediction or solution. Tversky and Kahneman (1974) identified three main heuristics often employed in decision making: representativeness, anchoring and adjustment, and availability. These heuristics have been heavily researched within the psychology literature. Such heuristics reduce the cognitively complex task of assessing probabilities to simpler judgemental operations, and while these heuristics are quite useful and can lead to efficient decision-making, they can also lead to severe and systematic errors because they omit several factors that should affect the judgements of subjective probabilities (Trotman, Tan and Ang, 2011, p. 285). According to Maines (1995, p. 83), individuals who use the representativeness heuristic assess the likelihood of items belonging to a category by considering how similar the item is to the typical member of this category. For example, the probability that a certain person is an accountant would be assessed by how closely they resemble the image of a typical accountant. The fact that there may be few, or many accountants, is ignored. An implication of this bias is that individuals typically ignore the base rate of the population in question. In some cases, this bias has the effect of overstating the number of cases placed within a particular category. For example, in bankruptcy prediction studies, this bias may lead to an overstatement in the prediction of bankrupt companies, as the base rate of real bankrupt companies is typically quite low. The representativeness heuristic also tends to make decision makers ignore source reliability and sample sizes. The anchoring and adjustment heuristic is another common heuristic and indicates that individuals often make an initial judgement or estimate (perhaps based on past experience or through partial computation of the various factors involved) and then only partially adjust their view as a result of access to additional information. That is, they ‘anchor’ on a particular view and then will not move sufficiently in the light of additional information or changing circumstances. Joyce and Biddle (1981) undertook research that sought to provide evidence of this heuristic being used by auditors when they assess internal control systems. They found that new information (obtained through various substantive testing) was used by auditors to revise their assessments about the quality of internal controls, and that no evidence could be found of anchoring and adjustment. However, results of anchoring and adjustment were found when Kinney and Ueker (1982) investigated similar tasks. Other research to support the use of this heuristic is provided in Biggs and Wild (1985) and Butler (1986). With the anchoring and adjustment heuristic in mind, Hogarth and Einhorn (1992) developed a model that predicted that when auditors receive both positive and negative evidence, there will be a ‘recency effect’, with the ‘recency effect’ meaning that the person, in this case an auditor, will place more weight on the evidence received most recently. Another common heuristic, the availability heuristic, relates to whether recollections of related occurrences and events can easily come to mind. That is, the probability judgements regarding the occurrence of an event are influenced by the ease with which the particular type of event can be recalled (Maines, 1995, p. 100). For example, in assessing the likelihood of a plane crash, 655
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a subject might overstate the probability as a result of remembering a number of highly publicised crashes. The actual base rates of such an occurrence are ignored. The implication of this heuristic is that the probabilities associated with sensational or widely reported events will tend to be overstated. In a study of this heuristic, Moser (1989) found that when subjects were required to make an assessment about whether the earnings of a company would increase, their assessments were influenced by the order of the information provided to them. Another related heuristic that has been discussed in the psychology literature and which has relevance to accounting is ‘conservatism’. Under the conservatism phenomenon, individuals will be slow to change their belief in the face of new evidence. Coram (2010) tested for the existence of the conservatism phenomenon. Specifically, he utilised a sample of subjects that was comprised of professional investors and non-professional investors, and he sought to determine how both groups used non-financial information (relating to information produced about a company and derived from the application of the ‘balanced scorecard’) when making investment decisions and whether there were apparent differences between the groups. He found (p. 273): In summary, both groups of investors react in a negative way in their stockprice estimates to negative nonfinancial disclosures. This reaction to the negative information suggests that irrespective of the task-specific knowledge, negative information per se, provokes an investor response. In relation to the positive non-financial disclosures, the professional investors with task-specific knowledge did react as expected to the provision of positive nonfinancial information in their stock-price estimates, however, on average, the nonprofessional investors did not react to this information, which is consistent with conservatism.
In terms of the relevance of his findings, Coram states (2010, p. 275): There have been many calls for enhanced corporate disclosure and also regulation to increase corporate transparency in recent years. A significant amount of this extra corporate disclosure is nonfinancial in nature. Archival research has consistently shown that this type of information is value relevant. However, the fact that the market-based research shows this information to be value relevant does not necessarily mean that it is viewed in that way by nonprofessional investors, particularly if there are biases in their decision-making that are exacerbated by their lack of task-specific knowledge. Given that one user group of interest in the calls for enhanced transparency and corporate disclosure are nonprofessional investors (Levitt, 1997), and that they comprise a growing segment of financial information users, how they evaluate and make decisions on this type of enhanced disclosure is an important issue to examine. An under-reaction to disclosure has been observed in the empirical finance literature (Barberis et al., 1998; Chan et al., 2004), which these studies note is consistent with conservatism in the face of new evidence from the psychology literature (Edwards, 1968).
Considering the implications of his findings to issues associated with regulating the disclosure of non-financial information, Coram further states (p. 276): These findings provide some evidence that there may be consequences to enhanced disclosures by firms that may not have been anticipated by regulators. … The conservative reaction of nonprofessional investors to positive nonfinancial disclosures by companies may be detrimental to their welfare if they then make decisions consistent with this reaction. This is a curious outcome given these users are an important group that the enhanced disclosure requirements are designed to protect. Future research should examine how biases and lack of task-specific knowledge of nonprofessional investors can be mitigated so that enhanced disclosures in the marketplace can be of benefit to all users of financial statements. 656
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A number of heuristics, or rules of thumb, that might be employed in decision making have been briefly considered. But, so what? Why would it be useful to know about such heuristics? First, if the heuristic results in inappropriate decisions being made (for example, lending funds to organisations that are not creditworthy or accepting that internal controls are functioning soundly when they are not), this behavioural tendency should be highlighted so that remedial action (perhaps training) can be undertaken.15 Second, perhaps the heuristic employed by experts is efficient relative to costly data gathering and processing. If this is the case, perhaps novices should be encouraged to adopt the rule of thumb. As another interesting example of behavioural research being undertaken to understand the actions of investors, we can consider Krishnan and Booker (2002). As a potential example of dysfunctional investor behaviour, investors might have a tendency to hold loss-making shares for too long when things are not going well, or they may have a tendency to sell ‘winning’ shares too early and thereby miss out on larger gains. This is often referred to as the ‘disposition effect’, in which investors have a tendency to sell assets that have increased in value, while holding onto assets that have decreased in value. The disposition effect is often linked to the notion of ‘loss aversion’, which is the tendency to value the avoidance of loss more highly than the making of a gain. Behavioural research, which we might refer to as behavioural finance research, could be used to investigate such investor tendencies (and any others). In this regard, Krishnan and Booker (2002) investigated the existence of a ‘disposition effect’ in relation to investor choices.16 They state (p. 130): Prior research in finance and economics has documented the presence of a ‘disposition effect’. The disposition effect is an application of prospect theory (Kahneman and Tversky 1979) to investments and predicts that investors are risk-averse in gains and risk-seeking in losses. Hence, they will sell a winning stock so as to cash in on their sure gains and hold on to a losing stock in order to avoid a sure loss. Empirical support for the disposition effect has been found in financial markets (Shefrin and Statman 1985; Ferris et al. 1988; Odean 1998) and experimental markets (Weber and Camerer 1998). We examine if executive subjects commit the disposition error and then examine whether the availability of an analyst summary recommendation report reduces the occurrence of the disposition error. We also examine if the reduction in the disposition error is a function of the strength of supporting arguments in the analysts’ summary recommendation report.
For the purposes of Krishnan and Booker’s research, an ‘analysts’ summary recommendation’ is a report that contains the average recommendation of several analysts to either buy (if the prospects seem favourable), hold (if the prospects seem marginally favourable) or sell (if the prospects seem unfavourable), and some supporting arguments. The investor evaluates the report and decides to buy, hold or sell the stock. The researchers vary the strength of the recommendations given to different subjects and the researchers predict that the strength of the supporting arguments provided with the analysts’ report will mitigate the ‘disposition effect’ by motivating investors to act in a manner consistent with the analysts’ recommendations
For example, Kida (1984) provides evidence that auditors, when undertaking particular tasks, often initially formulate a hypothesis to explain a certain event (for example, the reduction in bad debt write-offs) and then seek information to confirm this hypothesis (hypothesis-confirming strategies). Clearly, such information gathering is not objective and could expose the auditors to certain risks. Knowledge of this behavioural tendency would therefore be useful. 16 In their study, they actually used MBA students as surrogates for investors. They justified using MBA students as the subjects of their experiment because the MBA students were deemed likely to have had prior investing experience and would have read analyst reports. 15
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(that is, to sell losing stocks and hold winning stocks). In explaining how they conducted their behavioural experiment, Krishnan and Booker (2002, p. 136) state: In the first experiment, we examine subjects’ likelihood to sell or hold a stock on which they have a paper gain or loss position, when presented with a simple favorable or unfavorable future scenario in the absence of analysts’ recommendations. This experiment provides a benchmark to measure the extent of the disposition error. In the second experiment, we present information about a stock with expected values identical to the stock in Experiment 1, in the form of a summary analyst recommendation report. One-half of the subjects in Experiment 2 receive a ‘weak’ form of analysts’ recommendations, i.e., with no supporting information, while the second half of the subjects receive a ‘strong’ form of analysts’ recommendations, i.e., with supporting information.17 The second experiment allows us to examine whether the presence of an analysts’ summary recommendation report has any influence on subjects’ decisions. It also allows us to examine whether the strength of the analysts’ summary recommendation report has any effect on subjects’ decisions.
In relation to the results of their study, Krishnan and Booker (2002, p. 131) state: Our results indicate that information presented in the form of a summary report of analysts’ recommendations reduces the disposition error for winning stocks. That is, when subjects receive information about the future prospects of a stock, and the information is not presented in the form of a summary analyst recommendation report, subjects commit the disposition error and sell winning stocks too early and hold losers too long. However, when information about a stock with identical expected values is presented in the form of a summary analyst report, the disposition error is reduced for the winning stocks but not for losing stocks. Our findings also suggest that the strength of information disclosed in analysts’ recommendations affects the tendency for subjects to sell winners too soon and hold losers too long. A strong form of the summary analyst report (i.e., with supporting information used by the analysts to arrive at the stock judgment) further reduced the disposition error for winning stocks. For losing stocks, a weak-summary recommendation report did not reduce the dispositional tendency to hold. However, a strong summary recommendation report significantly reduced the tendency to hold. It appears that individuals have a much greater desire to avoid losses and that this ‘loss aversion’ is adequately mitigated only by a strong analyst summary recommendation report. Our study demonstrates that summary analysts’ reports are not only valuable for their information content, but also as instruments that reduce judgment errors and that this error-reduction property is enhanced by greater detail and strength of arguments in the summary analysts’ report.
In reflecting on the implications of their study, Krishnan and Booker (2002, p. 150) state: This study contributes to the literature on investors’ use of analyst recommendations in several ways. First, it shows that subjects’ acting in the absence of summary analyst recommendations expressed likelihood to sell winning stocks too early and hold losing stock for too long. These ‘noise traders’ with common judgmental biases can affect stock prices (De Long et al. 1989). Second, it finds that the mere presence of summary analyst recommendations reduces the level of the disposition error for winning stocks.
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Strength of the recommendation was manipulated via an additional paragraph that provided either supporting information for the recommendation (strong) or no details for the recommendation (weak).
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Thus, even the use of a weak analyst recommendation may reduce the irrational behavior of selling winning stocks too early. Third, we show that subjects pay attention to and appeared persuaded by supporting arguments to the analyst recommendation. Thus, the availability of strong analyst recommendations with supplementary information reduces the likelihood to sell winning stock too early and hold losers too long. The implications of our findings may extend beyond the current setting to error reduction properties of accounting disclosures in general.
The financial news media often make reference to the heuristics identified by behavioural research. For example, in an article in the Australian Financial Review entitled ‘ASIC’s loss of corporate memory’ (Boyd, 2018, p. 40) it was reported that – consistent with Krishnan and Booker (2002) – smaller individual investors tend to exhibit the disposition effect, meaning that they tend, as a group, to underperform relative to the returns being earned by the market as a whole and by institutional investors. It is argued within the article that institutional investors tend to profit at the expense of small investors. The article also refers to heuristics, such as ‘anchoring’, and how these can distort our decision-making processes. The article concludes with the view that if we can predict how people will behave, even if it appears to be irrational and not consistent with ‘normal’ notions of efficiency, we can use that knowledge to our own financial benefit. News media articles such as this demonstrate how research undertaken by accounting researchers can (and arguably, should) have ‘real world’ significance.
REFLECTION QUESTION 12.4 The inclination to avoid recognising a loss Question If the price of a share fell below its cost to an investor, would that make it more likely or less likely that the investor would want to sell it (relative to selling it at a price above its cost)?
Solution Logically, the fact that the share price has fallen, and a loss on the investment would be recognised, should have no bearing on an investor’s decision whether to sell the share. As we typically learn in our study of management accounting, the purchase price was paid in the past. As such, it is a ‘sunk cost’ and should not be directly relevant to future actions, such as whether we sell the asset. What is relevant is whether investors are aware of other investment opportunities that are expected to generate better returns than the share currently held. While this is what we are taught, and while it represents economically rational behaviour, behavioural finance
Reflection
research indicates that investors feel more distress from recognising losses than they do in terms of happiness from generating equivalent gains. Rather than being ‘risk averse’, investors are often found to act as if they are ‘loss averse’. Therefore, from the research we could expect that an investor could be less likely to sell an investment if it will result in a recognised loss. If investors are made personally aware of this form of bias, which they might not have realised was impacting their investment decisions, then they might, potentially, correct their behaviour. We can perhaps reflect on our own behaviour. If we have bought and sold shares in the past, have we been less likely to sell shares if it means we will generate a loss on that shareholding? Further, if we have acted like this, then would being aware of this potential bias now influence what we might do in the future? Ideally, it should.
Why do I need to know that even though heuristics can help us to save time and effort when making decisions, they can lead us towards making systematic mistakes? Why
Even though we often tend to do something in a particular way – that is, even though there might be a systematic bias in what we do – we might not realise it until we are informed of the ‘behavioural bias’. That is, something is not necessarily
obvious until somebody tells us that it is. Knowing there is a bias in what we do, we can then try to take actions to undo the bias and to stop making what might be referred to as systematic mistakes.
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Environmental factors that influence decisions LO12.5
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Another interesting aspect of decision making that can be researched from a behavioural perspective is how various environmental factors influence judgements. Reflecting on behavioural research that was undertaken in the 10 years following the year 2000 in the specific area of auditing, Trotman, Tan and Ang (2011, p. 304) state: Another aspect of the audit JDM research in the 2000s is the advances in the range of environmental factors examined and the type of audit judgment made. Many of these new environmental issues were original and widened our knowledge of the environmental factors that impact auditor judgment. Examples include press coverage of a client (Joe, 2003), complex accounting information systems environment (Brazel and Agoglia, 2007), multiple client audit environments where information of a previous decision is compared to information on another client (Bhattacharjee et al., 2007), different assessment techniques (Nelson et al., 2005), the source of the internal audit work relied on (internal versus outsourced) (Glover et al., 2008), incremental levels of accountability (review, justification, feedback) (DeZoort et al., 2006). These studies addressed a wide range of audit judgments: bankrupt prediction and audit opinions (Joe, 2003), control risk and planned scope of substantive testing (Brazel and Agoglia, 2007), materiality judgments including booking a misstatement (Nelson et al., 2005) and planning materiality (DeZoort et al., 2006), detecting a seeded error using analytical procedures (Moreno et al., 2007), external audit reliance of internal audit (Bhattacharjee et al., 2007; Glover et al., 2008).
While the above comments relate to audit-related behavioural research, there are many environmental variables that could be considered when undertaking investigations that examine how financial statements are used by people in different locations, environments and so forth. The area is certainly one that provides many research opportunities. LO12.8
Issues of decision accuracy
When looking at the actual output of the decision-making process (the decision or judgement), some research has considered how accurate the predictions are relative to the actual environmental outcomes. For example, Libby (1975) investigated the accuracy with which loan officers predict business failure. The results showed that loan officers were able to predict bankruptcies fairly regularly, with their various answers also being relatively consistent. In a similar study, Zimmer (1980) investigated how accurate bankers and accounting students were in predicting bankruptcy when provided with a number of accounting-related cues. The results showed that bankruptcies were typically correctly predicted. Also, a composite model of bankruptcy prediction generated from pooling all the bankers’ responses typically outperformed the judgements of individuals.18 A particularly interesting finding was that the students with limited experience performed nearly as well as the bankers. Research has also considered the potential improvements to decision making that might result from combining the decisions of multiple decision makers. As noted above, Zimmer (1980) found that the composite model developed by combining the judgements of the
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As the composite model out-predicted the individuals, there could be a case to make the model available to the lending officers, particularly the inexperienced bankers. The model could provide a low-cost approach to screening loan applications at the initial stages of the application.
Reactions of individuals to financial reporting: an examination of behavioural research in accounting CHAPTER 12
different subjects was able to outperform judgements and models derived from individual subjects. Such findings are also presented in Libby (1976). Further, evidence indicates that decision makers working together in an interactive team can also outperform individuals working alone. Chalos (1985) found this result when reviewing the bankruptcy predictions of interacting loan officers relative to predictions provided by loan officers working independently. Such results were subsequently explained by Chalos and Pickard (1985) as being due to the greater consistency in decision making that happens when groups, as opposed to individuals, are involved in making decisions. Again, these findings have implications for how organisations might make decisions in practice. Perhaps when major loans are being made, and assuming that these results are perceived as being reliable, banks should consider requiring approvals to be based on committee decisions. In other related research, which considered the differences in decisions made by experienced and inexperienced directors, we can consider Seow (2009). In response to various public suggestions about the need for directors to have relevant experience and training, and about the possibilities that directors be provided with various decision tools, Seow (2009, p. 201) states: In the present study, I show that directors who possess higher levels of technical knowledge perform better at identifying diagnostic (risk) factors associated with financial statement fraud. Although not all directors might assume the responsibility, authority and liability relating to oversight tasks relating specifically to financial matters in their companies, these results provide evidence to support recent moves by regulators to require greater expertise among directors, and, in particular, greater financial expertise among audit committee members (Blue Ribbon Report, 1999; United States Public Laws, 2002). However, in the presence of a generic decision aid, I find that directors with higher technical knowledge perform worse in that they consider more non-diagnostic (irrelevant) factors as relevant compared to directors with lower technical knowledge. These results suggest that caution should be exercised in the use of generic decision aids as a supplemental aid to directors’ decision-making, as unintended dysfunctional effects can occur.
That is, the decisions of some directors can potentially be adversely affected by providing them with information that was not previously used. In this regard, Seow (2009, p. 203) states: Although a generic decision aid can serve as a valuable tool for supplementing lack of knowledge on an unstructured judgement task to the novice user, the provision of a relatively simple decision aid might not improve task performance in experienced but low-knowledge users (e.g. low-knowledge directors), and can instead spur experienced and high-knowledge users (e.g. high-knowledge directors) to want to outperform it (Ashton, 1990), and to invoke ‘illusorily correlated’ cues that cause them to perform more poorly (Chapman and Chapman, 1967).
Again, we can see how behavioural research allows us to see how differences in the particular attributes of some user groups can influence the outcomes associated with the provision of particular information. LO12.7
Protocol analysis
Another approach to researching the decision-making processes at the individual level is research undertaken using verbal protocol analysis. This form of analysis usually requires subjects to think aloud (that is, to verbalise their thought processes) while they are making decisions or judgements. The subjects’ comments are taped and then transcribed for further coding 661
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and analysis.19 This form of research has tended to be more popular in auditing than in other financial accounting areas. We can compare protocol analysis with research that embraces the lens model, as described earlier. In research that embraced the lens model approach, the research is of a ‘stimulusresponse’ type. That is, the researcher determines the cues to provide to the research subjects and then, as a result of the experiment, weights assigned to each cue can be determined statistically. As such, this type of research is more appropriate to situations or tasks where objectives and information cues are clearly defined. By contrast, protocol analysis is useful for uncovering the use of various information cues that might not otherwise be known by the researcher and it is also useful for analysing tasks that are not well structured. As Trotman, Tan and Ang (2011, p. 310) state: Protocol analysis (or process-tracing technique) traces the actual decision-making process of users of financial information and is suited to studying ill-structured tasks. Protocol analysis allows the researcher to ‘identify cues, the sequence in which the cues are utilised and determine their relative importance by the frequency of their use or process modification accounted for by the cue’ (Dillard, 1984).
One of the first studies within the accounting literature to use this method was undertaken by Biggs and Mock (1983), who reviewed judgements being made by auditors when assessing internal controls. Other auditing-based studies to use verbal protocol analysis include Biggs, Mock and Watkins (1989) and Bedard and Biggs (1991). According to Trotman (1996), there are a number of advantages and disadvantages in the use of protocol analysis. In relation to possible advantages, he states (p. 56): One of the main advantages of verbal protocol analysis is the ability to examine the process by which judgements are made. Understanding how judgements are made is an important start in improving those judgements. Second, verbal protocols are particularly useful in examining information search. The sequence in which information is obtained can be traced and the amount of time a subject devotes to particular cues can be determined. Third, verbal protocol can be useful in theory development. For example, Biggs, Mock and Watkins (1989) suggest the need to ‘begin gathering data about how auditors make analytical review judgements in realistic settings and attempt to build a new theory from the results’ (p. 16).
In relation to some of the potential disadvantages or limitations that arise from using verbal protocol analysis, Trotman states (p. 56): Consistent with all other methods of studying auditor judgements, verbal protocol studies have a number of limitations. First, it has been noted that the process of verbalising can have an effect on the auditors’ decision process (Boritz, 1986). Second, there is an incompleteness argument (Klersy and Mock, 1989) which suggests that a considerable portion of the information utilised by the subjects may not be verbalised. Third, some have described the process as epiphenomenal, that is, subjects provide verbalisations which parallel but are independent of the actual thought process. Fourth, there has been some criticism of the coding methods. For example, Libby (1981) notes that the choice of coding categories, the choice of phrases that serve as the unit of
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This form of data collection can sometimes lead to many hundreds of pages of typed quotes, which can tend to become quite unmanageable. There are a number of computer packages available to organise transcribed data into a more manageable form. One such package is NUD*IST, which stands for non-numerical, unstructured, data indexing, searching and theorising. Another package is NVivo. (NVivo is not an acronym, but is based around the term ‘in vivo’, which means ‘it is done in real life’.)
Reactions of individuals to financial reporting: an examination of behavioural research in accounting CHAPTER 12
analysis, and the assignment of each phrase to categories are highly subjective. Libby suggests the need for comparisons using competing coding schemes. Finally, there are significant difficulties in communicating the results to the reader, given the large quantity of data and possibly large individual variations in decision processes.
Trotman has provided a number of limitations in relation to protocol analysis which, as he indicates, can also be applied to behavioural research in general. Simnett and Trotman (2018) noted that there was a gradual decrease in the use of verbal protocol as a data collection technique in the period of their review, which was 1991 to 2015. LO12.7
The relevance of differences in culture
The issue of ‘culture’ was considered in Chapter 5, where it was seen that culture can influence the accounting information being demanded and produced in different countries. In Chapter 9, in our discussion of Institutional Theory, we also explored how the institutional environment, and the related normative and cultural-cognitive expectations and beliefs, influences the types of accountabilities embraced by organisations. It was argued in these chapters that efforts to standardise financial accounting, and other forms of accounting, internationally ignore research that suggests that people from different cultures and institutional environments have different information demands and expectations. Some cultures, for example, are considered to be more secretive than others, some cultures seek greater uncertainty avoidance than others, some institutional environments have people with relatively greater concern for workplace safety or social and environmental performance, and so forth. In Chapter 5, these differences at a national level were related back to the international differences in accounting practices that existed prior to the international adoption of International Financial Reporting Standards issued by the IASB. Culture has also been suggested as a factor in influencing organisational structures, legal systems and so on. Given a view that differences in culture influence the cognitive functioning of individuals (Triandis, Malpass and Davidson, 1971), it is reasonable to argue that an individual’s use of particular cues (information items) will in part be dependent on the cultural background of the individual. Hence, although issues of culture have not been considered in this chapter so far, it is reasonable to expect that studies that investigate decision-making processes in particular countries will not necessarily be generalisable to other countries – particularly, if the respective countries have significantly different cultural attributes. That is, the studies might have limitations in terms of their ‘external validity’. Determining the validity of a particular decisionmaking model across different cultures would be an important area for future accounting research. At this point in time, there is relatively little behavioural accounting research that explores how the usage of cues in particular decisions is affected by specific cultural attributes or whether there are differences in decision-making processes in developed countries compared to developing countries. LO12.9
Limitations of behavioural research
First, as indicated in some of the material presented in this chapter, many of the studies that review similar issues generate conflicting results. This clearly has implications for whether the research can confidently provide guidance in particular areas. Unfortunately, it is often difficult or impossible to determine what causes the inconsistencies in the various results, because typically a number of variables differ between the studies (the issue of concern, the realism of the setting, the experience and background of the subjects, the incentives provided and so on). Further, within the studies, differences in judgements between the subjects are frequently not explored to any extent, meaning that some unknown but potentially important decision-making factor remains unknown. 663
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Another perceived limitation relates to the settings in which the research is undertaken. These settings are quite often very different from real-world settings, with obvious implications for the generalisability (and external validity) of the findings. In the ‘real world’, there would typically be real incentives to make particular decisions and real and ongoing implications from them, and this usually cannot be replicated in a laboratory setting.20 Further, there will be no real accountability for the decisions being made. Related to this point is the realism of the cues provided to the subjects. It is very difficult to replicate the various cues that would typically be available in the workplace. Also, knowing that the results of a particular judgement are being carefully scrutinised could clearly be expected to influence the decision-making processes being employed. A number of studies use students as surrogates for auditors, investors, lending officers and so on. This has also been seen as a limitation because such people may have had limited training in the area and may not have had the same background experiences as the parties for whom they are acting as proxies. (There has been some research that shows that students do make judgements comparable to those of particular experts; however, such findings are not universal.) In a 25-year overview of experimental auditing research, Simnett and Trotman (2018, p. 68) note a ‘disturbing trend’ in which there is a declining use of professional auditors in auditor judgement research. Not only are the authors concerned about the reduction in audit judgement research ‘at a time when there is increasing criticism of auditing’, but the reduction in use of experienced auditors as subjects on experiments can: lead to some of the important audit judgements being neglected by research because it reduces the likelihood of examining complex judgements made by audit managers/ partners and a consideration of the review process, a quality control that may eliminate/ reduce judgement errors of more junior staff. (Simnett and Trotman, 2018, p. 68)
A final criticism is the typically small number of subjects used in experiments and, again, whether results based on relatively small samples can be expected to apply to the larger population. What still appears to be lacking in this area of research is a theory as to why people rely on particular items of information, adopt simplifying heuristics in some situations and so on. For example, much of the research tells us that some decision makers were consistent in their judgements across time, while others were not, or that particular groups seemed to adopt a particular heuristic. But it is still not certain why they did this. Perhaps theory will develop in this area. If behavioural research indicates that particular biases and heuristics seem to be influencing decision making, then the researchers could apply insights from theories, such as those discussed in Chapters 8, 9 and 11, to explain, at least in part, the possible reasons/ motivations for the decisions being made. It is perhaps not surprising that behavioural accounting research is not grounded in a particular underlying theory. Unlike capital markets researchers (Chapter 11) and Positive Accounting Theorists (Chapter 8), who have theories that are generated from particular fields of economics, behavioural accounting researchers embrace a variety of theoretical backgrounds, from psychology, sociology and so on.
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Interestingly, at one meeting of professional accountants held in Sydney some time ago (attended by the author), some researchers made use of the assembled attendees to undertake an experiment related to interactive judgements and their impact on bankruptcy prediction tasks. In an attempt to provide an ‘incentive’ (perhaps in an effort to increase the ‘realism’ of the task) at the commencement of the task, the subjects were told that each member of the ‘winning team’ was to be provided with a bottle of fine Scotch whisky. Clearly, this is an imperfect incentive and might actually introduce other unwanted factors into the analysis. For example, people with a ‘drinking problem’ might find this a tremendous incentive and really try hard to win. Others might be fairly indifferent, whereas others, perhaps with a religious objection to alcohol, might actually make judgements that guarantee that they and their team mates will not ‘win’. What this indicates is that when offering incentives to increase the realism of a task, great care needs to be taken in selecting appropriate and ‘culturally sensitive’ incentives.
Reactions of individuals to financial reporting: an examination of behavioural research in accounting CHAPTER 12
STUDY TOOLS CHAPTER SUMMARY This chapter considered how individuals use information to make decisions. More specifically, it considered how individuals use accounting information to make a variety of judgements. Research pertaining to individual decision making (behavioural research) has shed a great deal of light on how various groups of individuals, such as auditors, lending officers, investors and bankers, make decisions. Financial statement users often employ simplifying heuristics when making particular judgements. The perspective taken by researchers is that, if it is known how individuals appear to make decisions, it can be anticipated how they will react to particular accounting disclosures and forms of disclosures. The psychology literature provides a vast amount of knowledge about what influences individual decision making by people, and this has obvious relevance when considering how people associated with accounting functions make decisions, Hence, this chapter emphasises how advances in particular disciplines (for example, psychology) can provide benefits to other disciplines (for example, accounting) in terms of answering questions that otherwise might be left unanswered. Behavioural accounting research is particularly relevant to the accounting profession and accounting regulators when they are contemplating the introduction of new accounting requirements. Knowledge of how financial statement users make decisions could also provide the basis for making suggestions about how decision making could be improved. For example, it might be found that certain financial statement users are inappropriately adopting particular heuristics, possibly unknowingly, that could lead to potentially costly implications. The chapter has also emphasised the many interesting research opportunities available in the area of behavioural research in accounting.
ANSWER TO OPENING QUESTION At the beginning of the chapter, we asked a question. As a result of reading this chapter, you should be able to provide an informed answer to this question – ours is shown below.
Module 1
Questions / The accounting profession often considers introducing new standards requiring the disclosure of Answers particular information or specifically requiring information to be disclosed in a standardised format. The information might be financial or non-financial. A concern that often arises is how, or whether, various potential users of the information will react to the new disclosures that might be mandated, particularly given that new disclosure requirements typically impose costs on those entities required to make the disclosures, as well as costs on users who seek to understand the relevance of the information.
How can behavioural research be used to address questions or concerns that accounting regulators might have about users’ reactions to the proposed requirements? As this chapter demonstrates, behavioural research can be used to test how intended users of information react to information; which items of information they tend to prioritise; what weighting is attributed to particular information items; how different presentation formats influence the use of the information; and whether the ultimate decision made by the users appears to be correct relative to expected or desired decisions. Introducing new disclosure regulations imposes costs on both users (for example, to understand what the new disclosures represent) and preparers (who might need to put in place new collection, assurance and reporting processes). It is arguably better that perceived shortcomings in proposed disclosure requirements are known prior to the introduction of related regulation. Behavioural research allows standard-setters and regulators to test user needs and reactions as part of the process of developing reporting requirements.
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QUESTIONS 12.1 12.2 12.3 12.4 12.5 12.6 12.7 12.8 12.9 12.10
12.11
12.12 12.13 12.14 12.15 12.16 12.17 12.18
From what other discipline (other than accounting) does behavioural research mainly originate? LO12.3 Why should students of accounting be aware of the insights provided by behavioural research in accounting? LO12.1 Contrast behavioural research with capital markets research. LO12.4 Provide an example of how behavioural accounting research can be used to address anomalies that might arise in capital markets research. LO12.4 Can behavioural research complement research undertaken using other paradigms (for example, capital markets research)? Explain your answer. LO12.4 How and why would the accounting profession use the results of behavioural research in accounting? LO12.7 LO12.8 Why would the management of individual reporting entities be interested in the results of behavioural research in accounting? LO12.7 LO12.8 Briefly explain the Brunswik Lens Model and its relevance to explaining the various facets of the decision-making process. LO12.2 LO12.5 What is a ‘heuristic’? Why could it be beneficial for a group of financial statement users to be informed that they are applying a particular heuristic? LO12.6 What is the rationale for modelling the decision-making processes of different financial statement user groups (that is, for example, identifying how they appear to weight particular cues when making judgements)? LO12.7 LO12.8 If the results of behavioural research indicate that a particular accounting-related information item (cue) is not used by individuals when making decisions, should this be grounds for the accounting profession to conclude that such information is not material and therefore does not warrant the related development of mandatory disclosure requirements? Explain your answer. LO12.5 LO12.7 There have been a number of behavioural studies in financial accounting and auditing that have generated conflicting results. What are some possible reasons for the disparity in results? LO12.9 What is ‘protocol analysis’? What are some of its strengths and weaknesses? LO12.2 Identify an advantage that protocol analysis has over other research that embraces the Brunswik Lens Model? LO12.2 What are some general strengths and limitations of behavioural research? LO12.9 How ‘generalisable’ are the results derived from behavioural accounting research? LO12.1 LO12.9 Would an experiment undertaken in a controlled environment have greater internal validity compared to one in a non-controlled environment? Why? LO12.2 Evaluate the following statement: A controlled experimental setting (often referred to as a laboratory setting) can help to ensure higher internal validity because external influences can be reduced, or ideally, eliminated. However, such an experimental setting reduces the external validity of research results because the research setting is different to the ‘outside world’. LO12.9
12.19 Positive Accounting Theory and Agency Theory make certain central assumptions about what influences people’s decisions. How does this differ from perspectives embraced within behavioural research in accounting? LO12.4 12.20 The IASB recently revised its Conceptual Framework for Financial Reporting. Ongoing revisions to the Conceptual Framework are expected. Could the IASB apply techniques from behavioural accounting when revising the Conceptual Framework and, if so, how? LO12.7 12.21 In a newspaper article entitled ‘How heuristics can help us deal with information overload’ (Ferraro, 2015), it was reported: Mostly, heuristics represent valuable shortcuts to help us make sense of the world based on our limited cognitive ability to process information. But occasionally they lead to costly systematic errors in judgment and decision-making. If enough investors suffer from such biases they also contribute to persistent mispricing and limits to arbitrage, which imposes significant costs and risks on less ‘irrational’ investors.
Explain the above statement.
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LO12.6
LO12.7
Reactions of individuals to financial reporting: an examination of behavioural research in accounting CHAPTER 12
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Dyckman, T. R. (1998), ‘The ascendancy of the behavioral paradigm in accounting: the last 20 years’, Behavioral Research in Accounting, 10, pp. 1–10. Elias, N. (1972), ‘The effects of human asset statements on the investment decision: an experiment’, Journal of Accounting Research, 10, pp. 215–33. Falk, H. & Ophir, T. (1973), ‘The influence of differences in accounting policies on investment decisions’, Journal of Accounting Research, 11, pp. 108–16. Ferraro, S. (2015), ‘How heuristics can help us deal with information overload’, Australian Financial Review, 5 January. Heintz, J. A. (1973), ‘Price-level restated financial statements and investment decision making’, The Accounting Review, 48, pp. 679–89. Hendricks, J. (1976), ‘The impact of human resource accounting information on stock investment decisions: an empirical study’, The Accounting Review, 51, pp. 292–305. Hogarth, R. & Einhorn, H. (1992), ‘Order effects in belief updating: the belief adjustment model’, Cognitive Psychology, 24, pp. 1–55. Iyengar, R. J. & Zampelli, E. M. (2010), ‘Does accounting conservatism pay?’, Accounting and Finance, 50, pp. 121–42. Joyce, E. J. & Biddle, G. C. (1981), ‘Anchoring and adjustment in probabilistic inference in auditing’, Journal of Accounting Research, 19, pp. 120–45. Kida, T. (1984), ‘The impact of hypothesis testing strategies on auditors’ use of judgement data’, Journal of Accounting Research, 22, pp. 332–40. Kinney, W. R. & Ueker, W. C. (1982), ‘Mitigating the consequences of anchoring in auditor judgements’, The Accounting Review, 57, pp. 55–69. Klersy, G. F. & Mock, T. J. (1989), ‘Verbal protocol research in auditing’, Accounting, Organizations and Society, 14(2), pp. 133–51. Krishnan, R. & Booker, D. (2002), ‘Investors’ use of analysts’ recommendation’, Behavioral Research in Accounting, 14, pp. 130–56. © American Accounting Association Libby, R. (1975), ‘Accounting ratios and the prediction of failure: some behavioral evidence’, Journal of Accounting Research, 13(1), pp. 150–61. Libby, R. (1976), ‘Man versus model of man: the need for a non-linear model’, Organizational Behavior and Human Performance, 16, pp. 13–26. Libby, R. (1981), Accounting and Human Information Processing: Theory and Applications, Englewood Cliffs, NJ: Prentice Hall. Lipe, M. (2018), ‘Unpacking the disclosure package: using experiments to investigate investor reactions to narrative disclosures’, Accounting, Organizations and Society, 68–69, pp. 15–20. Lobo, G. & Song, I. (1989), ‘The incremental information in SFAS 33 income disclosures over historical cost income and its cash and accrual components’, The Accounting Review, 64(2), pp. 329–43. Maines, L. A. (1995), ‘Judgment and decision making research in financial accounting: a review and analysis’, in R. H. Ashton & A. H. Ashton (eds), Judgment and Decision Making Research in Accounting and Auditing, Cambridge: Cambridge University Press. Martin, P. R. & Moser, D. V. (2016), ‘Managers’ green investment disclosures and investors’ reaction’, Journal of Accounting and Economics, 61(1), pp. 239–54.
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McIntyre, E. (1973), ‘Current cost financial statements and common stock investment decisions’, The Accounting Review, 48, pp. 575–85. Mear, R. & Firth, M. (1987), ‘Assessing the accuracy of financial analyst security return predictions’, Accounting, Organizations and Society, 12, pp. 331–40. Moriarity, S. (1979), ‘Communicating financial information through multidimensional graphics’, Journal of Accounting Research, 17, pp. 205–24. Moser, D. (1989), ‘The effects of output interference, availability, and accounting information on investors’ predictive judgements’, The Accounting Review, 64(3), pp. 433–44. Pankoff, L. & Virgil, R. (1970), ‘Some preliminary findings from a laboratory experiment on the usefulness of financial accounting information to security analysts’, Journal of Accounting Research, 8, pp. 1–48. Reimsbach, D. & Hahn, R. (2015), ‘The effects of negative incidents in sustainability reporting on investors’ judgments: an experimental study of third-party versus self-disclosure in the realm of sustainable development’, Business Strategy and the Environment, 24(4), pp. 217–35. Reimsbach, D., Hahn, R. & Gurturk, A. (2017), ‘Integrated reporting and assurance of sustainability information: an experimental study on professional investors’ information processing’, European Accounting Review, 27(3), pp. 559–81. Riedl, A. & Smeets, P. (2017), ‘Why do investors hold socially responsible mutual funds?’, Journal of Finance, 72(6), pp. 2505–50. Sami, H. & Schwartz, B. (1992), ‘Alternative pension liability disclosure and the effect on credit evaluation: an experiment’, Behavioral Research in Accounting, 4, pp. 49–62. Schultz, J. J. & Gustavson, S. G. (1978), ‘Actuaries’ perceptions of variables affecting the independent auditor’s legal liability’, The Accounting Review, 53, pp. 626–41.
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Seow, J. (2009), ‘Cue usage in financial statement fraud risk assessments: effects of technical knowledge and decision aid use’, Accounting and Finance, 49, pp. 183–205. Simnett, R. & Trotman, K. (2018), ‘Twenty-five-year overview of experimental auditing research: trends and links to audit quality’, Behavioral Research in Accounting, 30(2), pp. 55–76. Snowball, D. (1980), ‘Some effects of accounting expertise and information load: an empirical study’, Accounting, Organizations and Society, pp. 323–28. Stallman, J. (1969), ‘Toward experimental criteria for judging disclosure improvements’, Journal of Accounting Research, 7, pp. 29–43. Triandis, H., Malpass, R. & Davidson, A. (1971), ‘Crosscultural psychology’, in B. J. Siegel (ed.), Biennial Review of Anthropology 1971, Redwood City, CA: Stanford University Press. Trotman, K. T. (1996), Research Methods for Judgement and Decision Making Studies in Auditing: Coopers and Lybrand Research Methodology Monograph No. 3, Melbourne: Coopers and Lybrand. Trotman, K. T., Tan, H. & Ang, N. (2011), ‘Fifty year overview of judgment and decision-making research in accounting’, Accounting and Finance, 51, pp. 278–360. © John Wiley & Sons Tversky, A. & Kahneman, D. (1974), ‘Judgment under uncertainty: heuristics and biases’, Science, 185, pp. 1124–31. Watts, R. & Zimmerman, J. (1978), ‘Towards a positive theory of the determination of accounting standards’, The Accounting Review, 53(1), pp. 112–34. Wilkins, T. & Zimmer, I. (1983), ‘The effect of leasing and different methods of accounting for leases on credit evaluation’, The Accounting Review, 63, pp. 747–64. Wood, D. & Ross, D. (2006), ‘Environmental social controls and capital investments: Australian evidence’, Accounting and Finance, 46, pp. 677–95. Zimmer, I. (1980), ‘A lens study of the prediction of corporate failure by bank loan officers’, Journal of Accounting Research, 18(2), pp. 629–36.
CHAPTER
13
CRITICAL PERSPECTIVES OF ACCOUNTING LEARNING OBJECTIVES On completing this chapter, readers should: LO13.1
have gained an insight into particular perspectives that challenge conventional opinions about the role of accounting within society
LO13.2 have a broad understanding of what ‘critical theory’ and ‘critical analysis’ mean LO13.3 understand the basis of arguments that suggest that financial accounting and other forms of accounting tend to support the positions of individuals who hold power, wealth and social status, while undermining the positions of others LO13.4 understand that the disclosure (or non-disclosure) of information can be construed to be an important strategy to promote and legitimise particular social orders, and maintain the power and wealth of certain ‘elites’
LO13.5 understand the reasoning behind why some researchers embrace a view that governments frequently act to support powerful stakeholders (such as shareholders) rather than the interests of less powerful stakeholders (such as workers) LO13.6 understand arguments that suggest that accounting research will not only be influenced by current practice and dominant ideologies, but also has the potential to influence dominant ideologies and practice LO13.7 understand the meaning and roles of counter accounts, monologic accounts and dialogic accounts LO13.8 be able to question whether critical accounting researchers are actually embracing strategies that could realistically encourage social and structural change, or whether many ‘critical’ researchers are simply partaking in various intellectual debates with little real attempt to create positive change.
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OPENING QUESTIONS Before reading this chapter, please consider how you would answer the following question. We will return to this question at the end of the chapter, where we suggest an answer. 1 As we discussed in Chapter 7, conceptual framework projects promote approaches to financial accounting that are built on qualitative characteristics such as neutrality, objectivity and representational faithfulness. 2 How do arguments regarding the unequal distribution of power between different social groups, as espoused by critical accounting theorists, challenge the belief that financial statements prepared in accordance with generally accepted accounting principles will neutrally and objectively depict an organisation’s financial performance?
Introduction Previous chapters of this book have explored numerous issues, including how accounting can be used to: assist in decision making (Chapters 6 and 7); reduce agency, contracting and political costs (Chapter 8); maintain or assist in bringing legitimacy to an organisation (Chapter 9); and satisfy the information demands of particular stakeholders (Chapter 9). We also learned that accounting processes might be chosen on the basis of a perceived necessity to conform with certain institutionalised practices and related cultural-cognitive and normative expectations (Chapter 9). How the practice of accounting could be modified to take into account some social and environmental aspects of an organisation’s operations has also been explored (Chapter 10), along with a consideration of how accounting disclosures might impact the capital market and, therefore, share prices (Chapter 11). The effects of accounting disclosures on the behaviour of individuals was also explored (Chapter 12). This chapter is somewhat different to the others. It provides an overview of an alternative and very different perspective about the role of accounting. This perspective, which is often called the critical perspective, explicitly considers how the practice of accounting tends to support particular economic and social structures (which are typically considered by critical theorists as being unfair) and reinforces unequal distributions of power and wealth across society. In doing so, this form of accounting research, which is being undertaken by a growing number of accounting researchers, rejects the view that accounting typically provides an objective and unbiased account of particular transactions and events. ‘Critical thinking’, which we should all do, involves making reasoned judgements that are well considered, logical, and based on asking the right questions (developing the right problems) and collecting the appropriate supporting information. Critical thinking is a highly valued skill required by all managers, accountants and accounting researchers, and it requires us not to simply accept things at their ‘face value’. When we talk about critical accounting researchers, or critical theorists, we are not only talking about researchers who simply apply ‘critical thinking’, as just described. The terms ‘critical theorist’ or ‘critical accounting researcher’ also imply that the people in question are embracing a philosophy, whether informed by the works of Karl Marx, Michel Foucault, Paolo Freire, Jürgen Habermas or otherwise, that challenges various taken-forgranted assumptions held within the community about how society is or should be structured, why it is structured in the way it is, who benefits from such structures and so forth. The view promoted by researchers operating from a critical perspective is that accounting, far from being a practice that provides a neutral or unbiased representation of underlying (often economic) facts, actually provides the means of maintaining the powerful positions of some sectors of the community (those currently in power and with wealth) while suppressing 670
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the position and interests of those without power and wealth. These theorists challenge any perspectives that suggest that various rights and privileges are spread throughout society1 – instead, they argue that most rights, opportunities and associated power reside in a small (but perhaps well-defined) group (often referred to as an ‘elite’). Such researchers seek to highlight the perceived inequalities and structural problems inherent in existing social systems (and how accounting acts to sustain inequitable systems) – systems that are typically taken for granted by other ‘non-critical’ researchers. As Broadbent (2002, p. 434) notes: The broad role of critical accounting might be seen as one that makes transparent the assumptions and taken-for-granted values that lie behind accounting. Integral to this is the idea of social welfare.
Critical theorists explore how accounting potentially contributes to, and sustains, features of society which are perceived by the researchers as not being equitable for some stakeholders, such as employees or particular communities. Ideally, such researchers also provide possible solutions to such concerns. This can be contrasted with most accounting researchers who, while often testing for particular relationships between chosen variables, frequently do not question any inequities associated with the processes or systems that they are investigating. As Gaffikin (2010, p. 35) states: Generally speaking, accountants have avoided meaningful self-reflection. By far the majority of accounting researchers proceed without questioning the very essential features and assumptions of their discipline.
For example, in Chapter 11 we looked at capital markets research and we learned that many accounting researchers, whom we might call ‘capital markets researchers’, studied the relationship between particular news announcements and share process. They are particularly interested with the efficiency of capital markets in assimilating new information and in determining the ‘value relevance’ of particular disclosures. Critical theorists would not tend to be interested in such observations. Rather, they might ‘step back’ and question underlying inequities inherent in capital markets, which critical theorists argue are regulated in a manner that benefits investors to the detriment of many other stakeholders. Such considerations would not be part of the issues (or research questions) addressed by capital markets researchers. Critical accounting researchers would also tend to acknowledge that when profits surge (which might be associated with increasing share prices if corporate announcements about profits were unexpected), this could be the result of a social and economic system that does not price in the negative effects that the profit-making activities caused – perhaps in terms of instances of modern slavery, ongoing contributions to climate change, land degradation and so forth. Because of the nature of their research, critical accounting researchers place less emphasis on mathematical modelling and statistics (which in itself often attracts criticisms from other accounting researchers who employ such ‘sophisticated’ methods) and give more importance to historical accounts of how and why certain social structures and related processes came into existence in the first place, and what political forces are in place to sustain their existence. This chapter considers various (critical) arguments about the role of the state (government), the role of accounting research and the role of accounting practice, and therefore of accountants, in sustaining particular social orders that are already in place – social orders that some researchers (for example, critical theorists) argue function on the basis of inequities, where some individuals (with capital or wealth) prosper at the expense of those without capital and where accounting is therefore regarded as one of the tools used by those with (more) capital to help subjugate
1
The assumption that there is an equitable spread of rights and privileges across different groups within society is commonly referred to as ‘pluralism’. We considered the idea of pluralism in Chapter 10.
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Critical perspective of accounting Used to refer to an approach to accounting research that goes beyond questioning whether particular methods of accounting should be employed, and instead focuses on the role of accounting in sustaining the privileged positions of those in control of particular resources (capital) while undermining or restraining the voice and welfare of those without capital.
(undermine) those without (or with considerably less) capital. It will be seen that researchers adopting a critical perspective of accounting often do not provide direct solutions to particular inequities; rather, they seek to highlight the inequities they perceive as existing in society, and the role, they argue, that accounting plays in sustaining and legitimising the inequities. Again, it is emphasised that because the theoretical perspectives investigated in this chapter make calls for structural changes that will have broad impacts across society, they are quite different from the other ‘accounting theories’ addressed in this book. LO13.1
LO13.2
LO13.3
The critical perspective defined
Under the heading (or umbrella) of critical accounting theory, there are several different perspectives of critical accounting. Therefore, a single critical perspective is not easy to define. Broadly speaking, the term ‘critical accounting theory’ is used to refer to an approach to accounting research that goes beyond questioning whether particular methods of accounting should be employed, and instead focuses on the role of accounting, and therefore ‘accountants’ (and many accounting researchers), in sustaining the privileged positions of those in control of particular resources (financial capital) while undermining or restraining the voice of those without capital. According to Roslender (2006, p. 250): Critical Theory is intimately wedded to change. More specifically it is concerned with the promotion of a better society, one in which the prevailing social arrangements serve the interests of the mass of people, whose ‘potentialities’ are perceived to be constrained by those arrangements already in place … Critical Theory seeks to provide a form of knowledge that is questioning of the prevailing social arrangements, i.e. an alternative knowledge. More than this, however, the resulting knowledge will serve as an input into a process of reflection by society’s members on the nature of their involvement within the prevailing social arrangements and how this might be changed, for their benefit. Critical Theory is not concerned with the provision of insights for their own sake but for the purpose of informing the transformation of ‘what is’ into what those who experience it wish it to be, through a process of interaction and reflection. Or put another way, Critical Theory aims to promote self-awareness of both ‘what is’ and ‘what might be’, and how the former might be transformed to install the latter.
Roslender (2006, p. 264) further states that from a critical perspective: Simply interpreting or understanding what we chose to study is not enough. The purpose of the exercise is to turn this learning to the advantage of society, i.e. the promotion of a better society. The presupposition is that there are many things about the existing social arrangements that merit changing. ‘Traditional’ theory does not subscribe to this axiom. It is this quality that distinguishes ‘critical’ theory from traditional theory. This is not to imply that all of those scholars who elect to embrace other ways of seeing are committed to the reproduction of the existing social arrangements, rather that they do not avail themselves of a way of seeing, Critical Theory, that explicitly links understanding and change to the enactment of the philosophy of praxis (a philosophy in which ‘theory’ informs ‘practice’ and vice versa). Viewed in a slightly different way, Critical Theory makes no pretence of being objective. Those who embrace a Critical Theory perspective do so because they recognise and value its partiality.
The above discussion is also consistent with Chabrak, Haslam and Oakes (2019, p. 1420), who reflect on ‘traditional’ (non-critical and often positivistic) research in noting: there is a veritable tsunami of narrow and narrowing research with an absence on the part of its proponents of much self-critique or self-doubt but tunnel vision toward 672
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assembly of pseudo-facts or ‘artefacts’ (see Parker and Roffey, 1997). The researchers employ categories they inherited in an unreflective way without questioning the sources. Subjugated by tradition, researchers are in effect unaware of the possibility of better views through different lenses (Tinker, 1999). Beyond refinement and consolidation of their perspective, they by-pass the new and take few risks (Hopper et al., 2001; Parker, 2001). For Gaffikin (2009), accounting research is largely in an intellectual vacuum because it has ignored the crucial need for self-reflection.
The above perspective of the benefits of ‘critical’ analysis is also reflected by Gaffikin (2008, p. 151): Crudely speaking, if you do not think about what you know and how you know it, your actions may be simply reflecting what others want you to do, so you will be reinforcing the dominant and powerful views that exist in society … through self-reflection one is freed from past constraints (such as dominant ideology and traditional disciplinary boundaries) and thus critical theory is emancipatory.
The above quote makes reference to an ‘emancipatory’ process. The ‘emancipatory role’ of critical accounting research is something that is often referred to by critical theorists. An emancipatory process is a process that, somewhat obviously, promotes ‘emancipation’. Emancipation relates to efforts aimed at removing oppression of some groups or procuring political rights or equality for particular disenfranchised groups. As Roslender (2006, p. 252) states: A critical social science approach seeks to provide the knowledge required for the democratic communication and interaction required to promote emancipation and the construction of a new set of social arrangements that will serve the interests of the majority of people.
Tony Tinker (2005, p. 101), who is one of the founders of the critical accounting movement, has also offered a useful definition of critical accounting research in which he introduces the idea of ‘social praxis’ – another term that is typically not used by accounting researchers other than critical accounting researchers. He sees the critical accounting movement as encompassing: all forms of social praxis that are evaluative, and aim to engender progressive change within the conceptual, institutional, practical, and political territories of accounting.
A key element of this definition is the notion of ‘social praxis’, as distinct from the investigation (for example, in other branches of accounting theory and research) of social (accounting) practice.2 Praxis within critical accounting research envisages a broad understanding of both ‘theory’ and ‘practice’ and is generally understood to refer to the assumption that there is a two-way (and possibly circular) relationship between theories and practices, whereby theory influences social practices (that is, the theoretical views and assumptions we have about practice actually impact practice), while social practices also influence theory. That is, theory informs (or provides a foundation for) existing practice and existing practice informs theory.3 One implication of this 2
3
Emancipation Relates to efforts aimed at removing oppression of some groups or procuring political rights or equality for particular disenfranchised groups.
Social praxis Envisages a broad understanding of both ‘theory’ and ‘practice’ and is generally understood to refer to the assumption that there is a two-way (and possibly circular) relationship between theories and practices, whereby theory influences social practices while social practices also influence theory.
The Oxford English Dictionary (2nd edition, 1989) contains several definitions of the word ‘praxis’, including ‘The practice or exercise of a technical subject or art, as distinct from the theory of it’ and ‘Habitual action, accepted practice, custom’. However, as will become clear from the discussion in the next few paragraphs, the word ‘praxis’ in most critical accounting research is used in a very specific manner which accords with the following definition from the Oxford English Dictionary: ‘A term used ... to denote the willed action by which a theory or philosophy (esp. a Marxist one) becomes a social actuality’. For example, if we believe in, and promote, a theory of economics that says that markets operate most efficiently when left unregulated, this will influence market-based practices. Regulators may use the research to further support efforts to reduce market regulation. Conversely, if we observe markets and find that those markets that operate efficiently are regulated, this will influence the theories we develop. Hence, theories might impact practice, or existing practice might impact theories.
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relationship between theory and practice is that when social conditions (and practices) change, theories based on these conditions need also to change. This should not be a new concept to you, as many parts of this book discussed accounting theories that evolved to suit (or reflect) business practices. The other key implication of the two-way relationship between theory and practice embodied in the term praxis, and possibly the more important implication from the perspective of critical accounting, is that development of different theoretical perspectives can bring about (needed) changes in social practices and structures (such as the distribution of wealth and power within society). For example, if we develop theories that question the wealth distribution impacts of unregulated markets or question the operations of capital markets in terms of providing sustainable outcomes, and if our arguments gain acceptance with many stakeholder groups within society (which requires engagement with society), then this might have implications for how such markets are regulated. Our theories will impact practice. Similarly, if we have well-developed theories that question the objectivity or ‘representational faithfulness’ of financial accounting, and if we are able to generate sufficient support for the theory, then ultimately this could create the necessary impetus for changes in the way financial accounting is practised. For example, perhaps the compelling nature of our newly developed theories might act to reduce society’s focus on corporate financial performance (which critical theorists believe particularly promotes the interests of investors and senior managers); instead, our new theory might encourage a new business philosophy in which measures of corporate performance reflect efforts made towards benefiting a diverse group of stakeholders and the environment; that is, the theory could ultimately lead to reforms in how business and society operate (which again links to the notion of ‘social praxis’, in which theory informs practice, and vice versa). What is different about the relationship between theory and practice as embodied in the term praxis (as used in critical accounting research) is the explicit notion of a two-way relationship. Most of the theoretical perspectives studied earlier in this book tend to rely on a one-way relationship, whereby either theory determines practice or practice determines theory. What is also different is the focal point of changes in practice implied in the term praxis. While the normative theories examined in earlier chapters of this book (for example, see Chapter 6) sought to develop and then implement specific accounting practices that particular normative researchers argued were (in some way) superior to existing practices, the focus of the changes in practice embodied in the term praxis are usually at the broader level of society rather than specific technical accounting practices within that society. More specifically, a critical accounting understanding and use of the term praxis is often (but certainly not always) informed by a Marxist-inspired approach, ‘whose central concern [is] to study and influence the role of free creative activity in changing and shaping ethical, social, political, and economic life along humanistic socialist lines’ (De George, 1995, p. 713), and this is why we argue that the role of theory in changing social practices is probably more important to many critical accounting scholars than the role of changed social practices in altering theories. Tinker (2005, p. 101) argues that this approach to critical accounting both ‘promises a rich synthesis of new forms of praxis’ and requires that critical accounting scholars ‘who participate [in critical accounting research] must do so from committed, partisan, passionate, and sometimes militant positions’. As already noted, critical theorists are informed by various philosophies (whether they be based upon certain feminist philosophies, the works of Marx, Foucault, Freire, Habermas and so forth), and hence being ‘critical’ can be informed by different world views. As Gendron (2018, p. 2) states: ‘Critical’ does not have a single meaning. As a result, it is not surprising to see the field of critical research being characterized with a diversity of strands and intellectual 674
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trajectories, with overlapping points often not that obvious. In a sense, critical research may be conceived of as a pluralistic arena made up of qualitative studies, essays, and certain types of quantitative research. The theoretical lenses used by critical scholars vary greatly, from Marxism to more contemporary thinkers such as Michel Foucault. While this fragmentation makes it hard to define ‘what critical research is’, it nonetheless signals an important hallmark of the critical community: a commitment toward epistemological diversity.4 As such, critical research is particularly intolerant of intellectual dictatorships, where a single form of knowing is viewed as an ideal that should be promoted and actively encouraged. Instead, critical scholars tend to believe in the notion of multivocality (Abbott, 2001), considering that society is richer, in many ways, when knowledge is diversified.
The commitment to ‘epistemological diversity’ noted above can be contrasted with much accounting research that is undertaken where the researchers believe in an ‘objective world’ wherein we are assumed to all see things the same way and in which there are some universal truths that shall apply in all settings. The Positive Accounting Theorists we discussed in Chapter 8 believe in an objective world wherein all people are motivated by similar desires. In this regard, Chabrak, Haslam and Oakes (2019, p. 1426) state: Positive accounting theorists with commitment to neoclassical economics and their predecessors from the Chicago School continue to claim their approach as a disinterested and objective inquiry and as the only rigorous scientific procedure leading to correspondence with mind-independent reality and faithful representation of it. In doing so, they oriented accounting practices presupposing new rationales to sustain the authority of the type of capitalistic order they promote. … A pristine positivism is rooted in human desire for certainty and a fascination for absolute truth.
Returning to the aims of critical accounting research, Gendron (2018, p. 5) states: the ultimate aim of critical research is to inform people of the ways in which their subjectivity is subject to power, thereby potentially providing them with a platform to reduce the influence of subjugating forces on the mind.
The following excerpt from Rabinow (1984, p. 6) is particularly meaningful in this respect: Our task is to cast aside [...] utopian schemes, the search for first principles, and to ask instead how power actually operates in our society. ‘It seems to me,’ Foucault expounds, ‘that the real political task in a society such as ours is to criticize the working of institutions which appear to be both neutral and independent; to criticize them in such a manner that the political violence which has always exercised itself obscurely through them will be unmasked, so that one can fight them.’
In explaining his view of critical research, Gendron – who is a leading ‘critical theorist’ and coeditor of the renowned journal Critical Perspectives on Accounting – developed what he labelled a ‘conceptual compass’ of critical research, which he considered represented his perspective about the ‘boundaries’ of critical research. This perspective is reproduced in Table 13.1. In discussing his ‘conceptual compass’ Gendron (2018, p. 6) stated:
4
‘Epistemological diversity’ can be considered to represent an acceptance of a diversity of beliefs in how knowledge is developed; what methods and methodologies are appropriate for developing knowledge; and an acceptance of different world views. It represents an acceptance that there are different ‘truths’.
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Specifically, as a result of my unstructured and nonlinear journey through the labyrinth of critical research, I developed a ‘conceptual compass’. This sense-making device represents a synthesis of a quite personal, yet in several ways intersubjective, project. It is made up of provisional reference points, always subject to questioning and modification. In sum, the compass represents my current viewpoint on the boundaries of critical research.
In relation to the ontological assumptions or perspectives typically embraced by critical accounting researchers, Gendron (2018, p. 7) also states: my understanding of the ontological perspective on which critical research is predicated is informed by social constructivism and performativity. Reality is socially constructed. This applies to the categories and concepts we use to interpret the world, including the social structures surrounding us. What we ‘view’ (including what we view as objective) is inevitably affected by our interpretive schemes, which continuously develop through our socialization experiences (Schutz, 1967); ‘pure’ perception, therefore, constitutes an impossibility (Chalmers, 2013). Once constructed, however, ‘reality’ then has real, tangible effects – not least in advantaging certain viewpoints/parties while marginalizing others. In other words, the world becomes ‘real’ through the performative effects ensuing from the ways in which reality is socially constructed.
You should take the time to review Table 13.1 to see if you understand the various ‘dimensions’ and ‘reference points’ identified by Gendron.5 TABLE 13.1 Critical research sense-making compass and provisional reference points Dimension
Reference point
Purpose
Developing a better understanding of marginalisation processes in society as a basis to engage in social praxis
Characterisation of the ‘opponent’
Dominant institutions, discourses and practices that marginalise certain viewpoints, parties, and ways of thinking and doing in society
Ontological beliefs
Social reality is socially constructed, yet once constructed, it produces real, tangible effects, particularly marginalising ones
Methodological stance
Openness to any kind of research method (qualitative or quantitative) that allows the researcher to develop a better understanding of marginalisation processes (as a basis to engage in social praxis)
Prescriptive stance
If social reality is socially constructed, it can be deconstructed
Intervention setting
Academic journals and public arenas (including the classroom) Source: Gendron (2018), p. 6.
Insights into the partisan nature of accounting LO13.3
It has been argued earlier in this chapter, and in Chapter 1, that all research is likely to be influenced by the (possibly subconscious) biases of the researchers involved, but the explicit promotion of partisan research in critical accounting studies might upset and worry researchers
5
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For readers seeking more material that addresses the meaning of ‘critical accounting research’, a very useful reference is Gendron (2018).
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Why do I need to know about the insights provided by critical accounting theorists? The insights provided by the critical theorists are important as they provide a different, and potentially confronting way, of thinking about the role of accounting, the accounting profession and accountants within society – one that is often overlooked or ignored by researchers working from other paradigms. The insights will potentially cause us to re-examine some of our taken-for-granted assumptions about the role of accounting research and the role of
accounting practice within society. That is, as Why we read through the chapter, we will be exposed to various insights that will potentially shift our previous views about the role of accounting within society. If possible, we should also think about what social or educational mechanisms were in place throughout our lifetime that caused us to have certain beliefs about the way ‘accounting’ operates within society.
who adopt other approaches.6 However, it could be considered simply more honest, in that it is making explicit that all research in social sciences relies on the subjective (and therefore biased) interpretations of the researchers involved. Within critical accounting research, these explicit biases usually range from moderate socialism to more extreme anti-capitalist positions, and these biases could be regarded as threatening by accounting researchers (and students and practitioners) who have prospered under the capitalist system. This point will be returned to later in the chapter. Researchers within the critical accounting area – that is, critical accounting theorists – therefore seek to highlight, through critical analysis, the key role of accounting in society. The perspective they provide challenges the view that accounting can be construed as being objective, neutral or representationally faithful, and these researchers often seek to provide evidence to support this view. Accounting is seen as a means of constructing or legitimising particular social structures. As Hopper et al. (1995, p. 528) state: ... in communicating reality accountants simultaneously construct it (Hines, 1988) and accounting is a social practice within political struggles and not merely a market practice guided by equilibrium in an efficient market.
Socialism Any of various economic and political theories advocating collective or governmental ownership and administration of the means of production and distribution of goods.
Anti-capitalists Those who wish to completely replace capitalism with another system.
This view is supported by Baker and Bettner (1997, p. 305), who state: Critical researchers have convincingly and repeatedly argued that accounting does not produce an objective representation of economic ‘reality’, but rather provides a highly contested and partisan representation of the economic and social world. As such, the underlying substance of accounting cannot be obtained through an ever more sophisticated elaboration of quantitative methods. Accounting’s essence can be best captured through an understanding of its impacts on individuals, organisations and societies. Hence it is important for accounting research to adopt a critical perspective.
As noted at the beginning of this section, the term ‘critical accounting’ is a very broad term that captures a variety of different perspectives about accounting. However, what these perspectives have in common is that they seek to highlight, oppose and change the perceived role of accounting in supporting the privileged position of some people in society. As Hopper et al. (1995, p. 535) state:
6
According to the Oxford English Dictionary, a partisan approach is one taken ‘by an adherent or supporter of a person, party, or cause’. Therefore, if critical theorists and other theorists had a particular view (or theory) about how society should function to achieve certain ends or causes, then, in accord with a partisan approach, this will impact on the practices they support or oppose.
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Critical theory is an umbrella term for a wide variety of theoretical approaches perhaps more united in what they oppose than what they agree upon.
Consistent with the above perspective of critical theory, Reiter (1995, p. 53) states: In the critical world, there is no single established theory or approach, and little consensus on how to proceed, aside from an absolute horror of modernity and neoclassical economics.
REFLECTION QUESTION 13.1 The elements of financial reporting As we know, the elements of financial reporting as espoused in the IASB Conceptual Framework for Financial Reporting (see Chapter 7) are assets, liabilities, equity, income and expenses. We also know that organisations typically require both financial capital and labour/human capital to enable them to operate, and that payments to workers are an ‘expense’ (which decreases profits and therefore the amount available to pay dividends to investors), and that payments to investors are called dividends (which are not an expense, but are a distribution of profits). Indeed, the IASB Conceptual Framework defines expenses as decreases in assets, or increases in liabilities, that result in decreases in equity, other than those relating to distributions to holders of equity claims. We also know that when organisations are seeking to increase profits they will tend to introduce ‘cost-cutting’ exercises which include reducing various ‘expenses’, such as wages expense.
Question Evaluate the above paragraph in terms of whether the practice of financial reporting seems to favour the interests of some stakeholders over and above others.
Solution If we look at this critically, then we would understand that an organisation needs various factors of production, such as financial capital (which comes from investors) and labour capital (also referred to as human capital, which comes from employees/workers), to enable it to operate. Both groups
Reflection
of stakeholders contribute to organisational ‘successes’. Investors and workers both receive payments/compensation for contributing their respective forms of capital (financial capital and human capital, respectively). However, when we pay investors, we do not treat that payment as an expense, but as a distribution of profits. All things being equal, higher dividends are preferred and capital markets react positively to increases in dividend payments (see Chapter 11). But when we pay workers, we treat the payments as an ‘expense’. We are conditioned to believe that reducing expenses is a good thing, so it is generally considered (except by workers and their representatives) that reducing wages expense in the pursuit of profits is acceptable, indeed sometimes ‘laudable’, particularly if profits (and therefore dividend payments) have been declining. Considering this from a ‘critical perspective’, is it appropriate that payments to workers should be treated as an ‘expense’ when payments to another group of resource providers (investors who provide financial capital) are not treated as an expense? This system of double entry accounting, which has been in place for hundreds of years, does seem to favour one group within society (those with power) while, at the same time, undermining the interests of others (workers). Is this fair? If not, why would such a system be able to perpetuate without apparent challenge? What do you think? Critical theorists would encourage us to question systems like this that we might otherwise take for granted.
REFLECTION QUESTION 13.2 Accounting for externalities In Chapter 10 we discussed ‘externalities’. In doing so, we noted that the recognition of an ‘expense’ for financial reporting purposes requires either a decrease in assets, or an increase in liabilities that did not come about as a result of a distribution to owners (that is, through the payment of dividends). We also noted that for something to be recognised as an ‘asset’, one of the requirements was that it be ‘controlled’. Many resources used by an organisation
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are not ‘controlled’ (for example, the ‘environment’) and hence they are not ‘assets’, with the consequence that their use or abuse is not considered to be an ‘expense’.
Question Evaluate the above paragraph in terms of whether the practice of financial reporting seems to favour the interests of some stakeholders over and above others.
Critical perspectives of accounting
Solution Just as we did for Reflection question 13.1, if we look at this critically, we would understand that when an organisation impacts the environment – perhaps through releasing large amounts of carbon into the atmosphere – then unless some form of fines or other related payments or obligations were incurred, expenses would not be recognised. This means profits could be reported at the same time that significant (but unrecognised for financial reporting purposes) damage is being done to the environment and this could lead to dividends being paid to investors. Effectively, what is happening is that investors are gaining financially from the erosion of ‘natural capital’ at the same time that everybody, including future generations, is having environmental costs imposed upon them. That is, investors take all the financial gains that are linked to the damage, but they share all the associated costs (the externalities) with everybody else. If we look at
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this critically, does this really seem fair or appropriate? The eroded ‘natural capital’ is being applied to ultimately fund the payments to investors. This is consistent with the International Integrated Reporting Framework discussed within Chapter 10, which noted how some capitals (for example, ‘natural capital’) can decline in value if this causes a consequential increase in other capitals, such as ‘financial capital’. How different would the planet be now if investors had to cover the cost of all the social and environmental damage caused by organisations? This system of accounting – financial accounting – certainly does seem to advantage some stakeholders (with power and wealth) at the expense of others. Why would such a system of reporting, which ignores ‘externalities’, continue to be supported by the accounting profession, industry and government? What do you think? Critical accounting researchers would certainly have opinions on this, as we arguably all should.
A Marxist critique of accounting One of the main branches, and probably the founding branch, of critical accounting theory is grounded (as indicated above in discussing the term ‘social praxis’) in a Marxist-informed critique of capitalism. Within this Marxist critique, owners of capital are regarded as having (unfairly) accumulated their wealth by the historical exploitation and expropriation (over several centuries) of the value created by workers (or labour); workers are seen as feeling alienated both from society and from the products they produce, as their lives are largely controlled by external and impersonal markets rather than by their own free choices.7 The application of the double entry accounting system, with the associated definitions of ‘assets’ and ‘expenses’ – as discussed within Reflection questions 13.1 and 13.2 above – is consistent with this perspective, wherein the interests of owners of capital appear to be prioritised over the interests of other stakeholders. Capitalism is also regarded as being fundamentally structurally flawed. To give an example of one such structural flaw, a key Marxist argument is that one effective way for individual businesses to increase profits (or economic returns to capital) over a long period of history has been to increase the level of mechanisation in a factory or office process, and thereby replace the productive capacity of some workers (labour) – who have to be paid and cannot work 24 hours a day – with the productive capacity of additional machinery (capital, which ultimately has been paid for by accumulating the value created by labour and expropriated over the years by capital). The costs of usage of this machinery (such as depreciation, repairs and the opportunity cost of capital invested in the machinery) were historically often considerably lower than the cost of the labour displaced by the machinery, and the machinery could also be ‘worked’ for long periods with minimal stoppage (rest) periods. While such mechanisation might have been in the economic interests of the owners of one business, Marxists argue that there is a fundamental contradiction in the drive of all owners of all businesses to increase the returns to capital through ever greater mechanisation. This fundamental flaw in the structure of the capitalist system is that, for capital to earn returns, not only do costs need to be minimised, but also revenues need to be maximised. While the actions of one or two factory owners in replacing some labour with capital might not
7
In this Marxist perspective on workers’ feelings of alienation, ‘the market-place ... purports to be a sphere of individual freedom, but is in fact a sphere of collective slavery to inhuman and destructive forces’ (Wood, 1995, p. 525).
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affect the market for their goods, and therefore makes economic sense for these business owners individually, Marxists historically argued that if all business owners acted in this way, then the total amount paid to labour overall would decline and the total buying capacity in consumer markets overall would also decline. At some point, the reduction in resources available to consumers to purchase the end products of the production process would, it was argued, be greater than the increase in productive capacity from mechanisation and would therefore lead to a reduction (or collapse) in demand, and thereby threaten the overall prosperity of capital. As we considered in Reflection questions 13.1 and 13.2, the way we treat payments to workers as expenses, but do not consider payments to owners as expenses, is consistent with the concerns raised by Marx. Marxist theorists argue that as the capitalist system operates in a manner that alienates workers (and the working class), and is riddled with inherent structural contradictions (such as the one discussed), it is fundamentally unstable. This inherent instability will, it is argued, manifest itself in different symptoms in different eras, such as unemployment, inflation and economic depression. While action might be taken by governments and businesses to address the negative symptoms (or outcomes) of the instability of capitalism that manifest themselves in a particular era, Marxists regard this as treating a symptom (such as policies against unemployment in one era, anti-inflation policies in another era) rather than addressing the common cause of all these symptoms – the structural instability of the capitalist system itself. Furthermore, ‘successfully’ treating the current negative symptom of the inherent instability of capitalism will not, it is argued, prevent the inevitability of new symptoms (whose precise nature is unforeseen and largely unforeseeable) arising in future periods. Policies to address these symptoms are therefore regarded as acting at a relatively superficial level and, rather like pharmaceutical products that treat the symptoms rather than the underlying causes of a disease, will do little in the long term to cure what Marxists regard as the deeper malaise of capitalism. Many of these symptoms, and/or the social unrest caused by these symptoms, are regarded by Marxist scholars as threatening to undermine the power and wealth of capital (to quote Marx: ‘capitalism produces its own gravediggers’ (Marx and Engels, 1967, p. 94, as cited in Tinker, 2005, p. 122). Therefore, the privileges, power and wealth of capital are regarded by Marxists as being unstable, and owners of capital will take action to defend their privileges, power and wealth. Critical accounting theories (not all of which are informed by Marxist philosophies) regard accounting as a powerful tool in both enhancing the power and wealth of capital and helping to protect this power and wealth from threats arising from the structural instability of capitalism. As, following Tinker’s (2005) arguments outlined earlier, many critical accounting researchers tend to be opponents of many aspects of the capitalist system and of accounting, they seek to expose the role of accounting in supporting unequal distributions of power and wealth across society, and some seek to subvert this role of accounting. This aim also tends to be shared by several of the critical accounting researchers who do not adopt a Marxist perspective – for example, those who adopt insights more recently provided by Foucault. In relation to the works of Foucault, Gendron (2018, p. 4) states: While Foucault’s writings address various objects such as prisons, sexuality and modes of government, one of the central themes he investigates relates to devices in society that engender and establish regimes of power, and how these devices define, influence and regulate subjectivities (Bevir, 1999). Foucault was especially interested in the role of power devices, such as disciplinary techniques and technologies of the self, in influencing how people construct their self and their environment. From this perspective, critical research engages in the studying of power, particularly how people come to be subtly influenced by persuasive discourses (e.g., professional claims such as auditor independence, knowledge claims such as agency theory, political claims such as neoliberalism and its new public management avatar, etc.) to the point that the
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latter are viewed as well-founded, natural, and matter of fact. Foucault was particularly interested in the intertwining of discourse, practices and knowledge – knowledge being viewed not only as a key vector of marginalization, but also as an instrument at the disposal of critical researchers to analyze how marginalization operates, and inform people of these detrimental processes. As stressed in Rabinow (1984, p. 7), ‘For Foucault, the “will to knowledge” in our culture is simultaneously part of the danger and a tool to combat that danger.’
In recent years, many accounting researchers have been investigating social and environmental accounting as a means to address various inequities in society. However, as Gray, Owen and Adams (1996, p. 63) state, a major concern of the critical (or ‘radical’ theorists) is that: ... the very way in which society is ordered, the distribution of wealth, the power of corporations, the language of economics and business and so on, are so fundamentally flawed that nothing less than radical structural change has any hope of emancipating human and non-human life. The social, economic and political systems are seen as being fundamentally inimical.
Given that the practice of accounting is in the hands of reporting entities, such as large corporations, and accounting regulation is in the hands of government and associated regulatory bodies (which are viewed as being linked to, or under substantial influence from, large corporations and therefore as having a vested interest in maintaining the status quo), accounting information will, it is argued, never act to do anything other than support our current social system, complete with all its perceived problems and inequities.
Status quo A Latin term meaning the existing state of affairs.
Critical accounting research versus social and environmental accounting research LO13.3
LO13.4
One of the key areas in which our current social system is perceived by large numbers of people (and not just critical theorists) to produce many problems and inequities is the social and environmental impact of business. Many of the issues in this area, and their relationship to accounting theory and practice, are discussed in Chapters 9 and 10. Here, we consider how critical accounting research differs from and/or complements social and environmental accounting research, as it might be considered that both are seeking substantial changes in social practices. The critical perspective adopted by many critical accounting researchers is grounded in Political Economy Theory, which was also considered in Chapter 9. More specifically, critical accounting research tends to be grounded in ‘classical’ Political Economy Theory. As Chapter 9 indicates, the ‘political economy’ has been defined by Gray, Owen and Adams (1996, p. 47) as the ‘social, political and economic framework within which human life takes place’. The view is that society, politics and economics are inseparable, and economic issues cannot meaningfully be investigated in the absence of considerations about the political, social and institutional framework in which economic activity takes place. Relating these arguments specifically to accounting, Guthrie and Parker (1990, p. 166) state: The political economy perspective perceives accounting reports as social, political, and economic documents. They serve as a tool for constructing, sustaining and legitimising economic and political arrangements, institutions and ideological themes which contribute to the organisation’s private interests.
As Chapter 9 also indicates, Political Economy Theory has been divided into two broad streams that Gray, Owen and Adams (1996, p. 47) and others have classified as ‘classical’ and ‘bourgeois’ political economy. The ‘classical’ political economy perspective is informed by
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philosophies inherent in the works of people such as Marx wherein labour, and much of society, is considered as oppressed, with their wealth (the value created through the efforts of labour) being appropriated for the benefit of those who hold financial capital (Gray, Adams and Owen, 2014). By contrast, the ‘bourgeois’ political economy perspective does not explore structural inequities, sectional interests, class struggles and the like.8 It accepts the way society is currently structured as ‘a given’ and that different stakeholders are able to voice their expectations (often referred to as ‘pluralism’). Many critical theorists consider that research which simply accepts the existing nature and structure of society without challenge effectively supports that (undesirable) society (Hopper and Powell, 1985). By accepting a pluralist conception of society, it thereby tends to ignore the struggles and inequities within society (Puxty, 1991). Prominent critical researchers, such as Tinker, Puxty, Lehman, Hopper, Cooper and Gendron, have therefore often considered it necessary to challenge the work of researchers whom they regard as researching within the bourgeois stream of political economy, such as Gray, Owen, Maunders, Mathews and Bebbington (these researchers, plus a number of others, have researched numerous issues associated with corporate social responsibility reporting); individuals who have for many years been promoting the need for organisations to be more accountable for their social and environmental performance (that is, to provide more information in relation to whether corporations are meeting community expectations in relation to their social and environmental performance). As Gray, Owen and Adams (1996, p. 63) state, critical theorists believe that: Because corporate social reporting (CSR) will be controlled by the reporting corporations and a State which has a vested interest in keeping things more or less as they are, CSR has little radical content. Furthermore, CSR may do more harm than good because it gives the impression of concern and change but, in fact, will do no more than allow the system to ‘capture’ the radical elements of, for example, socialism, environmentalism or feminism and thus emasculate them.
Critical theorists argue that any such emasculation (undermining or weakening) of these movements, which seek to protect and advance the interests of groups or entities often regarded as negatively affected by capitalism, will have the effect of protecting the capitalist system from ‘threats’ these movements pose to the power and wealth of capital.9 Thus, while calls for greater disclosure of social responsibility information would seem to be a move in the right direction, some critical theorists argue that such efforts are wasted unless they are accompanied by fundamental changes in how society is structured. They would argue that the disclosure of corporate social responsibility information, which is predominantly under the control of the organisations themselves, acts to legitimise, and not challenge, those providing the information. Certainly, much evidence was provided in Chapter 9 about how organisations use social and environmental disclosures to legitimise their existence, particularly at times of major adverse social and environmental events. Cooper and Sherer (1984), for example, argue that attempts to resolve technical issues (such as how to account for environmental externalities) without consideration of inequities in the existing social and political environment may result in an imperfect and incomplete resolution, owing to the acceptance of current institutions and practices, which are seen to be part of the problem itself. Reflecting on some of the views of critical theorists about the deficiencies of social and environmental accounting research, Owen, Gray and Bebbington (1997, p. 181) note:
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Legitimacy Theory and Stakeholder Theory, which are both examined in Chapter 9, are generally embedded within a ‘bourgeois’ political economy perspective. Included in the Oxford English Dictionary’s (2nd edn, 1989) definition of emasculation is: ‘The depriving of force, vigour ... making weak’.
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REFLECTION QUESTION 13.3 A need for more accounting? Question Is it always a good thing to have additional systems of accounting implemented?
Solution Given some of the insights provided already in this chapter, we should understand that the answer to this question perhaps depends upon whose interests we are considering. That is, which stakeholders are likely to benefit from the new accounting practices that are implemented? Critical accounting theorists stress that it is naïve to expect that new accounting practices will benefit anyone other than the
Reflection
organisation’s managers and owners. It is possible that new practices might be implemented to simply bolster, legitimise or justify current practices that support the interests of those who already benefit the most from existing practices. For example, particular social and environmental accounting practices and related disclosures might be implemented to provide support for current practices rather than for the purpose of improving performance for a diverse group of stakeholders. So, it is quite possible that it will not necessarily be a ‘good thing’ for everybody that a new system of accounting is implemented.
Early radical critique of the social accounting movement emanated from a socialist, largely Marxist, perspective. For writers such as Tinker et al. (1991) and Puxty (1986, 1991) society is characterised by social conflict. In Tinker et al.’s (1991) analysis, the social accounting movement, particularly as represented in the work of Gray et al. (1987, 1988), fails to examine the basic contradictions and antinomies of the social system under investigation and is therefore, at best, irrelevant, and, at worst, malign, in implicitly adopting a stance of ‘political quietism’ that simply benefits the already powerful (i.e. the capitalist class). Thus, for example, Puxty writing in 1986 suggested the irrelevance of social accounting, in noting that ‘more radical critics of capitalist society have been more concerned with the broader issues of accountancy and accountants within that society than particular (almost parochial) issues such as social accounting which appears to be ... rearranging the deck chairs on the Titanic’ (p. 107). However, by 1991, Puxty had taken his critique a stage further in arguing that by leaving basic social structures intact, social accounting can even lead to legitimation ‘since the powerful can point to their existence as evidence of their openness in listening to criticism, it paves the way for ... the extension of power’ (p. 37).
Spence (2009) also claims that social and environmental accounting practices, and some related research, have grown rapidly not so much because of the benefits the practices create for societies, but because they provide additional avenues for bolstering the financial returns of shareholders and reinforcing business-as-usual practices. Spence (2009) argues that the way social accounting is applied within organisations supports the ‘established order’ and supports the ‘ideological autonomy’ of capital markets and business operations. This is also consistent with arguments advanced within Gallhofer and Haslam (2019). Therefore, a message that emanates from critical theorists is that accounting sustains particular social structures, and the introduction of new forms of accounting (for example, experimental methods relating to accounting for social costs) will only help to support that social system. Reflecting on the critical theorists’ perception of the ongoing research being undertaken to explore how to account for the social and environmental implications of business, Gray, Owen and Adams (1996, p. 63) state that some critical theorists consider that by undertaking such research: ... one is using the very process (current economics and accounting) that caused the problem (environmental crisis) to try to solve the problem. This is known as the process 683
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of ‘juridification’ and it is well established that one is unlikely to solve a problem by applying more of the thing which caused the problem.10
Although the above discussion indicates substantial disagreements (or even antagonisms) from some critical accounting researchers towards social and environmental accounting research, in recent years several social and environmental accounting researchers have made attempts to address the concerns expressed by these critical accounting researchers. However, there does not seem to have been much of a reciprocal movement by some critical accounting researchers towards recognising the potential impact that social and environmental accounting research may have had in reducing a variety of negative social and environmental externalities of some businesses. This lack of movement by some critical accounting researchers is implied, for example, in a statement by Tinker (2005, p. 124, footnote 18) that in selecting areas of accounting research for one of his critiques based on a Marxist approach to critical accounting, ‘Environmental research is another candidate; however as far as “the canon” is concerned I have little to add to the 1991 critique’ (Tinker et al., 1991). However, while many critical accounting scholars believe that social and environmental accounting scholars are naïve in simply seeking to alter existing practices, as this simply perpetuates and perhaps strengthens the existing inequitable social and political system, rather than seeking to overturn it, many social and environmental accounting scholars who recognise the inequities in the existing system take what they regard as a more pragmatic approach. They do not think that the demise of the capitalist system is likely in the short- to medium-term. Rather, they recognise that seeking to reform some of the ‘worst’ inequities in capitalism by engaging with, and winning the support of, key players in the business and political worlds is more likely to be successful in reducing some of the most damaging outcomes of business practices in the short- and medium-term. Unlike some critical accounting scholars, who appear to approach social change in dichotomous terms – either the existing system has to be overthrown or else no change is worthwhile – many social and environmental accounting scholars see the possibility for reform in terms of a spectrum ranging from no reform through to the critical scholars’ desire for fundamental change (Unerman and Bennett, 2004). Although some social and environmental accounting scholars do not appear to call for much, if any, reform to the existing role of business (these are often referred to as managerialist approaches, as they simply seek to develop social and environmental accounting practices that will help managers further the existing aims of their businesses), others draw on many insights provided by critical accounting researchers to help develop practices that reduce, as far as possible, some of the inequities and dysfunctionalities of the existing social, political and capital system. These researchers would argue that it is better to engage with businesses to seek to improve, through the development of new accounting practices, their social and environmental performance than simply critique the capitalist system while putting forward few (if any) practical proposals for how to improve the system. For example, Bailey, Harte and Sugden (2000), Lehman (1999, 2001), O’Dwyer (2005) and Unerman and Bennett (2004) are just some of the social and environmental accounting research studies that have touched upon issues and implications of differential power between organisations and different groups of stakeholders in accountability relationships.
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Similarly, we could make reference to emissions trading schemes (ETS), such as the European Union Emissions Trading Scheme, which is an example of a cap-and-trade system. As Deegan (2013) notes, the development of an ETS appears to be a case of using the very instrument that created the problem (the market which encourages production and therefore pollution as a byproduct) to then try to solve the problem (through market-traded pollution rights). Deegan (2013) also highlighted the somewhat strange situation associated with having a ‘right to pollute’ (the emission right) being presented as a financial asset that appears within a balance sheet.
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At a different (and less explicit) level, in the introductory chapter of a book of social and environmental accounting case studies aimed primarily at a readership of managers and practitioners, Hopwood, Unerman and Fries (2010, pp. 17–18) included the following argument that is informed by some ideas drawn from critical accounting perspectives: … without explicit connection within an organization’s reporting between financial and wider economic, social and environmental impacts, including an indication of the materiality of these impacts, it is easy for a company to convey a false sense of meaningful action on sustainability. Without this explicit connection, its sustainability reporting may focus on incremental changes in socially or environmentally immaterial impacts … There is a real difference between an organization genuinely striving to become sustainable and a company merely employing the rhetoric of sustainability in its external reports without much substance underlying this rhetoric … The latter type of company is unlikely to have information that would enable it to meaningfully report on its sustainability in a connected manner and may be using its external reporting as a form of greenwash.
Much more clearly drawing on core notions underlying critical accounting theory, the prominent and highly respected social and environmental accounting scholar, Rob Gray, published papers that theorise and/or analyse social and environmental reporting practices, at least in part, from a critical perspective (Tinker and Gray, 2003). For example, he argues that it is inappropriate and inaccurate for business organisations to describe their practices using the terms ‘sustainability’ or ‘sustainable development’ as these businesses and their practices are inherently socially and environmentally unsustainable (Gray, 2010). He argues that the terms ‘sustainability’ and ‘sustainable development’ have been captured and used by the powerful business sector to make their unsustainable practices appear safe, thereby protecting and enhancing the wealth of the owners of these corporations. Gray (2010, pp. 57–8) states: In the line-up of potential villains who might be charged with, if not causing, then significantly contributing to (un)sustainability, we have already seen modernity and to this we need to add modernity’s greatest spawn – capitalism. International financial capitalism has been identified as a principal component in (particularly) ecological destruction for much of the modern environmental movement’s history, (see, for example, Zimmerman, 1984, p. 153). Kovel (2002) offers a more strident critique of capitalism as the principal source of ecological destruction placing the nature of capitalism as ensuring that social justice and ecological destruction, are inevitable. Capitalism and its destructive tendencies are manifest through its greatest creation – the corporation (see, for example, Bakan, 2004). The corporation is placed at the heart of concern for three broad reasons. First, the nature of the publicly held corporation is such that its room for discretion is slight compared to the pressures upon it to deliver short-term financial return at virtually any price. Second, the corporation achieves this return through becoming a waste generating machine that thrives upon the ever expanding but increasingly fatuous consumption of wastefulness. Finally, the lobbying and legitimising powers of the corporation are turned towards civil society and the state to ensure that any tendencies to rein in or hold corporations to account is, at best muted (Bakan, 2004, Beder, 2006). Thus, we can place the organisation at the heart of our concerns about how sustainability is threatened, represented and manifested. As we see above, the increasingly seductive claims of the corporation to a state of sustainability are the natural deployment of simple discourse mechanisms to permit the organisation to pursue its psychopathic drives within capitalism. 685
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Having briefly explored the relationship between critical accounting research and social and environmental accounting research, we now turn to an examination of the impact of critical accounting research on accounting and business practices and on so-called ‘mainstream’ accounting research, including a discussion of some possible reasons for the marginalisation that many critical accounting scholars believe they experience.
Possible impact of critical accounting research on social practice LO13.3
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As previously explained, the critical perspective tends to be grounded in a ‘classical’ political economy perspective, and, as such, explicitly considers structural conflict, inequity and the role of the state at the heart of the analysis. By adopting a research (and, arguably, ideological) perspective that is often grounded in classical Political Economy Theory, critical accounting researchers can highlight particular issues that might not otherwise be addressed. According to Cooper and Sherer (1984, p. 208): Social welfare is likely to be improved if accounting practices are recognised as being consistently partial; that the strategic outcomes of accounting practices consistently (if not invariably) favour specific interests in society and disadvantage others. Therefore, we are arguing that there already exists an established, if implicit, conceptual framework for accounting practice. A political economy of accounting emphasises the infrastructure, the fundamental relations between classes in society. It recognises the institutional environment which supports the existing system of corporate reporting and subjects to critical scrutiny those issues (such as assumed importance of shareholders and securities markets) that are frequently taken for granted in current accounting research.
While a substantial amount of critical research is informed by the work of philosophers such as Marx, as we have already indicated, not all critical accounting research is based on a pure Marxist critique of capitalism. For example, reference is made by Owen, Gray and Bebbington (1997) to critical researchers who are identified as ‘deep ecologists’ and ‘radical feminists’. The ‘deep ecologists’ question the trade-off between economic performance and ecological damage – they question the morality of systems that justify the extinction of species on the basis of associated ‘economic benefits’. According to Gray, Owen and Adams (1996, p. 61): The essence of these views is that the very foundation – even the existence – of our economic (and social) system is an anathema. Put at its simplest, our economic system can, and does, contemplate trade-offs between, for example, the habitat of threatened species and economic imperatives. To a deep ecologist it is inconceivable that a tradeoff could have any form of moral justification. Such a view therefore challenges virtually every aspect of taken for granted ways of human existence, especially in the developed Western nations.11
The ‘radical feminists’, on the other hand, believe that accounting maintains and reinforces masculine traits, such as the need for success and competition, and that accounting as currently practised acts to reduce the relevance of issues such as cooperation, respect, compassion and so forth. As Gray, Adams and Owen (2014, p. 46) state:
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As we see in Chapter 10, the International Integrated Reporting Framework, now under the auspices of the International Sustainability Standards Board, contemplates situations where ‘natural capital’ can be eroded as part of efforts to enhance ‘financial capital’.
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The essence of this view is that our economic, social, political and business systems – and thus the language of business and accounting – are essentially ‘masculine’ constructs which emphasise, for example, aggression, traditional success, achievement, conflict, individualism, competition and so on. Our world thus denies a proper voice to, for example, compassion, love, reflection, cooperation, and other ‘feminine’ values … Such a view then suggests that there is an essential ‘sickness’ in much of what we take for granted. Even the way in which we think about apparently benign concepts like ‘social responsibility’ (for example) completely misses the point that this is no way for wise and compassionate human beings to organise their world.
The masculine versus feminine dichotomy was also discussed in Chapter 5, when various societal values were considered in the context of international accounting and how a country’s ranking in terms of ‘masculinity’ or ‘femininity’ in turn influenced the national accounting practices being adopted. According to Hofstede (1984, p. 84): Masculinity stands for a preference in society for achievement, heroism, assertiveness, and material success. Its opposite, Femininity, stands for a preference for relationships, modesty, caring for the weak, and the quality of life.
Researchers working with the feminist literature argue for the need for accounting to be less ‘masculine’ and more ‘feminine’ in orientation. According to Reiter (1995, p. 35): Feminist theory has many voices, and the considerable volume of feminist criticism published to date represents many different viewpoints. In the late 1980s, accounting scholars began exploring the idea that feminist theory could be used to critique accounting.
In relation to economic theory, on which much accounting theory is developed, Reiter (1995, p. 40) states: Economic theories tend to value the characteristics associated with masculine stereotypes such as abstraction, mind, efficiency, equilibrium, rationality, pursuit of self-interest, and autonomy. The opposite characteristics of concretism, body, randomness, humanity, mutuality and connectedness, which are associated with feminine stereotypes, are missing from economic theory.
In explaining how the incorporation of feminist values in economic theory could potentially lead to a more promising theory (and a better society), Reiter (1995, p. 47) states: Folbre and Hartmann (1988) explain that ‘a growing body of interdisciplinary feminist research complements the efforts many economists are making to develop a more complete theory of economic interests, one that can encompass concepts like cooperation, loyalty and reciprocity’ (p. 197). Nelson (1992) suggests that incorporation of positive feminine qualities such as flexibility, intuition, humanism and connectedness of individuals and the concept that individual choice is influenced by societal and cultural factors would lead to increased richness and applicability of economic theory. She also argues that the exclusive focus of neo-classical economics on problems of exchange is also a denial of the feminine quality of need … The view of economic behaviour incorporated in financial economic theories such as agency theory concentrated on conflict and discipline rather than on productive activity and mutuality of interests. A single goal (profit maximisation) benefiting a single group (shareholders) is promoted rather than a multiplicity of goals benefiting all parties. Suppose in contrast that we concerned ourselves with modes of co-operation
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between shareholders and managers to promote development of quality products and services and the skills to thrive in the complex international markets of the twentyfirst century? A different set of concepts and metaphors would be appropriate, and a different view of the roles of capital markets and accounting information would be needed.
Some researchers, such as Molisa (2011), have also suggested that issues of ‘spirituality’ should be used to inform the practice of accounting and accounting research. Spirituality would incorporate notions of love, care and respect, and it is argued that ‘corporate accountability’ should incorporate such notions. We can contrast such ideas with the fundamental qualitative characteristics espoused by the IASB Conceptual Framework (relevance and representational faithfulness). In adopting positions and/or pursuing outcomes that are at variance with the dominant capitalist ideology (whether motivated by a pure Marxist position or, as is the case with many critical accounting researchers, other philosophical positions, such as the deep ecologists, the radical feminists or those who embrace a more ‘spiritual’ perspective), critical theorists provide arguments that are often driven by a desire to create a climate for change in social structures. By arguing for a change in the status quo, it has been suggested that ‘critical researchers’ are often marginalised to a greater extent than researchers adopting other theoretical or ideological perspectives (Baker and Bettner, 1997). Another possible basis of some of this ‘marginalisation’ is that critical theorists often do not provide solutions to what they see as perceived problems (Sikka and Willmott, 2005). That is, they are often ‘critical’ without providing direct guidance on how the perceived problems can be solved.12 For example, Owen, Gray and Bebbington (1997) argue that critical analysis alone is perhaps not enough. As they state (p. 183): Restricting one’s activities to critique, rather than actively seeking to reform practice, we would suggest, poses a minimal threat to current orthodoxy. Thus, Neu and Cooper (1997) are led to observe that: ‘while critical accounting scholars have illuminated the partisan functioning of accounting, we have been less successful in transforming accounting (and social) practices’ (p. 1).
Further, Sikka and Willmott (2005, p. 142) state that: Marxist traditions must continuously be renewed through lived experiences and opposition to institutions of oppression and exploitation in an effort to enable human beings to live less brutalized and destructive lives. But how are the agents of such change to be galvanized? While there is a role for scholarship and related forms of rarefied intellectual engagement with radical ideas, this activity should not displace principled involvement in the mundane world of practical affairs.
Accountants are often trained to provide information to solve particular (predominantly economic) problems; hence, ‘culturally’ many accountants might be conditioned against criticism that does not provide a solution. Reflecting on the ‘attitudes and orientations’ of accountants, Cooper and Sherer (1984, p. 222) state: 12
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From a research perspective, and as already noted elsewhere within this chapter, it has also been argued that critical theorists have been marginalised because they do not tend to use mathematical modelling and statistical analysis, both of which have become (to many researchers, as well as to a number of editors of accounting journals) part of accepted accounting research. As Hopper et al. (1995, p. 532) state: ‘Critical researchers emphasise the social embeddedness of accounting practice, consequently, they tend to neglect mathematical modelling, preferring detailed historical and ethnological studies of structures and processes which help identify societal linkages to show that accounting is not merely a technically rational service activity but plays a vital role in effecting wealth transfers at micro-organisational and macro-societal levels (Chua, 1986).’
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A critical approach to accounting, however, starts from the premise that problems in accounting are potentially reflections of problems in and of society and accordingly that the latter should be critically analysed. Thus, if a major problem in accounting is identified, say as its overwhelming orientation to investors, then a critical perspective would suggest that this problem is a reflection of society’s orientation and to change accounting practice requires both social awareness (e.g. identification of alternative ‘accounts’ and the roles of accounting in society) and ultimately social change. Whether critical theory can in practice be applied to accounting research depends on whether researchers can free themselves from the attitudes and orientations which result from their social and educational training and which are reinforced by the beliefs of the accounting profession and the business community. For this socialisation process has produced accounting researchers who may exhibit subconscious bias in the definition of the problem set of accounting and the choice of theories to analyse and solve these problems. The criterion of critical awareness involves recognising the contested nature of the problem set and theories and demystifying the ideological character of those theories.
Critical theorists are often strong in their condemnation of accountants, and this in itself could provide a basis for some of the marginalisation that many believe they experience. Consider this statement by Tinker, Lehman and Neimark (1991, p. 37): The enduring nature of this ‘Radical Critique’ is attributable to the persistence of the underlying social antagonisms, to which it attempts to speak, and the complicity of accountants, which it seeks to elucidate.
More specifically, Sikka and Willmott (2005, p. 138) explain that some of the critical accounting studies in which they have been involved have: ... shown that [some accountancy professional associations] have a long history of opposing reforms which arguably would have advanced the accountability of major corporations (Puxty, et al., 1994); that accounting technologies play a major part in the exploitation of workers (Sikka, et al., 1999); and that the accountancy industry is engaged in a ruthless exploitation of citizens (Cousins, et al., 2000). We have also sought to mobilise opinion by holding a mirror to the accountancy trade associations and argue that their claims of ethics, integrity etc. are little more than rhetorical garnishes, and that neither their policies nor their actions come anywhere near their self-representations (Cousins, et al., 2000, Mitchell, et al., 1994, Puxty, et al., 1994, Willmott, 1990).
In reflecting on the quote from Sikka and Willmott (2005), reference can be made to a 2005–06 Australian Government inquiry by the Parliament of Australia Joint Committee on Corporations and Financial Services into corporate social responsibility, and, specifically, whether specific social responsibilities should be included within the Corporations Act 2001. Within the terms of reference of the inquiry, the government solicited views about whether corporate social responsibilities and associated reporting should be regulated. Sikka and Willmott claimed that some accounting professional associations ‘have a long history of opposing reforms which arguably would have advanced the accountability of major corporations’, so it is interesting to note that all three major accounting professional bodies within Australia (Chartered Accountants Australia and New Zealand, the Institute of Public Accountants and CPA Australia) made submissions which stated they were opposed to mandating corporate
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social responsibility disclosures. They referred to such factors as the effectiveness of corporate self-regulation and the disciplining mechanisms of the capital market as providing the basis for ensuring that companies move towards doing ‘the right thing’. Referring to its own research, CPA Australia (2005, p. 6) stated: While there is strong public (88%) and shareholder (86%) support for Government to mandate the reporting of companies’ social and environmental reporting this is not reflected in the views of business leaders (53%). CPA Australia believes this reflects a valid business concern that mandatory reporting would not enhance the value of the information provided and introduce an unnecessary layer of regulation.
To a critical theorist, such comments would coincide with their views that accounting practices, and the accounting profession itself, operates to support the views of ‘business’. CPA Australia further stated (p. 9): ‘A proactive approach towards voluntarism from business negates the risk of attracting excessive and inflexible regulations’. Again, from a ‘critical perspective’, such comments support a view that the accounting profession primarily promotes a position that favours business entities rather than promoting broader accountability to stakeholders other than corporate shareholders. In further considering the quote from Sikka and Willmott, accountants are being informed by the critical theorists that they are complicit in relation to ‘social antagonisms’, ‘exploitation of workers’ or ‘a ruthless exploitation of citizens’. This is not something that is likely to be seen in a favourable light by many accountants and accounting researchers. It is confronting. However, although accountants might elect not to agree with what a number of the critical theorists are saying (perhaps because of profound ideological differences), it is nevertheless useful, perhaps, for accountants to put themselves under scrutiny from a broader societal perspective. The critical theorists encourage such scrutiny. A review of the academic literature shows that a number of critical theorists have been vocal critics of research that has adopted Positive Accounting Theory (PAT) as its theoretical basis, as well as being critical of related capital markets research (this issue is looked at more closely later in the chapter). PAT focuses on conflicts between what might be construed as ‘powerful’ groupings within society (for example, owners, managers and debtholders) and does not consider conflicts between these powerful groups and parties that have less ability to impact on the wealth of such powerful parties. Many critical theorists have also been particularly critical of the anti-regulation stance, often advocated by Positive Accounting Theorists, because such a stance further advances the interests of those with power or wealth (for example, owners of corporations because lack of regulation enables the power and wealth of capital to be exercised largely unhindered by anything other than market forces, which operate to the benefit of many powerful businesses), while undermining the interests of those who might need some form of regulatory protection. Critical theorists would also argue that in assessing the usefulness of accounting information, we really need to look beyond capital market (share price) reactions. The capital market response is driven (obviously) by those with capital. Capital market studies ignore ‘other voices’. We now turn from an examination of the role and possible impact of critical accounting theorists to a consideration, informed by critical accounting theory, of perspectives about the role of the state, accounting research and, ultimately, accounting practice in supporting current social structures (and inequalities). Again, as has been emphasised throughout this book, the views that are presented are those of a subset of the research community. There will be other ‘subsets’ of the research community that challenge such views.
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Why do I need to know about alternative (critical) perspectives about the role of the accounting profession? Why
We are conditioned through our education, workplace and professional affiliations to accept, perhaps, that the accounting profession operates in the ‘public interest’. Arguably, it is naïve to believe this will always be the case. Critical theorists encourage us to question the view that professions will always act in the public interest. Such questioning is essential if we
really want a more just society. The insights provided by critical theorists encourage us to not take for granted that the policies and standards being released or supported by the accounting profession will provide benefits to stakeholders other than those directly related to the capital market.
REFLECTION QUESTION 13.4 The role of research in influencing practice Question Is it realistic to believe that accounting research influences accounting practice and that such influences can ultimately lead to improved social structures and outcomes?
Solution This is a matter of opinion, but it does seem to make sense that research, if promoted properly, can ultimately impact practice. If accounting practices change, and if they prioritise different aspects of performance and different stakeholders,
Reflection
then this might change the way organisations are structured and operated. Many researchers accept, as part of what they do, the duty to improve practices. How they improve them, and for whom they improve them, will be influenced by the world views and philosophies held by the researchers. Most critical accounting theorists would see the role of their research as being to change existing practices and social structures, although the degree to which this happens will be influenced by how they promote their work to the broader society.
The role of the state in supporting existing social structures LO13.5
Researchers working within the critical perspective typically see the state (government) as being a vehicle of support for the holders of capital (for example, shareholders), as well as for the capitalist system as a whole. Under this perspective, a government will undertake various actions from time to time to enhance the legitimacy of the social system, and thereby protect and advance the power and wealth of those who own capital, even though it might appear (to less critical eyes) that the government was acting in the interests of particular disadvantaged groups. Consistent with this, Andrew and Baker (2020, p. 3) note: In effect, within democracies, the state is expected to function as a representative of the people, but increasingly acts as an ‘administrative agent ... that protect(s) capital against the popular classes’ (Durand, 2014, p. 39). This involves ‘strategic selectivity’ and has been referred to as a ‘national-popular programme’ (Jessop, 1990, p. 209), in which the ‘national-popular’ is linked to particular ‘economiccorporate interests’ (Jessop, 1990, p. 209). Examples of these programmes might include the use of public money to bail out banks at times of financial crisis, public policy supporting private provision of social services such as healthcare, education and corrections, and the use of various state powers to ensure private firms have access to natural resources.
These critical theorists would therefore reject theories of regulation, such as public interest theory, which was discussed in Chapter 4. For instance, a government might impose mandatory 691
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disclosure requirements for corporations in terms of the disclosure of information about how the corporations attend to the needs of certain minorities or the disabled. Arnold (1990) argues, however, that such disclosures (which, on average, really do not cause excessive inconvenience for organisations) are really implemented to pacify the challenges, for example by or on behalf of particular minorities, that may be made against the capitalist system in which corporations are given many rights and powers. Relating this perspective to the development of various securities acts throughout the world, Merino and Neimark (1982, p. 49) contend that ‘the securities acts were designed to maintain the ideological, social, and economic status quo while restoring confidence in the existing system and its institutions’. Within the Australian context, it is interesting to note that a chief executive officer of one of Australia’s largest companies conceded that corporate regulations overwhelmingly support the interests of the owners of capital (shareholders) rather than stakeholders generally. Frank Cicutto, then chief executive officer of National Australia Bank, stated:13 In recent decades the efficient use of shareholder funds has been carefully protected by the creation of the Australian Securities and Investments Commission (ASIC) and the continuing development of the Australian Stock Exchange (ASX) listing rules. In a regulatory sense the focus of legislative change has been around accountability to investors rather than to the community.
It is generally accepted that to make informed decisions an individual or groups of individuals must have access to information. Restricting the flow of information, or the availability of specific types of information, can restrict the ability of other parties to make informed choices. Hence, restricting available information is one strategy that can be employed to assist in the maintenance of particular organisations and social structures. Puxty (1986, p. 87) promotes this view by arguing that: ... financial information is legislated by the governing body of society (the state) which is closely linked to the interests of the dominant power group in society (Miliband, 1969, 1983, Offe and Ronge, 1978) and regulated either by agencies of that state
REFLECTION QUESTION 13.5 Government support for accounting practices Question Why would the state (government) support accounting practices and related structures that appear to support stakeholders such as investors, but appear to undermine the interests of other stakeholders?
Solution In answering this question, we can link our answer into other theories examined in this book. For example, in Chapter 4 we discussed the ‘economic interest group theory of regulation’. In this theory, government officials and regulators were assumed to act in their own selfinterest and will support particular regulations and economic structures that benefit their own self-interest, such as their quest to be re-elected. It is generally accepted that investors, as a group, have large resources
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in their control that help re-election campaigns. Government will therefore support them. Something to consider is that if a group of researchers, such as some critical theorists, believe that regulators, investors, managers, accounting professions and so forth fixate on their own interests and the interests of other ‘elites’ within society, then how is this ‘self-interest cycle’ ever broken? How can we get fairer societies when we believe that people try to undermine others for advantage? If some workers can advance to management status, are they then expected to be like all other managers in trying to expropriate the wealth of the workers they have left behind? As has been stressed in this book, when evaluating various theories, we need to consider the inherent assumptions made by the researchers (for example, about human motivations) and then determine whether we are able to accept such assumptions.
As quoted in the Journal of Banking and Financial Services, December 2002, p. 17.
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or by institutions such as exist within societies like the United Kingdom, United States, and Australia that are linked to the needs of the dominant power group in partnership with the state apparatus (albeit a partnership that is potentially fraught with conflict).
Hence, we are left with a view that government does not operate in the public interest but in the interests of those groups that are already well off and powerful.14 Apart from the state and the accounting profession, researchers and research institutions have also been implicated as assisting in the promotion of particular (inequitable) social structures. Some of the arguments that have been advanced to support this view are now considered.
The role of accounting research in supporting existing social structures LO13.3
LO13.6
Rather than thinking of accounting researchers as being relatively inert with respect to their impact on parties outside their discipline, numerous critical theorists see many accounting researchers as providing research results and perspectives that help to legitimise and maintain particular political ideologies. Again, this is a different perspective from what most accountants, accounting researchers and accounting students would be used to.
Accounting research and support for deregulation of accounting As an example, in the late 1970s and in the 1980s there were moves by governments around the world towards deregulation. This was particularly the case in the United States and the United Kingdom. Around this time, researchers working within the PAT framework, and researchers who embraced the Efficient Markets Hypothesis (EMH), came to prominence.15 These researchers typically took an anti-regulation stance, a stance that matched the views of governments of the time. Coincidentally, perhaps, such research, which supported calls for deregulation, tended to attract considerable government-sourced research funding.16 As Hopper et al. (1995, p. 518) state: Academic debates do not exist in a vacuum. It is not enough for a paradigm to be intellectually convincing for its acceptance, it must also be congruent with prevailing powerful beliefs within society more generally. The history of ideas is littered with research that was mocked but which subsequently became the dominant paradigm when other social concerns, ideologies and beliefs became prevalent. The story of PAT can be told in such terms. Its rise was not just due to its addressal of academic threats and concerns at the time of its inception, but it was also in tandem with and connected to the right wing political ideologies dominant in the 1980s.
Mouck (1992) also adopts a position that argues that the rise of PAT was made possible because it was consistent with the political views of those in power (that is, the state): ... the credibility of Watts and Zimmerman’s rhetoric of revolt against government regulation of corporate accountability was conditioned, to a large extent, by the
Contrast this with the view provided by public interest theory – a theory of regulation described in Chapter 4 and in which it is argued that government puts in place rules and regulations for the benefit of society generally. 15 According to Tinker, Merino and Neimark (1982), researchers within the PAT and EMH paradigms adopted ‘a neoconservative ideological bias that encourages us to take the “free” market and implicit institutional apparatus as given’. PAT and EMH were discussed in Chapters 8 and 11, respectively. 16 Consistent with this perspective, in 1979 Milton Friedman, a leading advocate of deregulation, became a senior adviser to US President Reagan. 14
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widespread, ultra-conservative movement toward deregulation that was taking place in society at large ... I would argue that accountants have been willing to accept the PAT story, which is built on Chicago’s version of laissez faire economics, because the rhetoric of the story was very much attuned to the Reagan era revolt against government interference in economic affairs.
Consistent with the development of PAT, in the late 1970s a great deal of accounting research sought to highlight the economic consequences of new accounting regulation. This perspective (which was considered in Chapters 3 and 4) argues that the implementation of new accounting regulations can have many unwanted economic implications, and hence before a new requirement such as an accounting standard is mandated, careful consideration is warranted. Economic consequences analysis has often provided a rationale for not implementing accounting regulation. Critical researchers have argued that it was the economic implications for shareholders (for example, through changes in share prices) and managers (for example, through reductions in salary or loss of employment) that were the focus of attention by those who researched the economic consequences of accounting regulation. As Cooper and Sherer (1984, pp. 215, 217) argue: It seems unfortunate, however, that the ‘rise of economic consequences’ (Zeff, 1978) seems to have been motivated, at least in the United States, by a desire of large corporations to counter attempts to change the existing reporting systems and levels of disclosure. To date, it would seem that accounting researchers have generally reiterated the complaints of investors and businessmen about the consequences of changes in required accounting practice. Studies using ECA (economic consequences analysis) have almost invariably evaluated the consequences of accounting reports solely in terms of the behaviors and interest of the shareholder and/or corporate manager class (Selto and Neumann, 1981). ... More fundamentally, studies adopting the ECA approach have focused their attention on a very limited subset of the total economy, namely, the impact on the shareholder or manager class. The effects of accounting reports directly on other users, e.g. governments and unions, and indirectly on ‘non-users’, e.g. consumers, employees, and taxpayers, have been ignored. The basis of such a decision can, at best, be that any such effects are either secondary and/or lacking in economic significance. Thus, these studies have made an implicit value statement that the needs of the shareholder and manager class are of primary importance and the concentration on those needs is sufficient for an understanding of the role of accounting reports in society. Unless the insignificance of the effects on other users and ‘non-users’ is demonstrated rather than merely assumed, the conclusion from this research cannot be generalised for the economy as a whole and these studies are insufficient for making accounting prescriptions intended to improve overall social welfare.
Apart from indicating that economic consequences research focused predominantly on the economic implications for managers and shareholders, Cooper and Sherer (1984) also note that major studies that adopted this paradigm were funded by the US Securities and Exchange Commission and the US Financial Accounting Standards Board. It was considered that the interests of these bodies were aligned with the ‘shareholder and manager class’, rather than society as a whole. In a similar vein, Thompson (1978) and Burchell et al. (1980) suggest that the research efforts into inflation accounting in the 1960s and 1970s, which we discussed in Chapter 6, were not actually motivated by the rate of inflation per se. Instead, they argue that the research had 694
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been motivated by a desire to alleviate the shifts in real wealth away from owners (in the form of lower real profits and dividends) and towards higher wages.17 If research gains prominence because it supports the particular political beliefs of those in power, we might assume that as the views of those in ‘power’ change so will the focus of research. During the 1990s many governments around the world tended to move away from deregulation. Reflecting on this, Hopper et al. (1995, p. 540) noted: The environment is continually being reconstituted within changing economic and political conditions. Accordingly, the ability of PAT to resonate with the prevailing discursive climate may be subject to challenge ... Following the removal of the Republican government in the USA, this particular period and form of conservative reform may have ended. In the USA President Clinton is [was] adopting a more interventionist strategy and in the UK, the Major regime claims [claimed] to espouse an alternative ‘caring society’, albeit with market forces, in contrast to the harsher face of Thatcherism. In the 1990s a new set of values may be emerging which do not emphasise so greatly the efficiency and effectiveness of unregulated markets, for example, ecology, health care in the USA, gender issues. The ability of PAT to resonate with this changed environment may be brought into question; for example, the consecutive failure of some business enterprises and the stock market crash of 1987 augmented the call for more regulation.
A critical accounting interpretation of increased accounting regulation post-Enron Despite the election of what many people considered to be a highly pro-business and antiregulation (former) Republican president (George W. Bush) and government in the United States at the beginning of the twenty-first century, and their re-election at the end of 2004, few governments (including the US Government) have reversed the 1990s trend against the deregulation of accounting. Although the Bush government initially made moves towards greater deregulation of accounting, this policy direction was reversed following public revelations about the large-scale accounting failures (or abuses) at Enron, WorldCom and several other large US corporations in 2001 and 2002, and the apparent complicity of Enron’s auditor, Andersen, in some of these failed and damaging accounting practices. Despite any existing governmental desire there may have been to empower large corporations further by deregulating accounting practices, Unerman and O’Dwyer (2004) argue that these highly publicised accounting failures led to a considerable reduction in the trust placed by many investors and workers in both accounting practices and, more importantly, the reliability of capital markets as a medium for investment. One reaction of many governments throughout the world to these corporate and accounting failures was to increase the regulation of accounting and corporate governance, in an attempt to rebuild trust in the reliability of accounting information and in the capital markets, which are supposedly dependent on the claimed reliability of this accounting information. From a critical perspective, this increase in regulation would be regarded as serving the needs of large corporations (rather than protecting other stakeholders), as it was aimed at sustaining investor trust in the capital markets on which large corporations rely.
17
Attributing such a motivation to all people who researched a particular topic, however, is somewhat simplistic. Again, we must remember that critical researchers openly adopt a very subjective (partisan) approach to their analysis and this is reflected at times in the generalised nature of some comments and critiques. In Chapter 6 we discussed the works of Ray Chambers and his prescriptions for accounting that were particularly pertinent in times of rising prices. It is very questionable whether Chambers had any interest in undermining the interests of workers.
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The damaging impact of accounting failures at Enron, followed by highly publicised accounting failures over a relatively short period of time at several other large corporations – in North America, Australia and Europe (for example, Parmalat in Italy, Ahold in the Netherlands, Adecco in Switzerland and One.Tel and HIH in Australia) – could be regarded by critical accounting scholars as just another symptom of the inherent instability of the capitalist system (as discussed earlier). These researchers would tend to argue that any actions taken to prevent a reoccurrence of this latest symptom of the structural conflicts inherent in capitalism (accounting failures) misses the point that it is the capitalist system itself which is flawed, and the only way to prevent other (different) failures emerging in the future is to replace the capitalist system with a different system in which the weak (employees, the environment, many sections of society) are not exploited by the powerful (large corporations and the governments they support). Several researchers have indeed examined the early twenty-first-century accounting failures at Enron and other large corporations, and/or the regulatory reaction to these failures, from a variety of critical perspectives (see, for example, Arnold and De Lange, 2004; Baker, 2003; Briloff, 2004; Craig and Amernic, 2004; Froud et al., 2004; Fuerman, 2004; O’Connell, 2004; and Williams, 2004).
A critical accounting view on the active role of academic and non-academic discourse in protecting capitalism In another area, some critical theorists have implicated the editors of accounting journals in ensuring that accounting research does not challenge the interests of dominant groups in society, arguing that these editors will reject research that does not have ‘complementarity with themes prevailing in the social milieu’ (Mouck, 1992). In relation to the role of accounting journals, Tinker, Lehman and Neimark (1991, p. 44) state: Accounting literature represents the world in a manner conducive to the changing needs of capital accumulation. Journals such as Accounting Review adjudicate in secondary conflicts by filtering research, scholarship (and untenured scholars) in a manner conducive to this primary purpose. The hostility of this journal to even the tamest ‘deviants’ is well known.18
Throughout the world there are also government-backed programs that rank the quality of research undertaken within universities. As part of such exercises, various panels are established to rank the quality of different research journals. For example, within Australia a group known as the Australian Business Deans Council (ABDC) developed the ABDC Journal Quality List, and the rankings of university academics’ journal-based publications are assessed against the ABDC rankings. As Andrew, Cooper and Gendron (2020) note, the background and beliefs of panel members, which will be impacted by their views about the roles of government, professions, capital markets and so forth, will influence the rankings. Overwhelmingly, these panels have tended to be dominated by supporters of capital markets research and positivistic accounting research, and they have tended to rank lowly journals that publish research of a more qualitative
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In recent years, however, it does appear that more research of a critical nature is being published within some leading accounting journals. One journal that has been in existence for a number of years and that publishes various ‘critical’ papers is Critical Perspectives on Accounting. According to the journal (as per its ‘Instructions to Authors’), it ‘aims to provide a forum for a growing number of accounting researchers and practitioners who realize that conventional theory and practice is ill-suited to the challenges of the modern environment, and that accounting practices and corporate behaviour are inextricably connected with many allocative, social and ecological problems of our era. From such concerns, a new literature is emerging that seeks to reformulate corporate, social and political activity, and the theoretical and practical means by which we apprehend and affect that activity.’
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and critical nature. As editors of the journal Critical Perspectives on Accounting, Andrew, Cooper and Gendron (2020) sought information from the ABDC about why the journal was not ranked in the highest band of research quality. No direct reasons were given to the editors, other than the response from the ABDC that the research published in the journal ‘did not meet the quality threshold for inclusion at “A*”’ (Andrew, Cooper and Gendron, 2020, p. 2). The journal was assessed to be at the ‘A’ level of quality, which was the second-highest ranking possible. Many critical theorists believe that these government-related rankings exercises marginalise research that questions current social and economic systems. Other research in critical accounting demonstrates that it is not just academic discourse that is biased in a manner designed to support the interests of capitalism. For example, Collison (2003) characterises as propaganda many of the justifications that are given by organisations operating in the corporate sector in support of existing business and accounting practices, where subjective values (biased in the direction of furthering the power and wealth of capital) are portrayed as objective facts. He argues (p. 853): The effect of this use of propaganda ... is to buttress the hegemony of discourse ... in which the contestable values that are often implicit in the practices and terminology of accounting and finance are treated as though they are uncontentious ... [and that propaganda is] a tool that can be used by powerful interests, often covertly, to support and proselytise a prevailing ideology.
Developing this theme of accounting being used as a tool to ‘objectify’ subjective views, our analysis moves to the critical theorists’ perceptions of the role of accounting practice in supporting existing social structures.
Why do I need to know about the potential role accounting research has in supporting or legitimising existing (and potentially unfair) practices? Why
As we have noted previously, Gaffikin (2010) was of the opinion that accounting researchers tend to avoid ‘meaningful selfreflection’ and fail to question ‘the very essential features and assumptions of their discipline’. Gaffikin (2009) also claimed that accounting research generally operates in an ‘intellectual vacuum because it has ignored the crucial need for self-reflection’. Understanding the role that accounting research plays in potentially supporting existing practices means that, as
researchers, we need to reflect upon whether we believe the current ordering of society, complete with its usual accounting practices, is just and equitable. If we believe there are many problems within society, we need to think whether, and how, the accounting practices we are researching perhaps support the status quo. The argument is that there is no point refining an instrument that was only designed to cause damage to particular stakeholders. Rather, very different ‘instruments’ are required.
The role of accounting practice in supporting existing social structures LO13.6
As we learned in Chapter 7, when we addressed the IASB Conceptual Framework for Financial Reporting (which we classified as a normative theory of accounting), the Conceptual Framework has a number of ‘fundamental’ and ‘enhancing’ qualitative characteristics that useful financial information should possess. One of the fundamental qualitative characteristics is ‘faithful representation’ (the other fundamental qualitative characteristic being ‘relevance’). Faithful representation requires that information should ideally be complete, neutral and free from error. This is consistent with the generally accepted view that accounting information should be ‘objective’ – something that is promoted by professional accounting bodies internationally as
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being an important and valuable attribute of the accounting profession. Accounting is projected as providing an objective representation of underlying economic facts.19 However, a number of critical theorists see a different role for conceptual frameworks: a role that involves legitimising the accounting profession, as well as the financial statements produced by reporting entities. Hines (1991, p. 328) states: Conceptual Frameworks (CFs) presume, legitimise and reproduce the assumptions of an objective world and as such they play a part in constituting the social world ... CFs provide social legitimacy to the accounting profession. Since the objectivity assumption is the central premise of our society ... a fundamental form of social power accrues to those who are able to trade on the objectivity assumption. Legitimacy is achieved by tapping into this central proposition because accounts generated around this proposition are perceived as ‘normal’. It is perhaps not surprising or anomalous then that CF projects continue to be undertaken which rely on information qualities such as ‘representational faithfulness’, ‘neutrality’, ‘reliability’, etc., which presume a concrete, objective world, even though past CFs have not succeeded in generating Accounting Standards which achieve these qualities. The very talk, predicated on the assumption of an objective world to which accountants have privileged access via their ‘measurement expertise’, serves to construct a perceived legitimacy for the profession’s power and autonomy.
The role of accounting reports in creating a selective ‘reality’ Hines (1988) argues that accountants impose their own views about which performance characteristics are important and thereby require emphasis (for example, ‘profits’). Accountants also decide which attributes of organisation performance are not important, and therefore are not worthy of measurement or disclosure. Through the practice of accounting, attention will be directed to the particular measures the (apparently objective) accountant has emphasised and, in turn, these measures will become a means of differentiating ‘good’ organisations from ‘bad’ organisations. For example, if ‘profits’ are promoted as an objective measure of organisational performance, then people will focus on profits as calculated by the accountant, and a profitable company will be deemed to be a good company and a loss-making company will be deemed to be a bad company. This is despite the fact that ‘profits’, as determined by the accountant, will ignore many social and environmental externalities caused by the business (as discussed in Chapter 10). For example, if the organisation emits pollution but there are no costs or fines attached to the emissions, no expenses will be recognised despite the damage to the environment and society that is potentially being caused by the emissions. Hines argues that in communicating reality accountants simultaneously construct reality. Hence, for example, the failure to account for the effects of pollution emissions means that for many people such emissions are non-existent. They do not appear in the accounts of the company’s performance. If the accountant put a cost on such emissions, they would become ‘real’, and the organisation would become accountable. Accounting provides a selective visibility for particular issues within an organisation and accounting dictates which financial issues are ‘significant’ (Carpenter and Feroz, 1992). Cooper, Hayes and Wolf (1981, p. 182) also adopt this perspective in stating:
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This is consistent with the argument provided by Solomons (1978) that to increase the usefulness of accounting reports they should be as objective as cartography. That is, just as an area can be objectively ‘mapped’, so can the financial position and performance of an organisation.
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Accounting systems encourage imitation and coercion by defining the problematic (by choosing which variables are measured and reported) and they help to fashion solutions (by choosing which variables are to be treated as controllable). Of course, the way accounting systems are used is highly significant, but nevertheless the structure and elements of accounting systems help to create the appropriate and acceptable ways of acting, organising and talking about issues in organisations. Accounting systems are a significant component of the power system in an organisation.
Also reflecting the view that accounting makes certain things visible, and can act to obscure other things (that nevertheless might be important in terms of related impacts upon society), Broadbent (2002, p. 438) states: Hence the visibilities that accounting creates are important as they are implicated in the political and ideological processes of society – they create visibilities (Hopwood, 1984) and those visibilities are partial (Broadbent, 1995). The visibilities are linked to various sets of interests. Current constructions of accounting are arguably linked to the interests of capital and can also be seen as patriarchal, although this is not inevitable as the ‘realities’ that are created are mutable (Guthrie & Parker, 1999).
In exploring the role of accounting reports in ‘constructing’ particular ‘realities’, Macintosh and Baker (2002) and Macintosh (2001) draw on developments in literary theory and argue that accounting reports can be viewed as a form of literary text/document. They demonstrate that in literary theory the ‘expressive realism’ notion that a text is an objective reflection of an underlying reality – that a novel, for example, ‘acts like a mirror to reflect reality’ (Macintosh and Baker, 2002, p. 189) – has long been regarded as highly problematic, and they draw on these criticisms from literary theory to demonstrate how similar assumptions of accounting reports objectively reflecting an external economic reality are equally problematic (p. 192):
Expressive realism In literary theory, it is the notion that a text is an objective reflection of an underlying reality.
... the common sense view of accounting assumes that the financial reality of an enterprise is ‘out-there’ prior to its capture in accounting reports. The proper way of ascertaining this reality is thought to be with objective and verifiable measurement processes. This realist correspondence view of the accounting assumes the financial reality of a corporation exists independently of accountants, auditors, and accounting reports. Yet accounting runs up against the same problem that undermined expressive realism [in literary theory]. Different equally qualified professional accountants come up with different financial statements for identical transactions and events.
Macintosh (2001) and Macintosh and Baker (2002) use different paradigms in literary theory to analyse and explain the subjectivity of accounting reports, and the partial views of reality constructed by these reports. They argue that any accounting report will tend to present selective and biased information in a manner designed to lead to the construction of a single view of the underlying reality, with this view being the one that most favours management and providers of capital. These academics argue, based on poststructuralist literary theory, for the need for accounting reports to change so that they contain a sufficient variety of information to enable different users of accounts to see different, sometimes contradictory, views of the reality underlying the business, rather than accounting information being selectively presented in an objectified manner to ‘force’ a single partisan view of the business.
The power of accountants through a false image of neutrality For those people who have not previously considered accountants in the same light as do the critical theorists, there may be some form of bewilderment. How can accountants have so much 699
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power? In part, some arguments for this issue have been provided in the discussion above. The accounting profession is portrayed (through such vehicles as conceptual frameworks) as being objective and neutral – that is, free from any form of bias. Such characteristics (if true) are apparently beyond reproach. In fact, accountants are perceived as so objective and neutral that they have a reputation for being very dull. But if we are to believe the critical theorists, this ‘dullness’ is a façade that perhaps hides a great deal of social power.20 As Carpenter and Feroz (1992, p. 618) state: ... accounting may be viewed as a means of legitimising the current social and political structure of the organisation. Hopwood (1983) further suggests that the legitimising force of accounting derives in part from the apparently dull, unobtrusive, and routine nature of accounting procedures, which generate an aura of objectivity and legitimacy in the eyes of financial statement users. Far from being dull and routine, accounting and accountants can and do take sides in social conflicts.
Tinker, Merino and Neimark (1982, p. 184), argue: This image of the accountant – often as a disinterested, innocuous ‘historian’ – stems from a desire to deny the responsibility that accountants bear for shaping subjective expectations which, in turn, affect decisions about resource allocation and the distribution of income between and within social classes. The attachment to historical facts provides a veneer of pseudo-objectivity that allows accountants to claim that they merely record – not partake in – social conflicts.
Because of the apparent objectivity and neutrality of accounting, and accountants, the output of the accounting system (such as ‘profits’ or ‘losses’) can be used as justification for undertaking certain actions which might cause hardship for some less powerful groups. For example, declining ‘profits’ (which we know are calculated following various professional judgements made by accountants) might be used as a justification for reducing the size of the workforce in a particular company.21 As Broadbent (2002, p. 439) states: The existence of accounting, at the same time, provides the opportunity for disembedding – how much easier it is to legitimize the reduction of jobs through the existence of financial losses than it is to think about the effects on the individuals affected. Giddens goes on to argue that the disembedding of systems relies on the existence of trust. Accounting paradoxically provides a means of legitimating trust by being able to provide ‘accounts’ and accountants are the ‘experts’ who mediate that system. Seal and Vincent-Jones (1997) provide a view of the role of accounting in the development of trust in the development of new relationships when contracts are developed. Finally, accounting produces systematic information that is seen as integral to the reflexive development of knowledge about society.
Research that investigated the economic consequences of accounting requirements was discussed earlier in the chapter (as well as in Chapter 4). Once a profession starts considering the economic consequences of particular accounting standards, it is difficult to perceive that the accounting standards, and therefore accounting, would really be considered as truly objective and neutral.
We are again back to the position that was introduced in Chapter 3 – accountants are indeed very powerful individuals. 21 Indeed, the political cost hypothesis, which we discussed within Chapter 8 in our discussion of Positive Accounting Theory, and which is often supported by empirical evidence, shows that managers will adopt financial accounting methods that reduce the extent of political scrutiny imposed upon them. 20
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REFLECTION QUESTION 13.6 Question Can financial accountants really provide an objective account of financial performance as suggested by the IASB Conceptual Framework?
Solution As should be clear by now, critical theorists would argue that the whole system of financial accounting has been developed around an underlying (but masked) goal of supporting
powerful members of society while at the same Reflection time undermining the interests of other stakeholders. That is, the belief is that financial accounting practices are biased and not objective. Qualitative characteristics, such as ‘representational faithfulness’, are promoted in conceptual frameworks to apparently – if we believe the critical theorists – legitimise accounting practices that are otherwise biased in terms of which stakeholders the practices support.
A critical accounting perspective of accounting and legitimation Moving on to another aspect of how critical accounting researchers believe that accounting practices ‘silently’ and ‘stealthily’ reinforce capitalist power, among the other theoretical perspectives considered earlier is Legitimacy Theory (discussed in Chapter 9). Organisations often use documents, such as annual reports and sustainability reports, to legitimise the ongoing existence of the entity. While these disclosures can be explained in terms of a desire by the corporation to appear to be acting in terms of the ‘social contract’ (which may or may not be the case), some critical theorists see the legitimation motive as potentially quite harmful, particularly if it legitimises activities that are not in the interests of particular classes within society. As Puxty (1991, p. 39) states: I do not accept that I see legitimation as innocuous. It seems to me that the legitimation can be very harmful indeed, insofar as it acts as a barrier to enlightenment and hence progress.
In considering the use of social and environmental disclosures to legitimise corporate behaviour, Deegan, Rankin and Tobin (2002, p. 334) state: Legitimising disclosures mean that the organisation is responding to particular concerns that have arisen in relation to their operations. The implication is that unless concerns are aroused (and importantly, the managers perceive the existence of such concerns) then unregulated disclosures could be quite minimal. Disclosure decisions driven by the desire to be legitimate are not the same as disclosure policies driven by a management view that the community has a right-to-know about certain aspects of an organisation’s operations. One motivation relates to survival, whereas the other motivation relates to responsibility.
Deegan, Rankin and Tobin (2002, p. 335) further state: Legitimising disclosures are linked to corporate survival. In jurisdictions where there are limited regulatory requirements to provide social and environmental information, management appear to provide information when they are coerced into doing so. Conversely, where there is limited concern, there will be limited disclosures. The evidence suggests that higher levels of disclosure will only occur when community concerns are aroused, or alternatively, until such time that specific regulation is introduced to eliminate managements’ disclosure discretion. However, if corporate legitimising activities are successful then perhaps public pressure for government to introduce disclosure legislation will be low and managers will be able to retain control of their social and environmental reporting practices. 701
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Consistent with the above discussion, Guthrie and Parker (1990, p. 166) believe that the political economy perspective adopted by critical theorists emphasises the role of accounting reports in maintaining (or legitimising) particular social arrangements: The political economy perspective perceives accounting reports as social, political, and economic documents. They serve as a tool for constructing, sustaining, and legitimising economic and political arrangements, institutions, and ideological themes which contribute to the corporation’s private interests.
The role of accounting in legitimising the capitalist system Gaffikin provides a fairly critical perspective of the accounting profession in terms of what he sees as the profession’s uncritical acceptance of the capitalist system, which he believes acts to undermine the interests of certain people within society. As he states (2010, p. 34): Over the last four hundred or so years the majority of mainstream accountants have seen themselves as handmaidens of what we refer to as capitalism, providing information to facilitate optimal economic decision making. Accounting has been instrumental in maintaining the capitalist ethos – it has unashamedly served the interests of the providers of capital. Critical theories challenge the assumptions inherent in capitalism.
Given the role of accounting reports in ‘constructing, sustaining, and legitimising economic and political arrangements, institutions, and ideological themes which contribute to the corporation’s private interests’ (Guthrie and Parker, 1990, p. 166), the classical political economy perspective views one of the key roles of accounting reports as being to legitimise the capitalist system as a whole, and to protect this system from threats arising as a result of the outcomes of the structural conflict inherent in the capitalist system (as discussed earlier in the chapter). This, for example, is part of the reason why many critical accounting scholars are opposed to much research into corporate social reporting practices, as highlighted earlier. A major critical accounting empirical study examining the role that disclosures in annual reports played in protecting (and legitimising) the capitalist system as a whole from the outcomes of social conflict, analysed the annual reports of the US-based car multinational General Motors over the period 1917 to 1976. This empirical material was analysed in a series of papers (Neimark, 1983; Neimark and Tinker, 1986; Tinker, Lehman and Neimark, 1991; Tinker and Neimark, 1987, 1988) which demonstrated that the focus of voluntary, discursive material in the annual reports tended to change to address the changing challenges to capitalism arising from the structural instability of capitalism. For example, in times when the (claimed) symptoms of this structural instability were weaknesses in overall consumer demand, the annual reports focused on giving the impression that increased consumption – such as regularly buying a new car – was an ideal social norm. At other times, when the symptoms of the structural instability of capitalism was labour militancy, the focus of the core messages in the annual report switched to a demonstration that workers were better off if they acted in cooperation rather than in conflict with managers. The argument in these studies seems to be that while successful articulation of these management viewpoints might benefit General Motors economically, through maintaining the support of economically powerful stakeholders, they also benefited the capitalist system as a whole because, for example, developing a norm of consumption in times of weakened overall economic demand should result in greater demand for the products of many businesses. If other businesses also used their annual reports, in conjunction with messages in other media such as advertising and newspaper articles, at this point in history to help reinforce a consistent message about the social desirability of consumption, this would help protect and advance the power and wealth of many businesses by increasing overall consumer demand. As Tinker, Lehman and Neimark (1991, p. 39) state: 702
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The General Motors studies … focus on the various ways the company uses its annual reports as an ideological weapon, and the social circumstances that govern one use rather than another ... [they uncover] the conflictual and antagonistic situations that embroiled GM over that period, and the way the firm’s reports were used to modify and ameliorate these conflicts ... This is not to argue that annual reports have a dramatic impact on business and political decision making. Rather, like other ideological materials (party political statements, advertising, public relations ‘fluff’, religious dogma) it is the repetition of the mundane and particularly the censoring of other points of view that make these reports most effective.
REFLECTION QUESTION 13.7 The role of critique in creating change Question Is it realistic to believe that critiques of existing social systems and practices will ultimately lead to change?
Solution The simple answer to this is that if we do not challenge existing practices then we cannot expect them to change. There is also a view that research and related theory can inform and change practice, and practice can inform
LO13.7
Reflection
theory. For critiques of existing practice to create change, it is arguably necessary for widespread knowledge of these critiques to become known. This requires that critical theorists actively engage stakeholders across the community and not simply engage with other critical theorists. Whether critical theorists take this important step of engagement is something that we shall address later in this chapter.
Counter accounts and dialogic accounts
In Chapter 10, in our discussion of social and environmental reporting, we considered the use of ‘dialogic accounts’ and ‘counter accounts’ as a means of providing different perspectives of the social and environmental performance of an organisation. We learned that these accounts are developed from different philosophical and political standpoints relative to ‘traditional’ accounting practices and can potentially contradict the accounts being prepared by the managers of the focal organisation. Chapter 10 also noted that the production of counter accounts and dialogic accounts has the potential to stimulate debate, which can lead to managers taking on new views and implementing new processes that ultimately have favourable consequences for otherwise marginalised or disadvantaged stakeholders, inclusive of the environment. According to Brown and Dillard (2013), the forms of ‘accounting’ favoured by groups that operate in a relatively adversarial way towards particular organisations, industries or states can be quite different to those adopting a more collaborative approach. Stakeholders that seek to be adversarial will tend to have an interest in counter-accounting, whereas those stakeholders adopting a collaborative approach would be expected to embrace a more dialogical and collaborative approach to accounting, wherein various perspectives are represented and debated. Critical accounting theorists have, in recent years, devoted considerable attention to counter accounts and dialogic accounts. Hence, we will extend the discussion provided in Chapter 10. We start this section by focusing on ‘counter accounts’ before moving our attention to ‘dialogic accounts’. Counter accounts are alternative representations or alternative ‘accounts’ of organisations’ performance, produced often by NGOs with the intent to address alleged imbalances in power and various social inequities – something that critical theorists tend to focus upon (see our earlier discussion). Counter accounts are also referred to by other terms, such as ‘shadow accounts’, ‘silent accounts’, ‘anti-accounts’ and ‘external accounts’ (Andrew and Baker, 2020). Examples of counter accounts would be the reports prepared by various NGOs about instances of worker 703
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abuse in large multinational companies’ supply chains (when at the same time the companies might be reporting information about their respect for, and support of, workers), or reports about actual instances of animal abuse by organisations who claim to embrace animal welfare. As noted above, counter accounts tend to be produced by organisations that seek to operate in an adversarial manner, which can perhaps be contrasted to those groups that seek to be involved in dialogic accounting (Brown and Dillard, 2013). According to Himick and Ruff (2020, p. 700): Counter accounts are ‘alternative representations of organizations, industries or governance regimes, produced by civic society groups in order to rectify a state of affairs that is considered hateful or otherwise undesirable’ (Vinnari and Laine, 2017, p. 1). They are produced by those outside of the organization, industry or regime of which they speak (e.g. Lehman et al., 2016), for the purpose of affecting change (Thomson et al., 2015), usually on moral grounds (Denedo et al., 2017) … Counter accounts are alternative representations of a corporate or organizational entity or its practices with the intent to ‘challenge and confront dominant and unequal power relations,’ ‘delegitimise corporate practices’ and ‘give voice to oppressed groups’ (Denedo et al., 2017). By their nature, counter accounts often look quite different than the corporate reports they resist.
If we were to look at the website of, for example, People for the Ethical Treatment of Animals (PETA – see https://www.peta.org), we would see various ‘counter accounts’ prepared in relation to the animal welfare-related performance of various organisations and industries. These counter accounts are designed to evoke emotional reactions and to create real change. Himick and Ruff (2020) explore one form of counter accounting. In particular, they address the question: ‘How are counter accounts of profit used as tools of resistance?’ They examine three separate campaigns which used ‘counter accounts’, including a movement by the Brigitte Bardot Foundation to ban seal products from the European Union. According to Himick and Ruff (2020, p. 712): The Foundation’s resistance to the seal hunt had always relied on language and imagery to mobilize outrage. They produced images of Bardot hugging baby seals, and gory images of seal hunts (e.g. BBF, 2005), and described 15-day old baby seals ‘savagely beaten out of their senses’ (BBF, 2005). The pain of the seals was made vivid and relatable, ‘On the ice floes, the seals are bludgeoned, and some are skinned while still alive. Each spring, this vision of horror returns: The ice floes become an open-air slaughterhouse, where some pups are left in agony, their mothers trying desperately to revive their small bloody bodies’ (BBF, 2005).
The photos and associated narratives are considered to be ‘accounts’, in particular, ‘counter accounts’ which expose a different ‘reality’ to that exposed by the supporters of the seal hunts. In terms of the Brigitte Bardot Foundation’s use of ‘counter accounts of profit used as tools of resistance’, the authors noted that the Foundation ‘reframed profit’ by explicitly noting many of the ‘costs’ that were ignored or hidden when the profits of the seal hunt industry were calculated. For example, the Foundation, as author of the counter accounts, highlighted various subsidies that were excluded from reported profits. The Foundation noted (Himick and Ruff, 2020, p. 713): The seal hunt costs Canada more than it brings in […] There must be icebreakers at the disposal of hunters, and helicopters to ensure their safety. (BBF, 2009).
The counter accounts also were designed to implicate ordinary Canadians, as taxpayers, as enablers of the seal hunt. According to Himick and Ruff (2020, p. 713), the counter accounts prepared by the Foundation stated: 704
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Canadian taxpayers’ money is paying to enforce decisions that a majority of those taxpayers oppose. There are other costs to […] the provision of icebreakers that open the icy waters to the hunters’ boats, the provision of helicopters to spot seal herds for them […]. Despite all these subsidies [which actually contradicted claims that the hunts provided real economic benefits], the government continues to call this hunt commercially viable.
Himick and Ruff (2020, p. 713) explained that the Brigitte Bardot Foundation brought new items into the frame of ‘profits’, and in doing so: The new visibilities invited audiences to reconsider status quo conceptions of the profitability of the activity. Activists argued that profitability depended upon hidden subsidization and revealed such subsidies to mobilize public pressure for their reduction: ‘stopping subsidies […] will kill the market’ (BBF, 2014). Incorporating ‘hidden’ costs was a strategy used by the Foundation to problematize the profitability of the industry. Further, the public nature of the monies serves to implicate the Canadian taxpayer in the killing – a link made explicit by Canadian activists in the quote above. Profit was used as a tool by which to convert outrage into a target, offer a strategy for change, and connect the audience to the distant seals.
Therefore, the activists in question used the language of business, with its focus on ‘profits’, as a means to bring the legitimacy of a practice into question. Andrew and Baker (2020) provide another example of what they consider to be counter accounts (or as they also termed them, ‘shadow accounts’), in particular, the ‘accounts’ that emanate from the unauthorised leaking of company documents, such as internal emails. In making direct reference to the organisation known as Wikileaks, Andrew and Baker (2020, p. 5) note that high-profile organisations such as Wikileaks are able to apply particular technologies to locate and then distribute otherwise confidential information about powerful organisations and governments, which they claimed then opened ‘new possibilities (and challenges) for democracy’ as well as creating ‘new forms of organizational accountability’. According to Andrew and Baker (2020, p. 11): If shadow accounts offer an ‘independent, critical interpretation of corporate social performance’ (Dey, 2003, p. 8; Dey et al., 2010; Thomson et al., 2015; Tregidga, 2017) that can challenge the normalization of power relations founded in exploitation and inequality, then we need to keep exploring new and innovative ways to produce these accounts.
Andrew and Baker noted the potential of such ‘accounts’ (leaked emails) to destabilise the ‘moral and intellectual leadership’ that has supported current social and economic systems, and to increase knowledge about the processes in place to support such systems. The thoughts incorporated within Andrew and Baker (2020) reflect the confrontational stance often taken (necessarily, they would argue) by critical theorists. According to Andrew and Baker (2020, p. 11): At its heart, the shadow accounting [counter accounting] project is driven less by a commitment to the production of a correct or true account of power, and more by a desire to produce accounts capable of triggering change for the betterment of communities. With this as context, we believe that shadow accounts can help constitute ‘the struggle for power, resources and legitimacy’ (Tregidga, 2017, p. 511), but that more needs to be done to include the complex matrix of actors and vast array of potential sources in order to produce accounts that are meaningful in an empirical sense and can also underpin radical democratic debate. It is here that we believe the ‘change agenda’ that accompanies this field of research has significant potential (Tregidga, 2017, p. 511). 705
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This has motivated us to consider leaks as a means to expose the role of the state‒ corporate nexus in the production of neoliberal hegemony.
Andrew and Baker further state (2020, p. 13): Given the emancipatory ambitions of the critical accounting project, it is incumbent on those of us committed to democratic struggles and the principles that underpin equitable and sustainable societies to find ways to draw out the political and to find new opportunities to reignite collective imaginaries. It is here, as part of the project to hold power to account, and to both ‘radicalize democracy’ (Mouffe, 2018, p. 37) and ‘democratize accounting’ (Brown & Dillard, 2013b, p. 189) that we believe new forms of technologically enabled leaking provide an opportunity to challenge the privilege afforded by economic systems.
Many people within society might question the ethics or morality behind publishing details of emails that were obtained without permission. Nevertheless, they do provide an alternative (and otherwise ‘hidden’) picture, or ‘account’, of organisational operations and hence do constitute counter accounts. Consistent with the intended role of critical accounting, they can be expected to create some outrage, stimulate debate and provide a stimulus for potential change.
REFLECTION QUESTION 13.8 The nature of counter accounts In recent times, in countries like Australia, organisations such as the Royal Society for the Prevention of Cruelty to Animals (https://www.rspca.org.au/take-action), the Australian Greens (https://greens.org.au/campaigns/end-live-exports) and Animals Australia (https://animalsaustralia.org/our-work/liveexport) have highlighted details of the suffering and cruelty imposed upon animals that are shipped to other countries for their meat (often referred to as ‘live export’).
Question Would the facts being provided by these organisations (via the links provided above) constitute ‘counter accounts’?
Reflection
Solution These ‘accounts’ of what happens to the animals would be counter accounts. They provide information that challenges and contradicts the information being produced by exporting organisations, industry bodies and related government departments. They can cause outrage for those who read the accounts and they are released to create positive change for the stakeholders who are being poorly treated – in this case, the stakeholders are the animals.
Having discussed ‘counter accounts’, we now turn our attention to ‘dialogic accounts’ and, in so doing, we will also discuss monologic accounts. As Chapter 10 discussed, monologic accounts provide one world view. For example, they might provide management’s view about an organisation’s social and environmental performance, and this view might not coincide with the views expressed by other stakeholder groups. Monologic accounting is a practice which is overwhelmingly embraced by organisations throughout the world. While such accounts are likely biased in representing one world view (that of managers whose interests are assumed to be aligned with investors), managers, accountants and the accounting profession typically promote these corporate reports as objective (and, therefore, unbiased) representations of an underlying reality (just as the IASB Conceptual Framework promotes the representational faithfulness of general purpose financial reports). According to Brown and Dillard (2015, p. 251): Conventional accounting is notably monologic in approach, with an official narrative overwhelmed by capitalist perspectives, positivism and neoclassical economics (Cooper and Sherer 1984; Malsch 2013). 706
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This view of monologic accounts is also consistent with Manetti, Bellucci and Olivia (2021, p. 251): Monologic accounting is structured in such a way as to ensure that the information needs of investors affect the values and principles of accounting and reporting systems. In satisfying these needs, monologic accounting is assumed to serve everyone, regardless of their political viewpoints. Alternative perspectives are not considered because they can ‘distract’ from the main objective of monologic accounting: to provide current or potential investors with expected information. As Brown (2009, p. 316) argues, ‘Monologic accounting also reflects a finality orientation; the “facts speaking for themselves”’. (emphasis in original)
In relation to claims associated with providing an objective account of an underlying reality, Kingston et al. (2020, p. 449) state: Once a truth is established and concretised, it is like it was always there. It appears as objective, as a reality. Vinnari and Dillard (2016) concur that ‘accounting does not only reflect a reality; it participates in the construction of that reality’ (p. 25). Lehman (2013) suggests there are vast implications of accounting’s actual subjectivity when it is presented as objective. She highlights the importance of questioning what is chosen to be represented and what is chosen to be silenced (Lehman, 2013). The act of being able to ask these questions demonstrates the subjectivity of the phenomena.
Turning our attention to dialogic accounting (which can be considered to be the antithesis to monologic accounting), Brown and Dillard (2015, p. 250) note that the aim of dialogic accounting is to enable a diverse range of societal actors to account for things that traditional accounting ignores, and to develop systems of accounting that acknowledge divergent ideological positions. Brown and Dillard (2015) state that in contrast to monologic approaches, the role of dialogic accounting is to develop accounting systems that ‘prevent premature closure’ and ‘which infuse debate and dialogue, facilitating informed citizen participation in decision-making processes’ and which might also help make power relations more transparent. Dialogic accounting researchers believe in the merit of using insights from various disciplines of research. Brown and Dillard state (p. 252): The over-arching aim of those advocating dialogic accounting is to develop accounting theory and practice that: provides alternatives to traditional business-focused approaches; shifts accounting from a discipline overwhelmed by the assumptions of finance capitalism to one that fosters critical reflection and democratic debate; gives expression to diverse political and value standpoints about private and public sector policy matters; and encourages more democratic forms of social interaction in local community, organizational and civil society contexts.
According to Bebbington et al. (2007), dialogic processes of accountability would entail the creation of accountability relationships where the ‘usual’ roles of principal and agent are more fluid. Further, for accounting researchers that elect to engage with organisations, perhaps through some form of consulting engagement, the aim should not be to (p. 363): ‘put them right’ as an external academic expert. Nor is it an exercise whereby the company manipulates the person they are working with in order to legitimate the company position. Rather both parties should commit to a process whereby both expect to learn something of the worldview of the other, both address structural issues that constrain them and collectively they strive to create some better outcome. 707
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According to Bebbington et al. (2007, p. 369): A dialogic approach, however, will not attempt to replace one set of dominant stories with those of another group (this would merely replace one set of oppressors with another). Rather the aim is ‘to widen the number and kinds of stories that get told and the actors who tell them’ (Olson, 1996, p. 3) and thus prefigure the ‘unfinalizabilty’ of discourse processes. Nor does a dialogic approach preclude engagement with those who currently hold power (Davis, 2000).
Dialogic accounting would enable stakeholders to gather insights into other world views. As Bellucci et al. (2019, p. 1470) note: Stakeholders who participate in pluralistic processes are given a chance to better understand their differences, while also emphasizing their common ground, thus creating a public forum where diverse constituencies can share ideas and points of view, organize and formulate possible projects, and/or stimulate actions that are ‘more collectively robust’ (Stirling, 2008, p. 280). Participation, discussion and comparison quicken ‘critical reflection on taken for granted understandings and practices, opening the way for transformative change of individuals, groups, organizations and institutions’ (Brown and Dillard, 2015, p. 966).
Consistent with the views of Bellucci et al. (2019), Bebbington et al. (2007, p. 365) also note: Dialogic change is initiated by an incremental process of working with groups with an initial shared experience, empowering them to embark on authentic engagement that exposes the contradictions in their lives and allow them to begin to organize, cooperate and unite with other groups to uncover common goals and shared truths. This process is essential if they are to transcend their situation. If change is to occur then similar processes should be undertaken with the oppressors, working with them to recognize the dehumanizing and destructive nature of their actions. Once both groups uncover the common ground between them, then dialogic engagements can begin between these previously antagonist groups.
Bebbington et al. (2007) provide a diagrammatic representation of what they consider to be a dialogic engagement process (see Figure 13.1). In explaining the diagram, they state (p. 365): In broad terms a dialogic engagement is likely to involve: first, identifying a limit situation (itself a process of engagement and which initiates further engagement with the same and/or different individuals) in terms of raising consciousness as to why a problem exists that requires consideration. Second, there would be a process of dialogue, which creates the framework for praxis to take place. Praxis can lead back to either redeveloping the ‘solution’ to the problem identified and/or to identifying a new limit situation or to a new element or aspect of the existing limit situation being examined. However, it is plausible to start the process with praxis (where one is asked to contribute to or intervene in the life of an organization), which itself then feeds into re-examining the problem that the praxis was hoped to address. In turn this could feed back into a reconsideration of what exactly the limit situation is. This circular and multi-faceted process is, of course, ‘messy’ (see also Gray, 2002b). Dialogic thinking accepts this ‘messiness’ and works with it as an essential way of engaging with lived reality.
Bebbington et al. (2007) stress the ‘educative effect’ that is generated from a dialogic approach wherein critical reflection is encouraged that questions the status quo and encourages 708
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FIGURE 13.1 Attributes of dialogic engagement Delivery mechanism Content Inclusiveness in designing
Assessment
Aware of participants’ life experience
Problems
Multi-media, multidimensional representations
Solutions
Active listening Mutual trust and understanding Encourage systematic and transdisciplinary enquiry Dialogic encounter
Explain and justify process
Respect for peers
Contradictions
Interactive and co-evolving
Identify and discuss
Limit situations Obstacles
Action element
Reflective opportunity
Seek out and problematise
Transcendent actions Feasible solutions
Opportunities
Source: Bebbington et al. (2007), p. 365.
participants to evaluate their own world views and be open to the possibility for other views. Their argument is that dialogic processes can support change by encouraging critical reflection. However, they believe that some form of regulatory intervention may be required to create dialogical engagement. As they state (p. 373): How do you encourage transitions from monologic to dialogic states? – monological states do not (ultimately) serve society well; they lead to outcomes that are thought to be bad, even by those in power. For example, a loss of trust in organizations, governments and leaders is an outcome of past monologic approaches. One stage in moving to a dialogic state is recognition of the need to do so by those who currently hold power. Another stage of such a move is predicated on working alongside those who seek to create more dialogic engagements and using the principles of iteration and reiteration to get a sense of whether or not dialogue is genuine – that no one is being coerced, that the powerful accept that meaning making should be shared, and to surface underlying assumptions held by all parties (including yourself as a researcher).
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Bebbington et al. (2007) argue that a fundamental part of the dialogic process is the requirement to expose and reflect upon ‘invisible’ or ‘silenced’ factors that potentially oppress specific groups. There is also a necessity to (p. 373): re-examine focal situations in light of new understandings, problematizing existing situations, re-presenting and re-narrating existing situations, allowing for ‘perception of perceptions’ and identifying solutions to transcend existing situations of oppression, harm or unacceptable social and environmental outcomes.
In addressing dialogic accounting, Dillard and Vinnari (2019) argue that the traditional approach to accountability, as adopted by many accounting researchers, is premised on providing solutions to stakeholder demands by applying pre-existing corporate accounting and accountability systems. In Chapter 2, we introduced the four-step ‘accountability model’, which requires managers to identify stakeholders and then engage those stakeholders to determine what information is demanded or required. This then informs what is to be disclosed and how it will be disclosed. Dillard and Vinnari question the logic of this ‘top-down’ approach – an approach that is nevertheless promoted by many social and environmental (SEA) researchers. They state (p. 21): A mechanism that some SEA scholars believe improves accountability in the context of social and environmental reporting is stakeholder engagement (Joseph, 2012; Rinaldi, Unerman and Tilt, 2014; Unerman and Bennett, 2004). The prescription emanating from this literature and associated reporting standards (e.g. AccountAbility, 2008) is that organizations should identify and engage stakeholders in order to find out, among other things, their social, environmental, ethical, and economic information needs. Awareness of the stakeholders’ expectations, it is argued, enables the organization to disclose relevant information and thus discharge its accountability to the identified stakeholders (Rinaldi et al., 2014). … Unfortunately, empirical research results indicate that stakeholder engagement is often just stakeholder management in disguise.
Therefore, one of the key factors influencing Dillard and Vinnari is the belief that managers do not seek ‘real engagement’ with stakeholders; rather, they seek to simply manage and manipulate stakeholders, and they do this under the guise of seeking to demonstrate accountability. Whether most managers really behave like this is a matter of opinion. Dillard and Vinnari (2019) suggest an alternative approach to accountability, which is reproduced in Figure 13.2. They state (p. 21): Our proposal is predicated on the ideas emerging from critical dialogic accounting theorized using Mouffe’s (2013) agonistics, which presumes a pluralistic and FIGURE 13.2 One perspective of ‘critical dialogic accountability’ Pluralistic, democratically governed society
Accounting systems
Disclosures: transparent representations of actions
Accountability systems: comparing representations with evaluations criteria
Responsibility networks: specification of evaluation criteria
Affected groups: diverse needs and interests
Source: Dillard and Vinnari (2019), p. 20.
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democratically governed society made up of multiple constituencies with varying needs, interests, values and power. In addition to financers, these might include marginalized groups such as indigenous communities, racial minorities, sexual minorities, nonhuman animals, the poor, women or children. Accordingly, the critical dialogic accountability process begins with the identification of the various interested constituencies and a determined recognition of the pluralistic nature of their information needs. Unlike in what has come to be known as stakeholder engagement, the identification of the interested constituencies and their information needs are initiated outside the entity being held accountable, by groups such as political action committees, nongovernment organizations and government entities.
That is, the suggestion by Dillard and Vinnari (2019) is that the engagement should not be undertaken directly by the organisation. Instead, there should be some external (not organised or influenced by the focal organisation) collective gatherings of individuals, and through the dialogue and debate among the various groups, differences and possibilities would become more clearly articulated and understood. Different stakeholder groups who support particular aspects of organisational performance would perhaps constitute one ‘responsibility network’, whereas those who oppose aspects of organisational performance would form another network. The various ‘networks’ would ‘then develop a set of issues for which they believe the organisation should be held accountable. Some external entity such as the state would then, through legislation or regulation, ensure that the associated accountability and accounting criteria are incorporated into a viable accountability system’ (p. 21). Dillard and Vinnari suggest (2019, p. 22) that: the accounting system should be designed to provide information relevant to the specific accountability system with the accountability system explicitly addressing the evaluation criteria indicated by each responsibility network. A pluralistic environment would probably contain multiple accountability systems comprised of multiple evaluation criteria sets, and multiple, though not necessarily mutually exclusive, accounting systems. Such a perspective changes the question from ‘What can accounting hold someone accountable for?’ (accounting-based accountability) to ‘What accounting is needed for a specific accountability system?’ (accountability-based accounting).
The suggestions from Dillard and Vinnari (2019) are interesting, and they do challenge the accountability model we discussed in Chapter 2. Indeed, you should contrast the model reflected in Figure 13.2 with Figure 2.5 in Chapter 2. However, there would be many problems of a practical nature in implementing the accountability system proposed by Dillard and Vinnari (2019). For example, how will these groups or ‘responsibility networks’ organise themselves? What is the mechanism that brings the stakeholders together? How do the different groups reach some form of consensus about what should be reported? How many groups should be established? Why would we expect government or the state to support such an approach? What is the basis of including different and perhaps conflicting stakeholders within different groups? We conclude the discussion of dialogic accounting by noting that the implementation of dialogical accounting practices, in whatever form it might take (and we are now aware of some suggestions), would be consistent with the United Nations Sustainable Development Goals (UNSDGs), which we discussed within Chapter 10. Specifically, the practice of dialogic accounting relates to UNSDG 10, to reduce inequality, and UNSDG 16, the promotion of inclusive societies, and accountable, inclusive institutions, at a sub-national level.
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Why do I need to know about the meaning and nature of monologic accounting and dialogic accounting? Why
Knowing about monologic and dialogic accounting alerts us to the limits that many current accounting practices, which are likely monologic in nature, have in enabling an organisation to demonstrate accountability to a broad group of stakeholders. The knowledge can prompt us to consider whether the reporting practices that we might otherwise support do, in fact,
stifle debate and overly promote one world view above other potential – and legitimate – world views. The discussion of dialogic accounting should encourage us to consider whether the accountability approaches and models we individually prescribe need some form of refinement to prevent premature closure of important debate.
A critical reflection on the role of critical accounting researchers in creating change LO13.8
As we have already noted in this chapter, the accepted role of critical analysis is to identify problems inherent within existing structures and processes (such as accounting) with the ultimate aim of providing a fairer society that does not undermine the interests of particular groups, such as employees. That is, the ultimate goal of critical research is projected as being to create positive social change. To create change would seem to require constructive engagement with a broad cross-section of people to not only highlight problems, but to suggest pathways for improvement. As Roslender (2006, p. 264) states: Simply interpreting and understanding what we choose to study is not enough. The purpose of the exercise is to turn this learning to the promotion of society, that is, the promotion of a better society.
However, concerns have been raised from some critical theorists that their colleagues are failing to engage the broader community. For example, the leading critical theorist, Christine Cooper, has in the past been particularly critical of the language used by many critical theorists and the apparent neglect of efforts to usefully engage with practice. In relation to the difficult (and, perhaps, convoluted) nature of the language frequently used by critical theorists, Cooper (2002, p. 452) refers to the work of Callinicos (1999), whom she quotes as saying: In the self-contained university world, intellectual life is specialized and professionalized: academics, even those who think of themselves as political radicals, write for each other using an idiom which renders their work unintelligible to those outside. Perhaps the itinerary of the Frankfurt School is emblematic of this larger process: Marxism becomes ‘critical theory’, a body of thought elaborated in the academy at long remove from any political practice, profoundly pessimistic about the possibility of social revolution, and expressed in allusive and arcane language. In what is, however, all too common a feature of cultural life at the end of the twentieth century, an avantgarde activity has now been massified, as innumerable academics engage in what Althusser called theoretical practice, matching Adorno and Horkheimer in obscurity of expression, but not, alas, in novelty of content. (Callinicos, 1999, p. 309)
Reflecting upon the above quote, Cooper makes the following point (2002, p. 454): In short, academics at the beginning of the twenty-first century write theoretical pieces, which hardly anyone reads, mainly for each other using impenetrable language. 712
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While such criticism was raised more than two decades ago, similar concerns could be raised today. Of course, such criticism can be made of much research, not just critical accounting research, but it does seem somewhat odd that critical theorists who argue passionately against the exclusion of certain members from society will write in a manner that is very difficult to understand and which therefore is also potentially open to the criticism of being exclusionary in nature – other than for those well versed in reading the specific literature. In relation to concerns about the lack of engagement of many critical accounting researchers, Cooper (2002, p. 452) notes: I can’t help but feel that intellectual pessimism about the possibility of social change is alive and well in much critical accounting work. Many academics who describe themselves as critical do not seem to believe in the possibility of social change and certainly never strive to change the world, preferring instead to concentrate on theory alone or upon work which is strangely separate from contemporary social movements. There are of course notable exceptions. I hesitate to single out any critical accounting academics here for risk of causing offence to those whom I have negligently missed out.
In terms of the expectation that critical researchers should engage with the community (rather than perhaps restricting their movements to university offices and specialised academic conferences), Cooper (2002, p. 454) provides the positive example of a group of critical theorists who wrote material that was readable by people other than those working within universities and who have knowledge of particular philosophies: Wolfreys (2000) carefully traces the work of Bourdieu and his colleagues as follows. They set up a publishing house, Liber/Raisons d’Agir (Reasons to Act), and have used it to produce a series of reasonably priced, accessible books covering a range of issues, almost all of which have reached a wide audience. The first to be published, Bourdieu’s Sur la Télévision (1997), sold over 100 000 copies and his Contre-feux (1998) over 50 000, while Serge Halimi’s attack on the media, Les Nouveaux Chiens de Garde (1997) has sold over 150 000. Others, such as the collective work Le ‘Décembre’ des Intellectuels Français, on the effect of December 1995 on France’s intellectual elite, have all enjoyed similar success. The accessibility of much of Bourdieu’s and Liber/Raisons d’Agir’s material is an exemplar which could be followed by critical accountants. This isn’t to argue that academics should eschew theory. On the contrary, it is to argue that theory and practice should be merged and the complex picture they produce should be disseminated in an understandable form.
Cooper emphasises the need for critical theorists to leave the confines of comfortable offices and to take their concerns and insights to the broader community. She uses the work of well-known critical theorists as outstanding examples (exemplars) of engaging theory with practice (2002, p. 454): Some of the academics connected with Raisons d’Agir have gone on to create an International of intellectuals. There are now groups in Germany, Belgium and also in a number of French towns, notably Grenoble, forming part of a growing network of militant think-tanks, reviews and associations of various kinds all fighting, in diverse ways, the effects of global capitalism. The Fondation Copernic was established in November 1998 as a rival to the right-wing Fondation Saint-Simon. Other newly formed associations include the unemployed workers’ associations AC! and APEIS, the homeless association Droit au Logement (DAL), the SUD trade union and the loose Groupe des Dix federation of which it is a part, numerous anti-fascist and anti-racist groups. This demonstrates how the activities of academics will be strengthened by their joining with and perhaps even forming other groups. 713
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By contrast, Cooper notes (2002, p. 458) that the highly respected, and highly cited, critical theorists Jean-Paul Sartre and Foucault were known to be sympathetic to various movements that supported the rights of workers, but these researchers/philosophers unfortunately ‘did not have much empirical knowledge of workers’. Cooper further states (2002, p. 458): I am setting out a case that in order to have less pessimism in academia it is essential for those critical accountants who wish to do something about social inequality and injustice to participate in practice as well as the development of theory.
The views of Cooper are also consistent with the views provided by Sikka and Willmott as discussed earlier within this chapter (2005, p. 142): While there is a role for scholarship and related forms of rarefied intellectual engagement with radical ideas, this activity should not displace principled involvement in the mundane world of practical affairs.
Another notable critical theorist, Jane Broadbent, has also highlighted concerns about the lack of engagement of critical theorists (2002, p. 445): It becomes difficult to think of many examples of how critical accounting research has been directly successful in changing policy or practices.
At this point, we might ask why we have questioned the lack of engagement of many critical theorists and the inaccessible language often used when we have not raised similar concerns in relation to other accounting research paradigms and researchers discussed elsewhere in this book. Are we being unfair in singling out the critical theorists? Critical theorists often claim that the purpose of their work is to expose structural and social problems within existing social systems. This is a praiseworthy endeavour. They rightly express concern about the welfare of different groups and how different groups are excluded from having a ‘voice’, often because the ‘system’ does not allow them to have a ‘voice’. Therefore, to be consistent, such researchers should not write in a manner which is unintelligible other than to those who are privileged enough to have education in, or knowledge of, particular philosophies. It would also seem that, to be consistent with their discipline, they should engage with the community – with practice (perhaps in the way Cooper shows in the above examples). It is probably true that other researchers, for example Positive Accounting Theorists and capital markets researchers (as well as researchers operating within other paradigms), on average, do not use their research to engage the community to create positive social change. But many of these paradigms are based around economic assumptions, such as the rational economic person (guided by self-interest) so, in a sense, such researchers cannot be accused of hypocrisy for not undertaking efforts that benefit others. If their actions were limited to attaining publication in prestigious research journals and attending various academic conferences throughout the world, then that is not inconsistent with the self-interest perspective that they have adopted as a guiding assumption of their research. As we can see, reflecting on the role of research, and researchers, can raise many issues and opinions, many of which might not be popular to some individuals or groups. But hopefully such criticism can be the catalyst for self-reflection. Indeed, for researchers (who are often publicly funded to undertake research), it perhaps is important to reflect on the central role that they are assuming and whether they are indeed fulfilling the role that might be expected of researchers within that particular discipline.
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STUDY TOOLS CHAPTER SUMMARY This chapter provided an overview of research that has been undertaken by people who are classified as working within the critical perspective of accounting. These researchers are very critical of current accounting practices. They argue that existing financial accounting and social and environmental reporting practices support the current economic and social structures – structures that unfairly benefit some people at the expense of others. The view that financial accounting practices are neutral and objective (as promoted in various conceptual framework projects) is challenged. The critical perspective of accounting covers many different philosophical perspectives, and this chapter has explored only a few of the major ones. However, at a broad level, much critical accounting research is grounded in classical Political Economy Theory, in which conflict, inequity and the role of the state are central to the analysis. While the research positions of many critical accounting scholars are informed by a Marxist critique of capitalism, there are many other critical accounting researchers whose critiques of the role of accounting in sustaining inequities in society are not based on Marxist philosophy. A common theme among most Marxist (and some non-Marxist) critical accounting theorists is a call for fundamental changes in how society is structured as, without this restructuring, they believe that any changes or modifications to accounting practices will have no effect in making society more equitable for all. Critical theorists also argue that governments (the state) tend to put in place mechanisms and regulations to support existing social structures. Many accounting researchers are also believed to be supporters of particular political ideologies, with the results of their research being influential in supporting those people with privileged access to scarce capital. The aim of this chapter has been to provide an insight into a point of view that traditionally has not received a great deal of attention in accounting education or in most accounting journals. Perhaps, as the critical theorists would argue, this lack of attention is due to the fact that this branch of the accounting literature challenges so many of the views and values held not only by accountants, but also by many others within society. The literature can indeed be quite confronting. It does, however, provide a different perspective on the role of accountants, and accounting researchers, and one that we should not immediately dismiss. If the literature causes us to be critical of our own position as accountants within society, to stand back and question our role within society, then well and good. Having read this chapter, it is useful to reflect upon the following two quotes: Accounting’s capacity to create and control social reality translates into empowerment for those who use it. Such power resides in organisations and institutions, where it is used to instill values, sustain legitimising myths, mask conflict and promote self-perpetuating social orders. Throughout society, the influence of accounting permeates fundamental issues concerning wealth distribution, social justice, political ideology and environmental degradation. Contrary to public opinion, accounting is not a static reflection of economic reality, but rather is a highly partisan activity. (Baker and Bettner, 1997, p. 293) The adoption of a Critical Theory perspective should not be seen as being synonymous with the wholesale rejection of the institution of accountancy and its various practices. Whilst these have been developed to serve the interests of the minority, and in many instances to the great disadvantage of the majority, they may provide a basis on which to construct an alternative set of structures and processes consistent with social betterment. The Critical Theory perspective offers a means of establishing what it might be desirable to retain from what currently exists, while always being informed by the belief that it is possible to build something better, which will serve the interests of a much broader set of stakeholders. It is therefore not a perspective to be embraced lightly or deployed because it promises to furnish an(other) interesting set of insights. As the embodiment of the philosophy of praxis, Critical Theory does not content itself with understanding accounting. By means of intervention, Critical Theory seeks to promote a better fit between accounting and the interests of all society’s various stakeholder groups. (Roslender, 2006, p. 266)
This brings us to the end of this book. It is hoped that you have enjoyed reading the material in this book and that the material has emphasised to you that accounting is a fascinating practice that creates
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various impacts across society. Accounting is central to the functioning of society. The following quote from the late Anthony Hopwood (2007, p. 1367) seems a very good way to conclude our discussion: There were then, there have been in the intervening period, and there are now people who think that they know what accounting – and auditing for that matter – is. How wrong these people are. They are the ones who list the attributes of the status quo, seemingly wanting to confine the new to being within the boundaries of the old. They have no conception that accounting and accounting research have repeatedly changed across time, and when things change they become what they were not, at least in part. Accounting has been a craft that has had no essence. It has changed significantly across time, adopting new forms, methods, and roles. Likewise for accounting research. Historically, it too has developed in relation to a diverse series of circumstances and pressures, taking on different forms in different places and at different moments of time, repeatedly adopting approaches that were novel and contentious. Moreover, both accounting and accounting research will continue to do just that, regardless of the pleas and efforts of those who act in the name of the status quo.
ANSWER TO OPENING QUESTION At the beginning of this chapter, we asked the following question. As a result of reading this chapter, you should be able to provide an informed answer to this question – our answer is shown below. As we discussed in Chapter 7, conceptual framework projects promote approaches to financial accounting that are built on qualitative characteristics such as neutrality, objectivity and representational faithfulness.
Module 1 Questions / Answers
How do arguments regarding the unequal distribution of power between different social groups, as espoused by critical accounting theorists, challenge the belief that financial statements prepared in accordance with generally accepted accounting principles will neutrally and objectively depict an organisation’s financial performance? As should be clear as a result of reading this chapter, critical accounting theorists would argue that financial accounting practices are highly partisan in their support of investors, corporations and capitalist ideologies. The way financial accounting is practised is deemed to do nothing other than bolster the interests and wealth of those stakeholders already in control of most of society's wealth. Claims about neutrality, objectivity and representational faithfulness, as espoused within conceptual frameworks, are nothing other than a device to provide legitimacy to systems that are riddled with inequity. The accounting profession, accounting standardsetters and government are all perceived by critical theorists as supporters of the capitalist system, so any thought that they would develop reporting standards which benefited groups such as workers is nothing other than naïve.
QUESTIONS 13.1 What is a critical perspective of accounting? LO13.1 13.2 What are some of the fundamental differences between the research undertaken by critical theorists, relative to the work undertaken by other accounting researchers? LO13.1 LO13.3 13.3 From a critical perspective, what is the role of the IASB Conceptual Framework for Financial Reporting? LO13.3 LO13.4 13.4 From a critical perspective, can financial statements ever be considered objective or neutral? Explain your answer. LO13.3 13.5 If it is accepted that there are many inequities within society, would critical theorists argue that introducing more accounting, or improved methods of accounting, could help or would they argue that such a strategy will only compound existing problems? Explain your answer. Do you agree with the position taken by the critical theorists? Why? LO13.3 LO13.4 13.6 Critical theorists would challenge the work of authors whose work is grounded within Positive Accounting Theory. What is the basis of their opposition? LO13.1 LO13.2
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13.7 Roslender (2006, p. 265) states: Critical Theory makes no pretence of being objective. Those who embrace a Critical Theory perspective do so because they recognise and value its partiality.
Required: Explain the meaning of the above quote.
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LO13.2
13.8 Organisations need various resources to operate. Two such resources are labour and equity capital. Providers of labour and equity capital receive payments in return for their resources. Payments to labour are often referred to as wages, and payments to shareholders are referred to as dividends. Wages, which are a payment to one stakeholder group (employees), are expenses that reduce profits, whereas dividends, which are a payment to another stakeholder group (owners), are a distribution of profits and therefore do not reduce profits. Capital markets encourage organisations to maximise profits, which by implication puts pressures on organisations to reduce wages. At the same time, capital markets encourage higher dividend payments to owners. Required: a From a ‘critical perspective’, how would critical theorists view the fact that payments to one group (workers) are to be minimised but payments to others (owners) are to be maximised? b Would critical theorists see this as an example of accounting practice advancing the interests of the owners over and above the interests of workers? c How do you, personally, feel about the different accounting treatment relating to payments that are made to parties that are both considered as providers of necessary resources to an organisation? LO13.3 LO13.4 13.9 Critical theorists would challenge the work of authors whose work is grounded within Legitimacy Theory. What is the basis of their opposition? LO13.1 LO13.2 13.10 If accounting is deemed to be complicit in sustaining social inequities, how would critical theorists argue that accounting can be ‘fixed’? LO13.3 13.11 Tinker, Merino and Neimark (1982) argue that ‘the social allegiances and biases of accounting are rarely apparent; usually, they are “masked” pretensions of objectivity and independence’. Explain the basis of this argument. LO13.1 LO13.2 13.12 It is often claimed that individuals should embrace some form of ‘personal social responsibility’ and not simply expect corporations to be socially responsible (that is, the responsibility should be shared). Chandler (2010) states: Let’s get beyond the idea that firms are inherently evil. Such a perspective does not absolve firms of responsibility but recognizes that for-profit organizations add considerable social value in producing products and services that are in demand. It also recognizes that the relationship between firms and society is symbiotic and, as a result, the responsibility to ensure social responsible outcomes is shared. In the same way that we deserve the politicians we vote for, we also deserve the companies we purchase from.
Required: Explain how you think critical accounting theorists might respond to the above quote from Chandler. LO13.1 13.13 Cooper and Sherer (1984) argue that ‘accounting researchers should be explicit about the normative elements of any framework adopted by them. All research is normative in the sense that it contains the researcher’s value judgements about how society should be organised. However, very few accounting researchers make their value judgements explicit’. Do you agree or disagree with this claim? Why? LO13.1 LO13.2 13.14 What does Scott (2008, p. 23) mean when he says: The point of critique is to make visible those blind spots in order to open a system of change … To open the possibility of thinking (and so acting) differently. LO13.2
13.15 Explain the importance in critical accounting theory of assumptions regarding the distribution of power in society. How do these assumptions differ from those adopted in other theoretical perspectives? LO13.2 LO13.5
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13.16 CPA Australia (2005) made a submission to the Australian Government inquiry into corporate social responsibility in which it stated (p. 6): While there is strong public (88%) and shareholder (86%) support for Government to mandate the reporting of companies’ social and environmental reporting this is not reflected in the views of business leaders (53%). CPA Australia believes this reflects a valid business concern that mandatory reporting would not enhance the value of the information provided and introduce an unnecessary layer of regulation.
Evaluate this statement from a ‘critical’ perspective.
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LO13.5
13.17 Why might critical theorists be opposed to academic research that attempts to assist corporations to put a cost on their social and environmental impacts? LO13.6 13.18 Cooper (2002, p. 452) provides a quote from Callinicos (1999, p. 309), which states: In the self-contained university world, intellectual life is specialized and professionalized: academics, even those who think of themselves as political radicals, write for each other using an idiom which renders their work unintelligible to those outside.
Cooper then states (p. 452): In short, academics at the beginning of the twenty-first century write theoretical pieces, which hardly anyone reads, mainly for each other using impenetrable language.
Required: Explain the ideas that Cooper is trying to project. Further, if we accept the view being promoted, does this diminish the ‘contribution’ of such researchers? LO13.8 13.19 Evaluate the following quote from the Business Council of Australia (2005) from a ‘critical perspective’: Given the difficulty defining corporate social responsibility (CSR), as well as the fact that CSR activities are already broadly being pursued in Australia by large corporations, mandating CSR through legislative intervention runs the risk of stifling the innovative and creative approaches to CSR that are being adopted by Australian companies. LO13.4 LO13.5
13.20 Baker (2011, p. 209) states: By the end of the 1980s, there was a distinct separation in the accounting research disciplines, not only into sub-disciplines in the United States, but also into paradigmatically separate fields, such as positivist and critical accounting research. For most part, these two fields have had little interaction, with scholars in one field barely acknowledging the existence of scholars in the other field.
Why do you think there would have been such little ‘interaction’?
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LO13.2
13.21 Why might some critical accounting theorists argue that moves by many researchers to develop new systems to account for the social and environmental impacts created by organisations is simply a waste of time? LO13.4 13.22 Evaluate the following claim by Gaffikin (2008, p. 151): Crudely speaking, if you do not think about what you know and how you know it, your actions may be simply reflecting what others want you to do, so you will be reinforcing the dominant and powerful views that exist in society … through self-reflection one is freed from past constraints (such as dominant ideology and traditional disciplinary boundaries) and thus critical theory is emancipatory.
13.23 Explain the meaning of: a Counter accounts b Monologic accounting c Dialogic accounts. 13.24 What is the role of counter accounts? Why, and how, might they be utilised in an adversarial manner? LO13.7 13.25 Does the practice of dialogic accounting encourage ‘debate’ and ‘learning’, and if so, how? LO13.7 13.26 Why is it argued that the reports prepared by organisations are generally of a ‘monologic’ nature? Further, why might it be argued that monologic accounts sustain particular social and economic arrangements? LO13.7 13.27 Would critical accounting researchers argue that the accounting profession acts in the ‘public interest’? LO13.7
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Gaffikin, M. (2010), ‘Being critical in accounting’, International Review of Business Research Papers, 6(5), pp. 33–45. Gallhofer, S. & Haslam, J. (2019), ‘Some reflections on the construct of emancipatory accounting: shifting meaning and the possibilities of a new pragmatism’, Critical Perspectives on Accounting, 63, pp. 1–18. Gendron, Y. (2018), ‘On the elusive nature of critical (accounting) research’, Critical Perspectives on Accounting, 50, pp. 1–12. Gray, R. (2010), ‘Is accounting for sustainability actually accounting for sustainability ... and how would we know? An exploration of narratives of organisations and the planet’, Accounting, Organizations and Society, 35(1), pp. 47–62. Gray, R., Adams, C. & Owen, D. (2014), Accountability, Social Responsibility and Sustainability, London: Pearson. Gray, R., Owen, D. & Adams, C. (1996), Accounting and Accountability: Changes and Challenges in Corporate Social and Environmental Reporting, London: Prentice Hall. Gray, R., Owen, D. & Maunders, K. T. (1987), Corporate Social Reporting: Accounting and Accountability, Hemel Hempstead: Prentice Hall. Gray, R., Owen, D. & Maunders, K. (1988), ‘Corporate social reporting: emerging trends in accountability and the social contract’, Accounting, Auditing and Accountability Journal, 1(1), pp. 6–20. Guthrie, J. & Parker, L. (1990), ‘Corporate social disclosure practice: a comparative international analysis’, Advances in Public Interest Accounting, 3, pp. 159–75. Himick, D. & Ruff, K. (2020), ‘Counter accounts of profit: outrage to action through “just calculation”’, Accounting, Auditing and Accountability Journal, 33(4), pp. 699–725. Hines, R. (1988), ‘Financial accounting: in communicating reality, we construct reality’, Accounting, Organizations and Society, 13(3), pp. 251–62. Hines, R. (1991), ‘The FASB’s conceptual framework, financial accounting and the maintenance of the social world’, Accounting, Organizations and Society, 16(4), pp. 313–51. © Elsevier Hofstede, G. (1984), ‘Cultural dimensions in management and planning’, Asia Pacific Journal of Management, 1(2), pp. 81–98. Hopper, T., Annisette, M., Dastoor, N., Uddin, S. & Wickramasinghe, D. (1995), ‘Some challenges and alternatives to positive accounting research’, in S. Jones, C. Romano & J. Ratnatunga (eds), Accounting Theory: A Contemporary Review, Brisbane: Harcourt Brace & Company. Hopper, T. & Powell, A. (1985), ‘Making sense of research into the organisational and social aspects of management accounting: a review of its underlying assumptions’, Journal of Management Studies, pp. 429–65. Hopwood, A. G. (1983), ‘On trying to study accounting in the context in which it operates’, Accounting, Organizations and Society, 8(2/3), pp. 287–305. Hopwood, A. G. (2007), ‘Whither accounting research?’, The Accounting, Review, 82(5), pp. 1365–74. Hopwood, A. G., Unerman, J. & Fries, J. (eds) (2010), Accounting for Sustainability: Practical Insights, London: Earthscan. Kingston, K., Furneaux, C., de Zwaan, L. & Alderman, L. (2020), ‘From monologic to dialogic: accountability of nonprofit organisations on beneficiaries’ terms’, Accounting, Auditing & Accountability Journal, 33(2), pp. 447–71.
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Lehman, G. (1999), ‘Disclosing new worlds: a role for social and environmental accounting and auditing’, Accounting, Organizations and Society, 24(3), pp. 217–42. Lehman, G. (2001), ‘Reclaiming the public sphere: problems and prospects for corporate social and environmental accounting’, Critical Perspectives on Accounting, 12, pp. 713–33. Macintosh, N. B. (2001), Accounting, Accountants and Accountability, London: Routledge. Macintosh, N. B. & Baker, R. C. (2002), ‘A literary theory perspective on accounting: towards heteroglossic accounting reports’, Accounting, Auditing and Accountability Journal, 15(2), pp. 184–222. Manetti, G., Bellucci, M. & Olivia, S. (2021), ‘Unpacking dialogic accounting: a systematic literature review and research agenda’, Accounting, Auditing and Accountability Journal, 34(2), pp. 250–83. Marx, K. & Engels, F. (1967), The Communist Manifesto, Harmondsworth: Penguin. Merino, B. & Neimark, M. (1982), ‘Disclosure regulation and public policy: a socio-historical appraisal’, Journal of Accounting and Public Policy, 1, pp. 33–57. Miliband, R. (1969), The State in Capitalist Society, Weidenfeld & Nicolson. Miliband, R. (1983), ‘State power and class interest’, New Left Review (March), pp. 57–68. Mitchell, A., Puxty, A., Sikka, P. & Willmott, H. (1994), ‘Ethical statements as smokescreens for sectional interests: the case of the UK accountancy profession’, Journal of Business Ethics, 13(1), pp. 39–51. Molisa, P. (2011), ‘A spiritual reflection on emancipation and accounting’, Critical Perspectives on Accounting, 22, pp. 453–84. Moore, D. (1991), ‘Accounting on trial: the critical legal studies movement and its lessons for radical accounting’, Accounting, Organizations and Society, 16(8), pp. 763–91. Mouck, T. (1992), ‘The rhetoric of science and the rhetoric of revolt in the story of positive accounting theory’, Accounting, Auditing and Accountability Journal, 5(4), pp. 35–56. Neimark, M. (1983), ‘The social constructions of annual reports: a radical approach to corporate control’, unpublished Doctoral dissertation, New York University. Neimark, M. & Tinker, A. (1986), ‘The social construction of management control systems’, Accounting, Organizations and Society, 11(3), pp. 369–96. Neu, D. & Cooper, D. (1997), ‘Accounting interventions’, paper presented at Fifth Interdisciplinary Perspectives on Accounting Conference, University of Manchester. O’Connell, B. T. (2004), ‘Enron Inc.: “He that filches from me my good name ... makes me poor indeed”’, Critical Perspectives on Accounting, 15(6–7), p. 733. O’Dwyer, B. (2005), ‘The construction of a social account: a case study in an overseas aid agency’, Accounting, Organizations and Society, 30(3), pp. 279–96. Offe, C. & Ronge, V. (1978), ‘Theses on the theory of the state’, in A. Giddens & D. Held (eds), Class, Power and Conflict, London: Edward Arnold, pp. 32–9. Owen, D., Gray, R. & Bebbington, J. (1997), ‘Green accounting: cosmetic irrelevance or radical agenda for change?’, Asia-Pacific Journal of Accounting, 4(2), pp. 175–98. Puxty, A. (1986), ‘Social accounting as immanent legitimation: a critique of a technist ideology’, Advances in Public Interest Accounting, 4, pp. 95–112.
Critical perspectives of accounting
Puxty, A. (1991), ‘Social accountability and universal pragmatics’, Advances in Public Interest Accounting, 4, pp. 35–46. Puxty, A., Sikka, P. & Willmott, H. (1994), ‘(Re)Forming the circle: education, ethics and accountancy practices’, Accounting Education, 3(1), pp. 77–92. Rabinow, P. (ed.) (1984), The Foucault Reader, New York: Pantheon Books. Reiter, S. (1995), ‘Theory and politics: lessons from feminist economics’, Accounting, Auditing and Accountability Journal, 8(3), pp. 34–59. Roslender, R. (2006), ‘Critical theory’, in Z. Hoque (ed.), Methodological Issues in Accounting Research: Theories and Method, London: Spiramus Press, pp. 247–70. Scott, W. R. (2008), Institutions and Organizations: Ideas and Interests, Los Angeles, CA: Sage Publications. Selto, F. & Neumann, B. (1981), ‘A further guide to research on the economic consequences of accounting information’, Accounting and Business Research, 11(44), pp. 317–22. Sikka, P., Wearing, B. & Nayak, A. (1999), No Accounting for Exploitation, Basildon: Association for Accountancy and Business Affairs. Sikka, P. & Willmott, H. (2005), ‘The withering of tolerance and communication in interdisciplinary accounting studies’, Accounting, Auditing and Accountability Journal, 18(1), pp. 136–46. Solomons, D. (1978), ‘The politicization of accounting’, Journal of Accountancy, 146(5), pp. 65–72. Spence, C. (2009), ‘Social accounting’s emancipatory potential: a Gramscian critique’, Critical Perspectives on Accounting, 20(2), pp. 855–82. Thompson, G. (1978), ‘Capitalist profit calculation and inflation accounting’, Economy and Society, pp. 395–429. Tinker, A. & Gray, R. (2003), ‘Beyond a critique of pure reason: from policy to politics and praxis in environmental and social research’, Accounting, Auditing and Accountability Journal, 16(5), pp. 727–61.
CHAPTER 13
Tinker, A., Lehman, C. & Neimark, M. (1991), ‘Falling down the hole in the middle of the road: political quietism in corporate social reporting’, Accounting, Auditing and Accountability Journal, 4(1), pp. 28–54. Tinker, A. M., Merino, B. D & Neimark, M. D. (1982), ‘The normative origins of positive theories: ideology and accounting thought’, Accounting, Organizations and Society, 7(2), pp. 167–200. Tinker, A. & Neimark, M. (1987), ‘The role of annual reports in gender and class contradictions at General Motors: 1917–1976’, Accounting, Organizations and Society, 12(1), pp. 71–88. Tinker, A. & Neimark, M. (1988), ‘The struggle over meaning in accounting and corporate research: a comparative evaluation of conservative and critical historiography’, Accounting, Auditing and Accountability Journal, 1(1), pp. 55–74. Tinker, T. (2005), ‘The withering of criticism: a review of professional, Foucauldian, ethnographic, and epistemic studies in accounting’, Accounting, Auditing and Accountability Journal, 18(1), pp. 100–35. Unerman, J. & Bennett, M. (2004), ‘Increased stakeholder dialogue and the internet: towards greater corporate accountability or reinforcing capitalist hegemony?’, Accounting, Organizations and Society, 29(7), pp. 685–707. Unerman, J. & O’Dwyer, B. (2004), ‘Enron, WorldCom, Andersen et al. a challenge to modernity’, Critical Perspectives on Accounting, 15(6–7), pp. 971–93. Williams, P. F. (2004), ‘You reap what you sow: the ethical discourse of professional accounting’, Critical Perspectives on Accounting, 15(6–7), p. 995. Willmott, H. (1990), ‘Serving the public interest’, in D. J. Cooper & T. M. Hopper (eds), Critical Accounts, London: Macmillan. Wood, A. (1995), ‘Marx, Karl Heinrich’, in T. Honderich (ed.), The Oxford Companion to Philosophy, Oxford: Oxford University Press, pp. 523–6. Zeff, S. A. (1978), ‘The rise of economic consequences’, Journal of Accountancy, 146(6), pp. 56–63.
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Glossary Abnormal returns
In capital markets research, abnormal returns are the realised (actual) rate of return, less the expected rate of return (as calculated by reference to a market model).
where accounting practices are oriented towards meeting the general decision-making needs of large numbers of investors, lenders and creditors who are not directly involved in the management of the organisation.
Accountability
Anti-capitalists
The duty to provide an account of those actions for which an organisation is deemed to be responsible. The accounts can take a variety of forms and would be provided to those stakeholders most affected by the activities of the organisation.
Those who wish to completely replace capitalism with another system.
Accounting
A process of collecting, summarising, analysing and communicating information to enable users of that information to make informed decisions. It can involve the provision of information to stakeholders about aspects of the organisation’s social, environmental and economic performance. Accounts
Written records detailing an organisation’s performance in relation to a specific aspect of performance. Accrual-based earnings management
Occurs when managers make, or defer, recognising various items of accrued income or accrued expenses (such as accruals for unpaid expenses) with the intention of generating a preferred financial result.
Defined by the IASB Conceptual Framework as a present economic resource controlled by the entity as a result of past events. Assumption
An assumption is something taken for granted or accepted as true without further proof. Behavioural accounting research
Applies theories and methodologies from the behavioural sciences to examine the interface between accounting information and processes and human behaviour. Bonding cost
Bonding costs are typically thought of as costs that are borne by the agent. Bonding occurs when the agent gives a guarantee to undertake, or not to undertake, certain activities. Brundtland Report
A market in which transactions for the asset or liability take place with sufficient frequency and volume to provide pricing information on an ongoing basis.
A report published by the United Nations World Commission on Environment and Development (WCED) in 1987. Its targets were multilateralism and interdependence of nations in the search for a sustainable development path.
Agency cost
Brunswik Lens Model
Active market
Costs incurred by owners because of asymmetric information, or conflicts of interest, between principals (owners) and agents (managers). There are three commonly cited agency costs: monitoring costs, bonding costs and residual costs. Agency relationship
Involving the delegation of decision making from the principal to an agent. Agent
An individual (or organisation) appointed to act on behalf of another party (the principal). Anglo-American model
An approach to accounting embraced within the United Kingdom and United States (and some other countries) 722
Asset
Depicts the processes involved in making decisions. It represents the processes involved when people use information cues in a variety of ways to come to a decision about future events. The Brunswik Lens Model also suggests that some of the cues might be interrelated. No individual cue is expected to provide a perfect predictor of the future event. Capacity to adapt
A measure, promoted by Chambers, tied to the cash that could be obtained if an entity sold its assets. The greater the current cash equivalents of an organisation’s assets, the greater the capacity to adapt to changing circumstances. Capital markets research
Investigates how the disclosure of particular information influences the aggregate trading activities taken by individuals participating within capital markets.
Glossary
Capture theory
Corporate social responsibility (CSR)
This theory suggests that although regulation is often introduced to protect the public, the regulatory mechanisms are often subsequently captured so as to protect the interests of particular self-interested groups within society, typically those whose activities are most affected by the regulation.
The continuing commitment by business to behave ethically and to contribute to economic development while protecting the environment and improving the quality of life of the workforce and their families as well as that of the society.
Classical Political Economy Theory
Used to refer to an approach to accounting research that goes beyond questioning whether particular methods of accounting should be employed, and instead focuses on the role of accounting in sustaining the privileged positions of those in control of particular resources (capital) while undermining or restraining the voice and welfare of those without capital.
A theory which explicitly places sectional (class) interests, structural conflict, inequity, and the role of the State at the heart of the analysis. Climate change
Major changes in temperature, rainfall, snow or wind patterns lasting for decades or longer. Coercive isomorphism
Critical perspective of accounting
Culture
Arises where organisations change their practices to conform to accepted institutional practices because of pressure from those stakeholders upon whom the organisation is dependent.
The collective programming of the mind which distinguishes the members of one human group from another. According to Takatera and Yamamoto (1987) culture can be defined as ‘an expression of norms, values and customs which reflect typical behavioural characteristics’.
Common law system
Current cash equivalent
A system where law is made by judges, based upon precedent, where legal judgements on current cases are made by reference to judgements made by judges on past cases of a similar nature. Conservative accounting methods
Methods of financial accounting that tend to recognise losses when they appear probable but defer the recognition of gains until they are realised. Conservative accounting policies would measure assets at cost even when the net realisable value is above cost, but would recognise impairment losses as soon as the realisable value of an asset falls below cost. Continental European model
An approach to accounting where financial accounts are primarily prepared for an environment in which funding mainly comes from lenders and there are relatively low numbers of outside investors, and where financial reports are prepared primarily with taxation and other statutory requirements in mind rather than other qualitative requirements, such as truth and fairness.
Represented by the amount of cash that would be expected to be generated by selling an asset. Current cost accounting
A method of accounting that measures assets at their current cost and where profits from trading and gains from holding assets (holding gains) are separately disclosed. Current purchasing power accounting
A method of preparing financial statements wherein adjustments are made to non-monetary assets – initially recorded at historical cost – to reflect changes in the value of money as reflected by changes in general price level indices. Gains and losses recognised will relate to the holding of net monetary assets. Debt covenants
Undertakings provided by a borrower as part of a contract associated with a loan, and these undertakings (covenants) either specifically restrict the borrower from taking particular actions or specifically require the borrower to take particular actions.
Control
Decision usefulness theories
From an accounting perspective, control relates to the capacity of a reporting entity to benefit from an asset and to deny or regulate the access of others to the benefit.
Theories that ascribe a particular type of information for particular classes of users on the basis of assumed decisionmaking needs.
Corporate governance
Decoupling
Refers to the structures and processes put in place so that an organisation heads in a direction that is consistent with its overall mission.
Refers to the situation in which the formal organisational structure or practice is separate and distinct from actual organisational practice.
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Glossary
Deductive reasoning
Expense
A way to explain a set of particular facts which is based more on the use of logic rather than observation.
Defined in the IASB Conceptual Framework as decreases in assets or increases in liabilities that result in decreases in equity, other than those relating to distributions to holders of equity claims.
Due process
A process wherein the regulator involves those parties likely to be affected by the proposed regulation in the discussions leading to the regulation; it provides an opportunity to ‘be heard’.
In literary theory, it is the notion that a text is an objective reflection of an underlying reality.
Efficient Markets Hypothesis (EMH)
Fair value
EMH is based on the assumption that capital markets react in an efficient and unbiased manner to publicly available information.
The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.
Elements of financial reporting
Faithful representation
Pursuant to the IASB Conceptual Framework, the elements of financial reporting are assets, liabilities, income, expenses and equity.
To be a perfectly faithful representation, a depiction would have three characteristics. It would be complete, neutral and free from error.
Emancipation
Falsifiable
Relates to efforts aimed at removing oppression of some groups or procuring political rights or equality for particular disenfranchised groups.
A theory is considered to be falsifiable if it provides predictions that can be tested and ultimately rejected.
Empirical research
Research that relies upon observing actual phenomena or data.
Describing a philosophy that uses experiment and observation to attempt to show that a theory is false, rather than attempting to verify it.
Empirically based theories
Financial accounting
A theory developed on the basis of past observations, and developed to make predictions about likely occurrences of particular events.
A process involving the collection and processing of financial information to assist in the making of various decisions by many parties internal and external to the organisation.
Enhancing qualitative characteristics
Financial capital maintenance perspective
Characteristics or attributes that enhance the usefulness of information that otherwise satisfies the fundamental qualitative characteristics of useful information.
Under this perspective of capital maintenance, a profit is earned if the amount of net assets at the end of the reporting period exceeds the amount at the beginning of the year, excluding any contributions from, or distributions to, owners.
Enlightened self-interest
This would be in operation when managers of an organisation respond to community concerns (as if to appear to be caring) in those situations where doing so also fulfils the goal of maximising the value of the organisation, and therefore the wealth of owners and managers. Equity
Defined by the IASB Conceptual Framework as the residual interest in the assets of the entity after deducting all its liabilities. Events studies
Studies that examine the changes of share prices or trading volume over a short time around the occurrence of a particular event, or around the time of release of particular information, such as earnings announcements.
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Expressive realism
Falsificationist
Financial reporting
Can be said to be the periodic process of providing information in financial statements about the financial position and performance of a reporting entity to users external to that entity to assist them in making informed decisions about allocating scarce resources, and assessing managers’ stewardship of the resources that have been entrusted to them. Free riders
Parties that use goods or services without contributing to costs that are borne by other people. Free-market approach
An approach wherein somebody believes that how and whether a good or service is produced should be left to market forces of supply and demand.
Glossary
Fundamental qualitative characteristics
Holding gains
Characteristics or attributes that information must possess if it is to be useful to users of that information.
Increases in the value of assets or reductions in the value of liabilities that arise as a result of holding assets or liabilities over time without transforming or modifying them.
General price index
A price index calculated for a generally consumed bundle of goods. An example would be a consumer price index. General purpose financial statements (GPFSs)
Hypothesis
A proposition typically derived from theory which can be tested for causality or association using empirical data.
Financial statements that comply with conceptual framework requirements and accounting standards and meet the information needs common to users who are unable to command the preparation of reports tailored specifically to satisfy all their information needs.
Income
Generalisability
Individualism
Generalisability is concerned with whether research findings can be generalised beyond the specific context in which the research was conducted. A study may be valid in one setting but not in another and in this instance the research results would not be generalisable.
Stands for a preference for a loosely knit social framework in society wherein individuals are supposed to take care of themselves and their immediate families only.
Global Reporting Initiative (GRI)
Defined by the IASB Conceptual Framework as increases in assets or decreases in liabilities that result in increases in equity, other than those relating to contributions from holders of equity claims.
Induction
The development of ideas or theories through observation.
A multi-stakeholder, network-based organisation headquartered in Amsterdam. It has developed the world’s most widely used standards for sustainability reporting – the GRI Standards.
Inductive approach
Greenhouse effect
Inductive reasoning
The phenomenon whereby the Earth’s atmosphere traps solar radiation, caused by the presence in the atmosphere of gases such as carbon dioxide, water vapour and methane that allow incoming sunlight to pass through but absorb heat radiated back from the Earth’s surface. Grounded theory
A theory that is developed though the collection and analysis of data and which involves the application of inductive reasoning. Ideas, concepts and, ultimately, a theory ‘emerge’ from the data. Harmonisation
In relation to accounting, refers to a process of increasing the compatibility of accounting practices by setting bounds to their degree of variation. Historical cost
Assets are recorded at the amount of cash or cash equivalents paid, or the fair value of the consideration given, to acquire them at the time of their acquisition. Liabilities are recorded at the amount of proceeds received in exchange for the obligation, or in some circumstances (for example, income taxes), at the amounts of cash or cash equivalents expected to be paid to satisfy the liability in the normal course of business.
An inductive approach to research is based upon developing theory through observation of particular phenomena. A way to explain a set of particular facts, weighing up observational evidence for a general proposition about a set of facts. Information asymmetry
A situation where one party in a transaction has access to certain (superior) information that is not available to the other party to the transaction. This is potentially harmful, as one party could take advantage of the other party’s lack of knowledge. Insider-financed system
Where organisations are predominantly family owned and where longer-term funding typically comes from banks or government. Institutional Theory
A theory that explains how various practices, processes and organisational forms become similar or ‘institutionalised’ within society. Explains that organisations within particular ‘institutional environments’ will become similar because of various coercive, normative and mimetic pressures. This process of becoming similar is referred to as isomorphism. The theory also predicts that there will be a decoupling of formal (seen) structures or forms and actual structures or forms.
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Glossary
Isomorphism
Materiality
A constraining process that forces one unit in a population to resemble other units that face the same set of environmental conditions.
A threshold concept concerning the relevance of an event or transaction to financial statement users. Something is considered ‘material’ if its omission or misstatement could influence decisions that users of the information make.
Legitimacy Theory
A theory that proposes that organisations need to operate within the bounds and norms of their respective societies. Compliance with societal norms and expectations is assigned the status of ‘legitimacy’. If ‘legitimacy’ is not apparent, then managers will embrace the process of legitimation.
Measurement
Liability
Mimetic isomorphism
Defined by the IASB Conceptual Framework as a present obligation of the entity to transfer an economic resource as a result of past events.
Involves organisations seeking to emulate (perhaps copy) or improve upon the institutional practices of other organisations; often for reasons of competitive advantage in terms of legitimacy.
Logical deduction
A conclusion or judgement that is made based upon logical argument or reasoning. Often developed through a series of steps, where each step is true if the preceding step is deemed to be true. Represents a process of reasoning using a series of statements (premises) to generate a logical conclusion. Market efficiency
A measure of how rapidly a market adjusts to fully impound information into share prices when the information is released. Market failure
A situation where market forces of supply and demand do not lead to economically or socially optimal levels of production. Market for corporate takeovers
Mixed measurement model of accounting
An approach to accounting wherein a variety of measurement approaches are used to measure assets and liabilities. Monetary assets
Monetary assets are assets that remain fixed in terms of their monetary value, for example cash and claims to a specified amount of cash (such as accounts receivable and investments that are redeemable for a set amount of cash). These assets will not change their monetary value as a result of inflation. Monetary liabilities
Liabilities that remain fixed in terms of their monetary value and will not change their monetary value as a result of inflation. Most liabilities are monetary liabilities.
A market in which corporations are bought and sold. Managers will try to maximise firm value to minimise the likelihood that outsiders could seize control of the organisation at low cost.
Monitoring cost
Market for managers
Net monetary assets
A market in which managers negotiate their salaries on the basis of their ability and performance. Information about past performance is assumed to be known by participants in this market.
Are monetary assets less monetary liabilities.
Mark-to-market
An approach where the value of assets is determined on the basis of observable market values. Mark-to-model
An approach where the value of assets is determined by reference to valuation models.
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The assignment of a quantitative measure to a particular item. In financial accounting it results from the application of a measurement basis – such as historical cost or fair value – to an asset, liability and related income and expenses.
Costs incurred in monitoring the performance of others. In PAT and Agency Theory they refer to costs incurred when principals attempt to monitor the actions of agents.
Non-monetary assets
Can be defined as those assets whose monetary equivalents will change over time as a result of inflation, and would include such things as property, plant and equipment and inventory. Non-monetary liabilities
Liabilities that require the transfer of goods or services in the future, the monetary value of which can change across time.
Glossary
Normative isomorphism
Relates to the pressures arising from group norms to adopt particular institutional practices. Normative research
Research that is generally based on deductive reasoning and seeks to develop a basis for informing people as to what they should do. Normative theory or prescriptive theory
Based on the norms or values or beliefs held by the researchers proposing the theories, it is usually based on a process of deduction rather than induction. Outsider-financed system
lobby groups or government to justify efforts to transfer wealth away from the organisation. Positive Accounting Theory
A theory that seeks to predict and explain why managers and/or accountants elect to adopt particular accounting methods in preference to others. Developed by Watts and Zimmerman and others, it is concerned with explaining accounting practice. It is designed to explain and predict which organisations will and which organisations will not use a particular accounting method, but says nothing about which method an organisation should use. It is based on the central economics-based assumption that all individuals’ actions are driven by self-interest.
Where longer-term funding comes from parties such as large numbers of shareholders who are not involved in the management of the organisation (they are ‘outsiders’).
Positive research
Paradigm
Positive theories
Refers to the progress of scientific practice based on people’s philosophies and assumptions about the world and the nature of knowledge. Parsimonious theory
A theory that performs as well as other theories but, relative to alternative theories, has fewer assumptions and variables. It is a theory that embraces simplicity and is consistent with the view that simpler explanations are preferred to more complex ones. Perquisite consumption
A perquisite is something of value which is a right, privilege or benefit received as a result of holding a particular position, title or job. Perquisite consumption is often used to refer to a situation where managers give themselves more ‘luxury’ items than would seem reasonable from the principal’s point of view. Personal social responsibility (PSR)
The continuing individual commitment to behave ethically and contribute to responsible economic, environmental and social development. Physical capital maintenance approach
Under this perspective, a profit is earned only if the organisation’s productive or operating capacity at the end of the reporting period exceeds the capacity at the beginning of the period, excluding any contributions from, or distributions to, owners. Political costs
Costs that groups external to an organisation might be able to impose on the organisation as a result of political actions. For example, if an organisation reports high profits then these profits might be used as an excuse by trade unions,
Research that seeks to explain and/or predict particular phenomena. Theories that provide the basis for explaining or predicting particular phenomena. Power distance
The extent to which the members of a society accept that power in institutions and organisations is distributed unequally. Prescriptive research
Research that is generally based on deductive reasoning and provides prescriptions, or suggestions, about what people should do. Present value
The value of an item to be received or paid for in the future expressed in terms of its value today. Price index
A weighted average of the current prices of goods and services relative to a weighted average of prices in a prior period, often referred to as a ‘base period’. Price protect
An individual or organisation ‘price protects’ when it requires a higher rate of return to compensate it for a higher risk investment (or vice versa). Principal
The principal delegates work to another person, known as the agent, who performs the work. For example, an owner of a business (the principal) might delegate work to an agent. Professionalism
A preference for professional judgement and self-regulation as opposed to compliance with legal requirements enforced through statutory control.
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Glossary
Pro-regulation
Social audit
A position taken by people who favour the use of regulation, rather than market forces, as a means of influencing particular activities.
A process by which an organisation determines whether its operations are meeting the expectations of particular stakeholder groups or satisfying the social performance criteria set by the organisation. The results of a social audit often form the basis for the contents of a social report.
Public good
Something that can be used by people without having to pay for it. Generally, use by one party does not affect the ability of others to use the particular item. Public interest theory
A theory of regulation which suggests that regulation is developed in the ‘public interest’. Regulators are assumed to be motivated by the ‘public interest’ and will select regulation on the basis that the social benefits of the regulation exceed the social costs. Real earnings management
Occurs when management varies the time at which particular transactions are undertaken with the intention of influencing reported results. Regulation
A rule of order, as for conduct, prescribed by authority; a governing direction or law. It is designed to control or govern conduct. Relevance
Information that will make a difference to a decision maker. From a financial accounting perspective, relevant information will have predictive value, confirmatory value, or both. Reporting entity
When users are said to exist who do not have access to information relevant to decision making and who are judged to be dependent on general purpose financial statements, the entity is deemed to be a reporting entity. Representationally faithful
Information is ‘representationally faithful’ if it is complete, neutral and free from error; it depicts what it claims to depict. Residual cost
As PAT assumes that not all opportunistic actions of agents can be controlled by contractual arrangements, there will always be some residual costs associated with appointing an agent. These occur despite the potential use of various bonding and monitoring mechanisms. Roman law
A term used to refer to a system of law where detailed laws are developed to apply to potentially all crimes and aspects of daily lives, and where little emphasis is to be placed on professional judgement.
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Social contract
It is an implied contract representing the norms and expectations of the community in which an organisation operates. Social praxis
Envisages a broad understanding of both ‘theory’ and ‘practice’ and is generally understood to refer to the assumption that there is a two-way (and possibly circular) relationship between theories and practices, whereby theory influences social practices while social practices also influence theory. Socialism
Any of various economic and political theories advocating collective or governmental ownership and administration of the means of production and distribution of goods. Special purpose financial reports
Financial reports that meet specific information needs of particular parties. Stakeholder Theory
Has both an ethical and managerial branch and is effectively an umbrella term representing a number of alternative theories that address various issues associated with an organisation’s relationship with its stakeholders. Standardisation
A process that imposes a given set of rules or requirements on a particular item, process or practice. From an accounting perspective it effectively means that every nation applies the same accounting standards. Status quo
A Latin term meaning the existing state of affairs. Stewardship
The acceptance of a responsibility to look after, or safeguard, the assets or entitlements of identified parties. Refers to the process whereby a manager demonstrates how they have used the resources that have been entrusted to them by others who generally are not directly involved in the management of the entity. Sub-prime
A classification of borrowers with a tarnished or limited credit history.
Glossary
Sustainable
Timeliness
Something is sustainable if it is able to be maintained at a specific level for a period of time. From a social and environmental perspective, practices are sustainable if they do not compromise the ability of current and future generations of people, and the other inhabitants of the planet, to meet their respective needs.
Having information available to decision-makers in time to be capable of influencing their decisions.
Sustainable cost
Triple bottom line reporting
A reporting technique that allows organisations to assess and report their performance against economic, environmental and social criteria.
Can be defined as the amount an organisation must spend to put the biosphere at the end of the accounting period back into the state it was in (or its equivalent) at the beginning of the accounting period.
Uncertainty avoidance
Systems-oriented theories
Also referred to as open systems theories, these are theories that perceive of an organisation as being part of a broader social system in which the organisation is influenced by, as well as influences, the society in which it operates.
From an accounting perspective, and in accordance with the IASB Conceptual Framework, classifying, characterising and presenting information clearly and concisely makes it understandable. Considerations of understandability require judgements to be made about the proficiency of users of information.
Technical default
Unexpected earnings
In relation to debt agreements, a technical default occurs when one party, the borrower, breaches a particular requirement (covenant) that has been negotiated with the lender. Theory
A scheme or system of ideas or statements held as an explanation or account of a group of facts or phenomena.
The degree to which the members of a society feel uncomfortable with uncertainty and ambiguity. Understandability
The difference between reported earnings and expected earnings per share. Verifiability
Refers to the ability, through consensus among measurers, to ensure that information represents what it purports to represent, or that the chosen method of measurement has been used without error or bias.
729
Index A AA1000 Stakeholder Engagement Standard 460 AASB 2 Share-based Payments 141 AASB 6 Exploration for and Evaluation of Mineral Resources 139 AASB 16 Leases 101 AASB 138 Intangibles 92, 101, 141–2, 371, 397 AASB 139 Financial Instruments: Recognition and Measurement 104, 144 abnormal returns (in capital markets) 352 accidents of history, and accounting practice 206–7 accountability 46, 282 acceptance of to provide information 511–12 in corporate social reporting 463 definitions 48–9, 50, 463 different perceptions of 54–7 IASC Conceptual Framework as restricted view of 328 of IFRS Standards 179 and information about corporate governance 70 for modern slavery 576–7 and organisation’s responsibilities 49–50 relationship with responsibility and accounts 46–8 relevance to accounting education 50 responsibilities 463 versus value creation ( Framework) 547 what do we mean by accountability? 48–50 see also organisational accountability accountability model, four-step 45, 58–66, 80–3, 463, 710 application to corporate social reporting 463, 509 accountants power of 99–101, 104–5, 699–700 role in defining reality 101–2, 103 stereotypic perspective 99 accounting behavioural research in 639–64 critical perspective 670–714 definition 46 ‘function’ of 503 influence of organisational objectives 66–8 and legitimation, critical accounting perspective 701–2 Marxist critique 679–81, 683, 688 objectivity and impartiality 105 partisan nature of (critical accounting research) 676–81 relationship with accountability 46–8 role in legitimising the capitalist system 702–3 without accountability 50 accounting-based bonus schemes 115–16, 370–2, 374, 378, 396 reliant upon conservative accounting practices 374–5 accounting-based debt covenants 186, 383–6, 387, 395, 396 accounting-based performance pricing 388 accounting education, relevance of ‘accountability’ 50 accounting educators, differences in what is being taught 45
730
accounting firms, and economic interest group theory of regulation 144 accounting for climate change 46–7 accounting for externalities 563–9, 678–9 accounting information, as public good 120 accounting information processing 641 accounting information system design 641 accounting neutrality 302–5 Hines ‘myth’ of 303–4 accounting policy choices (Positive Accounting Theory) 362–94, 399–403, 408–9 and ‘creative accounting’ 404–6 accounting practice government support for (critical perspective) 692 international differences in 187–207 international standardisation of 179–86 role in supporting existing social structures (critical perspective) 697–703 Accounting Principles Board (APB) 87, 240 see also APB; FASB accounting profession ‘captures’ ASRB 93, 135, 136 conceptual framework ‘boosts’ their public standing 335–6 desire to retain control over standard-setting 136–7 strength of, and accounting practice 205–6 accounting regulation 112–13 21st-century political pressure on 88–91, 113 as an output of a political process 146–9 in Australia 87, 133–8 based upon generally accepted accounting practice 86 Capture Theory 93, 132–9 costs and benefits 94–5 critical accounting interpretation of increased regulation post-Enron 695–6 development 83–91 differences between accounting rules of different countries 161–2 economic interest group theory 128–9, 142–6 economic and social impacts 141–2 and enforcement 95–6 in Europe 88 ‘free-market’ perspective 85, 92, 113, 114–19 G-20 leaders agree to reform financial markets transparency and accountability 89–90 government intervention in 122, 124–5, 126, 130–1 international convergence 90, 140 ‘pro-regulation’ perspective 119–29 public interest theory 92–3, 113, 128, 130–2 public interest versus private interest 146 rationale for 91–6 reasons for/against 92 reasons for legislative reform 127–9 regulatory overload 121
Index
and self-interest assumption 131 social and environmental reporting 514 to protect public interest 134, 135 in US and UK 86–7, 88, 91, 130–1, 138 who should be responsible? 94 see also financial reporting standards accounting regulators as an interest group 144 and due process 146 greater independence 135–6 lobbying of 142–4, 250–1, 362–3 need to consider potential costs and benefits of particular reporting requirements 147 obstacles to compromise between 146–7 resources 144 to consider views of financial statement preparers when developing financial reporting standards 158 see also specific bodies, e.g. Securities and Exchange Commission Accounting Regulatory Committee (ARC) 143 accounting reports see financial reports accounting research shift in publications towards positive research 347, 350 and support for deregulation of accounting 693–5 trends 1950s to 1970s 347–8 see also critical accounting research Accounting Research Bulletins 87 accounting researchers embracement of Agency Theory 357 particular theory being used and choice of research method 32–3 perceptions affecting choice of theory 9–10, 14–15, 17–19, 29, 31–2, 44 use of pre-existing theories or development of their own 15 see also critical accounting researchers The Accounting Review 347, 363 accounting rules, early codification 85–6 accounting standard-setters awareness of Institutional Theory 485 legitimising 335, 336 use of behavioural research 654 accounting standard-setting process application of Institutional Theory to 476 political nature 221, 260 accounting standards economic and social implications 94–5, 101, 104–5, 113, 141–2, 147–8 international differences prior to recent standardisation initiatives 161–3 narrow focus compared to conceptual framework 278–9 ‘value relevance ‘ 625 see also AASB; IAS; IFRS; IFRS Standards Accounting Standards Authority of Canada 336 Accounting Standards Board (UK) 135, 276, 292 accounting standards overload 120, 121
Accounting Standards Review Board (ASRB) 93 accounting theories evaluating 18–22 factors in acceptance of a theory 21 importance of studying 4–6 overview 7–17 reasons for refinement 7 selection based on manager’s beliefs and perceptions 31–3, 43–4 accounts 46 as a neutral depiction of underlying reality 302–5 relationship with responsibility and accounting 48 accrual accounting 301 accrual-based earnings management 400, 401 active market 221 aerospace companies, as lobby group 143 agency costs 346, 355, 356, 358, 360, 361, 369 agency costs of debt 381, 382–3 agency costs of equity 346 ‘agency problem’ 355 agency relationships 346–7, 354–5, 399 Agency Theorists 410–11 Agency Theory 208, 346, 354–7 accounting researchers embracement of 357 focus on relationships between principals and agents 354–7, 360 incentives/contractual arrangements for agents 356–7 individuals driven by self-interest 349, 355–7, 358, 361 maintained assumption 355–6 monitoring and bonding costs 356 perspective of the organisation as a ‘nexus of contracts’ 358–60 teaching to business students and corporate scandals 411 to help explain and predict managerial choice of accounting policies 354–7 well-functioning organisation 356 agents 346, 355–7, 360 aggregate behaviour of investors in the capital market 593–632, 640 alternative accounting measurement systems 251–2 corporate opposition to 250–1 Alternative View (Whittington) 262 American Association of Public Accountants 85 American Institute of Certified Public Accountants (AICPA) 85, 86, 240 development of conceptual frameworks 251–2, 279–81, 335 anchoring and adjustment heuristic 655 Anglo-American Model of accounting 167, 187, 198, 206, 210 animal welfare groups 521, 540 anti-capitalists 677 anti-corruption 461 anti-dumping trade investigations, EU 402 anti-regulation viewpoint see ‘free-market’ perspective to accounting regulation; Smith, Adam
731
Index
APB Statement No. 4, Basic Concepts and Accounting Principles Underlying the Financial Statements of Business Enterprises 279–80, 335 asset/liability approach 307 asset revaluation reserves 625 asset substitution 381 asset valuations, and stewardship 292 assets 278, 306, 307, 330, 334–5 acquired at no cost 309–10 control 308–9, 330 definition and recognition of 308–15, 527 IASB Conceptual Framework definition 308 past event 309 potential to produce economic benefits 309 recognition of 310–15 AstraZeneca 161, 206 audit opinion of GCM, impact on share price 602–3 auditing process research 641 auditor quality, and earnings management 403 auditors consistency of judgements over time 655 and economic interest group theory of regulation 144 judgement and decision-making audit research 642, 660 relevance of behavioural research to 645 Australia accountants want to retain control over standards-setting 136–7 accounting regulation 87 adopts IAS/IFRS 165, 173–4, 175, 277 banking sector as lobby group 144 ‘capture’ of financial reporting standard-setting 136 conceptual framework 276, 277, 282 elements of financial reporting 306 enforcement of compliance with IFRS 182 and establishment of ASRB 93, 135, 136, 137 harmonisation of accounting standards with IAS 164, 173 private and public debt contracts 383–5 rolling GAAP 384–5 Australian Accounting Research Foundation (AARF) 87, 93, 137, 164 Australian Accounting Standards Board (AASB) 87, 93, 135, 174 Definition of the Reporting Entity 276, 286 development of conceptual framework 277 harmonisation of standards with IASB standards 174, 210 overseen by Financial Reporting Council 138 Australian Accounting Standards Review Board (ASRB) ‘captured’ by the accounting profession 93, 135, 136–8 establishment 93, 135, 136, 137 replaced by AASB 93, 135 Australian Competition and Consumer Commission (ACCC) 389 Australian Government Inquiry on Corporate Social Responsibility, submissions to 124–5, 464, 689–90 Australian Human Rights Commission, definitions of CSR 500
732
Australian Minerals Industry Code for Environmental Management 438, 515–16 Australian Securities and Investments Commission (ASIC) climate risk disclosure 572–3 power to enforce compliance with Corporations Act 2001 182 subject to regulatory capture 133, 134 Australian Shareholders’ Association 137 Australian Society of Accountants 87 Automobiles Sustainability Accounting Standard (SASB) 554–5 availability heuristic 655–6
B balance sheet 78 assets 313 elements in 306, 307 and fair values 399 Bangladesh garment suppliers social and reporting practices 469, 485 and supply chains of multinational corporations 577 workplace safety changes 485, 486–7 banking sector and ACCC 132–3 and ASIC 133, 134 as lobby group in Australia 144 as lobby group in Europe 143–4, 146–7 value relevance of financial statements, US 265 Baskerville, Rachel 191, 192 Baydoun and Willett, use of Hofstede–Gray theory to investigate French Uniform Accounting System 198–9 behavioural decision theory 642 behavioural research in accounting 597, 639–64 aims and applications 642–3, 644 Brunswik Lens Model 646–50 classification 641 commercial application 650 decision-making process and use of heuristics 654–9 environmental factors that influence decisions 660 environmental social controls and capital investment decisions 653 experimental research 643–5 implications of different forms of presentation 652 information ‘cues’ influence on decision making 646–50 ‘information overload’ 652–3 issues of decision accuracy 660–1 limitations 663–4 overview 641–5 protocol analysis 661–3 relevance of differences in culture 663 relevance to auditors 645 social factors in stakeholder decisions 653–4 standard-setters use 654 use of particular information items (cues) 650–2 Benson, Henry 166 BHP 53, 429, 431, 444, 466
Index
big-4 auditors, to curtail managerial manipulation 403 biodiversity impacts 520 biodiversity risk 506 Body Shop 434–5 bonding costs 346, 356, 360 bonus plan hypothesis see management compensation (bonus) hypothesis bonus schemes accounting-based 115–16, 370–2, 374–5, 378, 396 generally 370 market-based 375–81 book values 621, 622 change in 622 and market values 621–3, 625 ‘bourgeois’ Political Economy Theory 425, 426, 455, 682 Brigitte Bardot Foundation, counter accounts 704–5 British oil and gas companies, excessive profits and government-imposed windfall profits tax 389, 394 Brundtland Report 507, 518 Brunswik Lens Model 646–50 application to the decision by graduate schools to admit students 646–7 diagrammatic representation 646 general applicability to decision-making scenarios 647–9 processing information at the input, decision process and output level 649 ‘buffers’ 473 business ownership and financing systems, and accounting practice 202–4 buying price 244
C can (or should) more than one theory be used at a time? 30–1 Canada, conceptual framework 282–3, 336 Canadian Institute of Chartered Accountants (CICA) 336 capacity to adapt 243, 245 Capital Assets Pricing Model (CAPM) 347, 352, 608 capital-intensive firms, support for CCA 251 capital maintenance 234–5 capital maintenance adjustment 245 capital markets abnormal returns in 352 and Efficient Markets Hypothesis 351–3, 598, 631, 632 potential inefficiencies in 632 reaction to current cost and CPPA information 249 reaction to financial reporting 593–632 size affect on investors 614 use of non-financial information 628 capital markets research 13–14, 595, 640 aggregate behaviour of investors 593–632 assumption that equity markets are semi-strong-form efficient 598 differences from behavioural research 597 events studies 605–10 information content of earnings 605–10 ontological and epistemological assumptions 596–7
overview 595–605 reliance on market efficiency 597–605, 613, 615, 616, 630–2 share price reactions to earnings announcements 605–10 share price reactions to financial information releases 597–605 ‘stock/share return synchronicity’ 629 on whether current share prices anticipate future accounting earnings announcements? 620–9 capital markets research, results of into financial reporting 610–20 benefits associated with the voluntary disclosure of information 618 earnings announcements of other organisations in the same industry have information content 616–17 earnings forecasts have information content 617 earnings persistence depends on the relative magnitudes of cash and accruals components of current earnings 615–16 historical cost income is used by investors 611–12 information content of earnings announcements depends on the extent of alternative sources of information 614 prior to an earnings release investors obtain much of the information they need from other sources 612–14 recognition is perceived differently to mere footnote disclosure 618 size of a company affects whether the capital market will react to a company’s release of information 618–19 unexpected changes in earnings created by unexpected increases in revenues 619–20 unexpected changes in earnings dependent on whether the change is expected to be permanent or temporary 615 capitalism critical accounting view on the active role of academic and non-academic discourse in protecting 696–7 Marxist-informed critique of 679–81 capitalist system, accounting role in legitimising 702–3 ‘capitals’ ( Framework) 549–51 Capture Theory of regulation 93, 132–40 ASRB’s capture 93, 136, 136–8 and the extractive industries 138–40 financial reporting standard-setting within Australia 135, 136 regulation introduced to protect public interest 135 carbon dioxide 569 Carbon Disclosure Project (CDP) 575 carbon emissions 512, 529, 556, 565, 575 cost of 571–2 and market value of an organisation’s shares 626 as value-relevant 627–8 see also greenhouse gas emissions carbon taxes 102–3 carrying amount 306 cash 309 CEO Guide to Climate-related Financial Disclosures 556
733
Index
CEOs approaching retirement 373–4, 376, 401 changeover and earnings management 379–80 compensation tied to R&D spending 376 horizon problem and organisational identification 373–4 market-based bonus schemes 375–81 pay structure, cultural influences 208–9 personal motivations 375–6 salary and bonus compensation 378 share options as bonus 377, 378–9, 380 see also managers Certified General Accountants Association 336 Chambers’ Continuously Contemporary Accounting (CoCoA) 12, 30, 35, 243–9, 309 changing prices, treatment of Continuously Contemporary Accounting 243–9 current cost accounting 241–3 current purchasing power accounting 236–41 debate over most appropriate accounting method 251–2 historical cost accounting 230–6 changing social expectations, and legitimacy 431–3 Chartered Accountants Australia and New Zealand (CAANZ) 87, 137, 689 chief executive officers see CEOs claim dilution 381 classical Political Economy Theory 425, 426, 681–2, 686 clean surplus earnings 622 climate change 57, 70, 500, 508, 513, 529, 569–74 accounting for 46–7, 505, 556–7, 558 effects of 569, 572 financial risks from 570–1 risks and opportunities 556–7, 558, 570–1 see also carbon emissions; greenhouse gas emissions Climate Change Position Statements 556–7 climate change-related governance policies 573 Climate Reality Project 571, 572 climate-related financial disclosures 571, 572–3 reporting frameworks 573–4 TCFD recommendations 556–7, 571 climate-related risks as ‘material’ 573 potential financial implications 573
coercive isomorphism 478–80 hypotheses 478 pressure on US state governments to adopt GAAP 483 collectivism 192–3, 195 Commission of European Communities, definition of CSR 500–1 Committee on Accounting Procedure 87 common law systems 201, 202, 206 Commonwealth Bank 431, 528–9 communication and legitimacy 435 with shareholders 524 ‘community concern’, media coverage as measure of 443–4, 446
734
community expectations changing, and legitimacy 431–3 news media shaping 444 see also public expectations company performance, share returns as benchmark measure of 621 company value measures of 621–2 share price as benchmark measure of 621 comparability 299–300 Competition Commission (UK) 389 completeness 296 ‘conceptual compass’ of critical research 675–6 conceptual frameworks 274 advantages 327 Australia 276, 277, 282 boost the accounting profession’s public standing 335–6 broader focus than accounting standards 278–9 building blocks 285–324 Canada 282–3, 336 components 276–8 critical theorists perspective 697–8 and definition of general purpose financial reporting 277–8 definition of the reporting entity 285–8 definitions 275–6 elements of accounting 278 elements of financial reporting 305–24 FASB/IASB joint initiative 274, 275–6, 283–5 history of development 278, 279–85 IASC 283 legitimising accounting standard-setters 335, 336–7 measurement principles 324–6 neutrality and representational faithfulness 302–5 New Zealand 283 as normative theory of accounting 274, 275 and objectives of general purpose financial reporting 276, 278, 290–4 qualitative characteristics of financial reports 294–302 to legitimise accounting standard-setters 335, 336 UK 131, 276, 282 US 251–2, 279–82, 306, 335, 336 users of financial reports 288–90 what are they 275–9 what is meant by financial reporting? 276 see also IASB Conceptual Framework for Financial Reporting conceptual frameworks – criticisms 327–37 a device to legitimise accounting standard setters and the accounting profession 335–7 a potentially distorted view of an organisation’s ‘performance’ 329–34 restricted view of accountability 328 simply a reflection of existing accounting practice 334–5 stifles future reporting innovation 329 confounding events 606 conservatism 199 versus optimism 195, 196
Index
conservatism phenomenon (heuristic) 656 conservative accounting methods 374, 394–6 accounting-based bonus schemes reliant upon 374–5 advantages 396 contribution to efficient contracting 395 and debtholders 395–6 and IASB and FASB 397 and investment decisions 651 to reduce agency costs of debt 382–3 consistency in judgements over time 655 constructive obligation 317 consumer groups 540 continental European countries, accounting practice 197, 198, 202, 203, 204, 205, 207 continental European model of accounting 187, 206 Continuously Contemporary Accounting (CoCoA) 12, 30, 243–9, 309 doesn’t gain widespread support 149 Edwards and Bell’s criticism 248 example 245–7 strengths and weaknesses 247–8 contracting see debt contracting contracts, nexus of, in organisations (Agency Theory) 358–60 contractual compliance, and measurement 224 contributions from owners 306 control 308–9, 330, 358 controlled experiments 644 corporate accountability see organisational accountability corporate governance 45, 69–70, 573 climate change-related disclosure 573 elements 69 and organisational performance 70 corporate legitimacy 427–8, 433 and the legitimacy gap 431–3 corporate opposition to alternative methods of accounting 250–2 The Corporate Report (UK) 131, 282, 292–3, 328, 526 corporate responsibilities 51–2, 518 corporate social practices, and long-term decision making 627 corporate social responsibility (CSR) 26, 454 accountability for modern slavery 512, 576–7 counter and dialogic accounts 578–80 definitions 500–1 government anti-regulation approach 126–7 reporting see CSR reporting submissions to Australian Government inquiry on 124–5, 464, 689–90 see also personal social responsibility corporate sustainability practices, and uncertainty avoidance 627 Corporations Act 2001 182, 287 and corporate social responsibility 124–5, 689 cost cutting, and social costs 528–9 cost model, property, plant and equipment 227–8 costs and benefits of financial reporting 298–9 counter accounts 578, 579–80
critical perspective 703–6 nature of 706 courts, role of 119 CPA Australia 87, 577 on companies’ social and environmental reporting 689–90 ‘creative accounting’ 104, 404–6 credit crunch 88 credit watch, negative, and earnings management 402 crisis, response to a 60–1 critical accounting research 349 aims 675–6 counter accounts and dialogic accounts 703–11 emancipatory role 673 Gendron’s ‘conceptual compass’ of 675–6 insights into the partisan nature of accounting 676–81 possible impact on social practice 686–91 role of accounting research in supporting existing social structures 693–5 and ‘social praxis’ 673–4 and support for deregulation of accounting 693–5 versus social and environmental accounting research 681–6 critical accounting researchers critical reflection on role in creating change 712–14 need for engagement with the broader community 713–14 ontological assumptions 676 perspective grounded in Political Economy Theory 681 philosophical positions 680–1, 688 and social and environmental accounting research 684 critical accounting theorists 671, 673, 677, 688 beliefs about CSR reporting 682 deficiencies of social and environmental accounting research 682–4 informed by various philosophies 674–5 interpretation of increased accounting regulation postEnron 695–6 marginalisation 688, 689 and need for more accounting 683 perspective of accounting and legitimation 701–2 power of accountants through a false image of neutrality 699–700 purpose of their work 714 reflecting on the ‘attitudes and orientations’ of accountants 688–90 role of accounting practice in supporting existing social structures 697–703 role of accounting reports in creating a selective ‘reality’ 698–9 role of conceptual frameworks 698 role of the state in supporting existing social structures 691–3 view on the active role of academic and non-academic discourse in protecting capitalism 696–7 vocal critics of Positive Accounting Theory 690
735
Index
critical accounting theory 13–17, 95, 672 Marxist critique of accounting 679–81, 683, 688 philosophical perspectives 686–8 and praxis 673–4
current values 325 accounting reliant upon 240, 241 classification 325–6
critical dialogic accounting 710–11 critical perspective of accounting 670–714
D
accounting for externalities 678–9 defined 672–6 and elements of financial reporting 678 critical theory 672, 673 critical thinking 670 Crown Estate 567 CSR reporting benefits for organisations of 519 critical theorists beliefs 682 definition 503 Global Reporting Initiative (GRI) 535–45 and Gray, Adams and Owen’s ‘accountability model’ 463 incidence of 503–7 integrated reporting 545–63 meanings of social, environmental and sustainability reporting 501–3 as a means of gaining legitimacy 475 and mimetic isomorphism 480–1 and perceived legitimacy of the organisation 515–16 relevant stakeholders 522–3 triple bottom line reporting 525, 534–5 see also social and environmental reporting; sustainability reporting cultural-cognitive pillar (institutions) 473–4, 478, 485, 517 culture definitions 189 and individual’s decision-making processes 663 influence on CEOs pay structure 208–9 and international differences in accounting practice 189–99 and manager’s verbal communication about financial results 200 cumulative abnormal returns before and after the announcement of earnings 611–12 current cash equivalents 243, 245 current cost accounting (CCA) 241–3 capital-market reaction 249 corporate lobbying for 250–1 limited corporate support for 250 strengths and weaknesses 242–3 current costs 223, 249, 325, 326 current purchasing power accounting (CPPA) 236–41 calculating indices 237–8 capital-market reaction 249 corporate managers’ attitude to 250 performing adjustments 238–41 strengths/limitations 240–1
736
dangerous chemicals 512 debits and credits 84 debt contracting 381–93 conservative accounting methods to reduce agency costs of debt 382–3 evidence of the use of accounting-based debt covenants 383–6 incentives to manipulate accounting numbers in the presence of debt contracts 386–8 debt covenants 364 accounting-based 186, 383–6, 387, 395, 396 technical default 396–7 debt hypothesis (debt/equity hypothesis) 364, 366, 405, 408, 409 debtholders and conservative accounting methods 395–6 strategies by managers to disadvantage 382 and technical default of a debt covenant 396–7 decision-makers emphasis 13 decision making at the individual level 639–64 cultural influences 663 environmental factors that influence 660 environmental social controls and capital investment decisions 653 general applicability of the Lens Model 647–9 information ‘cues’ influence on 646–50 issues of decision accuracy 660–1 protocol analysis 661–3 and use of heuristics 654–9 decision-making authority, delegation of 346 decision-models emphasis 13, 14, 244 decision-usefulness approach 13, 225, 226, 244, 257, 291, 293 versus stewardship role, of fair value 262–5 decoupling (from institutionalised practices) 473, 478, 483–4 deductive reasoning 8, 9 ‘deep ecologists’ 686 definition and recognition of assets 308–15, 527 assets acquired at no cost 309–10 control 308–9 past event 309 potential to produce economic benefits 309–10 recognition of an asset 310–15 definition and recognition of expenses 321, 322, 527 definition and recognition of income 321–2 definition and recognition of liabilities 316–20 outflow from the entity of resources embodying economic benefits 316–17 past event 316 present obligation 316, 317 recognition of liabilities 317–20
Index
definition of equity 323 delegation of decision-making authority 346 demand for price-adjusted and value-adjusted accounting information 249–52 deprival value 223 derecognition of an asset 313 deregulation of accounting, accounting research support for 693–5 developing countries social and environmental disclosures 445, 469, 485–6 and World Bank coercive powers 479 development expenditure IASB and FASB treatment 397–8 pre- and post-IFRS period 625–6 development of accounting regulation 83–91 dialogic accounting 578–9, 703, 706–11, 712 critical 710–11 diagrammatic representation 708–9 over-arching aim 707–8 regulatory intervention to create dialogical engagement 709 disclosure of information and extent of media coverage as a measure of ‘community concern’ 443–4, 446 financial disclosure 442–3 general purpose financial reporting 80–3 GRI 541–3 how should it be disclosed? 63 legitimacy see legitimacy legitimising 445, 447–8 materiality determination process 65–6, 542 reasons for 58–61 where to disclose 63 see also reporting; social and environmental disclosure disclosure of private information, managers avoidance of 378–9 disclosure regulations, development 86–8 discretionary accounting choices 400 ‘disposition effect’ in relation to investor choices 657–9 distributions to owners 306 dividends, payment of 234 double-entry accounting, reliance on 83–4 due diligence process (GRI definition) 539 due process 146 dysfunctional investor behaviour 657
E earnings entity size and share price movements 618–19 persistence depends on the relative magnitudes of cash and accruals components of current earnings 615–16 predicted to be a more useful measure of firm performance than cash flows 624 prior to an earnings release investors obtain much of the information they need from other sources 612–14
unexpected changes created by unexpected increases in revenues 619–20 unexpected changes dependent on whether the change is expected to be permanent or temporary 615 earnings announcements cumulative abnormal returns before and after 611–12 do current share prices anticipate future accounting earnings announcements? 620–9 forecasts have information content 617 information content depends on the extent of alternative sources of information 614 information content of 605–20 linked to changes in the price of securities 606–10 of other organisations in the same industry have information content 616–17 earnings management 399–403 accrual-based 400, 401 and CEO changeover 379–80 definition 400 gender of directors influence on 401–2 and ‘negative credit watch’ 402 organisation-based factors impact on 401 political costs 403 and quality of the auditor 403 real 400 and strong labour unions 402–3 earnings/return relation 607 economic and political influences on financial reporting, differences in 181 economic and social impacts of accounting regulation 141–2 economic and social implications of accounting standards 94–5, 101, 104–5, 141–2, 147–8 economic benefits, outflow of 316–17 economic consequences analysis (ECA) approach 694 economic Darwinism 359 economic interest group theory of regulation 128–9, 142–6 and accounting firms/auditors 144 dominated by private interests 142, 144–5 and lobbying 142–4 regulation as a commodity subject to supply and demand 145 regulation serving the private interests of politically effective groups 144–6 regulator as an interest group 144 economic resource 309 economic sustainability 508 economic theory 687 feminist values 687–8 Edwards and Bell’s current cost accounting 242–3, 245 criticism of Chambers’ approach 248 efficiency of IFRS Standards 179 efficiency perspective 97, 299, 366–7 efficient market share price response in 600–3 see also market efficiency Efficient Markets Hypothesis (EMH) 346, 351–3, 390, 598, 631, 632
737
Index
elements of financial reporting 305–8 asset/liability approach 307 Australia 306 critical perspective 678 definition and recognition of assets 309–15 definition and recognition of expenses 321, 322 definition and recognition of income 321–2 definition and recognition of liabilities 316–20 definition of equity 323 FASB 305–6, 307 IASB 306, 307 revenue/expense approach 307 summary 323 emancipation 673 emotive or colourful language (to support a weak argument) 28 empirical research 3 empirically based theories 3 enforcement and regulation 95–6 enhancing qualitative characteristics 295, 299–302 enlightened self-interest 126–9 Enron 148, 162, 176–7, 206 critical accounting interpretation of increased accounting regulation post-Enron 695–6 mark-to-model approach to fair value accounting 259–61 entities, distinguishing from reporting entities 287–8 entity assumption 527 environment (UN Global Compact) 560–1 environmental costs, of pollution 332–3 environmental disclosures 440–1 legitimation strategies 442 see also social and environmental disclosures environmental factors that influence decisions 660 environmental groups 540 environmental profit and loss account 567–8 environmental reporting 503 see also social and environmental reporting environmental social controls 653 environmental sustainability 508 EPA-prosecuted companies, and environmental disclosures 440–1 epistemological assumptions 31, 349, 596, 597 epistemological diversity 675 equitable obligation 317 equity 278, 306, 307 definition of 323 equity compensation 380 equity markets as efficient 597–8 as semi-strong-form efficient 598 ethical (moral) branch of Stakeholder Theory 53, 458, 460, 461–5, 468, 470, 517, 521, 523 EU accounting regulation 88 adopts IAS/IFRS 171–2, 175 anti-dumping trade investigations 402 approach to accounting harmonisation 170
738
banking sector as lobby group 143, 146–7 delayed recognition of IFRS 9 143–4, 146–7 role in standardising accounting practices internationally 170–2, 175 view on global financial reporting 171 EU Accounting Regulatory Committee (ARC) 172 Europe accounting differences compared to US 161–2 Roman law systems 205 European-based multinationals, differences in reported results based on their home nation’s and US accounting rules 161–2 European Commission 167 European Financial Reporting Advisory Group (EFRAG) 172 European Union see EU evaluating accounting theories 18–21 is the theory parsimonious? 22–3 evaluating theories 24 can (or should) more than one theory be used at a time? 30–1 emotive or colourful language to support a weak argument 28 evaluating the underlying assumptions 26–8 generalising theories from the testing of samples 29–30 through logical deduction 24–5 universal applicability of theories 28–9 events studies 605–10, 620 ex ante perspective 366–7 ex post incentive 386 Excellence in Research for Australia (ERA) review 33–4 executive remuneration, cultural differences 208–9 existence uncertainty 311–12, 530 exit price accounting 243–9 exit values 263 expected earnings in the absence of earnings announcements 352–3 expected future earnings and share prices 606–10 expenses 278, 306, 307, 330 classifying resource flow as 322–3 definition and recognition 321, 322, 527 experimental researchers 641 experiments/experimental research 640, 643–5 problems of loss of control 645 explanatory and predictive (positive) accounting theories 10–12 expressive realism 699 external shareholders 202 external stakeholders 462 external validity 645 externalities accounting for 563–9, 678–9 definition 564 environmental, and generally accepted financial accounting practices 533, 564, 566 full cost accounting approach 566–7, 568–9 innovative accounting approaches 567–8 and measure of performance (profits) 566
Index
negative 564–5 positive 565–6 sustainable cost calculation 566–7 extractive industries, accounting standard 138–9 Exxon Oil Company 440
F fair value 325, 326, 396 appropriateness for balance sheet items generally 399 and basic financial accounting equation 252–3 changing prices, biological assets 233–4 classifying using fair-value hierarchy 256–7 comparing to historical cost 254, 398 cost model vs revaluation model (property, plant and equipment) 227–8 decision usefulness versus stewardship role of financial reporting 257, 262–5 definition 252, 253 determined by way of valuation models 254, 255 determined from observable market values 254, 256, 260–1 impairment to 183–4, 185 and intangibles 399 measurement based on 220, 221, 223, 227, 228, 248, 253–7, 398 relationship to volatility and procyclicality in accounting measures 257–61 and revenue recognition 399 use with US GAAP 259 use within IFRS 183–4, 185, 254–5, 259 fair value accounting 248–9, 252–65 contribution to ‘financial crises’ 258–60 mark-to-market approach 254, 255, 398 mark-to-model approach 254, 256, 260–1, 398–9 relevance of PAT-based research to efforts by the IASB and FASB to promote 394–9 relevance versus representational faithfulness 262–5 fair value hierarchy 255–7, 259, 263, 265, 398–9 Fair Value View (Whittington) 262 faithful representation see representational faithfulness ‘false rumours’ and share prices 601–2 falsifiable hypotheses 23, 348 falsificationists 23, 348 family-owned businesses 202–3 FASB 76, 87, 167, 207, 240, 694 borrowing practices and debt covenants 385–6 conceptual framework 281–2, 306, 336 conceptual framework definition 275 differences in accounting standards to IASB 283 does not have social and environmental performance as core focus 500 elements of financial reporting 306, 307 fails to prescribe a particular measurement approach 281 and fair value accounting 395–9 lobbying positions taken by US corporate managers on GPLAs 250, 362–3
measurement bases 220 opposed to retention of stewardship in Conceptual Framework 226 releases Statements of Financial Accounting Concepts (SFACs) 281–2 standards used in US 160–1, 176 treatment of development expenditure 397–8 useful life 336 FASB/IASB conceptual framework 274, 275–6, 282, 283–5, 324 definition of reporting entity concept 286 discussion papers 275 eight phases of work 284 Exposure Draft 275–6, 286 measurement 324 objective of financial reporting 275–6 reasons for one uniform conceptual framework 283–4 suspension of project 284–5 FASB/IASB convergence project 90, 161, 170, 283, 298 factors to consider when choosing between measurement bases 229–30 reasons against convergence 90, 140 and US GAAP rules 177 FASB Statement No. 33 250 Federal Trade Commission (US) 389 femininity 193, 687 feminist values in economic theory 687–8 Fiji adoption of IFRS 165, 199, 204 cultural attributes 199 ownership and financing systems 204 Final Report of the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry 134 financial accounting 75–6 elements of 305–23, 678 regulation 83–96 role of professional judgement 96–7, 98, 104 versus management accounting 80 financial accounting equation and fair value 252–3 impact of negative social and environmental impacts 330–1 Financial Accounting Foundation (FAF), opposition to US adoption of IFRS 178 financial accounting limitations in respect of its ability to reflect social and environmental performance 526 concept of ‘materiality’ 532 entity assumption 527 focus on short-term results 532 focusing on the information needs of stakeholders with a financial interest 526–7 practice of discounting liabilities to present value 532–4 recognition criteria of ‘measurability’ and ‘probability’ 530–1 the way we define the elements of financial accounting acts to exclude many social and environmental costs 527–9
739
Index
financial accounting methods, impact of different countries using different methods 163–5 financial accounting practices, and the social world 101–2, 330–4 financial accounting process, steps undertaken within 222–3 Financial Accounting Standards Board see FASB financial capital maintenance perspective 241 financial performance alternative measures 79–80 see also general purpose financial reports financial reporting 276 capital markets reaction to 593–632 considerations of costs and benefits 298–9 objective of 275–6 financial reporting, application of ‘accountability model’ 80–3 how are disclosures made? 82–3 to whom are the financial disclosures directed? 82 what types of disclosures are made? 82 why disclose financial accounting information? 81–2 Financial Reporting Council (FRC) Australia adopts IFRS 165, 173–4, 175, 277 financial contribution to IFRS Foundation 174 to oversee activities of AASB 138 financial reporting expectations gap 14 financial reporting standards economic and social impacts 141–2, 145, 147, 148 as the output of a political process 149 ‘public interest’ versus ‘private interest’ when developing 146 and ‘representationally faithful’ financial information 149 views of financial statement preparers when developing 148 see also IFRS; IFRS Standards financial reports alternative measures of financial performance disclosed within 79–80 and news media 101–2, 331, 365–6, 389, 391 as outcome of various political pressures 148 and profit levels, used in political debates 391–2 qualitative characteristics 54, 294–302, 395 role in creating a selective ‘reality’ (critical perspective) 698–9 who are the users? 288–90 see also general purpose financial reports Financial Stability Board 556 financial statements see general purpose financial statements (GPFSs) ‘floating GAAP’ 384 forced labour 576 forecasting future changes (legitimacy) 434 forestalling the imposition of more onerous reporting requirements 60, 514–15 format of presentation 652 Foucault’s perspective 680–1 four-step accountability model 45, 58–66, 463, 710 applicability to the practice of financial reporting 80–3 diagrammatic representation 59, 80–1
740
different ‘world views’ 64 how should information be disclosed? 59, 63 normative nature 63–4 to whom is the organisations reporting the information? 59, 61–2 what information needs to be reported? 59, 62 why is an organisation collecting and reporting particular information? 59–61 free goods, consumption of 120–1 ‘free-market’ perspective to accounting regulation 85, 92, 113, 114–19, 120 courts as impartial arbiters 119 and ‘free’ or ‘public’ goods 120–1 and the ‘invisible hand’ 122–5 market-related incentives 117–19 and notion of the ‘invisible hand’ 122–4 opponents 121 private incentives to produce accounting information 114–17 versus pro-regulation perspective 127, 128 free rider problem 120, 121, 184–5 freedom from error 297–8 French Uniform Accounting System 198–9 Friedman, Milton, on corporate responsibilities 51, 52 ‘frozen GAAP’ 370–1, 384, 386 fulfilment value 325, 326 full cost accounting 565, 566–7, 568–9 fundamental qualitative characteristics 295–9
G G-20 summit push for changes to IFRS 9 143 push for early completion of FASB/IASB convergence project 90 strengthening financial market transparency 89–90 G250 companies, CSR reporting 504–5, 506 gaining legitimacy 434, 435 gains 306, 329 gambling, social costs 331–2, 529 gambling companies, social and environmental disclosure practices 446 gender of directors, influence on earnings management 401–2 gender diverse boards, impact on extent of disclosure 520 Gendron, Yves, critical research 675–6 general price index 237 general price level adjustments (GPLAs), managers’ lobbying against 250–1, 362–3 general purpose financial reports 78, 79 application of ‘accountability model’ 80–3 decision usefulness approach 291 definition 76, 277–8 objectives 26–7, 76–7, 225–6, 276, 278, 290–4, 526, 596 readers understanding of 78, 290 regulation 77, 83–91 released by reporting entities 285–6
Index
restricted audience 77 role 77 and stewardship 227, 290–1 who are the users? 288–90 see also IASB Conceptual Framework for Financial Reporting general purpose financial statements (GPFSs) 76, 285 can they provide neutral and unbiased accounts of an entity’s performance and position? 302–4 definition 76 elements of 305–23 names of 78 prepared using accrual accounting 301 readers understanding of 78–9 regulation 77–8 released by reporting entities 285–6 requirement to produce 80, 81 as ‘true and fair’ 147–8 generalisability 29 generalising theories from the testing of samples 29–30 ‘generally accepted accounting principles’ (GAAP) 176, 279, 280, 334 and legitimacy 442–3 see also US GAAP ‘generally accepted financial accounting practices, ignore social and environmental externalities 533, 564, 566 Global Accountancy Profession’s Call to Action for G20 Leaders: Counting on Society 5.0 90, 91 global financial crisis (GFC) 88, 135, 143, 261, 337 Global Reporting Initiative see GRI glossary 722–9 going concern 301 going concern modification (GCM) in audit opinion, impact on share price 62–3 governance, definition 69 Government Accounting Standards Board (GASB) 483 government failure 122 government intervention through regulation 122, 124–5, 126, 130–1 for political interests or ideologies 131 for the ‘public interest’ 131 government support, opportunistic accounting to attract 394 governments move away from deregulation 695 role in supporting existing social structures (critical perspective) 691–3 support for accounting practices (critical perspective) 692 windfall profit tax imposed on British oil and gas companies 389, 394 see also political costs Grady’s theory of accounting 279–80, 335 Gray, Sid accounting values 194, 196 culture and international differences in accounting 189–90 hypotheses relating Hofstede’s four societal cultural dimensions to his four accounting values 193–7 hypothesised relationships between society values,
accounting values and accounting practice 196, 197 objective of his research 197 greenhouse effect 569, 570 greenhouse gas emissions 46–7, 57, 102–3, 505, 512, 522, 569 measurement 574–5 Greenhouse Gas Protocol 574–5 Greenpeace, mission statement and organisational objectives 67, 68 GRI benefits for organisations of reporting sustainability-related information 519 a conceptual framework for social and environmental reporting? 535–45 importance of stakeholder engagement 460 material topics 539, 541–2, 543 materiality determination process 542, 543 process to determine material impacts 541–2 reporting frameworks 301, 505 Sector Standards 536, 538, 543 selective reporting of GRI data 544–5 stakeholders 536–7 sustainability report 502 sustainability reporting 502 Sustainability Reporting Standards 54, 460, 525, 532, 536 Topic Standards 536, 538, 544 Universal Standards 536, 538–41 GRI 1: Foundation 2021 538–9 GRI 2: General Disclosures 2021 540–1 GRI 3: Material Topics 2021 541–2 GRI 11: Oil and Gas Sector 2021 543 GRI 12: Coal Sector 2022 543 GRI 13: Agriculture, Aquaculture and Fishing Sector 2022 543 GRI Sector Program 543 GRI Standards 536 framework structure 538–9 history 536 key concepts 538–9 overview 538–43 purpose 537–8 reporting principles 539 stakeholders 536–7 grounded theory 15–17, 19
H harmonisation of accounting 163 Australian accounting standards with IAS 164, 173–4 Harvard College, mission statement and organisational objectives 67, 68 health and safety disclosures 442 hermeneutics 16–17 heuristics and the decision-making process 654–9 use by news media 659
741
Index
historical cost 325, 326 comparison to fair value 254 definition 230 relevance and representational faithfulness 395 historical cost accounting 221, 223, 225 assumptions 231 Chambers’ concerns 245, 246 as conservative accounting approach 394 distortion of current year’s financial results 234 limitations in times of rising prices 230–6 and maintenance of purchasing power 235 and payment of dividends 234 and treatment of changing prices 233–4 historical cost income used by investors 611–12 Hofstede, Geert, cultural value dimensions 189–90, 192–3 criticisms and commentaries when applied to accounting 189–92, 193–8 and Gray’s accounting values 193–7 Hofstede–Gray theory 200 applications 197, 198–9 holding gains 241–2 ‘horizon problem’ 373–4 how should information be disclosed? 59, 63, 509 how should information be disclosed? (social and environmental reporting) 525–45 Global Reporting Initiative – a conceptual framework for social and environmental reporting? 535–45 limitations of traditional financial accounting in respect of its ability to reflect social and environmental performance 526–34 triple bottom line reporting 525, 534–5 human information processing (HIP) research 639, 641 human rights 560, 580 hyperinflationary economies 221 hypothesis 23, 348
I IAS 166, 167, 168 harmonisation of Australian accounting standards with 164, 173 IAS 1 Presentation of Financial Statements 553 IAS 2 Inventories 221, 279 IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors 139, 405, 553 IAS 16 Property, Plant and Equipment 221, 227–8, 279, 513 IAS 19 Employee Benefits 279 IAS 29 Financial Reporting in Hyperinflationary Economies 221 IAS 36 Impairment of Assets 183, 223 IAS 37 Provisions, Contingent Liabilities and Contingent Assets 221, 513, 530, 532 IAS 38 Intangibles 101, 141–2, 183, 371, 397, 625 IAS 39 Financial Instruments: Recognition and Measurement 104, 143, 146–7, 182 IAS 41 Agriculture 233–4, 279 IAS/IFRS Australia adopts 165, 173–4, 175
742
EU adopts 171–2, 175 see also IFRS Accounting Standards IASB 76, 160 attempts to develop the accounting standard for the extractive industry 138–9 develops accounting standards (IFRS Accounting Standards) 168 differences in accounting standards to FASB 283 does not have social and environmental performance as core focus 500 early history see IASC and fair value accounting 395–9 fair value hierarchy 255–6 finding concerns 178 and IFRS Foundation 168–70 independence 135–6 International Accounting Standards see IAS lack of enforcement powers 96, 182 measurement 325 measurement bases 220 measurement principles 226–7 members 169 objectives 166 and obstacles to ongoing standardisation of financial accounting 209–10 ‘one-size-fits-all’ perspective 190 perspective on the role of IFRS 179 Practice Statement 2: Making Materiality Judgements 513, 573 renamed from IASC 168 and standardisation efforts in Australia 164, 173–4 and standardisation efforts in EU 170–2 and standardisation efforts in US 176–7 treatment of development expenditure 397 uniform set of accounting standards for global use 160 see also IFRS Standards IASB Conceptual Framework for Financial Reporting 26–7, 76–7, 78, 85, 175, 274 accounting is complete, neutral and free from error 94, 102, 104, 105, 113, 146, 147, 149, 302 apparent abandonment of stewardship from 2010 version 225, 226, 291–3, 294 asset/liability approach 307 assets 308–15, 334–5, 527 control 308–9 cost constraints 95 criticisms 327–37 decision usefulness 291, 293 economic and social implications of new standards 104 elements of financial reporting 306, 307, 678 enhancing qualitative characteristics 295, 299–302 equity 323 existence uncertainty 311–12 expenses 321, 322, 527 financial accounting and economic reality 102 financial information should be ‘relevant’ and representationally faithful’ 226, 295–8
Index
fundamental qualitative characteristics 295–9 general guidance in 278–9 historical cost 230 income 253, 321–2 liabilities 316–20 measurement basis 222 measurement uncertainty 312–13 objective of general purpose financial reporting 26–7, 76–7, 225–6, 278, 290–4, 526, 596 obligation 316 primary user group 289–90 profit measurement 333–4 qualitative characteristics of financial reports 294–302, 395 recognition 306, 310–15, 317–20, 321–2, 530 relevance and representational faithfulness 295–8, 311–15, 317–19, 395 reporting entity definition 285–8 as restricted view of accountability 328 revised framework 27, 225–6, 285–302 status and purpose – users of financial reports 288–90 stewardship reinstatement in 2018 version 225–6, 293–4 IASB/FASB convergence project see FASB/IASB convergence project IASB/FASB joint development of conceptual framework 274, 275–6, 282, 283–5, 324 IASB Framework for the Preparation and Presentation of Financial Statements 274 IASC conceptual framework 283 history 166–8 objectives 166 replaced by IASB 168 IASC Foundation renamed IFRS Foundation 168 supervision of IASB 168 IFRS 2 Share-based Payments 141 IFRS 6 Exploration for and Evaluation of Mineral Resources 138–9 IFRS 9 Financial Instruments 143–4, 182, 221, 279 IFRS 13 Fair Value Measurement 253, 254, 255–6, 398 IFRS 15 Revenue from Contracts with Customers 247 IFRS 16 Leases 101, 279 IFRS Accounting Standards 168 IFRS Advisory Council 169 IFRS Foundation 87, 178 advantages of global standardisation 164–5 Australia’s financial contribution to via FRC 174 benefits of IFRS Standards 95–6 Constitution 168, 169 develops globally accepted financial reporting standards (IFRS Standards) 168 and IASB 168–70, 552 Monitoring Board 168 objectives 168 oversees operations of International Sustainability Standards Board (ISSB) 500, 552
renamed from IASC Foundation 168 Trustees and their role 135–6, 168–9, 500 see also IAS/IFRS IFRS Interpretations Committee 169 IFRS S1 General Requirements for Disclosure of Sustainabilityrelated Financial Information 500, 553 IFRS S2 Climate-related Disclosures 500, 553, 557, 574 IFRS Standards 168, 177, 207 adoption in Fiji 165, 199, 204 adoption and improved quality of reporting 184 and countries adoption of IASB conceptual framework 274 and differences in implementation, monitoring and enforcement 182–6 and ‘fair values’ 183–4, 185, 254–5, 259 and ‘free rider’ problem 184–5 IASB’s perspective on the role of 179 and international differences in auditing standards 186 and international differences in reporting 185 issue of translations 182 local modifications 182 modifications at a national level 182 obstacles to adoption 209–10 and problems of differences in accounting practice 187–207 reliance on judgement 184, 185 and revaluation of non-current assets 232 as signal informative 185 transparency, accountability and efficiency 179 treatment of development expenditure 625 and US GAAP rules 177 US opposition to IFRS 176, 178, 182, 210 IFRS Sustainability Disclosure Standards 168, 513, 552–3 impact (GRI definition) 538 incentives to manipulate accounting numbers owner-manager contracting 372–4 in the presence of debt contracts 386–8 income 278, 306, 307 definition and recognition 321–2 and increase in fair value 253 income and expense recognition, implications associated with timing of 404 income statement, elements in 307 increased profits, from disclosure 60 individualism 195, 196, 208 versus collectivism 192–3 individuals’ reaction to financial reporting 639–64 inductive accounting theories 8–10 inductive approach 8–9 inductive reasoning 3, 8 inductivists 24 inflation, impact on financial statements 235–6 information asymmetry 355, 369 information content of earnings 605–10 ‘information content’ research 620
743
Index
information cues and decision making 646–50 and information overload 652–3 related to social and environmental activities 653 use of particular cues from financial statements 650–2 ‘information overload’ 652–3 information requirements of stakeholders 54 ‘information transfer’ phenomenon 616, 617 insider-financed systems 202–3 and Roman law systems 203 and taxation systems 205 Institute of Chartered Accountants in Australia (ICAA) 87, 137, 689 Institute of Chartered Accountants in England and Wales (ICAEW) 84–5, 87, 328 Institutional Theorists 474, 487 Institutional Theory 423, 450, 471–87 in analysis of accounting standard-setting process 476 decoupling 473, 478, 483–4 definition 471 diagrammatic representation of the three pillars 474 empirical tests 485–7 high degree of similarity between organisations 476 importance to researchers 476–7 ‘institutional aspect’ 472 isomorphism 474, 475, 478–83 legitimacy as core concept 474, 475–6 purpose 477 in social accounting research 476 for social and environmental disclosure 477, 516–17 standard-setters awareness of 485 ‘strategic aspect’ 450, 472 three pillars 473–4, 477, 485, 486–7, 517 as ‘umbrella term’ 472 institutionalised approaches 472, 473, 477, 484 institutions definition 472 isomorphic processes 474, 475, 478–83 three pillars 473–4, 478, 485, 486–7 intangible assets 92, 101, 141–2, 329 and fair value 399 recognition of 396–7 integrated reporting 545–63 International Framework 447, 485, 545–53 International Sustainability Standards Board see ISSB other frameworks 561 Sustainability Accounting Standards Board 554–5 sustainability ratings 561–3 Task Force on Climate-related Financial Disclosures 556–7 United Nations Global Compact 560–1 United Nations Sustainable Development Goals 557–60 Intergovernmental Panel on Climate Change (IPCC) 508, 569 internal stakeholders 462 internal validity 645 International Accounting Standards Board see IASB International Accounting Standards Committee (IASC) 166– 8, 274
744
international comparability of financial statements 164 international differences in accounting practice 187–207 accidents of history 206–7 Anglo-American model 167, 187 business ownership and financing systems 202–4 continental European model 187 culture 189–200 legal systems 201–2 possible reasons for differences 187–9 religion 200–1 strength of the accounting profession 205–6 taxation systems 204–5 international differences in accounting prior to recent standardisation initiatives 161–3 International Financial Reporting Standards Foundation see IFRS Foundation International Integrated Reporting Council (IIRC) 545 International Framework 447, 485, 545–53 the ‘capitals’ 549–51 guiding principles and content elements 545–6 materiality 547–9 shortfalls and strengths 551–2 value creation, preservation or erosion over time 550 value creation versus accountability 547 International Monetary Fund 479 International Organization of Securities Commissions (IOSCO) 167 international standardisation of accounting practice, why it may not work 179–86 international standardisation of financial accounting 95–6, 163–4 advantages/disadvantages 164–5, 175 Australia 164, 173–4, 175 European Union 170–2, 175 obstacles 209–10 and problems of differences in accounting practice 187–207 United States 175–8 see also IASB; IFRS Standards international standardisation of financial accounting, reasons why it may not lead to international standardisation of accounting practice 179–80 differences in economic and political influences on financial reporting 181 differences in implementation, monitoring and enforcement 182–6 differences in taxation systems 181 issues of translation 182 modifications made to IFRS at a national level 182 International Sustainability Standards Board see ISSB internet-based communication 524 interpretivism 349 intra-generational equity, and sustainability 507–8 investor protection 127–9 investors aggregate behaviour in the capital market 593–632, 640
Index
choices, and disposition effect 657–9 dysfunctional investor behaviour 657 inclination to avoid recognising a loss 659 reaction to negative sustainability 654 social factors influencing investment decisions 653–4 ‘invisible hand’ 122–5, 127 Islamic law and Western accounting practices 200–1 isomorphism 474, 475, 478–83 applications to US state governments move to GAAP 483 coercive 478–80 mimetic 478, 480–1 normative 478, 481–2 not easy to distinguish between the three 483 and organisational efficiency 482 ISSB 552–4 industry-specific standards (from SASB) 554, 555 International Framework 54, 301, 545–52 overseen by IFRS Foundation 500, 552 and sustainability-related financial disclosures 552–4 to release IFRS Sustainability Disclosure Standards in 2023 168, 513, 552–3 see also IFRS S1; IFRS S2 ISSB Standards 551–3
J Journal of Accounting Research 347, 350 judgement, reliance on under IFRS 184, 185 judgement and decision making (JDM) research 639, 642–3, 660 judgement and decision-making audit research 642, 660
K KPMG climate-related risk disclosure 570–1 financial risks from climate change 570 KPMG survey of CSR reporting 504–6 reporting on UN SDGs 559–60
L labour (UN Global Compact) 560 labour groups 540 labour unions 390, 392, 402–3 large versus small power distance 193 legal requirements to report 59, 512–14 legal systems, and accounting practice 201–2 legislative reform to protect investors 127–9 legitimacy 427 abandonment of 436, 437 based on perceptions 427–8, 446 and changing social expectations 431–3 as core concept of Institutional Theory 474, 475–6 and corporate social reporting 475, 515–16 establishing 436, 453
how can it be measured? 452–3 and IR Framework adoption 447 and news media coverage 430, 432–3, 443–7 organisational 450, 455–6 public expectations and the social contract 56–7, 428–31, 443–4 of publicly committing to UN SDGs 560 and reporting frameworks 447 as a ‘resource’ 427 of stakeholders 466 strategies based on disclosure 435 strategies to gain, maintain or repair 433, 434–6, 437, 453 and three institutional pillars 474 legitimacy gap 432–3, 442, 450 Legitimacy Theorists 430, 449, 450, 451, 454, 460, 472, 474 Legitimacy Theory 423, 424, 425, 427–58, 487 applied to financial disclosure 442–3 applied to social and environmental disclosure 440–2, 445, 446, 451, 515–16 corporate views on the importance of the social contract 439–40 empirical tests 440–8 legitimising actions or demonstrating accountability 449 media coverage as measure for ‘community concern’ 443–4, 446 neo-pluralist view 447–8 organisation as part of a broader social system 460 providing a parsimonious explanation of an underlying phenomenon 449–51 and regulator’s knowledge 448 and response to a crisis 61 similarities to Stakeholder Theory 459–60, 465 in social and environmental accounting literature 450–1 use of accounting reports in legitimation strategies 437–8 Legitimacy Theory criticisms 451–2 assumptions that disclosure strategies are driven by self-interest 454 lack of detail about how ‘legitimacy’ can be measured 452–3 process of legitimation is really no different to reputation risk management 456–8 researchers do not consider actions that are aimed at legitimising the broader social system 454–6 which disclosures are more effective in the legitimation process? 453–4 legitimation 427, 433 and accounting, critical accounting perspective 701–2 loss phase 436 phases of 434–7 procedural 438 process, no different to reputation risk management 456–8 which disclosures are more effective in the legitimation process? 453–4
745
Index
legitimation strategies by corporate and government at Volkswagen 455–6 environmental disclosures 442 use in accounting reports 437–8, 450 legitimising disclosures 445, 447–8 legitimising symbols 438 legitimising the capitalist system, accounting role in 702–3 Lens Model 646–50 ‘level playing field’ argument 121 liabilities 278, 306, 307 definition and recognition 316–20 discounting to present value 532–4 IASB Conceptual Framework definition 316 outflow from the entity of resources embodying economic benefits 316–17 past event 316 present obligation 316, 317 recognition of 317–20 lobby groups 60 lobbying of accounting regulators 142–4, 250–1, 362–3 by politically sensitive companies in favour of current cost accounting 392–3 logical arguments, ‘dishonest tricks’ 27 logical deduction 24–5 long-term orientation 209, 627 losses 306 lost legitimacy, regaining 447
M McSweeney, Brendan 190–2 maintaining legitimacy 434–5, 437, 453 management accounting, versus financial accounting 80 management compensation (bonus) hypothesis 362–3, 364, 366, 405, 408 management performance, share price as ‘noisy’ measure 377 managerial control 641 managerial opportunism, influence on accounting practices 60 managerial (positive) branch of Stakeholder Theory 52–3, 458, 460, 464, 465–7, 468–9, 470, 479, 517 considerations of different stakeholder groups within society 465 managers and account-based bonus schemes 115–16, 370–2, 374–5 approaching retirement 373–4, 376 avoidance of disclosure of private information 378–9 beliefs and selection of accounting theory 31–3, 43–4 and corporate governance systems 69–70 earnings management 379–80, 399–403 incentives to manipulate accounting numbers 372–4 lobbying against general price level adjustments 250–1, 362–3 and market-based bonus schemes 374–81 perceptions of accountability influenced by a variety of factors 56
746
perceptions of responsibility impact on accounting practices 60 political-cost based motivations 390 self-interest see self-interest assumption share options as bonuses 377, 378–9 strategies to disadvantage debtholders 382 and wealth maximisation 32–3, 356, 410, 518–20 see also CEOs mark-to-market approach to fair value accounting 254, 255 mark-to-model approach to fair value accounting 254, 256, 260, 398–9 market-based benchmarks 621 market-based bonus schemes 375–81 ‘market for corporate takeovers’ argument 117–18 market efficiency 597–9 in capital market research 597–605, 613, 615, 616, 630–2 implications for financial accounting and reporting 599 relaxing assumptions 630–2 semi-strong-form efficiency 598 and share market response 598 strong-form efficiency 598 weak-form efficiency 598 market failure 120, 122 ‘market for lemons’ argument 118–19 ‘market for managers’ argument 117 market model 608–9, 610 market participants 253, 256 market prices, and fair value 262, 264 market-related incentives to reduce/eliminate accounting regulation 117–19 market values 621, 622 and book values 621–3, 625 and carbon emissions information 626 change in 622 of company’s securities as a benchmark 624 Marxist critique of accounting 679–81, 683, 688 masculinity 195–6, 197, 199, 208 versus femininity 193, 687 material impacts, process to determine (GRI) 541–2 material topics (GRI) 539, 541–2, 543 materiality 295–6, 532 Framework 547–9 materiality determination process, disclosure of information about 65–6, 542, 543 measurability 530–1 measurement and contractual compliance 224 definition 222 IASB’s three fundamental principles 226 IASB’s views 325 importance of 223 process of 221–7 measurement bases 221, 223–4, 325–6 broad categories 325 factors to consider when choosing between alternatives 229–30
Index
limitations of historical cost in times of rising prices 230–6 utilised within financial reporting standards 227–8 measurement principles 324–6 measurement uncertainty 312–13, 530 mechanisation, and retrenchment of the workforce 330–1 media see news media Media Agency Setting Theory 443–4, 445, 446, 515 mimetic isomorphism 478, 480–1 application to corporate social reporting 480–1 general hypotheses 480 mission statements 67 mixed measurement model of accounting 221–2, 227 modern slavery 430, 512, 576–7 Modern Slavery Act 2018 512, 576–7 modern slavery statements 512, 576, 577 monetary assets 238, 239–40 monetary liabilities 238 monitoring costs 346, 356, 360 monologic accounting 578, 579, 706–7, 709, 712 Moonitz study, on alternative accounting measurement systems 251–2, 279, 335 moral branch of Stakeholder Theory 53, 458, 460, 461–5, 468, 470 multinational organisations (MNCs) supply chains, compliance audits 577
N N100 companies, CSR reporting 504–5, 506 National Australia Bank 459, 529 National Pollutant Inventory (NPI) 512 natural capital 550, 567 negative social and environmental impacts, ignored by financial accounting practices 330–4 neo-institutional theory 471–2 neo-pluralist view of Legitimacy Theory 447–8 net realisable value 223 neutrality 296–7, 302–5 New York Stock Exchange (NYSE), develops accounting principles 85–6 New Zealand, conceptual framework 283 News Corporation Ltd 162 news media coverage as measure of ‘community concern’ 443–4, 446 and financial reports 101–2, 331, 365–6, 389, 391, 393 and legitimacy 430, 432–3, 443–7 and the legitimacy gap 432–3 negative media attention and social and environmental disclosure 515–16 praise for managers who reduce wages expense 528–9 revelations of unsafe, unhealthy or unethical practices 430, 433, 445, 469 shaping of community expectations 444 use of heuristics 659 ‘nexus of contracts’, organisation as (Agency Theory) 358–60 non-conservative accounting policies, and investment decisions 651
non-controlled experiments 644, 645 non-current assets depreciation 242 revaluation 232 non-disclosure tendency by managers 378–9 non-financial information capital markets use of 628 disclosure of 656 non-government organisations (NGOs) 445–6, 468, 703 non-market failure 122 non-monetary assets 238–9, 240 non-monetary liabilities 238 non-positivists 349 normative branch of Stakeholder Theory 53, 458, 460, 461–5, 468, 470 normative isomorphism 478, 481–2 normative judgement 47, 51 normative nature, four-step accountability model 63–4 normative pillar (institutions) 473, 474, 478, 485, 517 normative research 10, 13, 20, 244, 345, 347 opponents of 348 paradigm shift to positive research 348 normative theories of accounting 10, 12–14, 19, 220–1 comparison with positive theories 12, 345 conceptual frameworks 274, 275 Continuously Contemporary Accounting 12, 30, 243–9, 345 current cost accounting 241–3, 249–51 current purchasing power accounting (CPPA) 236–41, 249, 250 see also IASB Conceptual Framework for Financial Reporting normative theorists 18, 19
O objective of financial reporting 275–6 objective reality 31, 349 objectives of general purpose financial reporting 26–7, 76–7, 225–6, 276, 278, 290–4, 526, 596 obligation 316 observable inputs 254, 256 observable market values, to determine fair value 254, 256 observation to develop generalisable theories 8, 10 ‘Occam’s razor’ 21–2 ontological assumptions 32–3, 349, 596, 597 open system theories 423–4 Operating and Financial Review (OFR), and introduction of mandatory corporate social responsibility reporting 126 Opinions (Accounting Principles Board) 87 opportunistic perspective 97, 366, 368–9 orderly transactions 253, 259 organisation-based contracts 358 organisational accountability 54–5 different perceptions of 54–6 perceptions will change over time 56–7 stakeholder power influence on 57–8
747
Index
organisational identification (OI) 373–4 organisational legitimacy 450, 455–6 organisational objectives, influence of accounting on 66–8 organisational performance, and governance 70 organisational responsibilities and accountability 49–50 different perceptions of 54–7 subjective nature of views about 49 what are they? 51–2 organisational shadows 432–3 organisational sociology 641 organisations institutionalised approaches 473 as a ‘nexus of contracts’ (Agency Theory) 358–61 as part of a broader social system 424 ‘stakeholders’ see stakeholders outflow of economic benefits 316–17 outsider-financed systems 202, 203, 205 owner-manager contracting 369–81 accounting-based bonus plans 370–2 accounting-based bonus plans - reliant upon conservative accounting practices 374–5 bonus schemes generally 370 incentives to manipulate accounting numbers 372–4 market-based bonus schemes 375–81 ownership interest 306
P paradigms 19 Parliamentary Joint Committee on Corporations and Financial Services (PJCCFS), Inquiry into Corporate Responsibility 124–5, 126 parsimonious theory 21–2 parsimony 21 Legitimacy Theory 449–50 partisan nature of accounting 676–81 past event 309, 316 payment of excessive dividends 381 People for the Ethical Treatment of Animals (PETA) 521, 704 Perera, H. 189, 196, 198 performance pricing 387–8 perquisite consumption 369–70 personal social responsibility (PSR) 581 Perth Casino Royal Commission 133 petroleum industry, environmental disclosures 440 phenomenologists 32, 349 phenomenology 17 physical capital maintenance approach 241 political cost hypothesis 364–6, 392, 393, 394, 405, 408 political costs 388–94 accounting methods to reduce reported profits of politically sensitive organisations 389–90, 392, 394 and earnings management 402 reported profits used by news media, political parties and governments 389, 391–2, 393
748
voluntary social and environmental disclosures to reduce 393 political debates, and reported profits 391, 392 Political Economy Theory 425–6, 455, 681–2 political markets, less efficient than capital markets 390 political nature of standard-setting process 221, 260 political process accounting regulation as output of 146–9 and corporate managers’ attitude to general price level accounting 250–1 politically effective groups, economic regulation serving 144–6 politically sensitive organisations accounting methods that lead to a reduction in reported profits 389–90, 392, 394 lobbying in favour of current cost accounting 392–3 support for CCA 251 politicians self-interest assumption 390–1 taking actions against highly profitable companies in the ‘public interest’ 390–1
pollution, social costs 332–3 Positive Accounting Theorists 17, 18, 19, 20, 33, 410–11, 651, 675 Positive Accounting Theory (PAT) 11, 19, 32, 208, 250, 251, 303, 344–412 and accounting policy choices 362–94, 399–406, 408–9 adoption of the name 345 agency costs of debt 382–3 agency costs of equity 346 Agency Theory as facet in development 354–61 assumptions 31–2, 346, 350 bonding costs 346 bonus plan hypothesis/bonus schemes 364, 366, 370–2, 374–81, 405, 408 concerned with explaining accounting practice 345 critical theorists vocal critics of research that adopts 690 criticisms 18, 28–9, 406–12 debt contracting 381–93 debt hypothesis 364, 366, 405, 408, 409 defined 345–7 development 693–4 diagrammatic summary 413 and earnings management 399–403 efficiency (ex ante) perspective 366–7 Efficient Markets Hypothesis role in development of 351–3 emergence of 362–6 ex post incentive 386 failure to provide prescription 406–7 incentives to manipulate accounting numbers 372–4, 386–8 individuals’ actions driven by self-interest 31, 32, 346, 349, 362, 369, 390, 410 lobbying positions taken by US corporate managers in relation to GPLAs 250, 362–3 management compensation (bonus) hypothesis 362–3, 364, 366, 405, 408
Index
measurements or proxies are far too simplistic 409 monitoring costs 346 not value free 407–8 and objective reality 31, 349 opportunistic perspective 366, 368–9 origins and development 347–66 owner-manager contracting 369–81 perceived lack of development 408 political cost hypothesis/political costs 364–6, 388–94, 405, 408 predictions do not always hold 410 proponents 20 ‘rational’/’irrational’ forms of action 410–11 and realist perspective 410 relationships between individuals 345–6 relevance of PAT-based research to efforts by the IASB and FASB to promote fair value accounting 394–9 residual costs 346 as scientifically flawed 409 three key hypotheses 363–6, 405, 408 and value judgements 20, 407–8 and wealth maximisation 32, 356, 410, 518–20 positive (managerial) branch of Stakeholder Theory 52–3, 458, 459, 464, 465–7, 468–9, 470 positive research 10, 13, 345, 347, 348 and objective reality 349 ontological assumptions 349 paradigm shift 348, 350 shift in accounting publications towards 347–8, 350 positive theories of accounting 10–11, 19–20, 345 comparison with normative theories 12, 345 positivism 349, 350 positivist research/researchers 10–11, 32, 349, 672–3 post-earnings-announcement drift 631 potential to produce economic benefits 309 potentially distorted view of an organisation’s ‘performance’ 329–34 poverty and starvation 507–8 power of accountants 99–101, 104–5 of accountants through a false image of neutrality 699–700 and conflict in society 426 of stakeholders 57–8, 466 Power Distance 193, 195, 208 powerful constituents 479 powerful stakeholders 479 responding to 60, 465–7, 468–9, 517–18, 523 praxis (within critical accounting) 673–4 preliminary profit announcements 118–19 prescriptive accounting theories see normative theories of accounting prescriptive research 8, 244, 345, 347 present obligation 316, 317 present price 242, 243 present value 221, 223 price-adjusted accounting information, demand for 249–52
price index 235, 237–8 price informativeness 629 price protection 356, 369 primary stakeholders 462 primary user group (of financial reports) 289–90 principals 346, 354–7, 360, 369 private debt contracts, in Australia 383–5 private incentives to produce accounting information 114–17 to protect investors 128–9 private interests see economic interest group theory of regulation ‘pro-regulation’ perspective 119–29 enlightened self-interest 126–9 and the ‘invisible hand’ 122–5 versus ‘free-market’ perspective 127, 128 probability 530–1 procedural legitimation 438 process of measurement 221–7 procyclicality, and fair value 257–61 professional accounting bodies, early development 84–5 professional judgement, role in financial accounting 96–7, 98, 104 professional networks 482 professionalism 195, 196 versus statutory control (Gray) 194 profit and loss account 78 profits 321, 329 definition 234 differentiating from holding gains 242 measurement 307, 333–4 and negative environmental and social impacts 330–4 see also reported profits proper accountability 62 property, plant and equipment 221, 226–7 protecting past accomplishments (legitimacy) 434 protocol analysis 661–3 proving a theory 21–2 is the theory falsifiable? 23–4 proxy stakeholders 540 prudence 297 public debt contracts, in Australia 383–5 public expectations changing, and legitimacy 431–3 legitimacy and the social contract 56–7, 428–31, 443–4 news media shaping 444 public good 120 public interest assumption 390–1 public interest theory of regulation 92–3, 113, 128, 130–2, 142 Public Sector Accounting Standards Board 164 PUMA, Environmental Profit & Loss (EP&L) account 567–8 purchasing power gains and losses, treatment for income purposes 240 maintenance 235 see also current purchasing power accounting
749
Index
Q Qantas 528 qualitative characteristics of financial reports 294–302, 395 of useful financial information 54, 301, 302
R ‘radical feminists’ 686–7 real earnings management 400 realised holding gains 241 realist perspective 410 realizable price 244 recognition 306 perceived differently to mere footnote disclosure 618 recognition of assets 310–15, 330 conditions to be satisfied 314–15 faithful representation 312–13 relevance 311–12 recognition of expenses 321, 322–3 recognition of income 321–2 recognition of liabilities 317–20 conditions to be satisfied 320 faithful representation 318–19 relevance 317–18 recognition of revenue 399 regulation 77 of accounting practice see accounting regulation definition 114 of financial reports see general purpose financial reports regulative pillar (institutions) 473, 474, 478, 485, 486–7, 517 regulatory capture 93, 132–9 relevance 226, 295–6, 395 balancing with representational faithfulness 262–5, 298 of information for stakeholders 53–4, 226 recognition of assets 311–12 recognition of liabilities 317–18 religion, influence on accounting practice 200–1 repairing (defending) legitimacy 434, 435, 437 reported profits accounting methods to reduce, in politically sensitive organisations 389–90, 392 and news media reports 101–2, 365–6, 389, 391, 393 and revaluation of assets 229 used by governments, consumer groups, employee unions and other stakeholders as justification for actions to be taken against organisations 392, 393 used in political debates 391, 392 reporting how should the information be disclosed 63 reasons for 59–60 to whom do they report? 61–2 what information needs to be reported? 62 reporting entities definition 276, 285–8 distinguishing from entities 287–8 release of general purpose financial statements 285–6
750
representational faithfulness 226, 302, 304, 395, 530, 697 attributes 296–7 balancing with relevance 298 in fair value accounting 262–5 as fundamental qualitative characteristic 295, 296–8 limitations 297–8 recognition of an asset 312–13 recognition of liabilities 318–19 representativeness heuristic 655 reputation risk management (RRM), corporate disclosures as part of 456–8 research and development costs capitalisation 625–6 IASB and FASB treatment 397–8 research and development spending, and CEO compensation 376 research assessment exercises (RAEs) 33–4 research process interdependence of various factors 32 key factors that influence 31–4 residual costs 346 residual loss 360, 361 resource dependency theory 427 response to a crisis, disclosure as a 60–1 responsibilities of organisations see organisational responsibilities retirement, managers approaching 373–4, 376, 401 revaluation of assets, and implications for reported profits 229 revaluation model, property, plant and equipment 227–8 revenue/expense approach 307 revenue recognition, and fair values 399 revenues 306 Rio Tinto 429, 431, 439, 441 Rip Curl, using “slave labour” 430, 576 rising prices, limitations of historical cost accounting 230–6 ‘rolling GAAP’ 384–5 Roman law systems 201–2, 203 rumours, share price reaction to 600–2
S SAC 1 Definition of the Reporting Entity 276, 286, 287 Sarbanes–Oxley Act of 2002 (SOX) 88, 130, 138, 177 share price reaction to introduction of 603–4 secondary stakeholders 462 secrecy 199 versus transparency 195 Sector Standards (GRI) 536, 538, 543 Securities and Exchange Commission (SEC) 135, 140, 694 accepts both FASB and IFRS standards of reporting 160–1 accounting regulation 176, 177 closeness with industries they have to regulate 133 develops disclosure regulations 86–7 entrusts task of developing accounting standards to FASB 176
Index
investor protection 127–8 rejects IFRS/IAS reforms 167, 170 self-fulfilling prophecy 361, 411 self-interest assumption 131, 303 Agency Theory 349, 355–7, 358, 361 of corporate managers in relation to general price level adjustments 250, 362 enlightened self-interest 126–8 Legitimacy Theory 454 of politicians 390–1 Positive Accounting Theory 31, 32, 346, 349, 362, 369, 390, 410 selling price 242, 243, 245 semi-strong-form efficient equity markets 598 SFAC No. 1: Objectives of Financial Reporting by Business Enterprises 281, 289, 303 SFAC No. 3 (and subsequently No.7) 281, 305 SFAC No. 5: Recognition and Measurement in Financial Statements of Business Enterprises 281 SFAC No. 8: Chapter 1: The Objective of General Purpose Financial Reporting 281 SFAC No. 8: Chapter 3: Qualitative Characteristics of Useful Financial Information 281 SFAS 160 Noncontrolling Interests in Consolidated Financial Statements 385, 386 shadow accounts 578, 703, 705–6 share market evaluation as basis for evaluating financial accounting information 623–5 share options accounting treatment 141 as managers’ bonuses 377, 378–9, 380 ‘share price synchronicity’ 629 share prices in an ‘efficient market’ 600–3 as benchmark measure of company value (per share) 621 change in and change in retained earnings 623 do current share prices anticipate future accounting earnings announcements? 620–9 and earnings announcements (capital market research results) 610–20 and Efficient Markets Hypothesis 350–3 and expected future earnings 606–10 factors affecting daily prices 608 influenced by mood, days of the week, and sporting events 604 market model 608–10 as ‘noisy’ measure of management performance 377 and organisation’s social and environmental performance 628 reaction to companies receiving going concern modification (GCM) of their audit report 602–3 reaction to current cost and CPPA information 249 reaction to earnings announcements 605–10 reaction to financial information releases 597–605
reaction to introduction of Sarbanes–Oxley Act of 2002 603–4 reaction to takeover and false rumours 600–2 reaction to unexpected earnings announcements 352–3 and social and environmental performance 594, 628 share returns, as benchmark measure of company performance (per share) 621 shareholder wealth, maximising 518–20 shareholders communication with 524 external 202 short-term results, focus on 532 size effect and regulation of larger organisations 619 whether capital markets will react to a company’s release of information 618–19 Smith, Adam ‘free-market’ approach 113 ‘invisible hand’ 122–5, 127 social accounting 503 social accounting movement 683 social accounting research 476 social and environmental accounting 503 and social contract 431 social and environmental accounting research, versus critical accounting research 681–6 social and environmental costs excluded due to the way elements of financial accounting are defined 527–9 and profits 330–4 of unhealthy and unsafe work practices 330 see also environmental costs; social costs social and environmental disclosures 440–2 developing countries 445, 469, 485–6 and extent of media coverage as measure of ‘community concern’ 443–4, 446, 515–16 gambling companies 446 and Institutional Theory 477, 516–17 and Legitimacy Theory 440–2, 445, 446, 450–1, 515–16 and legitimation strategies 442 legitimising 445 as a means to counter negative community sentiment 444–5 and stakeholder power 468–9 voluntary 393, 451 social and environmental externalities accounting for 563–9 ignored by generally accepted financial accounting practices 533, 564, 566 social and environmental performance and information cues 653 and organisation’s share price 594, 628 see also climate change; modern slavery
751
Index
social and environmental reporting 498–581 CPA Australia views 689–90 Global Reporting Initiative (GRI) as conceptual framework for 535–45 identifying stakeholder information needs and expectations – the what do we report?’ stage 522–5 identifying stakeholders - the who stage 520–1 integrated reporting 545–63 legal requirements 512–14 link with increases in membership of environmental groups 504 objectives of the reporting process – the ‘why report?’ stage 510–20 referred to as ‘CSR reporting’ or ‘sustainability reporting’ 500 theoretical perspectives – the how stage 525–45 see also CSR reporting; sustainability reporting social auditing 524–5 social contract 428, 449–50, 524 breaching the 441 corporate views on importance of 429, 432, 439–40 explicit and implicit terms 430–1 historical perspective 429–30 legitimacy and public expectations 56–7, 428–31 in organisation’s public disclosures 429 as theoretical construct 430 where things can go wrong 430 social controls 653 social costs of cost cutting 528–9 of gambling 331–2, 529 of technology on unemployment 330–1 ‘social licence to operate’ 429, 431, 439 social media and managers use of disclosure 448 trading based on 601–2 social practice, possible impact of critical accounting research on 686–91 ‘social praxis’ 673–4 social reporting 501–2 social structures role of accounting practice in supporting (critical perspective) 697–703 role of accounting research in supporting existing (critical perspective) 693–7 role of the state in supporting existing (critical perspective) 691–3 social sustainability 508 social world, and financial accounting practices 101–2, 330–2 socialism 677 Society of Accountants 84 special purpose financial reports 75 spirituality 688 Sprouse and Moonitz study, on alternative accounting measurement systems 251–2, 279, 335 SSAP 13 Accounting for Research and Development 625 stakeholder engagement 710
752
critical dialogic accounting 710–11 definition 460 importance of 459, 460 stakeholder groups counter and dialogic accounts 578–80, 703–11 effectiveness in demanding social responsibility disclosures 467–8 expectations and power change over time 466 and social audits 524–5 stakeholder opinion 653 stakeholder power 57–8, 466, 467, 468–9 stakeholder rights ‘intrinsic rights’ (ethical branch of Stakeholder Theory) 461–2, 463 to information 282, 463 Stakeholder Theory 423, 424, 458–71, 487 as an umbrella term representing a number of alternative theories 458, 459 diagrammatic representation of differences between the ethical and managerial branches 467, 468 empirical test 467–71 ethical (moral) branch or normative branch 53, 458, 460, 461–5, 517, 521, 523 and influence of powerful stakeholders 60 managerial (positive) branch 52–3, 458, 459, 460, 464, 465–7, 479, 517 and news media coverage 469 organisation as part of a broader social system 460 and powerful stakeholders 57–8, 60, 465–7, 517–18 relevance of research to regulators 471 risk of discussing the two branches separately 470 similarities to Legitimacy Theory 459–60, 465 stakeholder engagement 459 stakeholders 52–4 BHP perspective 53 definitions 52, 462 engaging for ethical or managerial reasons? 470 and ethical (normative) branch of Stakeholder Theory 461–5 financial accounting focus on information needs 526–7 GRI definition 539 GRI Standards 536–7 identifying 520–1 identifying their information needs and expectations 522–5, 540 ‘internal’ or ‘external’ 462 and managerial (positive) branch of Stakeholder Theory 465–7, 468–9 power, legitimacy and urgency 57–8, 466 powerful 60, 465–7, 468–9, 517–18, 523 primary and secondary 462 prioritisation 521 relevance and reliability of information for 53–4 reporting to 61–2, 75 social and environmental reporting 520–5 social factors influencing investment decisions 653–4 Stamp Report 282–3
Index
standardisation of accounting 163 statement of cash flows 78 statement of changes in equity 78 Statement of Financial Accounting Concepts (SFACs) 281–2 statement of financial performance, elements related to 306, 307 statement of financial position 78 elements related to 306, 307 statement of profit or loss and other comprehensive income 78 Statements of Accounting Concepts 282 see also SAC status quo 681 stewardship 225–6 apparent abandonment of within IASB Conceptual Framework 225–6, 291–3, 294 implications of abandonment 292–3 as objective of general purpose financial reporting 227, 290–1 reinstatement in revised Conceptual Framework in 2018 225–6, 293–4 versus decision usefulness role, and fair value 257, 262–5 stifling future reporting innovation 329 ‘stock/share return synchronicity’ 629 strategic aspect of Institutional Theory 450, 472 of organisational legitimacy 450
strategic risk 431 strong versus weak uncertainty avoidance 193 strong-form efficiency 598 sub-prime banking crisis 88–9, 113, 135, 143, 258 subsidisation 653 substantive management techniques 437, 438 surrogate accountability 58, 521 surrogate stakeholders 521 surveys 249–50 sustainability developing notions of 507–8 negative and investor decisions 654 Sustainability Accounting Standards Board (SASB) 554–5 industry classification system 554, 555 standards transferred to control of ISSB 554, 555 Sustainability Disclosure Standards (IFRS) 552–3 sustainability ratings/sustainability ratings agencies (SRAs) 561–3 sustainability-related financial disclosures (ISSB) 552–4 sustainability report 502 sustainability reporting 499, 502–3 benefits for organisations 519 and gender diverse boards 520 steps in the reporting process 509–10 Sustainability Reporting Standards (GRI) 54, 460, 525 sustainable cost 566 calculation 566–7 definition 566 sustainable development 503
Sustainable Industry Classification System (SICS) 554, 555 Switzerland, standard-setting processes 203–4 symbolic management techniques 437, 438 synchronicity 629 system-oriented theories 423–87 Institutional Theory 423, 450, 471–88 Legitimacy Theory 423, 424, 425, 427–58 Stakeholder Theory 52–4, 423, 424, 458–71
T takeover rumours, share prices reaction to 600–1 Task Force on Climate-related Financial Disclosures (TCFD) 301, 505, 556–7, 570 guidance regarding identifying climate opportunities 556–7, 558 guidance regarding identifying climate risks 556–7, 558 recommended disclosures pertaining to the risks and opportunities associated with climate change 557 Task Force on Nature-related Financial Disclosures (TNFD) 506 taxation systems and accounting practice 204–5 differences in 181 technical default (of a debt agreement) 364, 382, 384–6, 389, 395, 396 theories can they be proved? 22–4 definitions 2 evaluating 24–31 and the research process 31–4 what are they 2–4 theories of accounting see accounting theories theories of regulation 59 theorising, levels of 3–4 ‘thinly trading markets’ 184 timeliness 300 to whom is the account information being directed? 61–2, 69, 509 social and environmental reporting 520–1 tobacco industry, smoking and health issue 436 Topic Standards (GRI) 536, 538, 544 total earnings per share 623 Toxics Release Inventory (TRI) Program 512, 562 trade unions 390, 392, 402–3 translations of IFRS Standards 182 transparency of IFRS Standards 179 ‘trickle-down’ effect 124, 518 triple bottom line (TBL) reporting 525, 534–5 Trueblood Report 280–1
U uncertainty avoidance 193, 195, 196, 197, 199, 208, 627 underinvestment 381 underlying assumptions, evaluating 26–8 understandability 300–1
753
Index
unexpected changes in earnings created by unexpected increases in revenues 619–20 dependent on whether the change is expected to be permanent or temporary 615 unexpected earnings per share 607, 623 uniformity 199 versus flexibility 195, 196 United Kingdom accounting regulation 87, 131, 162 conceptual framework 276, 282 United Nations Global Compact 560–1 United Nations Sustainable Development Goals 505, 508, 557–60 United States accounting differences compared to Europe and UK 161–2 accounting regulation 86–7, 88, 91, 130, 138, 161–2, 176–7 conceptual framework development 251–2, 279–82, 306, 335, 336 dual reporting systems 178 elements of financial reporting 305–6 finance systems and accounting practice 203–4 introduction of Sarbanes-Oxley Act of 2002 88, 130, 138, 177 opposition to adoption of IFRS 176, 178, 182, 210 perceived limitations of US accounting requirements 177 role in the international standardisation of financial accounting 175–8 uses FASB standards 160, 176 universal applicability of theories 28–9 Universal Standard GRI 1: Foundation 2021 538–9 Universal Standards (GRI) 536, 538–41 unobservable inputs 254, 256 unrealised holding gains 241 unregulated accounting decisions 97 unregulated corporate reporting decisions 422–87 urgency of stakeholder demands 466 US GAAP 176–7, 178 coercive isomorphic pressures on US state governments to adopt 483 impact on foreign companies listing on NYSE 161–2 narrowing of differences with IFRS 177 research and development costs 397–8 use of fair values 259, 265 US Securities and Exchange Commission see Securities and Exchange Commission useful financial information, qualitative characteristics 54, 301, 302
V valuation models, to determine fair value 254, 255 value creation versus accountability ( Framework) 547 value judgements 20
754
value in use 325, 326 value-adjusted accounting information, demand for 249–52 ‘value-relevance’ research 621, 625, 626–9 values 189 verbal protocol analysis 661–3 verifiability 300 volatility, and fair value 257–61 Volkswagen corporate and government disclosures 455–6 stakeholders 462 voluntary disclosures benefits 618 motivations driving 423 social and environment information 393, 451
W Walt Disney Company, mission statement and organisational objectives 67, 68 Water Accounting Standards Board (WASB) 301, 561 Watts and Zimmerman objective of accounting research 407 Positive Accounting Theory see Positive Accounting Theory trends in accounting research 347–8 value judgements in positive research 20, 407–8 weak-form efficiency 598 wealth maximisation 32–3, 356, 410, 518–20 Westpac 528 what information needs to be reported? 59, 62, 509 social and environmental reporting 522–5 why is an organisation collecting and disclosing particular information? 59 acceptance of accountability to provide information 511–12 managers’ perceived responsibilities 60 potentially forestalling the imposition of more onerous disclosure regulations 60, 514–15 as a response to a crisis 60–1 social and environmental reporting 509, 510–20 to align the organisation with its institutional environment 516–17 to comply with legal requirements 59, 512–14 to increase wealth of shareholders and managers of the organisation 60, 518–20 to influence the perceived legitimacy of the organisation 515–16 to manage particular powerful stakeholders 60, 517 Wikileaks 704 workplace equality 512 workplace safety-related disclosures 485–7, 512, 580 World Bank 479
Z Zarzeski, Marilyn 197–8
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