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3100 week2

Topic 2: The Recording Process


Entities need to record transactions and events that occur during a period to enable them to
prepare financial statements. There are two methods that underlie the recoding process:
1. Cash accounting = records revenues/expenses at the time cash is received or paid
cash flow may be in a different period to when the original transaction occurred
2. Accrual accounting = records revenues/expenses when the transaction occurs
regardless of whether cash has been received/paid (also includes non-cash expenses)

The Accounting Cycle


Identify measure/record communication
1. Identifying transactions source documents (inputs) = evidence the transaction has
occurred (receipts, invoices etc.)
2. Measuring/recording transactions accounting books (processing)
a. Journals: journalising = the process of entering transaction data into the journal
- Separate entries are made for each transaction
- Must include the date, accounts and amounts, narration
- Single entry (two accounts), compound journal entry (three +)
b. Ledgers
- Individual accounting record increases/decreases of specific element
- T format (balanced on balance day) or three column format (running balance)
- Accounting numbering: logical sequence for easy location of relevant accounts
Chart of Accounts = numbered index
- (A1, L2, OE3, R4, E5), current (0-50) non-current (50-100)
- Gaps are left in the numbering system to permit the insertion of new accounts
as needed during the business life
- Post Ref column
Journal = ledger account number found in the Chart of Accounts Ledger =
record the source of transaction (e.g. General journal page 1 GJ1)
c. Trial balance
- List of accounts and their balances at a given time
- Purpose: debits = credits
- Uncovers errors in journalising and posting (double check)
- May balance but still have errors: omitting a transaction, recorded more than
once, debit and credit reversed, a debit/credit posted as a debit/credit to the
wrong account
d. Adjusting journal entries
e. Closing journal entries
f. Post-closing trial balance

Communication financial information financial statements (output)


Accounting Theory a description, explanation or a prediction [of accounting practice] based
on observations and/or logical reasoning. Logical reasoning in the form of a set of broad
principles that provide a general framework of reference by which accounting practice can be
evaluated and guide the development of new practice and procedures

Normative Theories recommend what should happen. Prescribe action to achieve specific
objectives. (e.g. The Conceptual Framework prescribes the objective of financial reports and
the qualitative characteristics of information)
Positive Theories describes, explains or predicts activities. Help us understand what happens
in the world. Based around Hypotheses Also called empirical theories. (e.g. Agency theory
claims that self-interests drive managers to engage in opportunistic financial reporting)

Contracting Theory suggests that the organisation is characterised as a legal nexus of


contracts. (firm have contractual relationships with various parties)
Assumption: rational economic person (self-interest wealth maximization)

Agency Theory used to understand relationships whereby a principal employs the services
of, and delegates the decision making authority to, an agent.
Assumption: rational economic person (self-interest wealth maximization)

Institution Theory considers how rules, norms and routines become established as
authoritative guidelines, and considers how these elements are created, adopted and adapted
over time.

Legitimacy Theory base on the idea of a Social Contract. Relates to the explicit and implicit
expectations society has about how businesses should act to ensure they survive into the
future.

Stakeholder Theory considers the relationships that exist between the organisation and its
various stakeholders.
The normative branch of stakeholder theory relates to the ethical or moral treatment of
organizational stakeholders. It is argued that organizations should treat all stakeholders fairly,
and the organization should be managed for the benefit of all stakeholders.

The managerial branch of stakeholder theory is a positive theory that seeks to explain how
stakeholders might influence organizational action. Rather than considering each stakeholder
as equal (as is the case under the normative branch), the managerial branch proposes that the
extent to which an organization will consider its stakeholders is related to the power or
influence of those stakeholders, with executives managing these competing interests.
Owner-Manager Agency Relationship
- As previously mentioned, separation of ownership and control means that managers
as agents, are likely to act in their own interest and these actions might not necessarily
align with the principals or owners interests.
- Horizon Problems: Managers and shareholders tend to have differing time horizons in
relation to the entity. This is known as the horizon problem. The problem that arises
here is that investors (shareholders) are interested in the future cash flows of the firm,
as that is the underlying value of their share, but managers are only interested in cash
flows and generating profit for as long as they are employed.
- Risk Aversion: Managers generally prefer less risk than shareholders. Shareholders
are not likely to hold all their resources as shares in only one entity. They are able to
diversify their risk through investing across multiple entities, cash or property
investments. This means shareholders have been able to hedge or minimise the risk
that they have invested. As a managers ownership of the firm increases so does their
risk aversion, as it further decreases the managers ability to decrease their risk as
they are more and more tied to the entity (through human capital investment and share
investment)
- Dividend Retention: Managers when compared to shareholders, prefer to maintain a
greater level of funds within the entity, and pay less of the entitys earnings to
shareholders as dividends. This is known as the dividend retention problem.
Managers wish to retain money within the business to expand the size of the business
they control and to pay their own salaries and benefits. Shareholders, however, wish
to maximise their own wealth and receive dividends more frequently, or be of a
higher yield.
Manager-Lender Agency Relationships
- When a lender agrees to provide funds to an entity there is the risk that the lending
party may not repay those funds. Agency theory has also been used to understand the
relationship between lenders and management.
- Excess Dividend Payments: When lending funds, lenders price the debt to take into
account an assumed level of dividend payout. If managers issue a higher level of
dividend, or excessive dividend payment, this could lead to a reduction of the asset
base securing debt or leave insufficient funds with in the entity to service the debt. As
a result, there is an agreement in place between the managers and the lenders to
restrain dividend policy and restrict payouts.
- Underinvestment: Is an agency problem that arises when managers, on behalf of the
owners, have incentives not to undertake positive NPV project if the project would
lead to increased funds being available to lenders. This may be the case when an
entity is in financial difficulty. Creditors can rank above owners in order of payment
in the even an entity liquidates and any funds from these projects would go towards
debt rather than equity.
- Asset Substitution: Lenders, determine the interest rate and term of the loan in
accordance with the risk level of the asset or project the entity is borrowing funds to
invest in, they are lent these funds on the assumption that managers will not invest in
projects that exceed the agreed upon level of risk. Lenders bear the risk of this
strategy as they are subject to the downside risk, but do not share in any upside of the
investment decision.
- Claim Dilution: When entities take on debt of a higher priority than that on issue it is
referred to as claim dilution. While taking on additional debt increases funds
available to the entity, it decreases the security to lenders, making the lending riskier.
The most common method of avoiding claim dilution is to restrict the borrowing of
high priority debt, or debt with an earlier maturity date.
Role of Accounting Information in Reducing Agency Problems
- Terms are written into managerial remuneration contracts to link managers
performance to shareholders interests. Bonuses can be tied to measures or entity
financial performance or share performance. Accounting information plays two roles
in the contracting process;
1. To write the terms of managerial contracts
2. Determine performance against the terms of the contracts and consequently the
amount of bonus and other pay components managers will receive.
Information Asymmetry
- In addition to accounting information being used as part of the contracting process, it
is also commonly provided in order to reduce information asymmetry. Information
asymmetry result from managers having an advantage over investors and other
interested parties as they have more information about the current and future
prospects of the entity, and can choose when and how to disseminate this information.
Information asymmetry is likely to influence corporate disclosure policy as entities
are likely to be concerned about their reputation and the impact on the entity if they
fail to disclose pertinent information.

2.22 agency problem-----Manager-Shareholder


shareholder manager solutions
Horizon long-term short term Give shares or
growth and profit options
future cash
flow Link managerial pay
to share price
movements


Risk Prefer risks Prefer less Profit based
aversion risk than measurement
shareholder
Share based
compensation
Dividend prefer prefer Link bonuses to
retention receive retain dividend payout ratio
dividend profit

Link
bonuses to
profits

2.23 agency problem-----Manager-Lender


Excessive dividend
payments Shareholders love
dividend, so managers distribute excessively
Lenders are concerned with firms
paying too much dividend: cash , asset,
default risk
Underinvestment debtor

Managers, on behalf of owners, have
incentives not to invest in positive NPV
projects that can increase funds available to
lenders




200
50% 15050%

shareholders

Asset substitution lender
downside
Managers choose riskier investment to
maximize shareholder returns
Lenders bear the downside risk, but do
not share upside benefits of such riskier
investments (the repayment to lenders is
fixed)


Manager

lender
Claim dilution
Increase borrowing from higher
priority debt can reduce security to lenders
Solution

2.24 Accounting information agency problems?


- manager performance
- stakeholder creditor shareholder
manager
3. Institutional theory comes from management literature

4.legitimacy theory
Base on the idea of a Social contract ----Societys expectation about how
business should act


Organisations need to show they are acting in accordance with that expectation
legitimacy(Lindblom,1994) ( week 2 lectureS25 )

5. Stakeholder Theory
Stakeholder theory
definition Considers the relationships that exist between the organisation and
its various stakeholders
Normative branch (ethical branch) Managerial branch
Manager shareholders Stakeholder
stakeholder The extent to which an organisation will
Argues that organisations should consider its stakeholders is related to the
treat all their stakeholders fairly. power or influence of those
An organisation should be managed stakeholders.
for the benefit of all its stakeholders
Manager
stakeholder
report





Key hypotheses of agency theory


Bonus plan hypothesis
Managers are often rewarded based on accounting profit bonus. Such bonus is introduced to
align the interests of the managers with owners (Shareholders). The bonus plan hypothesis
predicts that managers who are rewarded based on accounting profit bonus are more likely to
select accounting methods that increase profit and that this will lead to an increase in the bonus.

Debt hypothesis
The higher the firms debt/equity (Debt covenant) ratio, the more likely managers use
accounting methods that increase income.

Political cost hypothesis


Large firms rather than small firms are more likely to use accounting choices that reduce
reported profits. Political costs arise because a firm has a high public profile and is deemed to
be an appropriate "target" for political action that transfers wealth away from the firm. Such
as increasing tax and salaries.

1) Theories focus on disclosure in social reporting (voluntary disclosures):


Legitimacy Theory
Legitimacy theory predicts that firms will undertake various actions to ensure that they operate
in a manner consistent with the norms and expectations of the community. That is, that they
comply with the social contract. Hence, various social responsibility disclosures will be made
in an effort to legitimise the ongoing existence of the organisation. Society allows the
organisation to continue operations to the extent that it meets their expectations. The
organisation may find it difficult to obtain the necessary support and resources to continue
operations if they do not meet social contract.

Social Contract
Social contract is considered to be an implied contract that the various expectations held by
society as to how an organisation should conduct its operations. Failure to comply with these
expectations is considered to be detrimental to the operations of the organisation.

Stakeholder Theory
There are two branches of stakeholder theorythe Managerial (or Positive) branch and the
Ethical (or Normative) branch.

The managerial branch of stakeholder theory suggests that managers will attempt to manage the
relationship with various stakeholders to ensure that the interests of the organisation are best
achieved. The more important the stakeholder is to the organisation achieving its goals, the more
effort will be spent in managing the relationship. The disclosure of information is considered to
represent an important strategy in managing the relationship. Not all stakeholder groups will be
treated equally and some rights might be ignored if they are not important to the organisations
operations. The disclosure of information is considered to manage powerful stakeholder groups.
The needs of powerful stakeholders are above the needs of other parties. If the powerful
stakeholders expect social responsibility disclosures then the firm is predicted to make them.
Example of powerful stakeholders as below:
Investors/owners investors, and particularly institutional investors have power
through the provision of equity funds, and their role in appointing the board of directors.
Some investors will have more power or influence than others,
Trade unions these bodies oversee the terms and conditions provided to the labour
forces employed by entities. They are in a position to significantly impact on the
ongoing operations of the organisation

The ethical (or normative) branch of stakeholder theory is concerned with prescribing how
management should act with regards to its various stakeholder groups. The ethical branch of
stakeholder theory is very much concerned with the responsibilities of an organisation. This
branch will argue that all stakeholders should benefit from the existence of an organisation and
the rights and interests of one class (for example, shareholders) should not dominate the rights or
interests of others. All stakeholders have a right to have information about how the organisation
is impacting them (Such as pollution from the organisation), even if they cannot directly impact
the survival of the organisation. Hence, under this branch, social responsibility disclosures are
made in response to an ethical responsibility, rather than in response to maximise wealth of
powerful parties.

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