Financial accounting theory

Question:

"The accounting profit figure is simply a measure of the true profit of an organisation."

Required: Discuss this statement, ensuring in doing this you explicitly reflect on how you have begun to think critically about different aspects of this statement during the learning you have done for this module.

Word count Part 1 = 325

Word count Part 2 = 888

Total word count = 1213

Why would a manager adapt different accounting policies in different circumstances? What does even an unqualified financial statement really tell us? Should accounting and accountants be regulated?

Not even 3 month ago, these questions were the last on my list when thinking about my first reflective piece, and even if I had considered them more extensively I doubt I had identified any relevant connections to the "accounting profit figure". Instead of focusing on the "why" I was more occupied with identifying the "how" and "what", taking a very shallow approach to the topic without considering the underlying reasons for manager's choices.

I see now that financial statement analysis doesn't end at looking at the income statement, but much rather begins at this point. The difference between this and actually investigating the context of the figures is much like the "difference between just taking at will what somebody tells you and actually validating what they are saying". (Anderson-Gough, et al., 2003)

In this essay, I would like to focus my discussion on the question whether there is a "true profit figure" and analyse this idea in the light of a "contracting perspective" of the Positive Accounting Theory (PAT) and its explanation for the choice of different "accounting policies", with a focus on the "agency theory".

PAT is, much like the name suggests, a positive approach, rather describing than prescribing (the normative approach) accounting practises in general. Instead of focusing on how certain techniques can be used to change accounting figures (as I did it in my first piece) "PAT is designed to explain and predict which firms will (or will not) use a particular method" (Watts & Zimmerman; 1986).

At first, this was rather surprising and seemed a bit futile to me. However, I soon realized that this tackles the true underlying issue of why different measures would be used and ultimately different profit figures will be found by different managers.

The contracting perspectives of PAT are based on the "agency theory" (Jensen & Meckling, 1976), which states that the managers (agents) and the shareholders (principals) pursue both self-interest maximisation, these might however not always coincide. The agent might use the information asymmetry that exists between him and the principle to pursue his own objectives instead of maximising the principals' wealth. (Deegan & Unerman, 2006)

Source: Lecture slides FAG

These costs resulting of this are referred to as agency costs, which can be decreased my different measures, such as employing auditors to monitor the agent's actions and assure the principals of the validity of the information contained in the financial statements.

This aspect of the relationship made me very curious, as I intend to qualify as an ACA myself some day. Especially the fact that auditors themselves only know parts encouraged me to think further, as this would mean that even an unqualified financial statement was still to a certain degree determined by the choice of the managers accounting methods (i.e. what is supposed to best represent the underlying business activity).

Can an auditor therefore really assure anybody, especially if in addition his remuneration depends on the outcome of the audit? The big conflict seemed to me that on the one hand as an auditor an extremely good insight into the companies' operations is needed (be employed by the company) and on the other hand complete independence in terms of payment from the company is essential (employed and paid by the state, not related to the outcome of the audit).

Agency costs can also be decreased by aligning the agent's interests with those of the principals, e.g. through a bonus plan:

This kind of alignment mechanism is often based on accounting figures such as the "profit figure" and this is where we return to our initial topic. As most accounting theories, PAT is based on Adam Smith's "Rational Economic Man"-theory (self-interest maximisation) and the "Management Compensation Hypothesis" therefore predicts, that if a manager's income is tied to reported profit, then he is more likely to use profit-increasing accounting methods.

The "Debt Hypothesis" states that a company that comes close to breaking its debt covenants restrictions will try to relax these by overstating income.

Ultimately, the "Political Cost Hypothesis" explains that large firms are more likely than small firms to use profit reducing methods, as this will cast less political attention on them. (Deegan & Unerman 2006)

They therefore all suggest, that especially in large companies, the profit figure rarely represents "the truth", should there even be one. This especially fascinated me, as without making any great "reality-distorting assumptions", it shows how much accounting figures (and especially profit) are influenced by contextual circumstances.

However, I still believe that the accounting profit is still simply a measure of the profit, and nothing more! The fact that many people regard it as a universal measure of the performance of a company could be explained by the fact that often the media when reporting on TV is focusing on the profit figures of companies without even mentioning the accounting methods used to calculate these. The media is therefore not only mirroring but also shaping public priorities (Deegan & Unerman, 2006).

Reading through my first piece and further thinking about the question, I feel that instead of having answered all my questions, "Accounting in Context" raised many more unanswered questions: "? If accounting figures are that often distorted, how much can we really rely on them? Or does the market realize these distortions and adjusts to them? "

Bibliography

  • Deegan, C., & Unerman, J. (2006). Financial Accounting Theory (European Edition ed.).
  • Anderson-Gough, F., Hoskin, K., & Lucas, U. (2003). Between Workplace and Qualification: Engineering Integrative Learning.
  • Jensen, M. C. (1976). Theory of the firm: Managerial behavior, agency costs and ownership structure. Journal of Financial Economics .
  • Smith, A. (1776). The Wealth of Nations.
  • Watts, R., & Zimmerman, J. (1986). Positive Accounting Theory.

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