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Accounting Theory Godfrey 7th Edition Solution

It finishes by providing an overview of the chapters in this book. Why do humans walk on two legs? TO answer these questions, we are likely to call upon the theories of gravity and evolution. These theories are generally held in high regard for their powers of explanation and prediction, but what is it that gives them their authority?

In fact, what is a theory? Furthermore, what is the relevance of accounting theory to accounting? In a perfect financial world there is no demand for published accounting reports and hence any accounting theory.

We would simply look up freely available prices for the value of assets, revenues, or the costs of all inputs including managerial costs. In such an Arrow-Debreu economy1 all this informatjon is available now and for all future time periods. But we do not live in such an economic world. Instead there is a demand for financial information to fill gaps in our knowledge and to reduce uncertainties about current and future values.

This demand comes from a wide range of stakeholders - both internal and external. In accounting theory a major issue is related to questions around measurement.

In general, how should assets and liabilities be measured? By their historic cost, their selling price, updated by current costs to buy, or by the present value of future cash flows? Should we recognise all internally generated intangibles or only recognise them when they are evidenced by an external transaction, such as in a takeover price?

Then again, what is the impact of implementing different measurement systems on the economy or market or on each individual stakeholder? The term 'theory' can be used in different ways.

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As such, it can take on several meanings. One definition is that a theory is a deductive system of statements of decreasing generality that arise from an agreed or hypothesised premise.

Another is that a theory is a set of ideas used to explain real-world observations. In his classic text on accounting theory, Hendriksen offered definitions of 'theory' and 'accounting theory' which are appropriate to this text.

These are defined in points 1 and 2 below, respectively: Whether the theory is accepted depends on: It is important to understand that accounting theory is not simply an abstract process. It is not divorced from reality.

In fact, its main objectives are to explain why and how current accounting practice evolved, to suggest improvements, and to provide the basis for developments in such practice. Accounting first developed as a set of tools to record activities or transactions.

Even Pacioli's treatise see next page on double- entry accounting was focused on documenting the processes involved and not about explaining the underlying basis for this method of recording. Chambers summarised a view that accounting has mainly developed in an improvised fashion rather than systematically from a structured theory: Accounting has frequently been described as a body of practices which have been developed in response to practical needs rather than by deliberate and systematic thinking3 That is, many accounting prescriptions on how to account were developed to resolve problems as they arose.

Hence, the theory underlying those prescriptions also developed in a largely unstructured manner. This has led to inconsistencies in practice. Examples of such inconsistencies include different methods of depreciation and inventory expensing even within the same industry; and measuring some assets at fair value whereas others are measured at cost. In other cases, some transactions are kept off the financial statements completely.

For example, the move to regulate disclosures concerned with the capitalisation of certain lease commitments was a direct response to practices being adopted that failed to recognise the lease liability in company accounts.

More recently, in response to increasing demand, an accounting standard was introduced requiring firms to report the cost of providing executive remuneration in the form of share options. These examples are consistent with and illustrate the historical development of accounting methods the inconsistency problem. It is worth pointing out at this juncture that some theoretical accountants argue that, because business situations vary across industry and countries , we need a variety of accounting methods that can be adapted to fit the changing, needs of business.

Accounting practices also have multiple demands from insiders, such as managers and employees, and outsiders such as investors, creditors, taxation, legislative authorities and society in general.

This means that accounting theory is complex and one of the issues under intense debate is who should financial accounting reports serve? That is, who are the primary users of accounting information? We call this the 'objective problem' - the problem of determining the objective of financial information.

For many years, accounting standard setters have been trying to solve the objective and inconsistency problems by developing a conceptual theoretical framework that would lead to more consistent treatment of like items.

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However, conceptual framework projects have not resolved the inconsistencies in practice, and have often been used to justify or support such inconsistencies rather than resolve them.

Because such frameworks seek to provide universal guidance, they have proved too general to provide a clear set of decision rules which lead to an obvious practical answer for the full range of choices required in preparing accounting reports. Before the double-entry system was formalised in the s, very little was written about the theory underlying accounting practices. During the developmental period of the double-entry system, the main emphasis was on practice.

It was not until that a Franciscan monk, Fra Pacioli, wrote the first book to document the double-entry accounting system as we know it. This is referred to as the 'pre-theory period'. No theory of accounting was devised from the time of Pacioli down to the opening of the nineteenth century.

Suggestions of theory appear here and there, but not to the extent necessary to place accounting on a systematic basis. However, developments in the s led to the formalisation of existing practices in textbooks and teaching methods. The rapid expansion in technology, accompanied by the large-scale separation of ownership from control of the means of production, increased the demand for both management and financial accounting information.

In particular, growth of the business sector and the construction of railroad networks in the United States and the United Kingdom increased the demand for detailed accounting information, for improved techniques, and for accounting practices such as depreciation which addressed the long-term nature of assets. The introduction of taxation legislation and the 'teething' problems associated with the birth of the corporation led to increased governrnent legislation regarding reporting requirements.

Further, some government and corporate economic policy decisions were beginning to be based on accounting numbers. Also during this period, economic theory was progressing rapidly and was beginning to be linked to the demands for accounting information. These developments occurred mainly in the United Kingdom. They provided an impetus for the growth of theories explaining accounting practice to enable accountants to deal with new issues as they arose and to explain to students why certain procedures were adopted.

After this, developments in accounting theory shifted from the United Kingdom to the United States. Pragmatic accounting The period is often referred to as the 'general scientific period'. The major focus of accounting was on the use of historical cost transactions and the application of the conservatism principle.

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The scientific method was interpreted as being based on empirics. However, while it has been labelled an empirical period in accounting development, there was a degree of logical debate about the merits of measurement procedures.

This was especially the case after the Great Wall Street Crash in The SEC had a brief and legislative power to improve financial regulation and reporting, with many seeing the crash being caused by questionable accounting methods. Stephen Zeff reports that Healy and Kripke, two leading practitioners, were highly critical of he accounting write up practices in the United States in the s.

Such comments as '. The nature of these bulletins and other accounting theory publications at the time was summarised in the preface of Bulletin No. Forty-two bulletins were issued during the period to Eight of these were reports on terminology. The other 34 were the result of research by the committee on accounting procedures directed to those segments of accounting practice where problems were most demanding and with which business and the accounting profession were most concerned at the time.

As a result of this sporadic approach to the development of accounting principles, the AICPA established the Accounting Principles Board and appointed a director of accounting research in Overall, this period focused on the existing practical 'viewpoint' of accounting and, as research gained momentum over the period, the theories promulgated to explain practice became more detailed and complex.

Normative accounting The period is labelled the 'normative period', because it was a period when accounting theorists attempted to establish 'norms' for 'best accounting practice'. During this period researchers, such as Edwards and Bell in and Chambers in , were less concerned about what actually happened in practice and more concerned about developing theories that prescribed what should happen.

In the years before , several authors produced preliminary normative works which related mainly to issues surrounding the appropriate basis for the valuation of assets and owners' claims. These theories made adjustments for the impact of inflation and specific increases in asset prices8 The normative period was one of significant debate.

It degenerated into a battle between competing viewpoints on the ideal approach to measuring and reporting accounting information. During this period, the debate was predominantly about measurement rather than the actual practice of recording and reporting information. However, the end result was no clear choice for changing practice to one ideal system of inflation or price adjusted accounting, leading to the continued use of the historical cost method.

The accounting profession in Australia has been reluctant to reignite the debate about recommending on a specific and ideal measurement system and has failed to issue comprehensive measurement guidelines. Instead, in the profession adopted the measurement guidelines contained in the International Accounting Standards Board's IASB conceptual framework.

The IASB has rather an unstructured approach, with the accounting standards allowing adoption of current value measurement concepts to be mixed with historical cost.

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Normative theories are distinguished because they adopt an objective ideal stance and then specify the means of achieving the stated objective. They provide prescriptions for what should occur to achieve their stated objective. As mentioned, the major focus of the normative accounting theories during the period was the impact of changing prices on the value of assets and the calculation of profit such theories were often seen as a consequence of the record levels of inflation experienced during this period.

During the normative period, the idea of a 'conceptual framework' gained increased popularity. A 'conceptual framework' is a structured theory of accounting. The result was the publication of An lnquiry into the Nature of Accounting, which aimed at developing a framework of accounting theory by providing a discussion of the nature and meaning of accounting. These frameworks had a common logical approach.

They first stated the objective purpose of accounting and then worked downwards to derive accounting principles and rules that fulfilled that objective. The normative period began drawing to an end in the early s, and was replaced by the 'specific scientific theory' period, or the 'positive era' The two main factors that prompted the demise of the normative period were: Because normative accounting theories prescribe how accounting should be practised, they are based on opinions of what the accounts should report, and the best way to do that.

Henderson, Peirson and Brown12 outline the two major criticisms of normative theories in the early s: Normative theories do not necessarily involve empirical hypothesis testing. Normative theories are based on value judgements.

Further, the underlying assumptions of some normative theories were untested, and it was unclear whether the theories had strong foundations or assumptions about the purpose of accounting.

Pragmatically, it was also difficult to obtain general acceptance of any particular normative accounting theory. The economics dictated it, as did the We will never know whether the world might have suffered a depression if Bernanke's Fed had not responded so aggressively.

The fact that the global economy is no longer uncontrollably spiraling downward for , the Economist Intelligence Unit predicts growth of 2.

Nor was it ordained that the panic gripping financial markets just six months ago would subside. From recent lows in March, the US stockmarket is now up roughly 50 per cent. It is not that Bernanke's performance was flawless. Far from it. He made two blunders.

First, he didn't see the crisis coming. Even after the collapse of the investment bank Bear Stearns in March , he didn't foresee a widespread financial panic or a savage recession. Second, along with the then-treasury secretary Henry Paulson, Bernanke allowed Lehman Brothers to go bankrupt in September. Both have said they lacked the legal power to rescue Lehman and that no one wanted to buy it. If Bernanke and Paulson had fully anticipated the consequences of Lehman's failure, they almost certainly would have found a way to save it.

Once Lehman collapsed, the crisis got much worse. Banks retreated from lending to each other, investors wouldn't buy new bonds, banks, consumers and businesses hoarded cash. The economy contracted at an annual rate of 5 per cent to 6 per cent. Here is where Bernanke distinguished himself.

A student of the Great Depression, and especially of the disastrous effects of bank failures, he went well beyond the standard response of lowering interest rates the overnight Fed funds rate dropped effectively to zero by December. It supported markets for mortgages, money market funds, commercial paper, auto loans and student loans. Although there were other actors, the Fed's interventions were decisive in halting the panic. It is an open question whether any other Fed chairman - someone without Bernanke's detailed knowledge of the Depression - would have been so bold in supporting credit markets.

Moreover, Bernanke's approach inspired similar moves abroad. But this is also Bernanke's burden. If the Fed doesn't withdraw all that extra credit quickly enough, it may spawn inflation. If it withdraws it too quickly, it may subvert recovery. The article describes how a particular theoretical approach has been replaced by another. Explain why one theory replaces another, and who, or what, determines whether an existing theory survives.

Does the reintroduction of a theory mean that it should not have been replaced in the first place? Should a theory be discarded if it does not specify the means of achieving a stated objective? Explain your answer. Positive accounting The dissatisfaction with normative theories, combined with increased access to empirical data sets and an increasing recognition of economic arguments within the accounting literature, led to the shift to a 'new' form of empiricism which operates under the broad label of 'positive theory'.

Positive theory sought to provide a framework for explaining the practices which were being observed; that is, whether what practising accountants produced had a decision- usefulness objective, whether it filled other roles, and whether it was inferior or superior to proposed alternatives. The objective of positive accounting theory is to explain and predict accounting practice.

An example of a positive accounting theory is the theory that leads to what is known as the 'bonus plan hypothesis'. If managers are remunerated partly with bonuses based on reported accounting profits, the managers have incentives to use accounting policies that maximise reported profits in periods when they are likely to receive bonuses.

This theory leads to the prediction hypothesis that managers who are remunerated via bonus plans use profit-increasing accounting methods more than managers who are not remunerated via bonus plans. Such theories are important since they explain the economic, or wealth, effects of accounting and why accounting is important to various parties such as shareholders, lenders and managers - all of whose personal wealth is affected by accounting decisions.

By explaining and predicting accounting practice, Watts and Zimmeiman consider that positive theory has given order to the apparent confusion associated with the choice of accounting techniques. They argue that positive accounting theory helps predict the reactions of investors in the market such as current shareholders to the actions of management and to reported accounting information.

The problem with this approach is that wealth maximisation became the answer to every question. Basically, whatever the observed practice, it could be construed as a means of inaximising wealth normally for the firm, but sometimes for management. To give the argument symmetry, the reverse argument could also be applied - namely, that the observed practice was to minimise the impact of costs or some external event on the value of the firm.

The positive literature involves developing hypotheses about reality which are subsequently tested by observation of impact, usually based upon the assumption of wealth maximisation. The approach has attracted criticisms which are largely based on the seemingly narrow approach that concentrated on agency theory and assumptions about the efficiency of markets. The potential role of positive accounting theories in explaining and predicting behaviour is illustrated in theory in action 1.

The Bank of France announced an enquiry by the Banking Commission. SocGen declined to name the trader, but said he had been suspended pending dismissal after confessing to his actions.

He now faces legal action from Societe Generale, which is in turn already being sued by a group of angry shareholders. The bank accused the trader of taking "massive fraudulent" positions in and on European equity market indexes, meaning he was gambling on broad movements in share prices.

When the bank discovered the concealed trades, it decided to close the positions in the market as quickly as possible, but this coincided with a sharp market sell-off, and the bank's losses on the deals spiraled to 4. Like Leeson before him, the trader apparently benefited from knowledge of the bank's control systems after working in the back office of its trading rooms, according to SocGen. It said he had used a "scheme of elaborate fictitious transactions" to try to cover up his mistakes, but did not accuse him of profiting personally from his actions.

The announcement sent a shiver through the world banking industry, which is suffering a credit crunch as high-risk U. Lehman Brothers chief executive and chairman Richard Fuld called it "everyone's worst nightmare" in a comment from the World Economic Forum in Davos, Switzerland. It seems incredible that the Societe Generale can lose 5 billion through one operator", said Alain Crouzat, a portfolio manager at Montsegur Finance. Other said the crisis at SocGen, one of the top 10 banks in the eurozone by market value, could spell trouble elsewhere.

In the light of this, what we've done is to downgrade banks that are very linked to trading income or whose capital base i s weak.

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Several said the bank, which has for years been coveted by larger French rival BNP Paribas, could face a battle to remain independent. SocGen said it expected a net profit of between and million euros, well below its profit figure. Excerpts from Reuters, 24 January ; published online, Financial Post, www. Questions 1. Given this definition, who is ultimately responsible for the rogue trading outlined in the Societe Generale scandal - the trader directly involved; management, who are responsible for the high-risk framework in which the trader operated; or a combination of both?

Discuss the role played in the SocGen case by each of the following three elements: How could Societe Generale have been unaware of the activity of its trader and of the environment that it had created for the trader to operate within?

Explaln your answer. Behavioural research is concerned with the broader sociological implications of accounting numbers and the associated actions of key participants such as managers, shareholders, creditors and the government as they react to accounting information.

An example is a theory that predicts that loan managers cannot process all the financial information they receive, so they assess firms' credit risk using the information that is most relevant to the background of the loan manager. If the loan manager had been involved with loans to firms that defaulted on their debt agreements because of poor cash flows, despite profitable activities, it is predicted that the manager will place more reliance on cash flow information than other information.

On the other hand, if the loan manager had been involved with loans to firms that defaulted because of unprofitable operations, it is predicted that the manager will place more reliance on the reported profit or loss and earnings prospects of prospective borrowers. Note that, although it had a resurgence in the s and continues to be important, behavioural research in accounting emerged in the early s and first appeared in the accounting literature in Many stakeholders shareholders, government, and creditors are concerned about the failure of accounting information to signal such financial catastrophes and the apparent manipulation of accounting information and of those meant to independently report on financial information auditors.

In fact, in some of these cases such as Enron in and the collapses in the financial sector in it appears that the auditors colluded with management to mislead the external stakeholders. In one sense, this supports the positive view that at least one party was acting to maximise its wealth to the obvious detriment of others. This leads to an alternative view - if theory focused on the impact of accounting on behaviour rather than or1 explanations after the event of observed behaviour, the current corporate and reporting failures could well have been predicted.

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Instead, as occurred in the aftermath of the s following the 'Great Crash' of the Wall Street exchange, the legislative reporting requirements have been increased significantly e. One view is that it is impossible to develop a single theory of accounting, as human greed, opportunism, future uncertainty, and a degree of naivety on the part of some stakeholders can never be captured in a theory of accounting per se. Accounting standards and legislated reporting measures are the outcome of competing sets of interests and this may well be the place to begin developing a new theory of accounting behaviour.

Either way, the current environment is one of increased disclosures and reporting requirements with legislated sanctions. But the key question is will this advance the development of theories relating to accounting measurements and disclosures? Recent developments Both academic and professional interests in theory development have tended to be aligned in the past. Whereas the academic research emphasis remains in the area of capital market, agency theory, and behavioural impacts, the profession has pursued a more normative approach.

In particular, the profession has sought normative theories to unify accounting practice and make it more homogeneous, whereas academic researchers have sought to better understand the role and impact of different forms of accounting information. These positive and normative approaches are not incompatible, since an understanding of the impact of accounting is a factor that accounting standard setters consider in developing prescriptions for practice.

In the mid to late s, the Australian accounting profession was heavily involved in the conceptual framework debate in an attempt to provide a definitive statement of the nature and purpose of financial reporting and to provide appropriate criteria for deciding between alternative accounting practices.

It also included a detailed outline of the 'tentative building blocks of a conceptual framework for regulation of financial reporting'. This was closely followed by ED 4GA-B in March , which outlined the concept of a reporting entity and provided definitions of the measurement and recognition of expenses. In , the AAR!? SAC 5, the controversial measurement statement, had not been released prior to the adoption of international financial reporting standards IFRS in The conceptual frameworks of the various countries are used in developing accounting standards and in attempting to reduce the inconsistencies arising from earlier fragmented theory and practice developments.

The need for a single, consistent framework has gained widespread acceptance in recent years. The IASB, in a joint project with the US Financial Accounting Standards Board, embarked on a new conceptual framework project in to update and improve the conceptual framework for standard setters and preparers of financial statements to use.

The need for a single set of international accounting standards was acknowledged by the accounting profession in Australia with the adoption of IFRS in January International standards seek to harmonise practices across international reporting boundaries and to reduce the differences in reported information which are a direct consequence of different accounting choices.

This approach aims to eliminate accounting disclosures and techniques specific to one or a small group of countries which subsequently affects the comparability or integration of information, particularly for multinational and listed corporations.

The assumption is that the same theoretical issues apply whether the standards are specific to one country or designed for global application. Figure 1.

Pre-theory period ontinued development of practice 7. General scientific period- lanations of practice and development of explanatory framework s: Normative period- s to Positive accounting nt of ideal practices and theory-a framework to explain r achieving such practices and predict behaviour to present: To reflect this, the book is divided into three parts: Part 1: Accounting theory chapters Part 2: Theory contributing to practice through accounting standards chapters Part 3: Accounting and research chapters Chapters 2 and 3 detail many different theory construction frameworks and then apply them to analyse examples from the accounting literature.

The 'parts' of a theory are detailed, the means of testing theories are considered and the chronological development of accounting theory is traced. Understanding the components of theory development is important for accountants, not just those who will become academics, but also those who need to understand the choice of alternative accounting methods and explain this to clients and stakeholders.

It is also important to distinguish between theory development as it relates to the natural versus human sciences. Accounting processes and information are the result of a complex set of human interactions and decisions which may not fit the traditional empirical or scientific process.

When it comes to interpreting human behaviour, completely rational and systematic approaches may not apply. To be a complete professional accountant one needs to understand the mainstream approaches to theory development, in order to specifically consider theories of accounting, the behaviours accounting information demands, and the advice needed by clients. Thus, these chapters set down the fundamentals of taking a scientific perspective. Chapter 4 describes how, over time, the different perspectives of the different users of financial statements have influenced the focus of accounting.

It covers issues such as whether the focus of accounting is on reporting the ownership interest in the firm or the financial affairs of the firm as a separate operating entity.

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Basically, a significant number of choices and decisions are made to ensure the accounting methods fit the reporting entity.

It is important to appreciate that human decisions, preferences and objectives will affect the accounting viewpoint adopted, which in turn drives the accounting choices made in recording, measuring and reporting accounting information. This is an important chapter in the context that the IFRS has adopted a shareholder perspective rather than an entity perspective when determining the focus of accounting. Since measurement is fundamental to accounting, chapter 5 provides an introduction to some important technical issues in relation to measurement and to how it applies to accounting theory and practice.

We learn that in fundamental measurement numbers can be assigned by reference to natural laws, but in accounting there is considerable debate over the nature of fundamental value. We also learn that accounting is derived measurement that depends on the previous measurement of two or more other quantities. For example, we calculate income and expenses before profit is determined. Fiat measurements are those that relate numbers to properties of objects or events on the basis of arbitrary definitions.

Chapter G provides an overview of the accounting measurement systems from which the principles of fair value accounting can be said to be derived. The first section describes conventional historical cost accounting and the theoretical bases, criticisms and defence of the system. During the normative period, the historical cost system came under attack, and theories were developed to deal with the effects of changing prices on asset valuation and profit determination.

These theories focused on either buying prices current costs or selling prices exit prices. Thus, this chapter enables the student to place into perspective arguments about accounting measurement and the current debates about measurement in IFRS. The definition and measurement of assets and liabilities are fundamental in determining the net value of the firm and, in many cases, the income and equity.

Chapter 7 provides the definition of an asset and addresses measurement issues related to tangible, intangible and financial assets. The mixed measurement attribute model applied by IFRS is outlined as well as the concepts and methods behind different measurement methods. Chapter 8 is concerned with the credit side of the balance sheet - liabilities and equity. Liabilities are first defined and applications associated with applying the recognition and mixed measurement criteria to employee benefits, pension liabilities, provisions and contingencies are discussed.

The chapter finishes with the definition of equity as the residual interest in assets, discusses the concept of capital, and outlines the difference between debt and equity.

The calculation of profit has been a key component in accounting measurement over many years and forms a fundamental component in many valuation models, capital market research, agency contracts, taxation issues, social issues and the behaviour of individuals. Chapters 9 and 10 provide overviews of the issues faced in rhe two main components used to derive income - revenue and expenses. Discussion is provided about recognition criterion - from cash transactions through to more recent concepts such as the acquisition of a customer valued at exit price.

We also discuss the concept oC the comprehensive income. Expenses are defined and concepts such as economic benefits, expired costs and matching expenses and revenue are discussed in chapter One outcome of these two chapters is the ultimate consideration of the nature of profit and the alternative measurement rules that can give rise to quite different levels of reported profit.

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