Political process model by positive theory

Do accounting numbers play a role in the political process of cost allocation in providing information to users? Discuss

I agree, because… the higher the profit the higher the intention of interest group and politician to

Political process model by positive theory

Rather than capital market, accounting information in political market is less demanded by the users because of less incentive to ask for it.

What is Political market? The market that company would enter to supply the interest group an enough information of FS. As we studied in last blog about capital market. The assumptions such as:

• people have a perfect knowledge (highlighted)
• no transaction cost (highlighted)

are considered as unrealistic and illogical when we compared to the real world, why so? It is because of people have to pay transaction cost to get an information from the management of the firm. People are not simply get all information that they want without incurring any costs at all. Therefore perfect knowledge assumptions in capital market is impossible and transaction cost is actually exists in order for someone to get information that they want.

Political market however confirms an existence of transaction costs, this cost would lead to lesser demand by the users depending on the cost benefit analysis that the user will incur higher cost than benefits that they will get from the information. Therefore it is not worthy to choose the otherwise option as we assume that individuals are the utility (profit) maximizer, they will choose to not incurring transaction cost. With this result, firms has power to decide to limit their supply of financial information and put less disclosure to the user for their vested interest (self interest).

High information cost problems to the user:

Individuals

• Individual actions are small effect to the person’s (company) wealth
• 1 individual as 1 voter will influence nothing to the management, 
• the opinion is insignificant to effect the management’s decision making
• Political cost = cost born by the user in order to lobby for challenging the decision made by the firm 
• It is ultimately high for an individual to bear political cost alone.

Interest group

• Forming interest group to make such power to influence management decision
• Once interest group is formed, it could enable the group lobbying. Which is reducing the cost of lobbying by diffusing the cost to each individuals in the group
• Cons, 

• Not easy to search people with the same interest (heterogeneity of interest)
• Cost to forming the organization (interest group) and cost to informing (communicate) members

Heterogeneity (diversity/different) of interests would also become the problem for the interest group to lobbying the information, they need to focus on certain information that they want notwithstanding individual interest only. 

Greater Residual opportunism probability to occur for the firm is still exist despite:

• having a greater information cost for lobbying
• diffused rewards by forming interest groups
• high monitoring cost by the shareholders

Example of political process in Stock market crash in US:

• US Gov pass securities act to increase gov control over public co to prevent future crash
• The act is not so effective to prevent a lot of future crashes
• Public still choose to stay rationally uninformed. Why??? Because of:
• Costly to get information
• Costly to lobby to come out with corrective action plan
• Individual are less expecting public to do so

Accounting numbers and political cost allocation

Accounting numbers is a tool for “crisis solving” and “promoting interest” to the firm and other parties. Why I said so?

Regarding crisis solving, 

Employees are very sensitive on the profit gained from the firm. Once they know the profit generated from the firm is unusually higher. Employees would criticize the firm had exploiting their labor to get unusual profit therefore they will demand for increment of wages/salaries.

Accounting numbers are used to understate the profit figure therefore it would give another point of view (window dressing) so that the censure would be minimized.

Regarding promoting interest,

Firms are also a utility maximizer, they also have interest in the profit of the firm. The benefit gained by the firm through a subsidies is something to be keep on so that the government will not have to retrieve its subsidies because the company had been matured in the industry.

To avoid from subsidy retrieval, firm has to understate their profit to keep enjoying the subsidy even though the firm has gaining a higher profit. Again the accounting figures plays an important role to this problem. 

Role of accountant in political process

Accountant is given a responsibility to window dressing the profit figure so that the unusual profit can be reduced within the scope of accounting practice (as long as it is legally to do so). Accountant has given a flexibility to choose which technique that they want in performing accounting job. This brings an opportunity for the firm to gain from unusual profit in the political process and at the same time avoid from critics and political costs. They will use conservatism principle as an excuse to understate the firms profit so that interest groups will believe the accountant is doing their job very well within the scope.

Another factor that lead to window dressing

• The size of firm, the bigger firm will be more political sensitive and have more tendency to use accounting method to reduce the reporting profit
• The volatility of the profit, the more volatile the profit, the more it attracts the political attention. The higher variance is something suspicious for someone to be attracted to.

Normative and Positive Theories in Accounting

Normative Theories (1950-1960) golden age

Accounting researcher became more concerned with:

 Policy recommendations &

What should / ought to be done, rather than analyzing and explaining the currently accepted practice.

They are focusing on issue of:

#1. Deriving the true income FYE

• Deriving a single measure for assets and unique profit figure subject to disagreement
• Much of them are discussing on merits and demerits of alternative measurement system

#2. Decision usefulness - Discussing the type of accounting info for economic decision making

• Providing useful and relevant accounting data to aid the users to make decision making
• The users seems to be not in particular group but categorized as all users

Assumptions of normative theorists which are not even tested empirically:

• Accounting should be a measurement system
• Profit and value can be measured reliably and precisely
• Financial accounting is useful in economic decision making
• Market are inefficient / can be fooled by ‘creative accountant’
• Conventional accounting is inefficient 
• There is one unique profit measure

The description of normative theorists

• They think that their assumptions are ideal, and “recommended” to replace HCA with it and to be used by all and sundry.
• They “labelled” their approach to theory formulation scientific & based their theory on analytic (syntactic/logical) and empirical (inductive/pragmatic) propositions
• Their “scope of research is general/holistic” (the whole financial statements, not just specific/narrowed scope such as accounting for doubtful debts)
• They also “made assumptions” about the nature of a firm’s operations based on their “observations”
• They outlining the detailed and precise accounting principles and rules and a “logical explanations outputs”
• Rigorous and consistent deductive framework
• FS “should” mean what they say and “Should have” semantic connections
• Using pragmatic test: observing FS , users should act as though they actually observed the event the FS represented.
• Relies mainly on syntactic relations labelled as ‘hypothetico-deductive’ even though has semantic elements in the methodology.

The main objective of the research: Usefulness of acc data to find answer whether it helped decision makers make the right financial decisions?

• Decision process = decision makers use acc data to make predictions and then decide what to do.
• Comparing the science approach, referring to either instrumentalism or realism

Instrumentalism and Realism

#1. Instrumentalism is a theory has no utility except as an instrument for prediction. According to friedman (probably a normative theorist), theories can only be judged by predictive power. However, this is not applicable in accounting where some problems is identified during the verification test:

• If the prediction is verified, it verifies the prediction model of the user, not accounting system
• If the decision is turns out to be right, it only verifies the decision model and also not accounting system.

Therefore instrumentalism is best describe a normative theory where it only considers on what should be done, decision making by predictions without mentioning the descriptive explanation to verify on what has occurred in the real world.

#2. Realism stressed the explanatory role of science (prediction in reverse), in accounting it means for an accounting theory to be valid, it must be more than an instrument for forecasting, it must also hold as a description of the reality that underlies the accounting phenomena. Its prediction ability is proved from the relevant feedback of what has occurred before.

Therefore realism is best describe a positive theory where the prediction (assumptions) of a normative theory is supported by description in reality.

Validation prediction in a different variables situation (controllable and uncontrollable)

In accounting, controllable variable recognized as accounting figures in financial statements. While uncontrollable variable recognized in economic environments such as inflation, interest rates or consumer confident.

• In validating prediction in a controllable variable situation, we can use scientific test
• In validating prediction in an uncontrollable variable situation, we can use statistic prediction, according to how probable the evidence supporting the prediction is representative.

Therefore, normative theorists only considered on a controllable variation where they can only uses scientific tests because their predicting ability only based on assumptions, not verified into the real world. However positive theorists can work with uncontrollable variable besides controllable variable which is because their predicting ability is based on the past events that has occurred. They can use both scientific test and statistic prediction for their research.

Positive Theories (1970-present)

If before this we know that normative theory is only pursuing on making assumptions, Positive theory is the other way round. Positive theory is heading back to the empirical methodology (also called positive methodology) where the assumptions is turns back into real world. What does it really mean? Actually, positive methodology is about to test assumptions made by the normative theorists and only accept which assumptions that can reflects the reality. Therefore the realism is best describe positive theory.

Example of research made by positive theorists

• Using questionnaires and other survey techniques to determine attitudes to the usefulness of different accounting techniques by gaining key person opinion on the economic decision making process.
•  Test the assumed importance of accounting outputs in the marketplace. Test attempted to determine whether:
• Inflation accounting increase the information efficiency of share markets
• Profit is an important determinant n share valuation
• Cost of gathering finer accounting data outweighed benefits
• Use of different accounting techniques affected value

Today, positive theory is concerned mainly with: 

• Explaining – reason for current practice
• Predicting – 
• role of accounting profession
• accounting information for economic decision making for users

Descriptive Approach by Positive Theory

Positive theory describe how people do behave (regardless of whether it is right or best behavior).

For example, how do positive theorists use their method to test on the accounting techniques used by managers to maximize their bonuses?

Suggested survey questions:

• Do firms substitute alternative ways of financing assets when the rules governing the accounting for leases change?
• Which firm are more likely to use Straight Line Depreciation rather than Diminishing Balance Depreciation? Why?

Suggested answers from management:

• Their incentives to avoid breaching accounting based debt covenants and thereby reducing cost of debt.
• Their Incentives to use accounting techniques to divert attention from their high profits that would lead to government/public scrutiny & also higher tax charged which lead to bad effect to their income.

Summary

NORMATIVE THEORY

POSITIVE THEORY

Policy recommendations, ought/should be done Instrumentalism Prescriptive - normative theory prescribe how people should behave to achieve an outcome that is judged to be right, moral, just, or otherwise a good outcome. Under control (Limited variables)  Info useful for decision making Make assumptions but not tested out Classifications of assumptions: Classical economics  Measurement theories HCA adjusted for inflation

Analyzing, explaining current practice Realism Descriptive - Positive theory describe how people do behave (regardless of whether it is right or best behaviour) Beyond control (many variables) Scientific: questionnaire Feedback received can be a predictive value Test out the assumptions and get feedback using questionnaires

Accounting Theories Construction. Do You Know How is it Constructed?

Accounting Theories Construction

Good theory would have 3 aspects / elements, they’re consists of:

1. Semantic theory (ability to relate to the real world)
2. Syntactic theory (must be logical)
3. Pragmatic theory (observation of accountant behavior in practice)

To ensure that the HCA (Historical Cost accounting) that have been used in accounting practice can be accepted as a good theory. It has to be conformed at least one elements of a good theory as stated above.

Semantic theory

The elements of "Semantic" in HCA is basically refers to the input of the HCA which have been verified to the real world by an Auditors. The components of accounting inputs such as vouchers, journals and ledgers of the business.

Auditors only have a duty to verify the semantic inputs by checking the calculations and manipulations in the double entry accounting. But the results of output in Financial Statements such as profit figure, assets & liabilities figures et cetera can’t be verified and reflex to the real world by the auditor.

It shows that managements or stakeholders that uses the information of financial statements are sometimes can’t rely 100% on the unverified output because sometimes the results of their decision making is not the same as what they expected.  (Refer case Enron).

Conclusion: Therefore HCA is failed to fulfill the Semantic theory extent in the scope of output verification.

Syntactic theory

The most components of HCA is "Syntactic theory", it means that the logical aspect of syntactic theory is to  the extent of all scope of accounting system including input and output of the accounting system, the process and its procedures. It is completely denying the semantic components because as long as it is logical, there is no need to verify both inputs and outputs in the real world. But, there are some criticism that shows that the HCA is somehow cannot be conforms 100% logical.

The criticism of HCA in syntactic theory:

#1 Summing up 2 same category of assets in the different timeframe. 

Example: adding a freehold land today with 20 years ago freehold land which is illogical unless the currency value is always the same as 20 years ago and today. But it is impossible because of the inflation of economics.

#2 Problems of doublethink (by Chambers)

• Define as holding contradictory beliefs in one’s mind simultaneously, and accepting both of them. Example: 
• Valuations are incorporated in balance sheets … but the balance sheet is not a valuation statement.
• Fixed assets should be carried at cost … in HCA, unless such cost is no longer meaningful.

#3 Imprecision of definition (Popperian approach) 

• Depreciation for the year:
• measurement expressed in monetary terms of the physical deterioration within the year, ordecline in monetary value within one year, or
• Indeed of anything actually occurs within the year, or
• Depreciation depends on allocation, which in turn depends on a future sale (disposal price) and expected useful life of the assets which are uncertain and can’t be verified.
• Determination of cost and profit:
• is a choice among conventions, or
• Present magnitude depends on future magnitude. 
• Under this logic, true profit cannot be determined until the firm has been liquidated.

Pragmatic (practical) theories

Consists of 2 types:

1. Descriptive pragmatic approach
2. Psychology pragmatic approach

Descriptive pragmatic approach

Definition:

• Inductive approach
• Oldest & most universally used method of accounting theory approach
• Based on theorists observes an accountants’ behaviour in practice, and learning by copying what accountants did. 
• For example; future accountants will learn accounting skills by becoming apprentice in accounting firm and from senior accountant.

Pragmatic test: 

test in term of whether and how people will use them

Sterling (a normative theorist) comments:

He called this method as anthropological approach. For example; Anthropologist has observed that accounting man normally records a conservative figure and generalized this as the principle of conservatism. Test can be done by observing whether or not the accounting man does the same.

Criticism of the approach:

• It doesn’t include analytical judgement (not questioning the quality of accounting work)
• It doesn’t challenge accounting technique & therefore not allowed for change
• Focuses on accounting behavior not measuring the attributes of the firm, assets, liabilities & profits as it is not concerning about semantics of accounting phenomena.

Conclusion from sterling:

The approach isn’t appropriate for accounting construction as pragmatic theory hasn’t related to normative theories of how accounting should be conducted rather than describing real world practices.

Psychological pragmatic approach

Definition:

Based on theorist observes the user (accountant’s output) reaction @ responses approach. If the user reacts positively, then the information is useful

Problem arose:

• If the user reacts in illogical manner – the information is not useful
• If the user doesn’t reacts at all – theorist can’t get any conclusion from it.

Conclusion:

Theorists can’t get any far with this approach.

My Conclusion at The End:

HCA is a theory made that have a lot of weaknesses, despite of it, it still being used as a practice as today. It is significantly out from semantic aspect in verifying the output. 

Even in syntactic approach that seemingly logical in all aspects of the accounting system, it also has a lot of criticism by a normative theorists such as summing up amount of a particular assets that has 2 different time frame, problems of doublethink, and an imprecise definition. 

Therefore, accountants (positive theorists) seems have a favour in the Pragmatic approach, which is just taking all of the knowledge from the past by observing from the practice and behaviour of an accountant. 

P/S: next week, we'll need to know who are Normative theorists and Positive theorists and how are they contribute in the construction of an accounting theory including HCA. Better stay tuned and subscribe to my channel. 

Does Accounting History relevant for our study nowadays?

Indeed Accounting history is important for our study. Yet it supports an importance to accounting pedagogy, policy and practice. It makes it possible to “better… Understand our present and to forecast or control our future”

Definition of Accounting Theory
It is a study of a heritage of accounting and its contribution to accounting pedagogy, policy and perspective.


With regards to Pedagogy

Accounting history can be very helpful to a better understanding and appreciation of the field of accounting and its evolution as a social science

• Profession build over many centuries should educate its members to appreciate their intellectual heritage.
• The import of advances in thought, of major contributors to the literature, and of crucial positive studies may be lost, fragmented, or inadequately recognized in the longer term unless they are documented and incorporated by scholars who have historical skills.
• Without access to analyses & interpretations of historical developments in accounting thought and practice, today's empiricists risk basing their investigations upon incomplete or unjustified claims about the past. 

With regards to Policy Perspective

Accounting history is instrumental to a better understanding of the accounting problems and their institutional contexts as well as the formulation of the public policy

With regards to Accounting Practice

Accounting history could provide a better assessment of the existing practices by a comparison with the methods used in the past. 

Accounting and Capitalism. Are they interrelated?

Overview:
This article provide us with information that whether accounting comes first before Capitalism or vice versa. Economic historian put a general claims that double entry book-keeping has been vital to the development and evolution of capitalism. later than that we'll meet another key person that would argue about this issue. They're: Max Weber, Sombart, Yamey and Winjum

Max Weber argument
He emphasizes that capitalistic enterprise wasn't been possible without 2 other important factor:

• Seperation on entity
• Rational bookkeping

Sombart Thesis
Sombart arguments is tally with Max Weber that both phenomenons are connected as intimately as form and content. it is irrational to say which one is started first. his arguments is further explained about the asset is transformed into statement and numbers made it possible for:
capitalistic entrepreneur to plan, conduct and measure the impact of his/her activities
for a separation of owners and the business itself thus allowing growth of corporation.


4 Role of D/E (Double Entry) in the economic expansion interpreted by Sombart

1. D/E contributed to a new attitude toward economic life. Goal of gaining profit is introduced. Spirit of acquisition was promoted and encouraged. D/E was used for the profit searching purposes and concept of capital was made possible.
2. Spirit of acquisition was aided and propelled by the refinement of economic calculations. Rationalization could be based on a rigorous calculations & present economic status could be readily determined and rational plans for future operations could be developed.
3. New rationalism was further enhanced by systematic organization. D/E very duality provides for a check on accuracy. Its mechanization and objectivity contribute to an orderly and continued recording of business affairs. It also promotes order in the accounts and organization in the firm (a unique system for classification)
4. D/E Bookkeeping permits a separation of ownership and management and thereby promotes the growth of the large joint stock company. By separation of entity's assets, it makes possible the autonomous existence of the enterprise.

Yameys' arguments
He indicate that businessman (1600-1800) didn't use D/E bookkeeping to keep track of profit and capital but simply a record of transactions.

D/E bookkeeping interpretations from Yamey's perspective

• D/E is just providing a framework.  
• D/E bookkeeping is not necessary for determining profits and capital
• D/E bookkeeping is only useful for routine problems
• It is not necessarily useful for the selection from the opportunities available for the businessmen.

Winjum interpretations for D/E Bookkeeping contradicts Yamey's
He provides evidence early in 1600 stating that "profit and loss determination was a foundation in D/E bookkeeping".

Winjum's Conclusion
He agree about Sombart that accounting has a relationship with capitalism, and D/E bookkeeping does have the capability of making a positive contribution towards economic growth. It also could bring order to the affairs and accounts of merchants and stimulated and rationalized the economic activities in the early English merchant.

Politicization Phase in the Development of Accounting Principles in USA

Politicization phase (1973-present)

The environment

Main contribution: FASB (Financial Accounting Standard Board) and various pressure groups are moving towards politicization of accounting.

How the idea of politicization is started? Reasons:

•  Limitations of both professional associations and management in formulating an accounting theory
• Created by the generally accepted view that accounting numbers affect economic behavior

Horngren statement: relationship between standards and political elements

The setting of standards is a social decision. That is why it is said to be a product of political action. He further define standards is define as to place a restrictions on behaviour. It must be accepted by affected parties to be stated as standards even though the way is to force or by voluntary or both.

FASB quasi and deductive political approach adoption has a political elements:

•  An effort to develop a theoretical framework @ accounting constitutions
•  By emergence of various interest groups, the contribution of which is required for the “general acceptance” of new standards.

Statements by FASB about the political elements

Setting standard is the same as democratic process, similarly it can be described as legislative because it must be deliberative & because all views must be heard. And the standards setter must represent the entire constituency as a whole and not be representatives of a specific constituent group.

“Metcalf report” better expressed the process of formulating accounting standards

The report charged that the ‘big eight’ accounting firms monopolize the auditing of large corporations and control the standard setting process. The “big eight” and AICPA have control over accounting standards approved by SEC. (you may want to search: the recommendations aimed at enhancing corporate accountability)

Development of Accounting Principles in USA

Overview: 

1900 Various groups in USA had implementing mix approaches in accounting practices have subjected to a constant re-examination & critical analysis.

4 phases identified such as:

1. Management contribution phase (1900-1933)
2. Institution contribution phase (1933-1959)
3. Professional contribution phase (1959-1973)
4. Politicization phase (1973-present)

 Management contribution phase (1900-1933)

The environment: 
management had complete control over the selection of financial information disclosed in annual reports

Reason:
increasing numbers of shareholders & dominant economic role played by industrial corporations after 1900. 

The effects:
Management have complete control over the format & content of accounting disclosures.Adoption of ad hoc (random) solutions to urgent problems & controversies 
The problems arose:

•  Most accounting techniques lacked theoretical support
• Focus on taxable income & minimize tax
•  Focus on income smoothing
• Adopting only on simple solutions but neglected complex solution
• Same problem, different accounting techniques.

Arguing the situation: Z. Ripley & Hoxley and (Adolph A, Berle & Gardier C ) are outspoken in arguing for an improvement in standards of financial reporting


 The main players:

• AIA (American institute of Accountant) established a board of Examiners to create a uniform CPA Examination.
• NYSE (New York Stock Exchange) required all corporations applying for listing to agree to publish annual financial statements.

The events occured:

• interest cost issue
• taxable profit issue

 Interest as a cost (production cost) controversy:

•   FASB traces the background of interest as a cost (production cost) controversy
•  Reason of controversy emergence:
• contribution on incremental amount of overhead
•   the increasing complexity of business
• increasing reliance on machinery &
• Consequent need to invest large amount of capital for long term.
• To develop realistic product cost as basis for establishing selling prices and measuring manufacturing efficiency.
• AIA position states that: no selling cost, interest charges, or administrative expenses are included in the overhead costs. And won the debate.

Accounting theory of taxation of business income:

• Revenue act 1913 provided for the calculation of taxable income on the cash basis.
• The 1918 act was the first to recognize the role of accounting procedures in the determination of taxable income.
• It set the stage of the beginning of a harmonization between tax accounting and financial accounting.

   

      P/S: Next post will be in institutional and professional contribution phase... stay tuned!

    

      source: Previts, Gary John, Parker, Lee D. and Edward N. Coffman, "An Accounting Historiography: Subject Matter and Methodology", Abacus (September, 1990), p.142.