Adopting an accounting perspective

Questions
1. Do accountants really construct their own reality with respect to what is measured and reported by an entity? In a sense, hasnt the accounting profession codified acceptance of this in broadly defining reporting entities in AASB 1025? Discuss. The answer to this question with respect to AASB 1025 is found below at question 14. Accountants have considerable discretion in classifying, measuring and reporting the economic activities of an entity. They can define the boundaries of an operating entity and, as highlighted in several cases in this chapter, can at any time divide the firm into any number of operating entities in accordance with their preferences. Although there are legislated accounting standards and disclosure requirements, there is considerable discretion as to the nature and extent of both measurement and disclosure of accounting information. At the basic level, accounting is a function of human activity, an extension (function) of our existence so we define it. 2. With respect to the proprietary theory: (a) What is the objective of the firm? (b) How important is the concept of stewardship? (c) What is the relationship between assets/liabilities and the owner? (d) How would you define revenues, expenses, profit? (e) What are three effects on current practice? (f) What are the theorys limitations? (a) The firm essentially is the proprietor. The firm is simply the proprietors instrument to achieve his or her purpose, which is to increase his or her wealth. Income represents the increase in the wealth of the proprietor in a given period. (b) Stewardship is relatively unimportant, because accountability to outside parties is not critical. The proprietor is, in effect, the firm, and therefore is in a privileged position to know what is happening. Liabilities are usually short term, and therefore there is no need to give a continual accounting to creditors. (c) The assets are owned by the owner, and the liabilities are owed by the owner. This shows that there is no separation between the firm and the owner. In the accounting equation, P stands for the net worth of the owner. AL=P (d) Revenue is the increase in proprietorship; expense is the decrease in proprietorship; and profit is the net effect of proprietorship, excluding additional investments and withdrawals by the owner. Revenue and expense accounts are truly subsidiary accounts of P. They have the same algebraic characteristic as net worth increases in net worth are credits and decreases in net worth are debits. The proprietary theory focuses on P in viewing income. Revenues and expenses are caused by the decisions and actions of the proprietor. The profit of the firm belongs to the proprietor and that is why P is affected in the accounting equation.

(e) The following are examples of the effect of the proprietary theory on accounting practice: Dividends paid are a distribution of earnings, not an expense; and interest charges are an expense. In a sole proprietorship or partnership, salaries to owners who work in the firm are not considered an expense of the business. The reason is that the firm and the owner are not separate entities; they are the same. The equity method for long-term investments focuses on the proprietary interest of the investor company in the invested company. The parent company theory for consolidating financial statements views the parent as owning the subsidiary. Minority interest is considered an outside claim, and logically should therefore be a liability on the consolidated statement of financial position. The pooling of interests method for business combinations emphasises the uniting (pooling) of the owners interests of the two combining companies. Common terms used reveal the proprietary interests of owners are: book value per share, earnings per share and income to shareholders. The use of the consumer price index for general price level adjustments shows that the consumer desires of owners are considered. The financial capital view is pertinent to owners. (f) The proprietary theory does not accord with the realities of the large corporation. The law recognises the corporation as a separate entity, distinct from the owners. The corporation not the shareholders owns (controls) the assets, and is liable for the debts. For the large corporation, withdrawals of cash or other assets by shareholders cannot be made without running afoul of the law. This shows that the ownership rights of shareholders are limited. Accountability to shareholders is significant; otherwise, shareholders have no knowledge of the status and operations of the business. The assumptions of the proprietary theory are not relevant to the shareholders of large firms.

3. With respect to the entity theory:

(a) What are the reasons for concentrating on the entity as a unit of accountability rather than the proprietor? (b) What is the objective of accounting? (c) How important is the concept of net worth? (d) What is the reason for modifying the accounting equation to Assets = Equities? (e) On what side of the equation in (d) would retained profits appear? (f) Why is there a stress on profit determination? (g) How do the concepts of revenues, expenses and profits differ from the proprietary theory? What about interest charges, dividends and income tax? (h) What are three effects on current practice? (a) Emphasis is on the entity, because in the 20th century the separation of owners from management in the corporate form of business is common. Shareholders of large corporations have little power to make decisions for the company. The corporation,

the entity, has a life of its own. It is therefore more realistic to view the entity as the unit of accountability that is, to see the accounting process from the point of view of the entity. It is the entity (through its management) that has the power to make decisions that affect the financial status and operations of the business. (b) Stewardship or accountability to equityholders is of primary significance. The entity needs to give an accounting to those who have supplied funds (shareholders and creditors). There are two views of the entity theory, but both stress accountability to equityholders. The conventional view emphasises stewardship because equityholders are seen as associates in business. The newer view focuses on stewardship because of legal, contractual requirements, and also to maintain good relations with equityholders in the event the company may need more funds. (c) The net worth of the owner is not a meaningful concept, because the owner is not recognised as such but as an equityholder, a provider of funds. So-called owners are not seen as having the power to make decisions for the firm. The net assets belong to the entity. However, net worth can be a meaningful concept. An argument can be made that the entity needs to know the worth of its net assets for its own purposes. (d) The reason is that the entity is the focus of attention, and therefore creditors and owners are seen simply as those who supplied the funds to the entity. Their financial interest in the company is equities claims on the assets. Thus, they are seen as equityholders. Their relationship with the company is a contractual one. (e) Paton and Littleton argue that the shareholders have a contractual residual claim on the assets, and it is for this reason that income is placed in the retained earnings account. Shareholders get the leftovers after the creditors have been paid, in the event of liquidation of the company. The newer view of the entity theory sees retained earnings as the firms equity or investment in itself. (f) Profit is stressed for two reasons: Profit is what equityholders are interested in, because it represents the results of their investment in the company The firm is in business to make a profit profit is essential to the firms survival. (g) Revenue is the inflow of assets (increase in total assets) due to the events undertaken by the firm with regard to its output. Under the proprietary theory, revenue is the increase in proprietorship. Expense is the decrease in assets or increase of liabilities due to the consumption of assets and services by the firm to generate current revenue. Under proprietary theory, expense is the decrease in proprietorship. For both the entity and proprietary theories, profit is the difference between revenues and expenses. The entity theory, however, emphasises the left side of the accounting equation (assets), whereas the proprietary theory concentrates on the

right side (proprietorship). The entity theory focuses on what the entity does, its performance; whereas the proprietary theory focuses on the effect on proprietorship. For the traditional entity theory, interest charges, dividends and income taxes should be distributions of earnings. The theory considers these as payments to the equityholders for the use of their funds. Of course, the government does not provide funds as the others, but provides intangible services (funds?) such as protection from foreign powers. The newer version of the entity theory sees interest charges, dividends and income taxes as payments to outsiders, and therefore they are expenses. (h) Although conventional accounting theory subscribes to the entity theory, the theory has had little effect on actual practice. The reason is that the theory was formulated in the 20th century, and many current practices were devised since the time of the Italian citystates and are based on the proprietary theory. The following show the effect of the entity theory on practice: The physical capital view is in consonance with the entity theory. Salaries to corporate employees who are also shareholders are expenses, because the company is a separate, distinct entity from the holders. In consolidating financial statements, an entity theoretical approach can be taken. Instead of concentrating on the proprietary interest of the parent (parent company theory), the entity theory sees the consolidation from the point of view of the consolidated entity. The use of profit and cost centres for internal purposes is based on the entity theory. The centre is seen as an individual entity. 4. With respect to the fund theory: (a) What are restrictions on assets? (b) How is the statement of financial position viewed? (c) How meaningful is the statement of financial performance? (a) Restrictions on assets are liabilities and owners equity. Usually liabilities and owners equity are seen as claims on the assets, but Vatter argues that claims do not arise against assets, but against people. The fund attempts to be impersonal. Liabilities represent future payments; therefore the significance of liabilities is the restriction they place on the assets, the earmarking of a certain portion for future payment. The owners equity represents a final, residual restriction on the assets. (b) The statement of financial position is seen as an inventory statement of assets and the restrictions on them. (c) The statement of financial performance is not considered meaningful. There are too many problems in determining income. The general-purpose statement of financial performance is limited in its usefulness, because different types of users need different kinds of information. Information should be reported in such a way that users, if they wished, can calculate their own income figure. But the focus should be on the flow of funds rather than income.

5. With respect to the commander theory: (a) Who is the commander? (b) What is the role of ownership? (c) How are the statement of financial position and statement of financial performance viewed? (a) A commander is any person who has command or control over resources. The general manager of a company would be the top commander, and the other officers would be his or her staff, who in turn may be commanders over a smaller set of resources. A holder is a commander over his or her own resources. The point of the commander theory is economic control over resources, and such control is in the hands of people; thus, the theory focuses on people people who are commanders. (b) Ownership is not meaningful in this theory. Rather, it is control over economic resources. The emphasis should be on the economic function of people rather than their legal relationship to the firm. (c) The financial statements are reports from the commander of the company to commanders of the funds that were provided to the company. The statement of financial performance is an explanation of the results of activities in a given period initiated by the commander and staff. The results are from the commanders point of view. He or she is explaining what types of expenditure were incurred and what the result is. The statement of financial position is truly a statement of accountability of the commander of the company. It shows the sources from which the commander has received resources and the applications of these resources. The statement of financial position is a statement of stewardship rather than of ownership; it is a statement of accountability. 6. (a) Can there be an investor theory, given the broad range of investor objectives? (b) Do investors have uniform information needs that fit within a single theory? Investors want information so that they can predict the future cash receipts to themselves due to their relationship with the company. Future cash receipts depend on: the companys ability to disburse cash the willingness of the company to pay investors the legal priority of the investors claim. Financial statements can provide information especially on the first and second factors.

7. With respect to the enterprise theory:

(a) What is profit? (b) What relevance do you see in the value added statement of financial performance? (c) How realistic are the implications of the theory? (d) Explain the relationship, if any, between enterprise theory and triple bottom-line accounting.

(a) Profit is value-added income. The figure shows the companys contribution to society that is, the wealth created by the company in a given period. Another way of looking at this is to say value-added income measures the distribution to the participants in the entity employees, holders, creditors and government. Of the total sales of the output of the company, the amount is divided as follows: wages and salaries to employees, dividends to holders, interest to creditors, income taxes to government, and the residual to the company itself for future expansion or replacement of assets. (b) This is an opinion question. In the United Kingdom, it is estimated that at least 20% of the listed corporations now publish a value-added statement as supplementary data. Some believe that the value-added income is becoming more important because it reflects a social change holders have become less powerful and organised labour and government more powerful. Many people in society want to know what the contribution of a company is to the economic wellbeing of society, and how the pie (the contribution) is divided for a company. What is a fair division is a matter of opinion, and ultimately depends on the values of the people of the given society. (c) The theory implies that the participants are to cooperate in their endeavour to create profit. Management is to serve as mediator. The participants need to cooperate if the firm is to survive. The idea of the cooperative effort of holders, creditors, employees and government does not appear to be realistic at present in Australia. History, tradition and values are such that cooperation does not appear likely in the foreseeable future. However, economic stress could change peoples attitudes. It is interesting to note that the Japanese model of the enterprise does take seriously the need for employees to have a participatory role in decision making in the company; and the representatives of government do appear to feel obligated to help companies with basic research and tax relief, and to create an environment that is pro business. (d) Enterprise theory and triple bottom-line accounting are very similar in the underlying view that a corporation has social responsibilities that should be reported. Enterprise theory has been more focused on quantifying these impacts, whereas triple bottom-line accounting has opened out reporting to both quantitative and qualitative information. 8. Based on information from the conventional statement of financial performance of Inberg Ltd for the current year, prepare a value-added statement. Sales revenue Materials used
Salaries and wages expenses

$5000 1200
900

Income tax Electricity expense

Interest expense

$800 300
200

Depreciation expense

400

Dividends paid

300

Although not asked for, a conventional statement of financial performance is also prepared for purposes of comparison. STATEMENT OF FINANCIAL PERFORMANCE

(conventional) Sales Less: Materials used Electricity Salaries and wages Depreciation expense Interest expense Profit before tax Income tax Net profit Less dividends Retained profits VALUE-ADDED STATEMENT Sales Less: materials, depreciation and services used ($1200 + $400 + $300) Value added Distribution of value added: To employees To providers of capital Dividends Interest To government To enterprise for expansion Retained profits $5000 1900 $3100 $5000 $1200 300 900 400 200

3000 $2000 800 $1200 300 $900

$900 $300 200

500 800

900 $3100 9. (a) Triple bottom-line reports seek to detail the activities of an entity as they relate to society, the economy and environment. Is the annual report of an entity an appropriate vehicle for such a broad base of information? (b) List the type of information that you consider would be relevant to the triple bottom-line approach. What would be the bottom line in such a statement? (a) Annual reports initially began as legal documents, which reported financial position and performance and fulfilled legislative requirements such as names of key office holders and directors. In more recent times the annual report has been seen as a key device not only to summarise past performance, but also to signal the future activities and minimise political costs, and perhaps influence perceptions of firm value. With quarterly reporting and the

requirement to report immediately on significant factors that can affect a firms value (under stock exchange listing requirements), information concerning financial performance is more immediate and readily available. This means that the annual report is increasingly used as a signalling device to key lobby groups. Is it appropriate for this purpose? It represents a formal communication from the firm and therefore carries a basic authority. It provides a clear channel of communication and allows firms a platform in which to legitimise communications pertaining to their activities, both actual and proposed. However, it should be considered whether lobby groups and key stakeholders accept the information provided in good faith. The instructor might like to take some examples of annual reports to class and ask students to consider whether they are effective communication devices or simply political statements. (b) Get students to classify the information according to categories such as social, employee, environmental, economic and community-based. In terms of an actual bottom-line, this does not exist because it is not about deriving a single outcome, such as profit, but about identifying the positive and negative impacts of the entitys activities on a broad range of stakeholders. 10. A company declares a 10% dividend. Discuss the nature of the dividend to the recipients from the point of view of the following theories: (a) proprietary theory (d) fund theory (b) entity theory (e) investor theory (c) commander theory (f) enterprise theory. (a) Under the proprietary theory, the firm is considered an instrument of the holders to achieve their objective of increasing their wealth. Holders equity belongs to the holders, and therefore a dividend, which is simply a redistribution from retained earnings to capital, is just another piece of paper to represent the same dollar amount of ownership interest. The dividend is not income to the holders; they are not receiving anything beyond what they had before in the company. (b) Under the entity theory (either traditional or newer view), since the corporation is a separate person from the holders, the dividend would be considered income to the recipients. The income of the company does not belong to the holders but to the company. Therefore, since the dividend comes out of retained income, the holders are receiving something they did not have before. The issuance of dividends is one entity transferring something of value to other entities (shareholders). (c) The commander is a steward who has been entrusted with the funds of the company and given the right to operate the company. The issuance of a dividend is due to his or her influence and decision. But who has given the commander authority? The commander acts on behalf of the entity, not the shareholders. Thus, the theory assumes that the commander receives authority from the entity. Because shareholders do not have economic control over the resources of the company, the theory implies that they do not have much power in the company. The theory also implies that the company on the one hand and the holders on the other, are distinct,

separate entities. If so, then dividends are income to the shareholders, because they are receiving something that they had no control over before. (d) The fund theory sees the firm as an impersonal fund. Owners equity is the restriction on the assets. In this sense, shareholders do not have any claims on the assets; their amount in the company is viewed as a sum that the company may have to pay in the future. A dividend does not change the sum that is owing to the shareholders; it simply shifts an amount from one holders account to another. It would seem that under the fund theory, dividends are just more pieces of paper to represent the same amount of restriction on the assets. Thus, dividends are not income to the recipients. (e) The investor theory is an extension of the entity theory, except that accountability to shareholders is emphasised. The separation of the firm from holders is taken for granted. Similar to the entity theory, dividends would be considered income to shareholders, because they are receiving something they did not own before. (f) The enterprise theory sees shareholders as one group of participants to help generate income from the enterprise. In particular they provide funds, and dividends are the compensation to shareholders for their contribution. Dividends constitute their share of the total value-added income. Since dividends reduce retained earnings (regarded as a distribution of income to the enterprise for expansion purposes that benefit all participants), they would be considered a distribution to shareholders. Thus, dividends are income to the recipients. 11. The point of view advocated depends on the particular user: the owner, manager, investor and provider of funds. Which perspective should take preference? This is an opinion question. Conventional theory opts for the entity theory. The FASB and the AARF appear to accept this view, but with the inclusion of the entitys responsibility for reporting information to users, mainly shareholders and creditors, which is the investor theorys emphasis. 12. If an entity theory viewpoint is taken, which of the following do you believe is appropriate in determining profit: (a) financial capital or physical capital? (b) historical cost or current cost? (c) nominal dollars or constant dollars? (a) Financial or physical capital What is capital in the entity theory? The right-hand side of the accounting equation is equities. This can be divided between specific equities (liabilities) and residual equity (shareholders equity). The traditional view of the entity theory emphasises accountability to equityholders for the funds provided by them. This relates to the investment of the equityholders, and therefore a financial capital view is implied. The newer interpretation of the entity theory would definitely take a physical capital approach, because the entity is seen as concerned about itself. Thus, the entity would

naturally be concerned about its operating capability. In fact, the accounting equation, Assets = Equities, fits well with the physical capital view because owners equity is not recognised directly. The focus is on assets, and the physical capital view is concerned about assets, of the entitys productive and operating capability. (b) Historical cost or current costs Under the traditional entity theory, any of the alternatives would fit in. However, it has been argued that since equityholders are mainly concerned about the amount of their investment, then historical cost is the logical choice. This is so, because the use of the funds provided by the equityholders is invested in assets, and for nonmonetary assets the amount of the investment is the purchase price the historical cost. This is the argument in conventional accounting. But whether equityholders are only interested in the original amount of their investment is debatable. Many believe they are also interested in changes in value. Under the newer entity theory, following along the physical capital alternative, then current cost is the logical choice. For physical capital, the question at the end of the period is: How much does the entity need in order to maintain its operating capability?. The amount needed at the end of the period is the amount to purchase the assets, which is current cost. (c) Nominal or constant dollars Under both views of the entity theory, neither is favoured. Constant dollar accounting attempts to correct a mathematical problem, of dollars of different purchasing power being added together. Mathematically, numbers must be of the same domain (same quality or unit of measurement) to be additive. If such a correction is desired, then a general price index that is pertinent to the entitys circumstances should be selected. 13. What is deprival value accounting? On what basis are non-current assets measured? Why would users of financial reports consider deprival values useful? Under the deprival value concept, assets are valued at an amount that represents the loss that might be expected to be incurred by an entity if that entity were deprived of the service potential or future economic benefits of those assets at the reporting date. Thus the value to the entity in most cases will be measured by the replacement cost of the services or benefits currently embodied in the asset, given that deprival value will normally represent the cost avoided as a result of controlling the asset and that the replacement cost represents the amount of cash necessary to obtain an equivalent or identical asset. In the case where it is expected that the asset will not be replaced, the asset should be valued at the net present value of the cash flows expected from continued use and subsequent disposal of the asset. Deprival value allows users of financial reports to consider the real value of assets in use, and how the relative importance of these assets changes over time. 14. What is the reporting entity concept? What impact does the reporting entity concept have on Australian financial reporting? Explain in the context of AASB 1025.

AASB 1025.27 defines a reporting entity as:

an entity (including an economic entity) in respect of which it is reasonable to expect the existence of users dependent on general purpose financial reports for information which will be useful to them for making and evaluating decisions about the allocation of scarce resources, and includes but is not limited to the following: (a) (b) (c) a listed corporation; a borrowing corporation; and a company which is not a subsidiary of a holding company incorporated in Australia and which is a subsidiary of a foreign company where that foreign company has its securities listed for quotation on a stock market or those securities are traded on a stock market.

In terms of the above definition, the key factor in determining whether a reporting entity exists or not is whether or not there are users dependent on general-purpose financial reports of a particular entity as a basis for making and evaluating decisions about the allocation of scarce resources. The application of AASB 1025 means that a significant number of entities are no longer required to disclose full GAAP statements. However, in terms of published financial reports, publicly listed companies will continue to report under full GAAP, so very little, if anything, will change for investors trading in shares in listed companies. Statement of Accounting Concept SAC 1, Definition of the Reporting Entity, suggests several indicators that may be used in determining whether a reporting entity exists. These factors include: separation of management from economic interests (paragraph 20) economic or political importance/influence (paragraph 21) financial characteristics (paragraph 22).

Further guidance is provided in Australian Professional Statement APS 1, Conformity with Accounting Standards and UIG Consensus Views. According to paragraph 16 of APS 1, the following types of entities will always exhibit the characteristics of reporting entities: companies whose securities are publicly listed listed trusts and other trusts which raise funds from the public government-controlled business undertakings federal, state and territorial governments local governments.

Conversely, according to paragraph 18 of APS 1, the following types of entities will often not exhibit the characteristics of reporting entities and, therefore, would generally not be required to prepare general-purpose financial reports: exempt proprietary companies family trusts

partnerships sole traders wholly owned subsidiaries of Australian reporting entities.

The above are examples only, and the classification of a particular entity will depend on the circumstances surrounding that entity. The classification could also change over time. When deciding whether a reporting entity exists, it is important to consider whether any financial report users are able to command the preparation of financial reports as and when requested by them, rather than relying on the general-purpose financial reports of an entity. AASB 1025 also requires the application of all existing AASB accounting standards to nonreporting entities that purport to prepare general-purpose financial reports. A general-purpose financial report is defined in AASB 1025.27 as a financial report intended to meet the information needs common to users who are unable to command the preparation of reports tailored so as to specifically satisfy all of their information needs. A diagram outlining the decision criteria is found on p. 126. 15. Why have government entities in Australia moved to accrual accounting? What perspective should government departments and agencies adopt? Until the recent adoption of the accrual system of accounting by government agencies, the cash flow model was adopted and revolved around an annual budget of funds available. This was because of the annual allocation of funds for both ongoing and capital expenditures. The shift to accrual accounting was supported by the accounting profession, because a single framework of accounting for organisations could be adopted in Australia. Possible reasons for its introduction, include: to introduce a corporate model of evaluation of the performance of agencies and departments to allow a base for valuation of assets to support the privatisation of certain government activities and assets held to provide a common platform for accounting education as a political device to bring forward expenditures of future periods, largely through capitalisation methods, in order to signal commitments by governments in a defined political cycle.