Introduction
The present-day business environment is full of diverse challenges. W ith new financial issues continually arising, new standards are regularly being developed or existing accounting standards are being updated. In the circumstance of creating new standards, the International Accounting Standards Board (IASB) must strive to construct the most practical and relevant standards, while giving consideration to the effects of the new regulations on accounting professionals, as well as the wellbeing of all members of society. This essay will consider the process of creating new accounting standards and attempt to determine the relationship between accounting and regulatory theory and the standard-setting process, as well as the impact new standards have on practising acc ountants. In section one of this essay, the two major types of accounting theory – normative and scientific – will be defined and explored. How these theories could be utilised by the IASB will also be discussed. In section two, the relationship between regulation theory and the standards that the IASB create will be outlined. In section three, further discussion will be given to the impact of the new standards on accountants working within the profession, their responsibilities and the part they play in the implementation of new standards. Section one - the accounting profession: practice vs theory Accounting practise and standard standard setting
It is important to recognise that accounting is a set of techniques practiced within an implicit theoretical framework (Riahi-Belkaoui 2004). This framework, paired with accounting standards, gives accountants the necessary context to understand and resolve accounting issues. However, in today’s ever-changing financial environment, new issues are continually arising that are not covered by existing accounting standards. In the hypothetical situation given, a form of financing has arisen, which is not covered under existing accounting standards. This financing can be classified as either debt or equity, depending on the viewpoints of managers. In this scenario, existing standards either need to be revised, or new standards may need to be created.
In Australia, the IASB is responsible for updating and developing new accounting standards. While the process they follow for this is well documented (International Accounting Standards Board 2015), it is important to also consider which branch of accounting theory the IASB may take into consideration during this process. Before attempting to answer this question, question, an outline of accounting theories must be given.
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Accounting theory
Accounting theory can be defined as a set of logical principles t hat 1. Provide a general frame of reference by which accounting practices can be evaluated, and 2. Guide the development of new practices and procedures. (Hendriksen1977)
However, there are many existing theories of accounting, and depending on their views and values, different accountants will embrace different theories (Dandago 2009). Accounting theories are useful, as they provide a system of thought, designed to assist decision making and influence behaviour (Gaffikin 2006). For example, accounting theories can prescribe how assets should be valued or predict why managers will choose particular accounting methods (Gray 1988). The most important goal of accounting theory should be to provide a set of clear and logical principles that form a frame of reference for the general evaluation and development of good accounting practices (Vorster 2007). As yet, there is no universally accepted theory of accounting, as no theory is able to explain and resolve all accounting issues (Riahi-Belkaoui 2004). Instead, there are several different theories of accounting, each with its benefits and weaknesses. Two major branches of accounting theory will be explored – normative and positive theory. Normative accounting theory
Normative, or deductive, theories seek to help i ndividuals to select the most appropriate accounting measures or policies in a given set of circumstances (Vorster 2007). Normative accounting theories start with a basic or general assumption from which a conclusion is developed. This conclusion can then be applied to a particular circumstance or case (Dandago 2009). This results in accounting principles that draw logical conclusions about the subject. An example of a normative accounting theory is MacNeal’s argument for market-valuation of assets (1939). According to MacNeal, the objective of accounting was to provide the most accurate and relevant information about business entities to assist investors and creditors in making investment and financing decisions. As information in financial statements could only be seen as relevant if it reflected true market prices, he postulated that historical cost accounting should be abandoned and (along with altering several other ot her aspects of financial statements) market-valuation should be implemented. Normative accounting theories have several benefits. They ‘prescribe’ or recommend particular accounting practices, hence why normative theories are also known as prescriptive theories. This 2
makes them useful when trying to determine a particular course of action (Dandago 2009). As well as this, normative theories do not need to reflect current accounting practice, only the best accounting practice that should be used within a given set of circumstances 1. This can be seen in the example of MacNeal (1939). At the time MacNeal released his theory, standard accounting practice was to value assets at historical cost and apply depreciation. However, because MacNeal developed a normative theory, current accounting practice was not relevant to his theory; only the best way to deal with asset valuation in a given set of circumstances. The major problem with the normative approach is that there is no definite knowledge of how new theories are going to affect future practice (Gaffikin 20 06). They are not, and often cannot, be empirically verified, so their implementation could cause more problems than they actually solve (Mattessich 2006). Without empirical evidence, it is also difficult to refute alternative theories. In the previous example of MacNeal (1939), while the use of market valuation could provide more accurate information for users, a counter-argument responds that reporting market prices of assets would create scope for managers to distort asset valuations in financial statements, unless restrictions were made as to which market prices could be used (Kabir 2005). Without the support of evidence or observations, there is no way of knowing how accurate a normative theory will be. Positive accounting theory
Positive accounting theory (PAT) seeks to explain and predict certain phenomena within the accounting practice (Whitley 1988). They are known as "positive" theories, because they deal with facts about how the world works as opposed to normative theories, which are concerned with how the world should work. PAT is an empirically-based theory, developed and supported on the basis of observations. PAT tends to focus on o n explaining the reasons behind decisions within an organisation (Kabir 2010). It asks such questions as, why do managers use particular accounting methods, or change from one accounting method to another? As rational people, what incentives influence them? (Watts and Zimmerman 1986) Positive accounting theory was first developed by Watts and Zimmerman (1986). An example of one of the key concepts within PAT is the management compensation plan, otherwise known as the bonus plan hypothesis. Bonus Plan Hypothesis:
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1) Assumes that managers with a bonus plan that is tied to their reported income are more likely to use accounting methods that shift reported income from future periods to the current period. 2) Predicts that if a manager is rewarded for performance of a measurable metric, such as accounting profit, the manager will attempt to increase profit (Watts, Zimmerman 1986) The bonus plan hypothesis shows the PAT methodology in action, with real firms and accountants being studied and observed, and a theory being created to fit and explain these observations. The benefit of PAT is that it is extremely relevant to real-world practice of accounting, as it focuses only on current behaviours and actions occurring within the industry (Kabir 2010). The fact that it is evidence-based, also allows users confidence that the theory is applicable in the working world, rather than just being a theoretical possibility (Watts, Zimmerman 1986). However, PAT does not provide guidance for practitioners, or prescribe a particular course of action for firms to take. Information is given on which firms will and will not use a particular accounting method, but there is nothing said regarding which method a firm should use (Boland, Gordon 1982) How is accounting theory useful to the IASB and the development of new standards?
Both normative and positive theories have their uses. However, there are inherent flaws in both theories that would make it impractical for the IASB to rely solely on either theory when developing new standards. Rather, it may beneficial for the IASB to use aspects of both. If this is applied to the given example of the new form of financing, the positive approach can be used to see what is currently being practised in industry, to gain a realistic idea of how acco untants are classifying the financing, and why they have chosen to do so. This information could then be used in conjunction with any existing normative theories on the treatment of similar kinds of financing, and a standard could be created based on the t he best outcome within the two disciplines. By employing both theories, the IASB is able to determine the best possible course of action, one that still strives to provide the best accounting practice, but also one that is realistic, and already has, to a given extent, been empirically verified. After examining the process by which the IASB approaches the creation of accounting standards, it can be seen that their methodology acts as a guide for overall perception given towards regulation within Australia. The method used by the IASB allows for greater understanding of the regulatory theory generally adhered to within Australia. Section two – Regulatory theory What is regulatory theory?
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The accounting practice within Australia is regulated, both by legislation - the CLERP 9 Act - and independent professional bodies – the IASB, the AASB. In recent years, there has been a greater shift from self-regulation within the profession to government regulation. This shift was made after a spare of unethical behaviour and corporate collapses caused a loss of public trust in the accounting industry (Cooper, Deo 2005). However, there are many professionals and academic who believe in a free and unregulated market. They argue that accounting information should be treated like any other good, and that demand and supply forces should be allowed to operate freely so as to generate an optimal supply of information about the entity (Benston 1985). The argument states that even in the absence of regulation, there are enough economic incentives for organisation to provide sufficient information regarding their operations to the public. However, pro-regulation advocates argue that due to market failures, regulation needs to be put into place to protect the general public and ensure greater market efficiency (Riahi-Belkaoui 2004) To determine how regulatory theory is relevant to the actions of the IASB, three popular regulatory theories will be examined - public interest theory; capture theory; private interest theory. Theories of regulation
The public interest model of regulation is the most commonly seen model (Gipper, Lombardi & Skinner 2013). This theory acknowledges that stakeholders require high-quality information, in order for them to make the best decisions regarding a company. However, it also recognises that due to self-interest and market failures, business may not always provide this information to the general public. Thus regulation exists to enforce entities to disclose particular information through the regulation of accounting standards (Gipper, Lombardi & Skinner 2013). Another theory is regulatory capture, which states that instead of regulation being created to best serve public interest, firms within the accounting industry ‘capture’ or heavily influence the regulator, leading to regulations that are in the best interests of the firm (Gipper, Lombardi & Skinner 2013). For example, if the Big Four accounting firms attempted to control the standards set by the IASB to further their or their clients own interests; this would be an example of regulatory capture. Thirdly, there is the private interest theory. This theory espouses the idea that standard-setters lack neutrality, and instead of developing standards that are in the public’s best interest, they will set standards based on popularity (Lev 1988), (Gray 1988). For example, accounting firms may petition
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the IASB when accounting standards are being developed or updated to try and protect the interests of their clients. How are regulatory theories relevant to standard setting?
The relationship between regulatory theories and accounting standards is highly dependent on the cultural and political climate of a country ( Gray 1988). This climate then determines the aims and motivations of the standard-setters. In looking at the connection between the standards set by the IASB and regulatory theory, it is relevant to know the goals of the IASB. The IASB is committed to developing high quality accounting standards, to meet the demand for high quality information that is of value to all users of financial statements (International Accounting Standards Board 2015). If this is examined in relation to the given situation of the new form of financing, it can be seen that the ability to classify the financing as either debt or equity, could lead to significant discrepancies between actual and reported levels of debt and equity. For stakeholders, this means t here would be a lack of consistent and accurate information. The IASB, by regulating the treatment of t his financing method, is protecting the interests of the public over the importance of a free market (Gipper, Lombardi & Skinner 2013). By looking at the IASB’s goals, it can be seen that the public interest model is the most applicable form of regulatory theory in Australia is the public interest Section Three – The role of accounting professionals in relation to new and updated standards
Accounting theory helps accountants to understand and make sense of the problems they may encounter in the workplace (Kabir 2005). Their preferences for accounting theory are largely reflective of their own personal views and values (Dandago 2009). This does not affect the accountant’s ability to perform their job, because, as yet, there is no universal theory that best explains accounting issues (Kabir 2005). However, while accounting standards are by no means definitive, and often leave much to professional judgement, accountants are not rightly able to pick and choose the standards with which they wish to agree and comply. Accountants must follow the standards set by the IASB, or risk incurring penalties, as well as damage to their professional reputation (International Accounting Standards Board 2015), (Accounting Professional & Ethical Standards Board Limited 2010). In relation to the example of the new form of financing, it has already been noted that the lack of conclusive standards allows for companies to classify the finance as they so desire, whether it be debt or equity, or a combination of the two. However, if the once a new standard is introduced, the accountant has a responsibility to ensure that their client complies with this. Even if the standard requires that the financing be classified in a way that is unfavourable to the client, or if the 6
accountant disagrees with the standard, it must still be complied with. For although the accountant has a duty to serve their client, they also have a greater duty to serve the public and uphold public interest (Accounting Professional & Ethical Standards Board Limited 2010). Conclusion
The IASB has much to consider when creating new accounting standards. As discussed, in following the accounting standard-setting process, accounting theory – both positive and normative – would be useful to the IASB to make sense of current issues within the accounting profession. It would not be advisable for the IASB to solely rely on one theory, as both theories have their limitations. Regulatory theory also has a relationship with standard-setting, and while numerous professionals and academics argue in favour of a free-market approach, the IASB must consider their responsibility to the public. Finally, it is important to note that it is the professional duty of acco untants to comply with the standards set by the IASB . Regardless of their opinions, or those of their clients, the standards must be adhered to in order for accountants fulfil their responsibility to act in the public’s best interests.
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