TITLE: ACCT 632 - Advanced Financial Accounting Theory
1: Positive Accounting Theory
Positive accounting theory or PAT gives more stress on understanding and forecasting
the accounting practices in terms of the empirical observation or the assumptions of
the economic man. Mainly advanced by Watts and Zimmerman, PAT stipulates that
people are self-maximizing, meaning they act in a rational manner to achieve specific
objectives. According to the theory, accounting practices and standards change to
correspond to the transactions and conduct of the firms and other economic entities.
As for the impact of PAT on accounting practices, it can be again identified that this
kind of approach focuses on the pattern analysis rather than the normative
evaluations. Through analyzing the actions of people and firms in relation to the
choice of certain rules of accounting, PAT aims to identify why some methods of
accounting are preferred to others. For instance, PAT can easily expound for the
increasing stringency of income smoothing amongst the various firms that have been
in the frontline forecasting earnings to meet market expectations and or sustain a
certain value of their stocks.
The opponents opine that due to self-interest assumptions, PAT might reduce
organizational behaviors into simplistic self-interest motives and ignore the socio
structural ramifications. Still, PAT continues to be used in empirical research and
helps explain the economic implications of accounting decisions.
Normative Accounting Theory
Whereas PAT seeks to explain the real life practice of business, Normative
Accounting Theory deals with what should prevail as dictated by our conscience,
society’s ethic and other normative factors. The use of the framing concept is directed
at nurturing the development of the processes for establishing accounting standards
that would improve the quality of financial reporting by as being as clear, useful and
accurate as possible.
Another important factor in purist’s normative theory is the concept that holds the
basics of developing accounting standards. IASB and FASB use the normative theory
to explain the accounting principles from which distilled concepts enhance the
decisional utility of the financial statements to the users.
Even normative theories such as the stewardship theory hold that management has
the responsibility of using the companies’ resources in the best interest of
shareholders. These theories theses state that accounting practices must provide
relevant and timely information for accountability to be achieved in corporate
governance.
Critical Accounting Theory
Critical Accounting Theory on the other hand is anti received Accounting practice
since Critical Accounting Theory looks for reasons why accounting operates in a
certain manner. They are to clarify and enlighten as to the political strategy, and game
which is played concerning the determination of the standards and practices of
accounting.
Critical Accounting Theory emanates from the critical social theory and is influenced
by the works of Marx, Foucault and Habermas where it disputes the present
accounting practices’ assertion of being neutral and objective. According to this
paper, accounting is not a value-neutral field but constitutes a part of social relations
of a certain society.
For example, it reveals how Critical Theory can impact this to break down
accounting rules that perpetuate inequality or hide social and environmental costs. It
supports accountability processes that presuppose stakeholders’ rights and
responsibilities of the minorities and the unborn generations through sustainability
reporting and the social accounting.
Therefore, parallel to with PAT, with NAT, and, lastly, with CAT, one can think
about motivation towards the basic accounting practices and standards. Thus, Positive
Accounting Theory derives its foundation from empirical findings as well as
economics; Normative Accounting Theory deals with the prescriptions of ethical
standards in the practice of accounting; while Critical Accounting Theory
incorporates social/political perspective in the practice of accounting. In total, the
theories identified contribute towards the enhancement of the systematic view of the
subject – the Advanced Financial Accounting Theory as well as the impact and
complexity arising therefrom.
2: Theoretical Foundations and Practical Applications
IFRS: IASB is also another organization, which has central role in setting of
International Financial Reporting Standards. IFRS, as can be surmised from the
abbreviation, is directed at delivering principles based standards of preparation of the
financial statements and the overall objectives sought to be achieved by IFRS is to
increase the transparency, comparability and relevance of the information disclosed
via financial statements across the borders. In this case, the contribution of IFRS lies
in the premise that IFRS is grounded on normative theories of accounting which
assimilates the process of creation of investory decision-useful information by
investors and stak holders.
In reality, 143 countries use IFRS standards with some regions like the European
Union, Australia, and Canada. They are intended to be flexible to the qualitative and
quantitative nature of the business atmosphere and economic system while keeping
precise comparison of different accounting principles.
GAAP: ‘Generally Accepted Accounting Principles’ are formulated by the ‘Financial
Accounting Standards Board’ (FASB) in USA. GAAP is prescriptive, stating clearly
how certain transactions and events should be accounted for in the company’s
financial statements. The sources of GAAP are Normative Theories and Positive
Theories of Accounting, which focus on factors like Reliability of information,
qualified conservative of accounts, and Historical Cost.
In practice, GAAP standards are compulsory for all companies listed in the United
States and are likewise implemented by virtually all private companies. Consequently,
GAAP is characterized by its emphasis on detail and concrete guidelines for preparing
and presenting financial statements, which is owing to the system’s goal to eliminate
significant variations in companies’ financial reporting within the United States
market.
Convergence Efforts and Implications for Global Accounting Practices
Convergence Efforts: Since the latter of the year 2000, certain strides towards the
convergence of IFRS and GAAP have been made in an effort to reduce the
international friction and the amount of complexity faced by international business
organisations. It appeared that the convergence attempts were aimed at achieving the
amalgamation with the internationalisation of accounting standards with an objective
of maintaining the quality of the report.
Among them have been the work done by this two accounting boards which signed
the Norwalk Agreement that advocates for the integration of IFRS and GAAP on
some accounting matters. However, this has not been done to perfection as the
foregoing two frameworks have some differences regarding principles and direction.
Implications for Global Accounting Practices: The synchronization of IFRS and
GAAP has a lot of significance to the firms all over the world and the stockholders.
By means of the IFRS reconciliation and other mechanisms it enables comparing FDI
across the borders and financial comparison eliminating the costly procedures to
compare the generally accepted accounting standards.
From the global organisation’s viewpoint, it aids in the comparative assessment of
their accounts in addition to acting as the agency of standard setting for the MNCs’
financial reporting. More importantly, It increases in the clarity and conformity of the
preparation of financial statements, which are characteristics that are vital in the
rejuvenation of investors’ confidence and attraction of international investors.
In connection with this, the theoretical basis of IFRS and GAAP, as well as the
overall comparative analysis of both concepts, can be described as containing specific
similarities, which, all the same, indicate the presence of the current convergence
processes. This convergence has giant consequences for the acknowledgement
practises on an world stage because of the contribution in raising the intercontinental
similarities the transparency in the financial reporting.
3: Theoretical Approaches to Accounting for Complex Financial Instruments
Derivatives: It is important to define derivatives, or the financial products which value
is tied to some specific item, index or rate. It is notable that for a long time,
accounting for derivatives has involved some theoretical practices in accounting,
which are fair value measurement and hedge accounting. Normative based fair value
accounting principles have financial instruments extracted from other instruments to
be recognized at the existing market price in the company’s balance sheet. Another
benefit of this approach seeks to attain relevancy whereby the value asculat¬ed in the
instrument in question reflects what the economies are at a certain period, and or
periodical, thus holding usefulness to the different users of the financial statements.
Hedge Accounting: Hedge accounting has its key focus entrenched on the exchange
of the volatility of the hedging instrument for that of hedged item. From a theoretical
perspective, Positive Accounting Theory proves the specificity of the thesis indicating
that hedge accounting takes place due to the managers’ intention to manage the
earnings variation as they deem the stable performance measurement to be more
valuable. Normative based theories stress on the need for hedge accounting in a bid to
ensure that there is a near correspondence between the hedging instruments and the
hedged items especially for the purpose of presenting a fairly realiable picture of the
entity’s financial position.
Fair Value Measurement: As measured by the fair value measurement principles
from the normative and positive theories of accounting, all the respective financial
instruments should be recorded in the firm’s fair value, namely, the amount at which
the financial item being an asset or liability can be sold or transferred to another party
in an efficient fashion within the market independently. This is a theoretical
orientation that is aimed at providing useful and relevant data for the users of financial
statements, this information must represent Market conditions and contain an
economic reality component.
Analyzing theoretical frameworks and the problems that arise with controversies and
challenges of applying on complex financial instruments
Complexity and Subjectivity: Among the challenges that account for financial
instruments include the fact that: Fair value measurements cannot be derived
objectively this calls for subjectivity and this is required in developing the fair value,
especially when it comes to valuing financial derivatives that refer to financial
instruments in which the market prices cannot easily be determined. CHOICE OF
VALUATION MEASURES: The problem with the existing body of theoretical
knowledge is that it is not very clear as to how such sorts of instruments may be
valued in suitable ways and which often leads to variations within the values recorded
in the balance sheets.
Volatility and Earnings Management: Derivatives and hedge accounting alone
introduce fluctuation to the company’s financial statements because changes in fair
value of derivates and hedging instruments affect earnings. This may be achieved
through the use of hedge accounting that created some questions on earnings
management and shifting of operational performance. The contentious discourses are
as follows; whether hedging accounting is employed to put into equal measure the
qualitative component of hedging relation, or is merely used to manage earnings
reports.
Regulatory and Standard Setting Challenges: However, these are the considerations
of the theoretical frameworks that are necessary: There are also regulatory
implications and the issues of what standards of practice should actually be used with
clients. Therefore, modifications are always made to the accounting standards by
various international and national accounting standard setting organisms such as the
IASB and the FASB with regard to how FIs should be accounted for because of the
emerging issue or change in the market practices. Nevertheless, the hardest task that
one encounters is to find a common ground between the policy makers and the
practitioners regarding the practical implementation of the theories and the various
jurisdictions.
Hence the theoretical assumptions concerning the valuation of such financial assets
like derivatives, hedge accounting and fair value measurement is relevant if the
specificity of financial reporting is to be given mileage. However, problems and
questions still persist in the application of the mentioned frameworks due to the
inherent problems, the problems associated with the application of fair value
measurements, the earnings management and the problem on the regulation. To
overcome these challenges, there must be a continuous talk among the stakeholders,
and at the same time, the theoretical models in the release of financial information
have to be enhanced to improve the precision of the work.
4: Role of Accounting Theories in Corporate Governance Practices
Business management can then be defined as frameworks and activities involved in
the running of business organizations. Employee and corporate governance practice is
therefore based on the theories that exist within the accounting discipline as these
form part of the theoretical foundations of decision making and reporting.
Agency Theory: The agency theory suggests conflict of interest because of the
different motives; since the objectives are different, and/or because the parties brings
forward different information to the two parties or because the parties have
discrepancies in the information available to them. Agency theory under the corporate
governance theme focuses on the possibilities of incentives, monitoring and
contracting is being used to make managers more accountable to shareholders.
The agency inspired theories of accounting supports the reporting process which will
developed the higher level of accountability of the financial status of an enterprise and
also transfer information to the shareholders. For example, disclosure rules and
separation of ownership and control are among the measures used to address agency
problems because it prod/compel the managers to operate as per the shareholder’s
direction.
Stewardship Theory: Thus, stewardship theory is different from agency theory in the
manner that the latter construes the managers as acting in the agency of the company
shareholders, while the Stewardship theory portrays the managers as the stewards of
the company’s resources to the shareholders, employees and other stakeholders.
Stewardship theory grounds the topics of corporate responsibility and ethical
responsibilities of the managers within the organization and their fidelity to it.
Some theories in accounting, which have their grounds in the given stewardship
theory, presuppose measures that can help to avoid the manifestations of unethical
behavior of the business and shifting of managers’ responsibilities. For instance, some
of the stewardship sources of financial reporting are on the business management
plan, the risk management approach, and the management’s action on environmental
responsibility programs. These are why these disclosures are intended to increase the
understanding that is available about a specific firm and therefore will show that the
managerial actions are appropriate for achieving the strategic goals.
Therefore, this paper aims to investigate the impact of Agency Theory and
Stewardship Theory on the issue of financial reporting and accountability.
Financial Reporting: Agency theory amd stewardship theory affect financial
reporting practices for the reason that both of them explain the goals and guidelines
that need to be followed when developing and disseminating the financial statements.
Fraud reporting as the next event formatted also best deals with agency problems as
perceived in the agency theory in providing information where necessary for the
decision making process to shareholders and other stakeholders.
While stewardship theory promotes management freedom in firms’ economic
actions, it assumes the management to produce and disseminate accurate financial
statements after a certain period, which shows their stewardship duties. They are;
reporting of executive and other related parties’ remuneration, business association,
and process of dealing and making appropriate ethical practices and decisions for the
corporation.
Accountability: Contribution: Such theories as agency theory helps in enhancing
accountability since such theories contain structures that present an evaluation of the
management’s performing. For instance, the idea of internal check and the plans by
exterior auditors are existing just to be capable of convincing the shareholders that the
current statement shows the right position of the firm.
Comparatively; based on the analyzed tenets of the theory, stewardship theory seems
to support the accountability by the structures that contain the communication, ethical
decision and business sustainability. Numbers-oriented practices ensure that the
stakeholders make the management requirements be in line with the goals hence
anything that is done is for the best interest of the organization and in the long run; the
set goals are achieved amicably.
Hence it may be safely concluded that, agency theory and stewardship theory have
tremendous importance in determining the practices of corporate governance through
the paradigms available on the proximate causes that influence the standards of
financial reporting, accountability and governance systems. Whereas agency theory
presupposes that it is feasible to ascertain the right incentives and constantly monitor
the agents in a bid to address the conflict of interest, stewardship theory calls for
ethical stewardship and the improvement of the company’s value for shareholders and
other stakeholders. along with the theories, help to facilitate the increase of the level
of great transparency, accountability, and confidence in the utilization of the ICGP.
5: How Behavioral Economics Theories Affect Financial Reporting Decisions
Prospect Theory: Kahneman and Tversky came up with what is referred to as the
prospect theory, this theory looks at decisions concerning the possible gains and or
losses based on the reference point Kagel and Levin (2004). With regard to the impact
of prospect theory on financial reporting one could conclude that through it; The
managers and the investors are able to see and how they relate to it.
For example, the managers might be exhibiting a loss aversion bias, that is they
would be prepared to forestall recognition of losses on investments or assets because
they would prefer to maintain a veneer of stability in the organization’s accounts. This
is practise may be accompanied by earnings management activities that include
income smoothing or aggressive recognition of revenues and thus, modifies the
credibility of a financial report.
Bounded Rationality: The concept of Bounded rationality formulated by Herbet
Simon developed this theory proposing that the actors make decisions mainly because
of their cognitive capabilities and the amount of information they can process. Even
when it comes to specific decisions like the process of preparing a company’s
financial statements, bounded rationality is evident by the manner in which the
managers interpret the various accounting standards and the regulatory frameworks.
They can thus be said to cause biases in accounting hence the fulfillment of the first
capacity of heuristics; This may be due to inconsistency that is normally associated
with simplified decision rules which are used by the managers in the application of
accounting standards. For instance, when making uncertainty-bearing or risk
contractual decisions that determine the fair value measurements of financial assets,
and liabilities, or of other financial instruments for reporting, there may be used
a’hypothesized rational model’ which in effect translates to a bounded rationality
whereby estimated values are derived from historical cost or market price
mechanisms that obscure rather than enlighten on critical aspects of the real world.
Conclusion and Recommendations Regarding the Current Status of the Nature
of Regulation and SSOs
Regulatory Frameworks: On which much of the design of legal regulation is based,
behavioral economics denies the concept of expected rationality. The authorities
should focus on cognitive biases and behavioral features and the way they may affect
the issues related to accounting standards and regulations compliance. For instance,
knowing of the presence of the influence of prospect theory entails that it is possible
to adjust changes to the laws and ensure that cases of earnings manipulation or
inadequate disclosure practices are avoided or brought to naught.
Standard-Setting Bodies: This paper reviews the current literature to determine how
the IASB and FASB are increasingly integrating findings from behaviour economics
when setting accounting standards. Since behavioural biases have an influence in the
financial reporting processes, the enhancement of standards will add to the
formulation of rules that are even less susceptible to manipulations and at the same
time will provide useful information to those who use the financial reports.
For example, standard setting process may extend the disclosure frameworks with
additional information about management’s judgments and estimates that have been
applied in implementing the current accounting standards. It helps the investors and
the analysts to determine credibility and reliability of the financial statements thus
reducing on information gap that is efficient for the market.
Therefore, it is possible to conclude that measurement and estimation in prospect
theory, as well as other components of behavioral economics, play a positive role in
implementing decisions in financial reporting by altering the nature of the
management’s actions and choice-making processes. Such and other behavioral biases
begin to dictate the choice of appropriate accounting standards by the regulatory
bodies and the standard-setting organisations that promulgate the accounting
standards to improve the reporting of financial information. Therefore, based on the
behavioral economics knowledge, the regulators, and the standard setters can improve
the usefulness and quality of F reported by firms hence increasing investor’s
confidence and better capital allocation decisions.
6: Ethical Considerations within Different Accounting Theories
For such reasons, ethics is as inevitable an element in the paths leading to the creation
of a professional accountant; thus theories and principles have been categorically
pointed to the tasks and responsibilities of ascertaining credibility of reported and
disclosed financial information and its proper utilization in manner that is ethical and
beneficial to several stakeholders. Different ethical theories provide frameworks for
evaluating the ethical implications of accounting decisions:Based on this, there are
various ethical theories through which several frameworks for ethical ideology when
choosing accounting decisions are provided as follows:
Utilitarianism: Thus, the criterion that forms the core of the utilitarian belief is aimed
and raises the quest to increase the quantity of pleasure, or the sum of the utility of the
subject to the highest level. In financial accounting the legal rules that act as rational
in the decision-making related to utilization of a resource with the objective of
realizing the maximum return for a business in terms of the economic profit possible
for shareholders and other interest groups while at the same time ensuring fairness to
creditors, employees and the public. For instance, in the system of revenue
recognition ethical issues in managers can pass through issues on when to recognize
the revenue in an effort to improve the stock holders’ value at the expense of other
stakeholders.
Virtue Ethics: As for W Kohlberg virtue ethics was predominantly focused on the
features as well as the nature of ethics to that person that includes; integrity, honesty,
and prudence. Concerning the application of the virtue ethics, it provides the general
standard guideline for the accountants and managers and the executives of the
business entity and guarantee the accomplishment of the goal of the financial
statement of the business fully exercise the high-pitch ethical values. This concept
involves the promotion of ethical standards in culture/behaviour of the organisation
for the aspects considered worthy through the identification of credit-worthy features
of the reporting.
Deontology: Deontological ethics is the branch that concerns the rights and the
wrongs, the duties of the men and the women and the corporations, the organizations
in careers and moral right/wrong principles. Among them, it is possible to identify
two applications that are used in the financial accounting when the main accent is
made concerning the need to adhere to ethicality provided and any established
standards even if it leads to or in some cases, to negative outcomes. For instance, the
Accounting Standards require the accountants to use specific therapies in preparing
and presenting the organisation’s accounting profit irrespective of the results, which
would be generated by the applications of those therapies.
Information details, which can be derived from the aforementioned information, will
lead to the inference that ethical theories have a rather important impact on the
decision-making of the Financial Reporting Practices and Disclosures.
Transparency and Disclosure: Ethical theories can be employed in the interpretation
of the company’s practices in its financial reporting activities since she subscribe to
some of the principles some of which include provision of enough information to the
users of the financial statements. For instance, virtue ethics looks at any fact that may
influence a stakeholder’s decision as information that should be hidden; On the other
hand, when consolidating Company financial statements, it is supposed to portray
credible and reliable figures of the company.
Fairness and Equity: In this regard, such ethical theories pertain to the decisions
introduced regarding the fairness of as well as the objectivity of financial statements.
Therefore, utilitarianism encourages managers to consider those others who in one
capacity or another may be affected by the organization’s financial reporting and
those who gain/lose from it. This is evident thru the capturing of deontological ethics
that we earlier discussed the managers are supposed to be fairly remunerated and
hired in distributing all these resources as they are hired to present the financial
statements.
Accountability and Responsibility: Ethical theories assist in the right and proper to be
done particularly on issues that are associated with the financial reporting system of
an organization. Virtue ethics where the manager is constantly reminded that he/she is
the economic artist of the company and therefore tunes the work to the correct
modeling of the figures and proper data presentation and reporting. Therefore,
deontological business ethic only focuses on the right, right action, and right way of
performing activities duly assigned as mandatory or obligatory for individuals to
uphold a company’s standards or the established ethical norms.
Thus, it seems relevant to acknowledge that, while the ethical dilemmas which were
incorporated into the analytical framework pursuant to the several theoretical
narratives of accounting based on the principles of utilitarianism, virtues, and
deontology have been duly noted, it is important to note that the kinds of the South
African reporting and disclosure regulation procedures stem from the deontology. The
above specified ethical theories are useful to both the accountants as well as the
managers at that specific stage of presenting; factual, accurate or unbiased
information to users of the financial statements of a given organisation. This
assessment of the three concepts indicates the fact that there is a fairly valid
hypothesis that shall also be positive due to the correction of the ethical problems as
soon as the financial information is presented to gain the lost trust from the
population, thus minimizing chances of embezzlement and promoting generation of
values in the future for all the members of the concerned society.
