AC3091_vle Financial reporting

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Financial reporting

J. Haslam and D. Chow

AC3

091, 2790091

2012

Undergraduate study in

Economics, Management,

Finance and the Social Sciences

This subject guide is for a 300 course offered as part of the University of London International Programmes in Economics, Management, Finance and the Social Sciences. This is equivalent to Level 6 within the Framework for Higher Education Qualifi cations in England, Wales and Northern Ireland (FHEQ).

For more information about the University of London International Programmes undergraduate study in Economics, Management, Finance and the Social Sciences, see: www.londoninternational.ac.uk

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Programmes by:

Professor J. Haslam, Heriot-Watt University and

Dr D.Chow, Durham University

It draws on previous editions of the guide prepared by J. Horton and S. Miles

Professor J. Horton, BSc, M Phil, PhD, Department of Accounting, University of Exeter Business School.

It was revised and updated in 2007 by:

S. Miles, PhD. Department of Accounting, The Business School, Oxford Brookes University. This is one of a series of subject guides published by the University. We regret that due to pressure of work the authors are unable to enter into any correspondence relating to, or arising from, the guide. If you have any comments on this subject guide, favourable or unfavourable, please use the form at the back of this guide.

University of London International Programmes Publications Office Stewart House 32 Russell Square London WC1B 5DN United Kingdom www.londoninternational.ac.uk

Published by: University of London © University of London 2012

The University of London asserts copyright over all material in this subject guide except where otherwise indicated. All rights reserved. No part of this work may be reproduced in any form, or by any means, without permission in writing from the publisher.

We make every effort to contact copyright holders. If you think we have inadvertently used your copyright material, please let us know.

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Introduction

What is or should be the role of accounting in society? How important is or might be accounting in this respect? In what sense is and should accounting be regulated?

You may have encountered the financial accounting statements of companies, a major focus here, as part of your work or as a shareholder or other user. These statements will probably have been prepared by accountants and audited by an independent firm of auditors. The statements would still require some analysis by the user, for instance: Which figures are subject to management discretion? Which figures depend on accounting choice? How can you distinguish between two companies with identical earnings? How should accounting be regulated? Who should regulate or organise the production of accounting?

This subject guide is concerned with helping you to develop an understanding of financial accounting consistent with the aims and objectives of the course specified below.

Aims and objectives of this course

The Financial reporting syllabus is concerned with the theory and practice of financial accounting. This involves a sound understanding of the concepts and choices that underlie measurement and disclosure in financial statements. The aims and objectives of the course are to: • stimulate theoretical enquiry into financial accounting issues • develop your knowledge and understanding of financial accounting • prepare you for further academic study in accounting and related areas • enable you to pursue a professional accountancy qualification • equip you for employment in areas where an understanding of

accounting issues and tools is helpful.

Learning outcomes

At the end of this course and having completed the Essential readings and activities, you should be able to:

• explain and apply a number of theoretical approaches to financial accounting

• record and analyse data

• prepare financial statements under alternative accounting conventions • describe a number of regulatory issues relating to financial accounting • critically evaluate theories and practices of, and other matters relating

to, financial accounting.

The learning outcomes that you are expected to achieve for the various topics are listed at the end of each chapter.

Syllabus

The rationale for financial reporting. Arguments for and against regulation of financial reporting. Methods or regulation, including standarisation of accounting practices. The nature and purposes of a conceptual framework for financial reporting: the objectives of financial reporting; the qualitative

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characteristics of accounting information; the definitions of an asset and a liability; recognition and measurement in financial statements; international framework. Narrative reporting and issues of corporate social responsibility. Economic and accounting concepts of income, capital and value with particular reference to Hicks’ income concepts.

Strengths and weaknesses of historical cost accounting. Bases of asset valuation. Capital maintenance concepts and various associated techniques: current value accounting systems, current purchasing power accounting, replacement cost accounting; in addition to entry (historical cost) and exit value accounting.

Accounting for investments and groups of companies. The merger and acquisition methods. Associated companies and joint ventures. Accounting for foreign currency transactions, foreign subsidiaries and branches: the temporal and closing rate/net investment methods of foreign currency translation.

Accounting for tangible and intangible assets: fixed assets and

depreciation; stocks and long-term contracts; research and development; goodwill. Accounting for leases. Accounting for liabilities. Accounting for taxation, including deferred taxation.

Analysis and interpretation of corporate financial reports; introduction to international differences in financial reporting.

Accounting standards in this subject guide

This subject guide is written for International Programmes students, who will be studying in many different countries subject to different accounting rules and regulations. The International Accounting Standards Board (IASB) is quickly becoming the generally accepted accounting regulator at the international level. In the EU and Australia, for example, all listed companies are required to produce group financial statements in accordance with current International Accounting Standards (IASs) and International Financial Reporting Standards (IFRSs) – the latter are gradually replacing the former as the IASs come to be updated and revised. Many other countries such as the USA and China are working towards closing the convergence gap between IASs/IFRSs and national regulations. This subject guide has been written with this in mind. The subject guide has an international focus but within that we give some particular consideration to the UK (e.g. in the context of accounting for changing prices) because it serves to illustrate some key developments. All worked examples use £ sterling as the currency. A list of abbreviations reflecting the emphases of the guide is given at the end of the

Introduction.

How to use this guide

This subject guide is intended to supplement the Essential reading, not to replace it. It should be read in conjunction with the Essential reading and supported by Further reading. The list of Further reading is a selection from many possible sources. Please seek additional reading on any topics that you find difficult to grasp. Please note that, given the rapid pace of change in financial accounting, you should use the latest editions of texts, particularly the Essential reading text for the course.

In addition to the Essential reading listed at the beginning of each chapter, you should read the appropriate available accounting practitioner journal

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(e.g. Accountancy and Certified Accountant in the UK). Journals of other professional accountancy bodies in other countries are just as relevant. It may also be useful for you to obtain a copy of the Annual Reports and

Accounts of a large company in your country. This will provide you with a

good reference aid for some of the main issues addressed in this guide. You can generally obtain these reports on the company’s website. Alternatively you could write to the company asking for a copy of their report.

Websites

It is also recommended that you use the internet and investigate the different professional bodies and government organisations’ websites which are a useful source of information on current developments in financial reporting and regulation. Examples include:

• www.frc.org.uk for the UK Accounting Standards Board (ASB)

• www.fasb.org for the US Financial Accounting Standards Board (FASB) • www.iasb.org.uk for the International Accounting Standards Board

(IASB).

Unless otherwise stated, all websites in this subject guide were accessed in April 2012. We cannot guarantee, however, that they will stay current and you may need to perform an internet search to find the relevant pages.

Activities

This subject guide is divided into 12 chapters, the majority of which are self-contained. Most chapters contain worked numerical examples, where appropriate, and activities appear throughout the guide. It is strongly recommended that you attempt to answer, or consider the implications of, all activities. Many of them require you to do additional reading. Solutions to some of the activities and sample examination questions are available in Appendix 2 at the back of the guide.

Sample examination questions

There are sample examination questions at the end of each chapter, aimed to test your knowledge and prepare you for the examination. However, the Sample examination paper in Appendix 1 is a more accurate reflection of the type of questions that are likely to come up in the examination.

Reading advice

There is no single wholly satisfactory textbook covering all the topics discussed in this course. References are given to one of the main advanced financial accounting textbooks. References for specific Further reading will also be given where appropriate. You are advised to check if new editions of these textbooks are available.

Essential reading

Alexander, D., A. Britton and A. Jorissen International Financial Reporting

and Analysis. (Andover: Cengange Learning EMEA, 2011) fifth edition

[ISBN 9781408032282]. Hereafter, we will refer to this book simply as

International Financial Reporting.

Detailed reading references in this subject guide refer to the editions of the set textbooks listed below. New editions of one or more of these textbooks may have been published by the time you study this course. You can use a more recent edition of any of the books; use the detailed chapter and section headings and the index to identify relevant readings. Also check

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the virtual learning environment (VLE) regularly for updated guidance on readings.

Online study resources

In addition to the subject guide and the Essential reading, it is crucial that you take advantage of the study resources that are available online for this course, including the VLE and the Online Library.

You can access the VLE, the Online Library and your University of London email account via the Student Portal at:

http://my.londoninternational.ac.uk

You should have received your login details for the Student Portal with your official offer, which was emailed to the address that you gave on your application form. You have probably already logged in to the Student Portal in order to register! As soon as you registered, you will automatically have been granted access to the VLE, Online Library and your fully functional University of London email account.

If you forget your login details at any point, please email uolia.support@ london.ac.uk quoting your student number.

The VLE

The VLE, which complements this subject guide, has been designed to enhance your learning experience, providing additional support and a sense of community. It forms an important part of your study experience with the University of London and you should access it regularly.

The VLE provides a range of resources for EMFSS courses:

• Self-testing activities: Doing these allows you to test your own understanding of subject material.

• Electronic study materials: The printed materials that you receive from the University of London are available to download, including updated reading lists and references.

• Past examination papers and Examiners’ commentaries: These provide advice on how each examination question might best be answered. • A student discussion forum: This is an open space for you to discuss

interests and experiences, seek support from your peers, work collaboratively to solve problems and discuss subject material. • Videos: There are recorded academic introductions to the subject,

interviews and debates and, for some courses, audio-visual tutorials and conclusions.

• Recorded lectures: For some courses, where appropriate, the sessions from previous years’ Study Weekends have been recorded and made available.

• Study skills: Expert advice on preparing for examinations and developing your digital literacy skills.

• Feedback forms.

Some of these resources are available for certain courses only, but we are expanding our provision all the time and you should check the VLE regularly for updates.

Making use of the Online Library

The Online Library contains a huge array of journal articles and other resources to help you read widely and extensively.

To access the majority of resources via the Online Library you will either need to use your University of London Student Portal login details, or you

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will be required to register and use an Athens login: http://tinyurl.com/ollathens

The easiest way to locate relevant content and journal articles in the Online Library is to use the Summon search engine.

If you are having trouble finding an article listed in a reading list, try removing any punctuation from the title, such as single quotation marks, question marks and colons.

For further advice, please see the online help pages: www.external.shl.lon.ac.uk/summon/about.php

Changes to the syllabus

The material contained in this subject guide reflects the syllabus for the year 2012–2013.

The field of accounting changes regularly, and there may be updates to the syllabus for this course that are not included in this subject guide. Any such updates will be posted on the VLE. It is essential that you check the VLE at the beginning of each academic year (September) for new material and changes to the syllabus. Any additional material posted on the VLE will be examinable.

Preparation for the examination

Important: the information and advice given here are based on the examination structure used at the time this guide was written. Please note that subject guides may be used for several years. Because of this we strongly advise you to always check both the current Regulations for relevant information about the examination, and the VLE where you should be advised of any forthcoming changes. You should also carefully check the rubric/instructions on the paper you actually sit and follow those instructions.

Remember, it is important to check the VLE for:

• up-to-date information on examination and assessment arrangements for this course

• where available, past examination papers and Examiners’ commentaries for the course which give advice on how each question might best be answered.

With regard to this subject guide, you should:

• refer to the Essential reading and any Further reading you might require to fully understand the topics in the syllabus

• attempt all the activities in each chapter • complete all the sample examination questions.

We also recommend that you read through the section on examinations in

Strategies for success. It contains some useful guidelines on preparing for

examinations.

Format of the examination

The examination could cover any of the subjects that are addressed in this syllabus. The examination is three hours long, and you are normally required to answer four questions from a choice of seven. These will be a mixture of essay-style questions and computation with discussion questions. You therefore need to concentrate on both the qualitative and quantitative characteristics of the topics. You cannot rely purely upon, for

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example, the computation aspects to pass the examination. The entire syllabus is examinable. Appendix 1 contains a Sample examination paper and Appendix 2 contains solutions to activities and to Sample examination questions. Note that solutions are available only for selected activities and questions.

The examination also has an additional 15 minutes which is given as reading time. You may begin writing at any point after the start of the examination (which remains three hours in length). The total time available to you in the examination hall will therefore be 3 hours and 15 minutes.

Overview of the guide

As emphasised throughout this subject guide, accounting is a

communication tool. The business entity communicates financial information to interested parties (e.g. potential and existing shareholders, creditors, managers, employees, NGOs, suppliers, the government, etc.) in the form of financial statements. These financial statements will in themselves impart information about the economic resources of the entity which are under the control of management.

Policy-makers (e.g. standard-setters) and others helping to shape accounting (including practising accountants) have to ask themselves a number of basic questions before they can even begin to construct the financial statements. For example:

• Which disclosures and figures should be included in these Financial accounting statements? How much detail should be given?

• How should these figures be calculated? • Who are the users of this information?

• Will they find the figures useful for their decisions and purposes? What is accounting’s role?

T. Smith quotes an old joke which summarises some criticisms of accounting:

An old man was lost in a hot air balloon. Fortunately he saw someone walking in a field below him so he lost height and when he was within range shouted ‘Can you tell me where I am?’ The walker stopped paused for thought and shouted back ‘You’re in a hot air balloon.’ ‘You must be an accountant’ retorted the balloonist. ‘Amazing’, said the walker. ‘How did you know that?’ ‘Because the information you just gave me was both totally accurate and completely useless!’

(Smith, T. Accounting for Growth, 1996, p.73)

Chapter 2 of this subject guide addresses some key accounting issues: • What is and should be accounting’s role in society?

• Who are the users?

• What information would they benefit from?

• What should the underlying criteria be: relevant information, reliable information, or both (if possible)?

• In what sense is or should accounting be regulated?

The remaining chapters consider a number of basic questions and issues that have been debated over the years when deciding upon which disclosures and figures should be reported in the accounts, for instance:

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• What alternative measurement methods are available?

• Will they capture the underlying economic reality of the business? • Will they be useful and understandable to users?

• Will the figures enable users to make optimal decisions concerning the allocation of their own scarce economic resources?

• What do the standard-setters believe firms should be measuring and reporting, and why?

• Are the standards theoretically and conceptually correct in requiring companies to report and measure certain figures?

• Are the methods appropriate given the environment in which companies now operate?

• What issues still need to be addressed and why?

Chapters 3–4 deal with income measurement and capital maintenance (and also consider economic approaches, such as those proposed by Hicks), historical cost accounting, current purchasing power accounting and current value accounting. Chapters 5–12 are firmly based upon the modified historical cost/mixed measurement systems relating possibilities to the Hicks income concepts. We discuss implications if Hicksian

theory and would also recommend Biekpe, N., M. Tippett and R. Willett ‘Accounting Earnings, Permanent Cash Flow And The Distribution Of The Earnings To Price Ratio’, The British Accounting Review 30(2) 1998, pp.105–40. We are concerned to point to the relevance of context and seek to broaden horizons on financial accounting. We consider possible futures for accounting.

Index of abbreviations used in this guide

AEC Annual equivalent costs ASB Accounting Standards Board CBS Consolidated Balance Sheet CIS Consolidated Income Statement CPP current purchasing power CVA current value accounting

DV deprival value, also known as ‘value to the business’ or ‘value to

the owner’.

EPS earnings per share

EC European Community

EU European Union

FASB Financial Accounting Standards Board FIFO first-in, first-out

FPPFS Framework for the Preparation and Presentation of Financial Statements

FRS Financial Reporting Standard GPP General Purchasing Power HCA Historical Cost Accounting

IAS International Accounting Standard IASB International Accounting Standards Board IASC International Accounting Standards Committee

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IFRS International Financial Reporting Standard

IOSCO International Organization of Securities Commissions LIFO last-in, first-out

NBV net book value NPV net present value

NRV net realisable value, also known as ‘current exit value’ P/E price/earnings ratio

PV present value, also known as ‘economic value’ RC replacement cost, also known as ‘current entry cost’ ROCE return on capital employed

RPI Retail Price Index

SEC Securities Exchange Commission SOP Statement of Principles

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Chapter 1: Rationale for financial

reporting and its regulation

Aims of the chapter

This chapter introduces:

• the role of accounting in society

• the regulatory framework (discussion focused upon the international framework)

• arguments for and against forms of consideration of accounting regulation, including voluntary disclosure

Learning outcomes

By the end of this chapter, and having completed the Essential reading and activities, you should be able to:

• delineate the basic character of financial accounting theory • discuss the role of accounting in society

• explain the different levels of authority in the UK regulatory framework • explain and discuss the implications of the International Accounting

Standards Board (IASB)

• discuss the arguments for and against accounting standards • discuss the theory of regulation.

Essential reading

International Financial Reporting, Chapter 1.

Financial accounting theory

What is financial accounting? There are different understandings of it. Some would equate it to ‘external accounting’, which indicates an accounting that, in the case of the business firm, goes outside the organisation to owners not closely involved in internal business

management or into the broader public realm. This is potentially a quite broad understanding of financial accounting. Interestingly, it could actually go beyond the financial, if including it, and may reflect very old notions of rendering an account more generally.

A common, narrower usage understands financial accounting to be external and financial. In most university courses on financial accounting there is a further narrowing with the typical focus being on the commercial business organisation that is owned by shareholders who are understood to be other than the company’s management. Financial accounting, where it is seen as external, which is usually the case, is often distinguished from internal ‘management accounting’.

In broad terms, all accounting can be understood in terms of decision making and control roles (where these encompass dimensions of accountability and stewardship).

The relation between financial accounting and financial reporting is also not a settled one. In some usages they are taken to be the same or at least substantively so. In others, the accounting implies a broader activity (e.g. recording) and reporting is understood as a branch of it. In yet other usages, financial reporting equates to a broader external reporting that need not be restricted to the financial whereas financial accounting (or simply accounting) is understood to be so restricted. In trying to introduce the subject matter, it is appropriate to give insight into these nuances that are found in what is a quite diverse literature on accounting. Both financial reporting and financial accounting may be distinguished from financial statements in perhaps including narrative reports.

In this subject guide, we shall typically equate financial accounting and financial reporting and where we intend a different connotation we shall make that explicit. Often, reflecting much of the literature and practice, we shall use the term financial accounting where we mean the external and financial accounting of organisations (typically commercial business organisations) but we shall give some recognition to broader definitions (e.g. in referring to some notions of corporate social responsibility accounting) and in those cases make clear that we are departing from the narrower view. We shall adopt the broad understanding of accounting’s role. But here we need to introduce a further framework for understanding. Controversies do not end with issues of definition or delineation.

The study of financial accounting (whether understood broadly or narrowly) is the study of a social phenomenon. Accounting is constructed by people in a context and impacts upon them and the context.

Presumably its justification is in terms of social well-being.

The study of accounting may clearly be seen, and is typically understood, as a social science. One common way of classifying theories in the social sciences (e.g. in economics) is to distinguish between normative and positive approaches, or (as is preferred here) between prescriptive and descriptive approaches. Prescriptive approaches are concerned with developing a theory of accounting ‘as it should be’ and descriptive approaches with developing a theory of accounting ‘as it is’.

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In this subject guide we give insights into the more prescriptive and the more descriptive approaches. Again, there are different approaches within this broad categorisation. For instance, there are those who draw primarily from economics in formulating either prescriptive or descriptive theories of accounting. And one should note here that there are different views within economics! Others draw from sociology or adopt a more interdisciplinary perspective. The latter approach overlaps with concerns to understand financial accounting more broadly and especially in terms of its scope, the variety of influences upon it and its diverse consequences. Many academics and policy-makers consider mainstream economic theory to be a good basis for theorising financial accounting prescriptively and descriptively while for others it is a narrow approach that does not take into account the actual and potential repercussions of financial accounting. We shall try to give insights into major instances of the more economistic approaches and other approaches and also here try to draw bridges between them. We shall thus begin to explore how accounting’s role has been variously theorised prescriptively, e.g. as improving economic decisions so as to enhance social welfare or as contributing to a better democracy and shall consider descriptive studies of accounting so as to also reflect the diverse approaches of the literature.

In this chapter we consider prescriptive views that have emerged in relation to issues of accounting’s regulation. We shall see that many views here reflect mainstream economistic thinking. We offer descriptions of financial accounting practice and its context in the UK and internationally, with again an emphasis on how financial accounting is regulated. It becomes clear here that a mainstream economistic thinking has been influential in the construction of a regulatory framework with linked institutions in this area. We also give some attention to ways of seeing beyond the economistic.

Financial accounting and its role

Mainstream economistic views see financial accounting as information that guides economic decisions. Actually, in many abstract models that are not uncommon in economic reasoning, perfect information is simply taken to exist.

To the extent that information in general and financial accounting in particular are considered more realistically, the approaching of perfect information is often taken as desired. As the information increases in quality (a notion encompassing increased transparency) economic decisions are understood to improve. Perhaps more detailed, disaggregated information could be given. Perhaps companies could be valued better or report better their value. The view is that scarce resources are better allocated in the economy and social welfare increased.

A modification of this position again in the direction of greater realism appreciates that information is costly. Its benefits should exceed its costs. Substantively, the latter are ostensibly the dominant views of the

influential accounting policy-makers. The IASB, for instance, emphasises the role of financial accounting information in guiding economic

decisions and thus enhancing social welfare. Less frequently in official pronouncements but often used to justify actual policy decisions, explicit reference is made to the costliness of this or that possible provision (although the UK’s ASB does make reference to it in its stated aims – as well as pointing out that it is not in favour of revolutionary changes to financial reporting!).

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Those giving thought to further dimensions of the imperfect character of real world economies have added further layers of complexity in their prescriptions. The assumption that more transparency is better than less is brought into question beyond simple cost-benefit analysis. Lipsey and Lancaster (1957) argue that in imperfect market contexts, improving information without improving other aspects of the economic system might even reduce social welfare. Possible reasons include that in a competitive economy businesses need to have incentives to innovate that might be countered if too much is made transparent. Thus, even shareholders have an interest in keeping some information within the firm. If more information is publicly available it may be easier for monopolistic firms to strengthen monopolistic positions, to the detriment of social welfare (Gallhofer and Haslam, 2007).

Such considerations may help us with descriptive theory. Factors such as the above, together with information’s costliness, as well as lack of shareholder control over corporate management, may explain why many commentators believe that financial accounting information falls short of the information that one might assume, from a more mainstream position, capital providers would want (Tinker, 1985, even refers to shareholder alienation). This is in spite of the apparent shareholder and investor orientation of the influential policy-makers. Perhaps it is the case that financial accounting does reflect the conventionally assumed interests of shareholders – but in an imperfect market – or perhaps those interests are only partially or imperfectly satisfied.

Returning to prescription, another view from someone well versed in an information economics perspective takes further the notion of imperfect markets (towards an appreciation of the imperfect character of the socio-economic and political context) and fuses with a more interdisciplinary perspective, indicating that financial accounting cannot be understood to have only narrowly conceived economic consequences. Joseph Stiglitz, a Nobel prize winner in economics, notes that when information like financial accounting enters the public realm it enters a complex context of conflicting forces. One cannot assume that information produced for purpose X will not be used for purpose Y. Purpose Y may include the desire to impose stricter regulations on business and/or enhance the general democratic control over business. The prescriptive implication may not be so clear but the suggestion is that some kind of trade off may be necessary in an imperfect context.

Drawing from such an insight, some researchers point to financial accounting’s role in potentially changing (for the better) the character of the socio-political and economic system as well as serving it (Gallhofer and Haslam, 2007). Similar prescriptive thinking is behind other socio-economic and socio-political theorising, in which forms of corporate social responsibility accounting are envisioned that transform the narrower economistic financial accounting towards a more holistic form of accounting that reflects (from their perspectives) all things of relevance to social well-being (in relation to corporate operations). More generally, the concern for a more holistic external accounting involves going beyond mainstream perceptions and includes prescriptions of non-financial information (see Gallhofer and Haslam, 2007).

These prescriptive suggestions have had little influence on accounting policy-makers, although The Corporate Report (1975), a draft policy statement of the UK Accounting Standards Steering Committee (a forerunner of today’s UK ASB), did put forward a stakeholder-orientated form of external accounting that included non-financial as well as financial

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Financial accounting regulation

Mainstream economistic reasoning has also been influential in respect of the issue of how best to regulate financial accounting. Some of the above perspectives have implications for how accounting should be regulated. Perspectives that assume the existence of perfect information clearly would not see the need for further regulation. Under the scenario of perfect and complete markets, a company that accepted all projects with non-negative present values would simply have to announce these present values or cash flows to the market, if we take a slightly less abstract view (although strictly in such reasoning this would automatically happen for markets to be perfect and complete). The value of the company would then equal the present value of these cash flows, which in turn would equal the market price. Under these circumstances one may even question whether annual reports are necessary. Within mainstream economic thinking (that assumes ‘perfect and complete markets’ to maximise well-being and the role of ‘accounting information’ to be confined to serving markets), the answer to this question would be in the negative as it would be to the question ‘is the regulation of accounting necessary in this context?’ The market here provides what is deemed an unambiguous and value free measure of wealth. Even in a broader, more holistic view, the argument might weigh against state and/or quasi-state regulation in this economic sphere where markets were more perfect and complete.

In any case, the scenario of perfect and complete markets does not reflect the real world. Markets are not complete and perfect and thus the market does not provide an unambiguous measure. So we can consider the case for state and/or quasi-state regulation within a mainstream economics perspective.

Other perspectives hold that the functioning of markets (within an institutional, regulatory framework) is enough to regulate financial accounting adequately. Businesses have an incentive to provide accounting information to the market to raise capital and an interest in being honest and providing good quality information due to the negative impacts of loss of reputation (organisations failing to inform or misleading the capital market will be regarded as ‘lemons’ – and punished). Another way of seeing this is that there are strong incentives for managers to disclose information, e.g. they may need to raise finance in the competitive market and will thus provide relevant information to aid them in this (and reputation has a value here so honesty may pay). In addition there is a market for managers, in so far as the managers themselves would want to inform the market as to how well they are doing and hence enable them to seek other jobs elsewhere. The ‘free market’ camp would thus argue that, even in the real world, we should leave it to the market or what some call ‘market regulation’ (noting that markets themselves always appear to require some form of state regulation in practice). Some argue the market for information is good enough to produce an optimal supply.

There are also contracting arguments that have been put forward. Companies could simply have a contract with their suppliers of capital to disclose certain information to them, including having the information audited. Any undisclosed information could then be obtained by private searches and/or payment for additional information that may be required. One point that may be made here too is that regulation beyond the market may displace some of the positives of market functioning. It may problematically, for instance, restrict the accounting methods that may be used (although that may also reflect a poor form of interventionist

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regulation). Further, users will tend to overstate their desire for disclosure if they do not have to pay for it (although indirectly they may bear costs). The costs will be borne by those supplying the information.

History does indicate that companies will voluntarily disclose at least some information (at least they will disclose some information under other pressures). While those observing practice historically admit to some evidence of this type of market-induced effect, substantively they point to weak financial accounting here and the case for regulating financial accounting in terms of state and/or state-backed or quasi-state professional regulation, beyond the more liberal approach. The view here is that the market for information is such that without interventionist regulation a sub-optimal amount of information will be produced. And the comparability it facilitates may be less than desirable. The case for likewise regulating notions of broader corporate social responsibility accounting is similar. This said, contexts vary and a great deal of pressure may be placed on business (e.g. by competitive forces, a strong civil society) without legislation or quasi-law.

Under the contracting arguments, the actual cost of enforcing the individual contracts or ‘group contracts’ would be higher than those costs associated with state and/or state-like regulation. Even with these contracts there would be a need for comparability of accounting practices. A number of related arguments for regulation have been suggested, reflecting the assumption of an imperfect markets context, including the following:

• Left unregulated as envisaged, market forces would ‘lead to an uneven possession of information among investors’. Consequently the regulation would provide an equitable solution. ‘It is only fair that the less informed be protected from the more informed.’ Some have more power than others (over others) in terms of accessing information. • Accounting information shares the characteristics of a public good, and

therefore suffers the same problems of externalities and free riders. Under these conditions the absence of the regulation envisaged could result in the under provision of information.

• Managers have incentives not to disclose unfavourable information. Consequently investors would be unable to distinguish good companies from bad ones, resulting in ‘adverse selection’. Further, investors need protection from the fraudulent, which would actually produce misleading information. Due to information asymmetries, the disclosures may not obviously be seen as fraudulent.

Others argue markets are not so speedy in re-adjusting to changes. If they may keep returning to reasonable positions or an equilibrium (a contestable view for some), people may get hurt in the process, given its slow speed. Indeed this may be in ways they can scarcely be compensated for.

The ‘balanced’ view on financial accounting discussed above may be taken as implying that regulation to improve transparency should not be universally overly strict, or it might imply the need for a regulation that has limits and that might be set so as to prevent firms competing in the market place in terms of information disclosure, which may drive disclosure towards too much transparency. In an imperfect markets context, a particular level of disclosure or transparency would be optimal for social welfare. A degree of secrecy or confidentiality is required

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to allow the system to function for the best (e.g. create incentives for research and development, discourage monopolistic practice that might be encouraged through information sharing). A degree of transparency is required to facilitate financing and the better allocation of resources. The regulation envisaged may bring this balanced disclosure about better. Markets functioning without that may lead to ‘beggar-my-neighbour’ disruptive forms of competition in respect of disclosure.

Some analysts of the issues have used game theory as a framework and tried to model (appreciating the possibility of audit) external financial accounting disclosures in relation to the incentives of regulators and corporate managers (e.g. incentives to disclose or hide, to be honest or dishonest). From this quasi-descriptive modelling (to which dimensions of uncertainty and the costliness of information can be built in) an attempt is made to see if answers can be found to questions such as: Is rigid regulation better than flexible regulation? Is mandatory disclosure better than a looser more voluntary approach? This framework can enhance appreciation of the character and feasibility of actual and potential regulatory forms, although it is not straightforward to translate this into social welfare implications in an imperfect markets and imperfect societal context.

Activity 1.1

Read Beaver (1981) Chapter 7 and Gallhofer and Haslam (2007), taking notes.

Critically appraise the main arguments that Beaver puts forward for increased regulation. How do Gallhofer and Haslam (2007) see accounting regulation?

Accounting standards: what form should they take?

One way of regulating accounting, suggesting intervention beyond the more liberal approach, is through accounting standards. These could be prescribed by law or by ostensibly independent professional bodies (and the latter’s prescriptions may then in some way be backed by law). If we believe in regulating accounting through the use of accounting standards, what form should the standards take? We could consider Edey (1977)’s discussion. Edey (1977) discussed and illustrated four possible types of accounting standards, all with different levels of detailed rules, with the lowest level (Type 1) being less prescriptive than the highest level (Type 4).

Type 1: ‘Tell people what you have done.’ This type of standard in the first place restricts accounting to information about what has happened but Edey emphasises that the restriction is to basic disclosure rules.

Type 2: Uniformity of presentation. This type of standard would only concern rules on how you should present your financial results and hence create some form of uniformity and consistency. Type 3: Disclosure of specific matters. This type of standard would

require disclosure of specific matters in certain cases. Type 4: How to value assets/liabilities, what is regarded as income,

how income is allocated to periods, and so on. Edey here characterises this type of standard as specifying considerable detail.

In terms of the earlier argumentation, the more detailed and the less flexible the requirements then the stronger the regulation.

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Comparing arguments for and against standards is clearly related, then, to arguments for and against forms of regulation. We extend or refine the earlier argumentation by considering Baxter. These reflect an understanding of the nature of company law in the UK context, whereby that law is assumed not to prescribe very detailed inflexible accounting standards.

Arguments for accounting standards

Baxter outlines the arguments for the imposition of accounting standards, suggesting that:

• standards provide handy rules for the daily work of accountants. Types 1–3 in Edey’s typology would:

• help improve published reports

• supplement company law with fuller, clearer and more consistent figures

• foster comparability which in turn would help analysts and potential investors compare and evaluate firms

• force weaker accountants to improve their work

• provide a defence for accountants in court, and strengthen resistance ‘if a tycoon tries to bully his accountants into producing biased figures’. Other arguments put forward include the following:

• They would provide credibility to the accounting profession which might otherwise be undermined if there are continued scandals over the extreme subjectivity of some companies’ financial statements. • They provide discipline – although some believe that if companies were

left to their own devices they would ultimately be disciplined by the financial markets.

• In the short term, the use of standards attempts to alleviate the risk to investors.

Arguments against accounting standards

The following arguments have been made:

• Accounting standards are costly and bureaucratic.

• Accounting figures (due to their very nature) do not lend themselves to standardisation; industries differ, so do firms; the needs of users vary. Thus standards may be suitable for the average but may not suit the fringes.

• Standards can lead to a kind of rule following, where two similar situations might be treated differently becuase they fall either side of a rule.

• Standard-setters may bow to political pressures and thus the

development of accounting standards may be merely consensus-seeking (e.g. accounting standards could be over-influenced by those parties with easiest access to the standard-setters or the most vocal lobbyist). • Standards in themselves could actually reduce professional judgement

and be bad for the academic education of accountants (e.g. they might be more interested in what is required to comply with the standard than in investigating the ideal accounting system).

• Standards may lull users into a false sense of security (i.e. investors may believe that the accounts are all based on the same specific rules,

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when in fact a standard principle may still leave room for different estimates). Consequently investors and other users need to be educated about this.

• If they do not take account of possible economic consequences, standards may result in adverse allocation effects. Accounting

standards might result in sub-optimal behaviour purely to ensure that accounting earnings are not reduced.

• Standards could result in overload, e.g. if there are too many standards; if standards are too detailed; if standards are not specific enough; if there are too many standard-setters.

Activity 1.2

What criteria are relevant in deciding upon accounting standards? Should standards specify the detail or be more in the nature of general guidelines?

Descriptions of accounting and its regulation

There are various types of descriptive theory. They may be more or less subjective or subjectivist in their orientation. They may be developed from a quite precise theoretical proposition or hypothesis or from a much looser, open stance. All theories may be considered mixtures of the deductive and inductive (i.e. they are developed through a process of logical deduction from underlying premises and from reflection on observed reality) but they may have a deductive or an inductive emphasis. They can draw upon different understandings of context and have different themes. They may be more or less critical (i.e. their prescriptive dimension may imply a more or less radical position).

Deegan and Unerman (2011) provided an overview of different descriptive theories of financial accounting. Financial accounting may be understood in practice to equate to what it should be in a prescriptive theory or it could be understood as failing against its prescriptive benchmark. Deegan and Unerman (2011) point to theorists who suggest it is biased to serve the relatively rich and powerful in society. Others suggest that financial accounting may promote a materialist or narrow culture. For instance, they suggest that accounting portrays that a materialist profit making is the only thing important about a business organisation, which accounting constructs as a financial machine, and it encourages a simplistic

dichotomous debit-credit kind of thinking in areas beyond technical accounting. In terms of accounting regulation, again this may be seen in a descriptive theory to equate with a prescriptive theory of accounting regulation as it should be. Other theories include capture theory – where those who are meant to be regulated control the regulations – and theories that, for example, suggest that accounting regulation is largely controlled by the relatively rich and powerful.

Many descriptive theories begin with an attempt to understand what accounting and accounting regulation are like in terms of basic content and form, e.g. what are the requirements of a law or standard? This is an emphasis in what follows. Many theories see actual regulatory developments as appropriately responding to regulatory failures (although these developments may be found wanting as things change – giving rise to new regulations also deemed appropriate). Such theories are very similar to those that equate actual practice to some variant of prescriptive theory. They may also be considered official theories as they are theories that official regulatory bodies would use to describe themselves.

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We focus here initially on accounting regulation in ways that substantively reflect such basic description and mainstream interpretation. We focus on accounting regulation in the UK but in the global context, reflecting the significant influence of international accounting standards in the UK (and beyond).

UK accounting regulation and the influence of

international accounting standards

The regulatory framework relating to financial reporting varies from country to country. For Cooke and Parker (1994), the nature of the regulatory framework will depend upon (among other things): • the influence of tax rules

• the type of legal system

• the history and influence of the accounting profession.

In the UK, the regulatory framework has developed over many years and consists of a mass of rules and regulations – some statutory, some mandatory, others customary. We shall consider the variety of rules and regulations that exist in the UK. Note that the UK regulatory framework has been influential in many other countries. For instance, Cooke and Parker (1994) state that:

Malaysia’s colonial past is reflected in many ways in the current reporting environment, which is very similar, though not identical to the UK environment.

Impetus for regulation

Often, regulations are implemented after well-publicised scandals. This was the case with the establishment of the UK’s Accounting Standards Steering Committee (ASSC) in 1970. Two scandals in the late 1960s were understood to highlight the extent of subjectivity in financial reporting: the General Electric Corporation (GEC) takeover of AEI Ltd and Pergamon Press’s profit figure both led to questions about the correctness of published financial statements of UK companies. Even today, with the existence of standards that have over time tended to become more extensive and detailed, similar questions are asked, e.g. in the US following the scandal of Enron.

Institutional setting for accounting regulation: the UK

The rules applicable to large UK companies (rather than small or medium-sized ones) come in three main forms:

• Statutory legislation: primarily the Companies Act 1985 and the Companies Act 1989 (revised). The European Union (EU) instigated a harmonisation programme that involved the issuing of a number of directives in order to harmonise the accounting practices of companies within the EU. In November 1995 the EU announced: ‘Rather than amend existing Directives, the proposal is to improve the present situation by associating the EU with the efforts undertaken by IASC and IOSCO towards a broader international harmonisation of accounting standards.’ The EU adopted regulations with effect from 1 January 2005 that required listed companies in Europe to use generally accepted international accounting principles (IASs/IFRSs) when preparing their group accounts.

AC3091_vle Financial reporting

Financial reporting

J. Haslam and D. Chow

AC3

091, 2790091

2012

Undergraduate study in

Economics, Management,

Finance and the Social Sciences

Contents

Introduction

Aims and objectives of this course

Learning outcomes

Syllabus

Accounting standards in this subject guide

How to use this guide

Websites

Activities

Sample examination questions

Reading advice

Essential reading

Further reading

Online study resources

The VLE

Making use of the Online Library

Changes to the syllabus

Preparation for the examination

Format of the examination

Overview of the guide

Index of abbreviations used in this guide

Chapter 1: Rationale for financial

reporting and its regulation

Aims of the chapter

Learning outcomes

Essential reading

Further reading

Financial accounting theory

Financial accounting and its role

Financial accounting regulation

Accounting standards: what form should they take?

Arguments for accounting standards

Arguments against accounting standards

Descriptions of accounting and its regulation

UK accounting regulation and the influence of

international accounting standards

Impetus for regulation

Institutional setting for accounting regulation: the UK