BBAT4103 Accounting Theory PDF

BBAT4103
ACCOUNTING
THEORY
Sabrina Chong Yee Ching
Prof Ong Tze San
Copyright Open University Malaysia (OUM)
Project Directors:
Prof Dato Dr Mansor Fadzil

Prof Dr Wardah Mohamad
Open University Malaysia
Module Writers:
Sabrina Chong Yee Ching

Prof Ong Tze San
Moderators:
Assoc Prof Dr Wan Fadzilah Wan Yusoff

Universiti Tenaga Nasional
Noral Hidayah Alwi
Developed by:
Centre for Instructional Design and Technology

Printed by:
Meteor Doc. Sdn. Bhd.

Lot 47-48, Jalan SR 1/9, Seksyen 9,
Jalan Serdang Raya, Taman Serdang Raya,
43300 Seri Kembangan, Selangor Darul Ehsan
First Edition, August 2008

Second Edition, December 2015
Copyright Open University Malaysia (OUM), December 2015, BBAT4103
All rights reserved. No part of this work may be reproduced in any form or by any means without
the written permission of the President, Open University Malaysia (OUM).
Table of Contents
Course Guide
xiiixviii
Topic 1
Introduction to Accounting Theory

1.1 The Nature of Accounting Theory
1.1.1 What is a Theory?
1.1.2 Why Accounting Theory?
1.2 The Formulation of Accounting Theory
1.2.1 How is a Theory Formulated?
1.2.2 How is a Theory Tested?
1.3 The Role of Accounting
1.4 The Developments in Accounting Theory
1.4.1 Accounting Theory Timeline
Summary
Key Terms
Self-test 1
Self-test 2
1
2
3
3
4
4
6
7
12
13
15
16
16
17
Topic 2
Historical Development of Accounting

2.1 Pragmatic Approaches
2.1.1 What is a Pragmatic Relationship?
2.1.2 Descriptive Pragmatic Approach
2.1.3 Psychological Pragmatic Approach
2.2 Normative Approach
2.2.1 What are Normative Theories?
2.2.2 What is True Income?
2.2.3 What is Decision-usefulness?
2.2.4 Criticisms of Normative Approach
2.2.5 A Shift towards Empiricism
2.3 Positive Approach
2.3.1 What are Positive Theories?
2.3.2 How are Positive Theories Developed and Tested?
2.3.3 Main Differences between Normative and
Positive Theories
2.3.4 Criticisms of Positive Approach
2.4 Behavioural Approach
2.4.1 What are Behavioural Theories?
2.4.2 Why is Behavioural Approach Important?
2.4.3 Defining Human Judgement Theory (HJT)
2.4.4 Limitations of BAR
18
19
19
20
21
21
21
22
22
22
22
23
23
23
24
24
25
25
25
26
30
iv
Topic 3
Topic 4
TABLE OF CONTENTS
Summary
Key Terms
Self-test 1
Self-test 2
30
31
31
32
Paradigms in Accounting Research

3.1 The Definition of Paradigm
3.2 Paradigms: Advantages and Disadvantages
3.2.1 Paradigms Comparison
3.3 Functionalist Paradigms Substitutes In Accounting Research
3.4 Homogeneity Of Different Paradigms
3.4.1 Normative Approach
3.4.2 Positive Approach
3.4.3 Behavioural Approach
3.5 Inter-Paradigmatic Communication Challenge in
Accounting Research
3.6 Inter-Paradigmatic Dialogue by Mixed Method Research
Summary
Key Terms
Self-Test 1
Self-Test 2
33
34
36
37
37
38
39
39
39
40
Conceptual Framework and Standard Setting Process

4.1 What is a Conceptual Framework?
4.1.1 Objectives of the Conceptual Framework
4.1.2 Reasons for a Conceptual Framework
4.1.3 The Development of a Conceptual Framework
for Financial Reporting
4.2 The International Accounting Standard Board
(IASB) Framework
4.2.1 Background of the Proposed Framework by
the Malaysian Accounting Standard Board (MASB)
4.3 Arguments For and Against the Conceptual Framework
4.4 The Structure of the Conceptual Framework
4.4.1 Objective of Financial Statements
4.4.2 Qualitative Characteristics
4.4.3 Underlying Assumptions
4.4.4 Constraints
4.4.5 The Elements of Financial Statements
(Definition, Recognition and Measurement)
4.5 Standard-setting Process
4.5.1 Accounting Standard and the Needs for
Accounting Standards
44
46
47
48
48
41
42
42
43
43
51
51
52
53
54
56
60
61
62
64
64
TABLE OF CONTENTS
4.5.2
4.5.3
4.5.4
Issues in Standard Setting

Due Process of Standard-setting in Malaysia
Overview of FRS and the Adoption of FRS
in Malaysia
64
66
68
Summary
Key Terms
Self-test 1
Self-test 2
71
72
72
74
Topic 5
Earnings Measurement and Creative Accounting

5.1 Overview of Earnings Management
5.2 Patterns of Earning Management
5.3 Evidence of Earning Management for Bonus Purposes
5.4 Motivations for Earnings Management
5.5 The Advantages and Disadvantages of Earning Management
5.6 Creative Accounting
5.6.1 Local and Foreign Cases of Creative Accounting
Summary
Key Terms
Self-test 1
Self-test 2
76
77
77
78
79
80
81
83
86
86
86
86
Topic 6
Recognition of Issues Associated with Assets and Liability

6.1 What are Assets?
6.1.1 Types of Assets
6.1.2 Definition
6.1.3 Recognition Criteria
6.2 What is Liability?
6.2.1 Types of Liabilities
6.2.2 Definition
6.2.3 Recognition Criteria
6.3 Measurement
6.3.1 Why Measurement Matters?
6.3.2 What Do We Measure?
Summary
Key Terms
Self-test 1
Self-test 2
87
88
88
90
92
93
93
94
96
97
97
98
101
102
102
103
Topic 7
Recognition of Issues Associated with Profit,

Revenue and Expense
7.1 What is Profit?
7.1.1 Definition of Profit
105
106
107
vi
Topic 8
TABLE OF CONTENTS
7.1.2 Accounting View Versus Economic View of Profit

7.2 Nature of Revenue
7.2.1 Definition of Revenue
7.2.2 Recognition of Revenue
7.3 Nature of Expense
7.3.1 Definition of Expense
7.3.2 Recognition Criteria and Matching
Summary
Key Terms
Self-test 1
Self-test 2
109
110
110
111
116
116
116
122
123
123
124
Realibility and Relevance Issues

8.1 Reliability and Relevance
8.2 Qualitative Characteristics of Accounting Information
8.3 Definition and Mechanism of Relevance and Reliability
8.3.1
Relevance
8.3.2
Reliability
8.4 Trade Off: Relevance and Reliability
8.5 Challenges on Reliability and Relevance
8.6 Fair Value Measurements and its Caveats
8.7 Historical Cost Accounting
8.7.1
Principal Assumptions of Historical
Cost Accounting
8.7.2
Reasons For Dominance of Historical Cost
Accounting
8.7.3
Criticisms of Historical Cost Accounting
8.7.4
Historical Cost Under Attack
8.8 Current Cost Accounting
8.8.1
The Nature of Current Cost Accounting
8.8.2
Valuation Principles Under Current
Cost Accounting
8.8.3
The Criticisms of Current Cost Accounting
8.9 Exit Price Accounting
8.9.1
The Nature of Exit Price Accounting
8.9.2
In Support of Exit Price Accounting
8.9.3
Criticisms of Exit Price Accounting
8.9.4
Current Cost versus Exit Price
Summary
Key Terms
Self-test 1
Self-test 2
125
126
126
128
128
129
130
131
133
135
135
136
136
138
139
139
140
141
142
142
142
144
145
145
147
147
147
TABLE OF CONTENTS
Topic 9
Topic 10
vii
Specifics Issues
9.1 International Financial Reporting Standards
9.2 Accounting Standards Influences on Related Parties
9.3 Economic Consequences of Standards
9.4 Advantages and Disadvantages of Financial
9.4.1
Advantages
9.4.2
Disadvantages
9.5 Recent Empirical Researches on the Economic
Consequences of IFRS Adoption
9.6 Philosophy of Positive Accounting Theory
9.7 The Efficient Market Hypothesis
9.8 Capital Market Research
9.8.1
The Impact of Accounting Profits
Announcement on Share Prices
9.8.2
Mechanistic or Behavioural Effect
9.9 What is a "Legal Nexus of Contract?"
9.9.1
Defining Legal Nexus of Contracting Relationship
9.9.2
Contracting Theory and Coases Argument
9.10 Agency Theory
9.10.1 What is an Agency Relationship?
9.10.2 Defining Agency Cost
9.11 Manager-Shareholder Agency Relationship
9.11.1 What is Bonus Plan Hypothesis?
9.12 Shareholders/Managers Debt-Holders
Agency Relationship
9.12.1 Purpose of a Debt Contract
9.12.2 What are Debt Covenants?
Summary
Key Terms
Self-test 1
Self-test 2
148
149
150
152
153
Social and Environmental Reporting

10.1 Social and Environmental Reporting
10.1.1 Traditional Financial Reporting versus
Alternative View Reporting
10.1.2 Defining Social and Environmental Reporting
10.2 What is Corporate Social Responsibility (CSR)?
10.2.1 Definition of CSR
10.2.2 Factors Motivating CSR
10.3 Theoretical Understanding of Social and
Environmental Issues
179
180
180
153
154
155
156
159
160
160
161
162
164
166
166
167
169
172
173
176
176
176
177
178
178
181
183
183
183
184
viii
TABLE OF CONTENTS
10.4 Voluntary Reporting

10.4.1 International Guidelines for Social
and Environmental Disclosure
10.4.2 Corporate Environmental Reporting (CER)
in Malaysia
10.5 What is Triple-Bottom-Line (TBL) Reporting?
10.6 Measurement Issue
Summary
Key Terms
Self-test 1
Self-test 2
187
187
Topic 11
Other Current Issues in Financial Reporting

11.1 Online Reporting and XBRL
11.2 Performance Reporting
11.3 Management Commentary
11.4 Human Resource and Intellectual Capital
Summary
Key Terms
Self-test 1
Self-test 2
195
196
197
200
202
202
203
204
204
Topic 12
Islamic Accounting
12.1 Meaning of Islamic Accounting
12.2 Objectives of Accounting in Islamic Methodology
12.3 Features of Accounting in Islamic Methodology
12.4 ClassificationS of Accounting in Islamic Methodology
12.5 Principles of Accounting in Islamic Methodology
12.5.1 Accounting Entity/Unit
12.5.2 Going Concern Concept
12.5.3 Accounting Period Concept
12.5.4 Unit Measurement Concept
12.6 Accounting and Auditing OrganiSation for Islamic
Financial Institutions
Summary
Key Terms
Self-test 1
Self-test 2
205
206
207
209
210
211
211
212
212
212
213
187
189
190
192
193
193
194
214
215
215
215
TABLE OF CONTENTS
Topic 13
ix
Comprehensive Cases
13.1 Case 1: Ethics in Accounting
13.1.1 Key Fundamental Principles
13.1.2 Possible Actions
13.2 Case 2: Internal Auditor Function in Fraud Detection
13.3 Case 3: Successful People are Not a Mystery; They
Just Use the Right Chemistry
13.4 Case 4: Big Bath in China, Accounting and
Corporate Governance
13.5 Case 5: Financial Turnaround of Indian Railways (B)
Key Terms
Self-Test 1
Self-Test 2
216
216
217
217
217
218
Answers
239
References
Self-test 1
Self-test 2
268
238
238
222
229
237
238
238
xxvi
X COURSE ASSIGNMENT GUIDE
COURSE GUIDE
COURSE GUIDE DESCRIPTION

You must read this Course Guide carefully from the beginning to the end. It tells
you briefly what the course is about and how you can work your way through
the course material. It also suggests the amount of time you are likely to spend in
order to complete the course successfully. Please keep on referring to the Course
Guide as you go through the course material as it will help you to clarify
important study components or points that you might miss or overlook.
INTRODUCTION
BBAT4103 Accounting Theory is one of the courses offered by the OUM Business
School at Open University Malaysia (OUM). This course is worth 3 credit hours
and should be covered over 8 to 15 weeks.
COURSE AUDIENCE
This is a core course for all learners undertaking the Bachelor of Accounting
programme.
As an open and distance learner, you should be acquainted with learning
independently and being able to optimise the learning modes and environment
available to you. Before you begin this course, please ensure that you have the
right course material, and understand the course requirements as well as how the
course is conducted.
STUDY SCHEDULE
It is a standard OUM practice that learners accumulate 40 study hours for every
credit hour. As such, for a three-credit hour course, you are expected to spend
120 study hours. Table 1 gives an estimation of how the 120 study hours could be
accumulated.
xiv
COURSE GUIDE
Table 1: Estimation of Time Accumulation of Study Hours

Study Activities
Study
Hours
Briefly go through the course content and participate in initial discussion
Study the module
60
Attend 3 to 5 tutorial sessions
10
Online participation
12
Revision
15
Assignment(s), Test(s) and Examination(s)
20
TOTAL STUDY HOURS
120
COURSE OUTCOMES
By the end of this course, you should be able to:
1.
Discuss accounting theory, major theoretical accounting frameworks and

the purpose of accounting theory;
2.
Evaluate the development of accounting;
3.
Assess the various paradigms in accounting research;
4.
Discuss the accounting profession based on the conceptual framework and

the accounting standard-setting process.
5.
Examine the issues related to earning management and creative accounting;
6.
Discuss the issues of measurement in accounting with regards to assets and

liabilities recognition;
7.
Analyse issues associated with profit, revenue and expense;
8.
Evaluate the reliability and relevance issues in accounting;
9.
Critically comment on the economic consequences of accounting standards;
COURSE GUIDE
xv
10.
Explain various current issues in financial reporting such as social and

environmental reporting;
11.
Discuss the issues relating to online reporting and XBRL
12.
Explore the issues relating to Islamic accounting; and
13.
Critically analyse case studies with regards to accounting issues.
COURSE SYNOPSIS
This course is divided into 13 topics. The synopsis for each topic can be listed as
follows:
Topic 1 explores the accounting theory and accounting practices. The topic also
discusses the developments in accounting theory and the role of accounting.
Topic 2 begins with the historical development of accounting which includes an
overview of the past, present and future directions of accounting.
Topic 3 deals with paradigms in accounting research. Issues relating to different
paradigms, functionalism of paradigms, homogeneity of paradigms, interparadigms and using mixed method for paradigms dialogues are also
demonstrated.
Topic 4 discusses the attempts by the accounting profession to position
accounting based on conceptual frameworks. The standard-setting process is
discussed extensively at the end of this topic.
Topic 5 discusses issues of earning measurement and creative accounting. It also
explains some of the practical cases in earning management, its consequences
and effects in Malaysia.
Topic 6 deals with recognition of issues associated with assets and liability. The
topic examines the impact of the recognition criteria on assets and liabilities and
the value in the measurement of assets and liabilities.
Topic 7 looks at the recognition of issues associated with profit, revenue and
expense. The topic also discusses the impact of uncertainty on profit
determination.
xvi
COURSE GUIDE
Topic 8 deals with reliability and relevance issues in accounting. It provides the
definition of relevance and reliability. The justification for the trade-off between
reliability and relevance is also discussed. Finally, the challenges posed to
qualities of accounting information are reviewed.
Topic 9 explores the economic consequences of accounting standards. This topic
begins with the definition of accounting standards as well as its benefits and
costs. Next, it discusses the effects of accounting standards on related parties.
Finally, this topic ends with a discussion on the empirical evidence of accounting
standards adoption.
Topic 10 explains social and environmental responsibility reporting. The topic
also discusses the theoretical model to the development of social and
environmental issues; elaborates the measurement issues pertaining to the social
and environmental reporting and triple bottom line reporting.
Topic 11 elaborates on the current issues in financial reporting. Issues discussed
include corporate social environmental reporting, online reporting and the
eXtensible Business Reporting Language, performance reporting, management
commentary, human resource and intellectual capital.
Topic 12 discusses aspects related to Islamic accounting. The subtopics include
objectives of Islamic accounting, principles of Islamic accounting, classifications
of Islamic accounting and the role of accounting and auditing organisations for
Islamic financial institutions.
Topic 13 includes comprehensive case studies so that students can encapsulate
their learning from the earlier topics for this course. This topic mainly focuses on
issues relating to earnings management and integrity as well as ethics in the
accounting profession.
TEXT ARRANGEMENT GUIDE

Before you go through this module, it is important that you note the text
arrangement. Understanding the text arrangement should help you to organise
your study of this course in a more objective and effective way. Generally, the
text arrangement for each topic is as follows:
Learning Outcomes: This section refers to what you should achieve after you had
completely covered a topic. As you go through each topic, you should frequently
refer to these learning outcomes. By doing this, you can continuously gauge your
understanding of the topic.
COURSE GUIDE
xvii
Self-Check: This component of the module is inserted at strategic locations

throughout the module. It may be inserted after one sub-section or a few subsections. It usually comes in a form of a question. When you come across this
component, try to reflect on what you have already learnt thus far. By attempting
to answer the question, you should be able to gauge how well you have
understood the sub-section(s). Most of the time, the answers to the questions can
be found directly from the module itself.
Activity: Like Self-Check, the Activity component is also placed at various
locations or junctures throughout the module. This component may require you
to solve questions, explore short case studies or conduct an observation or
research. It may even require you to evaluate a given scenario. When you come
across an Activity, you should try to reflect on what you have gathered from the
module and apply it to real situations. You should, at the same time, engage
yourself in higher order thinking where you might be required to analyse,
synthesise and evaluate instead of just having to recall and define.
Summary: You will find this component at the end of each topic. This component
helps you to recap the whole topic. By going through the summary, you should
be able to gauge your knowledge retention level. Should you find points in the
summary that you do not fully understand, it would be a good idea for you to
revisit the details from the module.
Key Terms: This component can be found at the end of each topic. You should go
through this component to remind yourself of important terms or jargon used
throughout the module. Should you find terms here that you are not able to
explain, you should look for the terms in the module.
References: The References section is where a list of relevant and useful
textbooks, journals, articles, electronic contents or sources can be found. This list
can appear in a few locations such as in the Course Guide (at the References
section), at the end of every topic or at the back of the module. You are
encouraged to read and refer to the suggested sources to obtain the additional
information needed as well as to enhance you overall understanding of the
course.
PRIOR KNOWLEDGE
Learners of this course are required to pass the BBFA1103 Introductory
Accounting course.
xviii
COURSE GUIDE
ASSESSMENT METHOD
Please refer to myVLE.
REFERENCES
Larson, K. D., Wild, J. J., & Chiappetta, B. (Omar, R., Hassan, H., Sulaiman, A.J.,
and Mohamad, L.) (2005). Accounting Principles. Malaysia: McGraw-Hill.
Lerner, J. L. & Cashin, J. M. (1998). Schaums outline of theory and problems of
principles of accounting 1 (5th ed.). Black Lick, OH: McGraw-Hill.
Loh, B. F. & Ng, K. H. Principles of accounts. Singapore: Longman/Pearson
Education Asia.
Lazar, L., Arshad, R., & Choo. (2006). Financial reporting an introduction.
Malaysia: McGraw-Hill.
Ng, E. (2009). A practical guide to financial reporting standards, Malaysia.
Singapore: CCH.
Stice, E. K., Stice, J. D., and Skousen, K. F. (2004). Intermediate Accounting (15th
ed.). Mason, OH: Thompson South-Western.
Tan, L. (2000). Financial accounting & reporting in Malaysia, Volume 1 (2nd ed.).
Malaysia: PAAC.
Tan, L. (2000). Financial accounting & reporting in Malaysia, Volume 2 (2nd ed.).
Malaysia: PAAC.
Thomson, A. (2006). Introduction to Financial Accounting. (5th ed.). Singapore:
McGraw Hill Education Asia.
Wood, F., & Sangster, A. (2002). Business accounting 1 (9th ed.). Great Britain:
Financial Times/Pearson Education.
Raymond A. Serway & John W. Jewett Jr, (2002). Principles of Physics: A
calculus-based text, Singapore: Thomson Learning.
Welcome To ICAEW.Com (2015). Retrieved from http://www.icaew.com
Topic Introduction to
Accounting
Theory
LEARNING OUTCOMES
By the end of this topic, you should be able to:
1. Explain the nature of accounting theory and its accounting contexts;
2. Differentiate between deductive and inductive approaches to theory
formulation;
3. Discuss the roles of accounting; and
4. Describe the development of accounting theory.
INTRODUCTION
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 thinking.
Chambers (1963)
Let us consider these scenarios:
Why do apples fall from tree?

Why do changes in total spending in an economy have the greatest short
term impact on real output and employment?
Why is intellectual capital not recognised on the balance sheet?
TOPIC 1 INTRODUCTION TO ACCOUNTING THEORY
In order to answer the above questions, we would probably refer to the theory of
gravity (as shown in Figure 1.1), the Keynesian theory of money and accounting
theory respectively.
Figure 1.1: Theory of gravity
So, why do we have such high regard towards these theories for their powers of
explanation and prediction? In fact, what is a theory? Why is accounting theory
important to accounting?
Accounting standard setters have been, for a long time, trying to develop a
theoretical framework that would provide a more consistent treatment of like
items. However, instead of resolving the inconsistencies in practice, the
frameworks have often been used to justify or support such inconsistencies. In
addition, such frameworks are universal guidances, and thus are often too general
to provide a clear set of decision rules for the preparation of financial statements.
In this topic, we will look at the definition of accounting theory. Then, we will
examine the formulation of accounting theories and their significance. Lastly, we
will discuss the developments in accounting theories.
1.1
THE NATURE OF ACCOUNTING THEORY
Accounting has wide scope and area of application. Nowadays, financial

transactions are taking place everywhere, whether in business institutions or non
business institutions such as universities, charitable clubs and hospitals. So, there
is a need for recording and summarising transactions.
In this subtopic, you will learn about the accounting theory and the purposes of
these accounting theories.
1.1.1
What is a Theory?
A theory is the logical flow of argument leading from fundamental assumptions

and connected statements to final conclusions.
A theory is derived from observation of situations or events, or as a result of
logical reasoning.
Commonly, theories exist only until they are replaced by a better theory.
1.1.2
Why Accounting Theory?
The purposes of accounting theories are:

(a)
To provide a general framework of reference by which accounting practices

can be evaluated; and
(b)
To guide the development of new practices and procedures.
However, the financial world is never so simple; it is complex, unsystematic and

imprecise. Accountants are often required to impose some logical and
quantitative order on imprecise events or transactions so that they can present
the financial implications of these events or transactions. For example, in the case
of depreciation on a non-current asset, we need to make judgements on the
useful life of the asset, its residual value as well as the pattern of its usage. Thus,
objectivity and verifiability of these measurements are questionable.
The problems faced by the accountants are further complicated by the
existence of a vast number of conflicting accounting theories. In fact,
accounting theorists seem to agree not to agree (refer to Figure 1.2)!
Accounting theories are often developed from different perspectives which
lead to many interpretations of accounting practices. For example, take the
measurement issue of whether the assets and liabilities should be valued
using historical cost or current cost accounting.
Figure 1.2: Conflicting accounting theories

ACTIVITY 1.1
How does one develop a theory? How do we know whether the
theory is acceptable or not?
1.2
THE FORMULATION OF ACCOUNTING

THEORY
In this subtopic, we will discuss the different approaches of formulation of an

accounting theory.
1.2.1
How is a Theory Formulated?
There are two approaches to theory formulation:

(a)
Deductive Reasoning
Theories can be developed through deduction, that is, through reasoning
from general statements to specific statements.
Example:
(b)
Inductive Reasoning
Theories can be developed through induction that is through reasoning
from particular statements to general statements.
Example:
Here is another example of deduction and induction approaches to theory

formulation:
Deduction
Proposition 1: All companies should prepare financial reports to satisfy the
information requirements of all users of the reports.
Proposition 2: All users of financial reports are concerned about the solvency of
reporting companies.
---------------------------------------------------------------------------------------------Conclusion and
Proposition 3: All companies should prepare financial reports to report the
solvency of the companies.
Proposition 4: The solvency of all companies is indicated by the net realisable
value of their assets.
----------------------------------------------------------------------------------------------Conclusion:
All companies should measure assets at net realisable value in
their financial reports.
Induction
Proposition 1: Companies A and B will measure assets at net realisable value in
their financial reports.
Proposition 2: Companies C, D and E will measure assets at net realisable value

in their financial reports.
----------------------------------------------------------------------------------------------Conclusion:
All companies will measure assets at net realisable value in their

financial reports.
Source: Adopted from Godfrey, J., Hodgson, A., & Holmes, S. (2003)
1.2.2
How is a Theory Tested?
It is important to test a theory to determine whether it is worthy of acceptance.

Abdel-Khalid and Ajinkyas (1979) inductive-deductive cycle (as shown in Figure
1.3) is an example of a typical accounting research programme.
Figure 1.3: The inductive-deductive cycle

Source: Adopted from Godfrey, J., Hodgson, A., & Holmes, S. (2003).
The explanation of Figure 1.3 is as follows:

1.
Identify the research problem by observation (induction).
2.
Develop the conceptual and theoretical framework to resolve the

research problem.
3.
Operationalise the theoretical framework by stating the specific hypothesis

to be tested. Researchers must find a way to measure the components of the
theory and test their associations with the real world.
4.
Construct the research design or methodology of study.
5.
Implement the research design by sampling and gathering data.
6.
Analyse data in order to test hypothesis.
7.
Evaluate the results.
8.
Consider the specific limitations and constraints of the various stages of

the research.
It is important to note that the assessments of the limitations and constraints will
restart the cycle if a research problem is identified.
ACTIVITY 1.2
How does accounting affect our lives?
1.3
THE ROLE OF ACCOUNTING
Accounting affects many peoples lives. In order for accounting to be used to its
best advantage, accounting theories are developed to help us understand the
various roles of accounting (as shown in Figure 1.4).
Figure 1.4: The roles of accounting
(a)
Accounting as a Historical Record

Accounting is concerned with providing a faithful record of transactions of
a business entity. However, it is important to note that we do not view the
role of accounting as providing a valuation of the company at a particular
point in time. Based on the observation of actions of past accountants, it has
been obvious that the alignment between the principles of conservatism,
objectivity and consistency are questionable. For instance, transactions that
increase profits might be treated differently from transactions that decrease
profits.
(b)
Accounting as a Language
Accounting is a language through which management can translate
economic events and transactions into words and numbers that can be
communicated and understood by users of the accounting reports. Through
accounting, the firm can convey its financial performance, the utilisation of
the resources provided by various parties and also the details of past
transactions that had been entered into.
(c)
Accounting as Intra-corporate Politics

An accounting system reflects and supports the values and needs of special
interest groups. This means that the information is formed and used as a
resource in shaping company policies. It is also used in decision making, as
a way of enhancing and furthering the aim of management.
For example, the apparently more efficient department in a company may
use the accounting report to convince the management to increase resource
allocation to it at the expense of other departments that appear less
efficient.
(d)
Accounting Standard Setting as Politics/Political Process

Accounting standards are products of a political process rather than of an
outcome of technical efficiency. This is because managers often lobby for
accounting standards to serve their own interest and select accounting
techniques that maximise their own utility.
For example, managers will support standards that lower taxes, reduce
political and bookkeeping costs and increase management compensation.
(e)
Accounting as a Mythology
Accounting system supports the concept of professionalism. This means
that accounting is used to justify, rationalise and legitimise decisions that
are made.
(f)
Accounting as Magic
Accounting is viewed as a method of deceiving the users of reports.
As stated by Godfrey, Hodgson and Holmes (2003), ...an accountant can
perform sleight-of-hand accounting tricks which can be compared to
magicians tricks. In this way, the accounting magician is able to make the
financial statements appear to be something they are not.
For example, Enron used accounting techniques to disguise its loss-making
investments. Figure 1.5 shows an illustration of accounting as magic.
10
Figure 1.5: Accounting as magic
(g)
Accounting as Communication-Decision Information

Accounting reports are prepared to suit the needs of users and this, in turn,
will impact the decision-making behaviour of managers and investors.
(h)
Accounting as an Economic Good

Accounting is believed to be part of a wider information set which includes
macroeconomic, political, taxation and other specific information that
affects the performance of the firm. As costs are involved in producing
accounting information, managers will often lobby for accounting
standards that minimise information costs. On the other hand, the resource
providers such as the shareholders and creditors will lobby for accounting
rules that enhance their ability or right to control and monitor the conducts
of the management.
(i)
Accounting as a Social Commodity

Accounting is an agent of social change. This is because accounting
information can affect the welfare of different groups in society.
For example, accounting figures can be used by certain firms and
regulatory bodies to promote or discourage different investments in
industry. Also, for the purpose of fulfilling its social responsibility, the
government may use the accounting information to aid its policies.
11
(j)
Accounting as an Ideology and Exploitation

This theory views accounting as the ideological apparatus used by the
capitalist society to reinforce the structure of society. This means that it is
used to exploit and extract wealth in support of elite interest groups at the
expense of employees and society at large.
(k)
Accounting as a Social Club

This theory believes that accounting principles, standards and societies
exist, firstly, to promote the group interests and aims of accountants;
secondly, to instil a professional culture and enhance a monopoly in
professional knowledge and; thirdly, to enhance the accountants public
image of professional competency (refer to Figure 1.6).
Figure 1.6: Accounting as a social club
SELF-CHECK 1.1
What role does history play in the development of accounting
theory?
12
1.4
THE DEVELOPMENTS IN ACCOUNTING

THEORY
Accounting prescriptions were made to resolve problems as they arose. Hence,

the theory underlying those prescriptions was developed in a largely
unstructured manner. This led to inconsistencies in practice.
For many years, accounting standard-setters have been trying to resolve the
inconsistent problems by developing a conceptual (theoretical) framework that
provides more consistent treatment of like items. However, rather than resolve
the inconsistencies in practice, the frameworks are used to justify or support such
inconsistencies. Beside, these universal guidances are too general to be able to
provide any clear set of decision rules.
It is widely believed that an understanding of the past development of ideas will
help us in the present and the future. Thus, it is important to examine the
historical influences on the development of accounting theories (refer to Figure
1.7) and how the practices of accounting have adapted to the theories.
Figure 1.7: The historical influences in accounting theories
1.4.1
Accounting Theory Timeline
Figure 1.8 describes the development of accounting theory.
13
14
15
Figure 1.8: Development of accounting theory
Theory helps us to make sense of reality.
Theory is derived from observations of situation or events, or as a result of

logical reasoning.
Accounting theory provides a general framework of reference and guidance

for the evaluation and the development of accounting practices and
procedures.
Accounting theory can be formulated through deductive or inductive

approaches.
Deductive reasoning is from general statements to specific statements.
16
Inductive reasoning is from the particular statements to the general

statements.
Accounting theory and principles have emerged with a range of different

interpretations.
Accounting theory
Induction
Deduction
1.
Explain what a theory is.
2.
Identify the purpose(s) of an accounting theory.
3.
Identify some of the contemporary accounting issues faced by accountants.
4.
Identify and explain the two approaches to theory formulation.
5.
Pacioli documented accounting processes during a period described as:
6.
7.
(a)
Practice development period
(b)
Pre-theory period
(c)
Practice formalisation period
(d) General scientific period

What caused the demise of the normative period?
What is the main problem with the accounting theories developed during
the positive era?
17
1.
What are the roles of explanation and prediction in accounting theory?
2.
What is the relevance of accounting history to the study of accounting?
3.
Identify and explain the role of accounting theories.
4.
Based on your answers in Question 3, do you find them helpful in your

understanding of accounting?
5.
What factors do you think might have contributed to the emergence of such
a diverse range of ideas in the golden age of accounting theory during the
1960s?
6.
What is truth in science? What is truth in accounting?
7.
Using a deductive theory, develop a syllogism that moves from the premise
that (a) All firms that are unable to pay a certain rate of dividends to their
shareholders should cut back on their unprofitable operations, to the
conclusion (b) ABC company should retrench 1,000 workers from its Kuala
Selangor-based assembly plant.
Topic Historical
Development of
Accounting
LEARNING OUTCOMES
1. Explain how pragmatic approaches to theory development apply to
accounting;
2. Identify the features of normative theories;
3. Identify how positive accounting theories are constructed; and
4. Explain behavioural approaches and the influence of accounting
information on individual behaviour.
INTRODUCTION
How do we study accounting theories? How do we know whether a particular
accounting theory is useful to us?
One way of doing it is to classify the theories according to the assumptions they
rely on, how they are formulated and their approaches to explaining and
predicting actual events.
There are several classifications on the development of accounting theories. This
topic will deal with four of the approaches that have proven to be useful. They
are pragmatic, normative, positive and behavioural approaches. Pragmatic
approaches are based on observation of the behaviour of the accountants, or the
users of the information generated by the accountants. Normative theories focus
on deriving the true income for an accounting period, or on discussing the type
of accounting information which would be useful in making economic decisions.
TOPIC 2 HISTORICAL DEVELOPMENT OF ACCOUNTING
19
As for positive approaches, hypotheses are tested against actual events.

Behavioural approaches rely on the study of the behaviour of accountants and
non-accountants, as they are influenced by accounting functions and reports.
The purpose of this topic is to explain how these classifications influence the
development of the accounting theories. The weaknesses and criticisms of these
various theories will also be discussed.
2.1
PRAGMATIC APPROACHES
The pragmatic approach to science involves using the method which appears
best suited to the research practices. Let us examine the pragmatic approaches
in accounting.
2.1.1
What is a Pragmatic Relationship?
A pragmatic relationship is a relationship that relates to the effect of words or

symbols on people. Its ultimate objective is to provide useful information for the
allocation of scarce economic resources. In other words, accounting procedures
that were found to be useful have become generally accepted, regardless of
whether they were tested for any relevance to a particular hypothesis (refer to
Figure 2.1).
Figure 2.1: Pragmatic relationship in accounting
20
There are two types of pragmatic approaches: descriptive and psychological.

Let us now examine both of these approaches.
2.1.2
Descriptive Pragmatic Approach
The descriptive pragmatic approach is probably the oldest and most universally
used method of accounting theory development (refer to Figure 2.2). Theories are
developed from continual observing of the behaviour of accountants in certain
situations, so that their accounting procedures and principles can be copied.
Thus, this approach is an inductive approach.
Figure 2.2: Descriptive pragmatic approach
However, this approach has been criticised for not providing a logical assessment
of the accountants actions, that is, it does not analyse whether the accountants
are reporting in the manner that they should be reporting. Also, this approach
does not allow for changes in the accounting techniques. For example, we teach
students the accounting techniques through our observation of the practices of
accountants, and those students will one day become practising accountants,
whom we will observe to learn what to teach.
Sterling (1970) criticised the pragmatic approach for focusing too much on the
behaviour of accountants instead of measuring the attributes of the firm, such as
assets, liability and profit.
Sterling comments:
it is my value judgement that the theory of accounting ought to be concerned
with accounting phenomena, not practising accountants, in the same way that
theories of physics are concerned with physical phenomena, not practising
physicists
2.1.3
21
Psychological Pragmatic Approach
Instead of observing the behaviour of accountants, the psychological pragmatic

approach examines closely the users responses to the accountants output, such
as financial reports. The reaction of the users will be taken as evidence of the
usefulness of the financial information.
However, according to Godfrey et al. (2006), the weaknesses of this approach are
that some users may react in an illogical manner, some may already have a
preconceived opinion and others may not react when they should.
ACTIVITY 2.1
Can you think of examples of the types of issue that might cause users
to react in an illogical manner?
2.2
NORMATIVE APPROACH
Generally, normative approach is a theory that is not based on observation, but

on how an accounting process should be done. Now, let us go in-depth into the
theory.
2.2.1
What are Normative Theories?
The period between the 1950s and 1960s has been described as the golden age
of normative accounting research. During this period, accounting researchers
were more concerned with policy recommendations and with what should be
done, rather than with analysing and explaining current or accepted practice.
Here are the features of the normative theories:
(a)
They are market-based theories which use methods other than historical
cost methods;
(b)
They have their respective concepts of true income and financial positions;
(c)
They assume profit maximisation is the primary goal of management;
(d)
They have been constructed on the basis of deductive reasoning; and
(e)
They regard the provision of information for decision making as the main
function of financial statements.
22
Therefore, in summary, normative theories concentrated either on deriving the

true income (profit) for an accounting period, or on discussing the types of
accounting information which would be useful in making economic decisions.
2.2.2
What is True Income?
True income refers to a single measure for assets and a unique (and correct)
profit figure. However, there is no agreement as to what constitutes a correct or
true measure of value and profit.
2.2.3
What is Decision-usefulness?
Decision-usefulness refers to the assumption that the basic objective of

accounting is to aid the decision-making process of certain users of accounting
reports by providing relevant, useful accounting data, for example, to help
investors to buy, sell or hold shares.
2.2.4
Criticisms of Normative Approach
Decision makers can use accounting data to make predictions on the company,
and based on these predictions, they decide what to do. However, normative
approach is based on value judgements or personal opinion, and these value
judgements cannot be verified or tested.
Even if the prediction can be verified, it verifies the prediction model of the user,
not the accounting system. Other variables such as inflation, interest rates and
consumer confidence might also affect a prediction.
2.2.5
A Shift towards Empiricism
There was a major shift towards empiricism in accounting research in the 1970s.
Emphasis placed on the need for accounting reports to be more relevant to
decision makers in the 1960s has resulted in the development of empirical,
experimental and analytical research in accounting. This has, thus, given rise to
the birth of positive accounting theories.
23
ACTIVITY 2.2
Describe the differences between a descriptive and a prescriptive
accounting theory.
2.3
POSITIVE APPROACH
The positive accounting approach focuses on analysing the economic statistics

and data; and deriving conclusion based on those elements. Let us examine this
in detail.
2.3.1
What are Positive Theories?
During the 1970s, accounting theory observed a move to positive methodology.

Positivism or empiricism means testing or relating accounting hypothesis or
theories back to the experience or fact of the real world.
The positive theories are concerned with:
(a)
Explaining the reasons for current practice; and
(b)
Predicting the role of accounting and associated information in the

economic decisions of individuals, firms and other parties in the economy.
(Godfrey et. al., 2006)
It is assumed that accounting information is an economic and political commodity,

and that people act in their own self-interest. These theories essentially look at the
costs and benefits of alternative accounting methods, and which valuation models
give the best prediction of future returns, share prices, etc.
2.3.2
How are Positive Theories Developed and

Tested?
Positive theories are generally developed and tested using the scientific method,
whereby the truth or falsity of statements is assessed by correspondence to
observable real-world phenomena. Evidence is then gathered. The evidence must
be unbiased, external and public so that others can also verify it.
It is also important to note that the observations must be sufficiently large in
number to allow a generalisation. They must be repeated under a wide variety of
24
conditions. Observations that conflict with the universal law of the theory will
not be accepted.
2.3.3
Main Differences between Normative and

Positive Theories
Table 2.1 below shows the main differences between normative and positive
theories:
Table 2.1: Differences between Normative and Positive Theories
Normative Theories
Positive Theories
They are prescriptive.

They prescribe how people should behave
to achieve an outcome that is judged to be
right, moral or good.
They are descriptive and explanatory or

predictive.
They describe how people behave and
explain why people behave in a certain
manner, or predict what people will do.
These theories can co-exist, and can complement each other. For example,
positive accounting theory can help provide understanding of the role of
accounting, which, in turn, can form a basis for developing normative theories to
improve the practice of accounting.
2.3.4
Criticisms of Positive Approach
On their main objective of explaining and predicting accounting practices,

positive accounting theories have not shown much development since their
general inception in the 1970s. This is because they do not provide a means of
improving accounting practice.
In addition, according to Godfrey et al. (2006), the positive approachs
fundamental assumption that all action is driven by a desire to maximise ones
wealth, is a far too negative and too simplistic a perspective of humankind.
ACTIVITY 2.3
List factors that will influence the accounting system adopted by a
firm and the information disclosed. Which of these factors are direct
functions of human behaviour?
2.4
25
BEHAVIOURAL APPROACH
In the era of technology, it can be said that behavioural accounting approach is

concerned with the relationship between the accounting information system and
human behaviour. Now, let us see the meaning beneath it.
2.4.1
What are Behavioural Theories?
Behavioural accounting theories are derived from disciplines such as psychology,

sociology and organisational theories. Their objectives are mainly to discover
why people behave as they do.
According to Hofstedt and Kinard (1970), behavioural accounting research is
defined as:
The study of the behaviour of accountants, or the behaviour of nonaccountants, as they are influenced by accounting functions and reports.
In other words, behavioural accounting research encompasses:

(a)
The judgement and decision making of accountants and auditors; and
(b)
The influence of the output on users judgements and decisions making.
2.4.2
Why is Behavioural Approach Important?
Behavioural accounting research is important because:

(a)
It identifies how people use and process accounting information.

Specifically, it examines the decision-making activities of the preparers,
users and auditors of accounting information;
(b)
It can provide valuable insights into the ways of how different decisions are
produced, processed and how people react to particular items of
accounting information and communication methods. By improving the
decision- making process, users of financial information can avoid making
bad decisions that lead to losses, and preparers and auditors of financial
information can avoid being sued;
(c)
It can lead to training and increase in knowledge for accountants to improve

their skills in information gathering, processing and communication;
26
(d)
It can provide useful information to accounting regulators, particularly in

the aspect of providing decision-useful information to the users of financial
statements. Behavioural accounting researchers can directly study specific
accounting options, and then report to standard-setters on which methods
or disclosures improve users decisions; and
(e)
It can lead to efficiencies in the work practices of accountants and other

professionals. For example, a computerised expert system for decision
making can be developed through the harnessing and recording of the
expertise and skills of experienced accountants using the behavioural
research methods. This system will then be used to train inexperienced
practitioners. Some auditors have also used behavioural research methods
to develop an expert system to conduct risk assessment of potential audit
clients.
2.4.3
Defining Human Judgement Theory (HJT)
According to Bamber (1993), human judgement theory (HJT) or human

information process is a major type of behavioural accounting research that aims
at more than explaining and predicting behaviour of an individual or group
level. It also aims to improve the quality of decision making.
The HJT research describes the way in which people use and process pieces of
accounting information in a particular decision-making context.
There are three decision-making processes as presented in Figure 2.3:
Figure 2.3: Decision-making processes
(a)
The Brunswik Lens Model

Since the mid-1970s, studies involving predictions such as bankruptcy and
evaluations such as internal control have been using the Brunswik Lens
model as the basis for judgement. Researchers use this model to analyse the
relationship between pieces of information with the decisions, judgements
or predictions, by looking for regularities in response to those cues.
For example: A bank officer (the decision maker) will look at the financial
ratios and other financial information (look through the lens of cues which
27
are probabilistically related to an event), and make a judgement on the

likelihood of loan default or non-default (reach conclusion on that event)
(refer to Figure 2.4).
Figure 2.4: Brunswik Lens model
The strength of the Brunswik Lens model is that it is a statistical model, and
thus the random error in human judgement owing to factors such as
tiredness, illness or lack of concentration is removed.
However, the limitation of the Brunswik Lens model is that it does not
explain how a decision is made. It assumes that the decision maker is able
to process simultaneously all the information; in reality, the majority of
decision makers analyse problems in a step-by-step process, assessing one
piece of information first, then moving on to the next piece and so on until a
decision is reached.
(b)
Process Tracing Method

The process tracing method uses the step-wise approach to decision
making, whereby gathered information is processed by process tracing,
followed by verbal protocol, and finally decision trees are drawn up. In
other words, the decision maker will analyse a series of case studies, and
verbally describe each step gone through in making a decision. The verbal
descriptions are then analysed to produce a decision tree diagram, to
represent the decision processes (refer to Figure 2.5).
28
Figure 2.5: Process tracing method
An example of a hypothetical decision tree for a bank loan officer is shown in

Figure 2.6 below.
Figure 2.6: Hypothetical decision tree for a bank loan officer

Source: Adopted from Godfrey, J., Hodgson, A., Holmes, S., & Tarca, A. (2006).
29
However, as compared to the Brunswik Lens model, the process tracing

methods are not always good predictors of the events of interest. This is
because decision makers often have difficulty explaining all the steps they
go through, as they carry out the tasks routinely. As a result, the task
becomes so familiar that the decision processes are implicit and
unconscious in the mind of the decision maker.
In order to overcome the limitations of both the Brunswik Lens model and
the process tracing methods, some researchers combined the predictive and
descriptive powers of the two approaches, and produced a statistical
technique known as Classification and Regression Trees (CART).
However, it was found that under CART, the more data is available for
analysis, the more complex the resulting decision tree.
(c)
Probabilistic Judgement
The probabilistic judgement model is useful in accounting, where initial
belief of a prediction or evaluation needs to be revised, once further
evidence becomes available. This model uses the conditional probability
theory, whereby the revised (posterior) probability in the light of additional
evidence is equal to the original belief multiplied by the amount by which
prior expectations should be revised (Libby, 1981). See Figure 2.7.
Figure 2.7: Conditional probability theory
However, evidence from studies (Birnberg and Shields, 1989; Libby, 1981)
suggests that human decision makers that include accountants and auditors
are generally not good intuitive statisticians. Instead, the accountants and
auditors use the rules of thumb or biases, because of the complexity of
the types of judgements they need to make. In fact, these rules of thumb
may represent an efficient and effective method of dealing with complexity
and the limitation of human cognitive processes.
30
2.4.4
Limitations of BAR
The major limitation of BAR (Behavioural Accounting Research) is the lack of a

single underlying theory, which helps in the unification of the diverse research
questions and findings of BAR. As argued by Maines (1995):
... First, studies on the same topic have produced conflicting results, preventing
conclusive guidance for policy decisions. In addition, the experimental subjects
and settings used in these studies often differ from those found in real judgement
settings. Finally, accounting researchers have questioned whether policy should
be influenced by research on individual decision makers.
In other words, the frequent contradictions among findings of similar studies
show that human information processing is too complex for the current research
theories and methods. Thus, till now, BAR researchers are still unable to develop
a common framework that is useful for generalisation for policy makers.
ACTIVITY 2.4
Accounting is a function of human behaviour and activity. As such, is
not all accounting research behavioural? Justify your answer.
Accounting theories and principles have emerged with a range of different

interpretations.
Pragmatic theories document what is.
Normative theories attempts to outline what should happen.
Positive research attempts to explain what is happening.
Philosophical objective of positive accounting theory is to explain and predict

current accounting practice.
31
Behavioural research in accounting focuses on human judgement theory and

the use of that theory in explaining, predicting and improving decision
making.
Behavioural research has relied heavily on the Brunswik Lens model and the
probabilistic judgement model.
Behavioural theory
Pragmatic
Brunswik Lens model
Probabilistic judgement
Human judgement theory
Positive theory
Normative theory
Process tracing
1.
2.
Which of the following statements are incorrect?

(a)
Normative theories are based on value judgement.
(b)
Normative theories can be empirically tested.
(c)
Normative theories adopt an ideal stance and then specify means of

achieving their objective.
(d)
Normative theories are based on deductive logic.
Which of the following would be an example of a normative theory?

(a)
A researcher, through observation, documents the breeding cycle of a

rare species of butterfly.
(b)
An economist develops a method of using last months stock market

prices to predict unemployment levels.
(c)
In order to ensure consistency in schooling outcomes, an education

researcher recommends that all final year school students undertake
the same six subjects for assessment purposes.
(d)
An accounting researcher predicts that auditors will perform faster

audits when the audit materials are presented in graphical rather than
tabular form.
32
3.
Which of the following is not indicative of a positive accounting theory?
4.
(a)
Explains the reasons for current practice
(b)
Predicts the role of accounting information in decision making
(c)
Outlines what should happen
(d)
Focuses on expectation or facts of the real world
Positive accounting theory is criticised on the grounds of:

(a)
Being too prescriptive
(b)
Failing to improve accounting practice
(c)
Being based on the assumptions of neo-classical economics
(d)
Describing individuals as rational and self-interested
5.
What is behavioural accounting research?
6.
What is the limitation of behavioural accounting research?
1.
Researchers who develop positive theories and researchers who develop

normative theories often do not share the same views on the roles of their
respective approaches to theory construction. How do positive and
normative theories differ?
2.
Can positive theories assist normative theories, or vice versa? If yes, give an
example. If no, why not?
3.
The decision-usefulness approach to theory development can be used to

develop theories of accounting. Explain what is meant by decisionusefulness approach to theory development.
4.
How can the decision-usefulness approach relate to accounting theory

formulation?
5.
Describe the three decision-making processes based on the human

judgement theory.
Topic Paradigms in
Accounting
Research
LEARNING OUTCOMES
1. Define paradigms;
2. Explain advantages and disadvantages of using paradigms;
3. Compare different paradigms;
4. Recognise alternatives of functionalist paradigms;
5. Discuss the homogeneity of paradigms;
6. Explain inter-paradigms dialogue and its barriers; and
7. Discuss the conditions of using mixed methods for paradigm
dialogues.
INTRODUCTION
Nowadays, there is a debate over using and usefulness of paradigms in
accounting literature. This topic aims to discuss the meaning and implications of
different paradigms in accounting research topics. The paradigms discussed are
Mainstream (Functionalism), Interpretive, and the Critical schools of thought.
Each of these paradigms investigates one aspect of research which is also true for
accounting. But using solely one paradigm is not enough to offer a
comprehensive view of the research issue. That is why researchers are strongly
advised to analyse their research topics by the use of different paradigms.
However, this cannot be performed easily due to lack of sufficient interparadigm communications. The usage of paradigms to create theories has also
been practically questioned by research scholars. A case in this point was when
34
TOPIC 3
PARADIGMS IN ACCOUNTING RESEARCH
Gross and Levitt (1994) wrote a book entitled Higher Superstition: The academic
left and its quarrels with science. Another case for this point is the paper written
by Alain Sokalwho, who later admitted that this paper was full of nonsense. The
reason that Alain published it was to show the extent that it is not at all a big deal
to have nonsense published to the public. However, these cases are not intended
to confirm that paradigms are useless. No one can deny the fact that paradigms
are not free from mistakes, but if researchers are performing the research with
appropriate approaches and also with enough precision, the resultant theories
will definitely be useful, practical and valuable.
3.1
THE DEFINITION OF PARADIGM
Paradigm specifies a series of scientific works to be done within a time frame.

Specifically, paradigms are used to define the area of research, topic-related
questions on the research, scientific approaches to conduct the study and the way
of clarifying the results of the research. Paradigms illustrate a within-a-box
procedure for users; however, new paradigms are derived from the results of
some studies, since the current paradigms do not fit the findings. A case in point
is Einsteins theory of relativity which questioned the certainty of Newtons
theories in physics. With the advent of paradigms, the researchers significant
contribution to science became clearer.
The meaning of paradigm was first defined by Thomas Kuhn in 1962 as The
Structure of Scientific Revolutions. According to this definition, researchers and
academicians conduct their research within the borders of a set of rules for a
period of time. But paradigms may not be fixed forever because they are subject
to changes, obsolescent or diminishment. This can happen as a result of new
emerging approaches which may confirm, reject, or question the previous
paradigms. Figure 3.1 presents the idea of the structure of scientific revolutions.
TOPIC 3 PARADIGMS IN ACCOUNTING RESEARCH
35
Figure 3.1: The structure of scientific revolutions

Source: http://www.structural-communication.com
The changes between paradigms have caused some debates. Historically

speaking, some of the debates on paradigms started shortly after Kuhns
paradigm definition between 1975 and 1978. But science wars were initiated in
the last decade of the 20th century. Within this period two main groups, called
postmodernists and realists, had serious conflicts on the accuracy of theories
used in sciences.
These two groups did not have the same idea on the objectivity of science. While
postmodernists kept criticising the existence of objectivity of methods used in
science and technology, the realists group pinpointed that the methods used in
science are pursuing a specific and clearly defined objective. Realists claimed that
postmodernists did not address the objectivity of paradigms precisely, because
postmodernists combined paradigms objectivity and political issues.
ACTIVITY 3.1
1. What are the benefits of using paradigms?
2. What type of paradigms have you ever used in accounting?
36
3.2
TOPIC 3
PARADIGMS: ADVANTAGES AND

DISADVANTAGES
Paradigms are created based on assumptions, notions and estimations and they
are well-suited for scientific studies. Consequently, paradigms have substantial
advantages for researchers to gather the related knowledge on a specific topic.
This helps the young learners and researchers to create knowledge in their
scientific careers such as the studies done by a number of postgraduate students.
However, after paradigms reach their saturation stage, the rate of return derived
from them will decline. In addition, paradigms narrow down the scope of
consideration to the framework defined by them. Then, it is possible one day to
find out that the whole picture illustrated by the paradigm had been wrong from
the beginning. Moreover, creativity and thinking out of the box is restricted by
paradigms. That is why the problems which cannot be dealt by paradigms
continue to exist. But, the paradigms of other researchers can assist to solve these
challenges. Therefore, the co-operations of paradigms foster creativity and make
up the puzzle.
Research in accounting can be done by the use of three paradigms, including the
functionalism, interpretive and critical approaches.
Based on the functionalism approach, also called the mainstream method, people
and organisations behave externally, and they live in the surrounding
environment around them. Consequently, functionalism utilises the quantitative
methods in science. Although powers may be distributed unequally among
individuals, this method adopts this phenomenon so as to keep moving towards
a targeted purpose and avoid chaos in the society.
The interpretive school of thought discusses the interpretation of individuals
adaptations to the symbols of the environment they are residing in. Similar to the
functionality approach, the interpretive method victimises social disagreements
for general goals and purposes.
The critical method, however, underscores disharmonies in the society and
believes that structural discriminations are due to the power system which rules
the society. Hence, critical thinking challenges the current social and economic
status and tries to create knowledge due to the existing disparities.
3.2.1
37
Paradigms Comparison
Although both interpretive and critical methods approach behaviour societal

researches subjectively, the interpretive method prioritises concepts and refers to
the different interests received by parties, whereas interpretive accounting
scholars investigate the social process of accounting creation and its implications
on maintaining current situations.
A number of extant researches in accounting have been conducted within the
boundaries of functionalist paradigms. In spite of the advantages of this method,
what comes in theory rarely happens in reality. This imposed limitations on the
scope of addressable questions which can be answered by this paradigm, because
pure quantitative measurements cannot deal with qualitative and reasoning
aspects of complicated accounting issues. This shortcoming of functionalist
paradigms can be settled by the use of interpretive paradigms, to have a
comprehensive perspective in accounting studies. Therefore, it is paramount for
investigation methods in accounting environment to be based on multiparadigmatic disciplines.
Nowadays, functionalist paradigm dominates most accounting researches. These
studies are performed on the roots of economics theories and their applications
in accounting as well as experimental researches, with less popularity in recent
years. The main weakness of the economic-based orientations is that some
research topics are undervalued in accounting, solely due to their incompatibility
in functionalist paradigms.
ACTIVITY 3.2
Based on the above discussion, which paradigm(s) is/are useful to
address accounting research? Why?
3.3
FUNCTIONALIST PARADIGMS
SUBSTITUTES IN ACCOUNTING RESEARCH
As mentioned in the previous subtopic, the functionalist paradigm, also known

as mainstream paradigm, suffers some cons. That is why Burrell and Morgan in
1979 suggested the suitable substitutes for the mainstream method. One of them
is the interpretive paradigm which deals with the fact that society members
should be referred directly as inseparable parts of the research, making subjective
study indispensable.
38
TOPIC 3
The other paradigm is critical school of thought which focuses on the disparities
existing in the society. According to the critical method, people must be liberated
from the constraints imposed on them in the societal context.
Despite these substitutes offered, paradigms are not capable of communicating
and co-integrating well. This is significantly true for the functionalist
paradigms relation with its other options. Figure 3.2 illustrates the accountingrelated research.
Figure 3.2: Accounting-related research
ACTIVITY 3.3
What is the obstacle towards using different paradigms?
3.4
HOMOGENEITY OF DIFFERENT
PARADIGMS
The extent of homogeneity among accounting researches is the outcome of

applying the mainstream paradigm in increasing number of studies. On one
hand, this has resulted in effective and efficient performance of knowledge
contribution, though within the subject areas covered.
39
On the other hand, marginal return of the knowledge creation has significantly
diminished, due to the increasing number of studies on a specific topic which has
reached its saturation stage. Moreover, sticking to a unique paradigm imprisons
creativity and innovation. That is why heterogeneity is encouraged in accounting
research, since more fresh ideas and research prepositions have the chance to be
surveyed by the use of other research methods, facilitating variety in the literature.
But low efficiency within the frames of a topic is a risk of heterogeneity, which can
imprison knowledge contribution, particularly for newcomers.
Now, let us examine the methods.
3.4.1
Normative Approach
A subjective and future-oriented economic activity is investigated by the

normative accounting theory. Moral issues are included in accounting by this
method, since personal judgments on the values are provided for a company or
investors. A case for this point is when the company is evaluating the amount of
investment to improve its corporate social responsibility activities. Another
example is when the company intends to define its mission and vision
statements. Consequently, normative accounting is well-suited to planning for
theory-based future projects.
3.4.2
Positive Approach
While normative accounting theory focuses on subjective and future

evaluations, positive accounting theory scrutinises accounting information and
data to describe the causes of past activities. For example, this method can be
used to investigate whether the company performance is acceptable enough to
increase the dividend payment to shareholders or not. This is done by
analysing the past financial operations of the company and the reports are
provided accordingly. Hence, positive accounting theory is best used in
preparation of financial statements.
3.4.3
Behavioural Approach
Behavioural accounting approach discusses the influence of human variables in

the value of the company. According to this theory, employees who are in charge
of making significant decisions must be accountable for the company valuation.
Behaviourally speaking, the accounting profession within companies must take
into account the value of prominent decision makers. Nowadays, this issue has
become substantially notable because companies are pushed to be more
accountable, and to use more precise judgments in their value evaluations. For
40
TOPIC 3
instance, if two companies have the same financial statements, but different
levels of employees experience and management competency, they are not
worth the same.
ACTIVITY 3.4
1. In your opinion, is it an effective approach if each research is
separately conducted by different paradigms? Discuss.
2. What are the ways to evaluate the value of companies
behaviourally? Discuss in class.
3.5
INTER-PARADIGMATIC COMMUNICATION
CHALLENGE IN ACCOUNTING RESEARCH
As discussed in the previous subtopic, increasing homogeneity solely in

the functionalist paradigm acts as a barrier to this research method in
communicating with other paradigms. Positive accounting theory (PAT) is a case
in this point within the mainstream paradigm. PAT uses quantitative
measurements to discuss and forecast accounting research theories. Evidences of
PAT researches illustrate the incompatible nature of PAT principles with other
methods in accounting. One solution to this barrier is to use economic-based
researches, because a number of researches in accounting is rooted in economic
theories within the functionalist paradigm.
Academicians can use this ground as an opportunity to establish conversations
on economics with other disciplines in the social field.
ACTIVITY 3.5
What are the economic theories which can be used to facilitate the
accounting paradigms inter-communication?
3.6
41
INTER-PARADIGMATIC DIALOGUE BY
MIXED METHOD RESEARCH
Dialogue between paradigms can be provided by the meta-triangulation

approach in mixed method research. Meta-triangulation discusses that social
researches be conducted with the use of different paradigms, while researchers
are aware of the overlapping possibilities among different paradigms
boundaries. After utilising a variety of research paradigms, analyses are required
to figure out the agreements or disagreements arising in results, so that the
research topic is viewed from different perspectives. To do this, it is necessary to
negotiate with the professional bodies within each functionalist paradigm and
critical paradigm, for instance, within accounting research.
Investigating the social science topics with the use of different research
tools assists the researcher to figure out the origins of occurring contradictions
or parities. The sources include methodology, assumptions, backgrounds,
affiliations and so on. Creating ontological and epistemological assumptions
and surveying the practical feasibility of these assumptions play a key role
in commencing a mixed method approach in accounting issues. Meanwhile,
scholars in each paradigm are required to check the empirical evidences of using
functionalist, critical and imperative schools of thoughts.
Such communication offers researchers within each paradigm to open their
insights to other methodologies, encouraging them to welcome other aspects
within the box of other paradigms.
For example, PAT researchers have underscored the contribution of differences
in emerging theories developments. Therefore, mixed method research and
meta-triangulation method measures functionalist researchers openness to the
implications of alternative paradigms. Critical and imperative studies show the
power of generalisation of their findings in subjective areas within accounting
literature, through the use of mixed method approach.
ACTIVITY 3.6
Find some recent accounting research papers which have used different
paradigms. Explain the way different methods are related by the
author.
42
TOPIC 3
Paradigms are the scientific methods of doing research during a pre-defined

period of time.
Research in accounting can be done by the use of three paradigms including

the functionalism, interpretive and critical approaches.
Based on the functionalism approach, also called the mainstream method,

people and organisations behave externally and they live in the surrounding
environment around them. The interpretive school of thought discusses the
interpretation of individuals adaptations to the symbols of the environment
they are residing in.
The critical method, however, underscores disharmonies in the society and

believes that the structural discriminations are due to the power system
which rules the society.
Paradigms offer some advantages such as increased efficiency in some

mature accounting topics, while lack of ability to survey innovative topics is
among its disadvantages.
There are some difficulties for inter-paradigmatic applications in accounting

research, because each of them views the issue from different angles.
Mixed method research is an approach that facilitates dialogue among

different paradigms.
Behavioural approach
Interpretive paradigm
Critical paradigm
Mixed method research
Functionalist/mainstream paradigm
Normative approach
Homogeneity
Positive approach
Inter-paradigmatic dialogue
Paradigm
43
According to the current homogeneity of functionalist paradigm, what are the

methods to increase harmonies in other accounting paradigms? Elaborate your
answer with the mixed method approach.
Are using paradigms always beneficial for researchers? Why or why not?
Topic Conceptual
Framework and
Standard
Setting Process
LEARNING OUTCOMES
1. Describe the objectives of a conceptual framework;
2. Explain the development of a conceptual framework for financial
reporting;
3. Identify the usefulness of a conceptual framework;
4. Explain the conceptual framework of IASB and the proposed
Malaysian conceptual framework;
5. Discuss the arguments for and against a conceptual framework;
6. Discuss the structure of a conceptual framework; and
7. Explain the accounting standard-setting process.
INTRODUCTION
Luca Pacioli, a Franciscan monk (refer to Figure 4.1), introduced the double-entry
bookkeeping system in 1494. This system was designed to meet the needs of
small business operations such as sole proprietorships, partnerships and joint
ventures in the social and legal environment at that time.
TOPIC 4 CONCEPTUAL FRAMEWORK AND STANDARD SETTING PROCESS
45
Figure 4.1: Financial reporting in early days
Since then, the developments and changes in business structure, in legislative

requirements and in social behaviour have caused accountants to revise the ways
to measure and disclose new transactions. Examples of present day transactions
that the accountants need not deal with in earlier times include company
taxations, leases, superannuation and intercorporate investments.
In practice, there have been differences in opinion on the treatment of these
new transactions. Also, accountants have been facing legislative and social
pressure from increased disclosure requirements.
Therefore, to resolve these issues in a manner consistent with the objectives of
financial reporting, a conceptual framework for financial reporting has been
developed. The conceptual framework serves as a reference point to evaluate
existing and proposed accounting standards, and accounting practices that are
not covered by the existing and proposed accounting standards.
46
4.1
WHAT IS A CONCEPTUAL FRAMEWORK?
You may ask the question as shown in Figure 4.2.
Figure 4.2: The accounting profession
Well, the accounting profession will probably continue to survive even without a
general theory of accounting. However, many problems have arisen due to the
lack of it. For example, allowing firms to select their own accounting methods
(refer to Figure 4.3) within the boundaries of generally accepted accounting
principles have caused confusion and debate as to what is the single most
appropriate practice for a specific circumstance.
47
Figure 4.3: The accounting methods
A conceptual framework is a structured theory of accounting that specifies function,

scope and purpose of financial accounting. Specifically, it identifies and defines
qualitative characteristics of financial information, such as relevance and
reliability, and develops principles and rules of recognition and measurement.
It is a normative theory (do refer to Topic 2 if you have forgotten what this means)
and applies to general purpose financial reports only.
4.1.1
Objectives of the Conceptual Framework
The main objectives of the conceptual framework require accountants to

communicate selected financial information to the users that:
(a)
Measures performance over time; and
(b)
Is useful in assessing the resources necessary to enable the firm to continue

operation at a certain level.
48
4.1.2
Reasons for a Conceptual Framework
There are several reasons why we should have a conceptual framework:

(a)
Before the conceptual framework, accounting standards allowed alternative

accounting practices to be applied to similar circumstances. The
permissiveness of the accounting practices had become a source of
confusion and debate as to what is the most appropriate practice for the
circumstances. Also, there had been an inconsistency of practices by
allowing the firms to select their own accounting method within the
boundaries of generally accepted accounting principles;
(b)
Accounting standard-setters followed the practice of previous professional

bodies in trying to provide random solutions to contemporary accounting
problems;
(c)
According to Solomon (1983), the conceptual framework is seen by some as

a defence against political interference. The implementation of accounting
policies requires value judgement, and there is no way of proving that the
value judgement of one party is better than the other. Therefore it is crucial
to have some sort of coherent theoretical base as a conceptual defence,
where the standards and policies can be derived.
ACTIVITY 4.1
A principle or practice would be declared to be right because it was
generally accepted; it would not be generally accepted because it was
right (Solomon, 1983).
Comment on Solomons argument.
4.1.3
The Development of a Conceptual Framework

for Financial Reporting
Figure 4.4 shows the development of a conceptual framework for financial

reporting.
49
50
Figure 4.4: Development of a conceptual framework for financial reporting

4.2
51
THE INTERNATIONAL ACCOUNTING

STANDARD BOARD (IASB) FRAMEWORK
As we have learned in the previous subtopic, IASBs Framework was developed

following the lead of the US standard setter, the FASB. The IASB Framework is a
conceptual accounting framework that sets out concepts that assist in the
preparation and presentation of financial statements for external users. It guides
IASB in accounting standard development, as well as resolves accounting issues
that are not directly covered in the international accounting standards (IAS) and
the international financial reporting standards (IFRS).
Figure 4.5 presents an overview of the purposes of the IASB Framework.
Figure 4.5: Purpose of IASB framework
4.2.1
Background of the Proposed Framework by the

Malaysian Accounting Standard Board (MASB)
The proposed framework by the MASB is developed based on the IASB

Framework.
According to Devi, Hooper and Davey (2004), the first working group that was
formed upon the establishment of MASB is Working Group 1: Conceptual
Framework.
52
In July 1998, DP (Discussion Paper) 1, Framework for the Preparation and

Presentation of Financial Statements was issued. Since then, the DP1 has been
revised numerous times by the Working Group.
Currently, MASB is still in the process of finalising the Malaysian Conceptual
Framework.
4.3
ARGUMENTS FOR AND AGAINST THE

CONCEPTUAL FRAMEWORK
Table 4.1 indicates the arguments for and against the conceptual framework.
Table 4.1: Arguments for and Against the Conceptual Framework
Arguments for the
Conceptual Framework
Arguments Against the

Conceptual Framework
Technical Benefit
The Framework improves the quality
of financial statements by providing
guidance to the standard-setters, users
and preparers as well as provides a
basis for answering specific accounting
questions and problems.
The Framework
Practice
Does
Not
Work
in
The Frameworks principles and definitions

are abstract and unclear. For example, the
definition of assets and liabilities are rather
vague, and the recognition criteria are based
on the subjective concept of probability.
In addition, the qualitative characteristics of
the financial information do not provide a
clear guideline, due to inconsistency and
opportunistic reporting.
Also, the measurement is based on
unspecified rules. The current Framework
simply acknowledges that a variety of
measurement bases (such as historical cost,
current cost, net realisable value, etc.) is used
in financial reports, but does not include
principles for selecting the measurement
bases.
Political Benefit
The Framework is too Descriptive
The Framework reduces political

interference in setting of accounting
requirements. When standard setters
use agreed conceptual principles, they
can provide rationales for their
positions. Thus, they can better resist
pressures to produce standards to
meet the preferences of interest groups
The current Framework simply describes

existing practice. This indicates that political
process prevails in the development of the
Framework. In other words, it is likely that
political persuasion, pressure and conflict will
affect the development of the Framework.
Some critics also view the Framework as
policy documents based on professional
53
which do not satisfy sound conceptual

principles.
values and self-interest. The accounting

profession is perceived as seeking to maintain
its positions in social acceptance and
economic power.
Professional Benefit
Risk of Mechanical Decision
The Framework provides a claim of a

body of knowledge to ensure that the
professional status of accountants is
maintained.
Accounting is a social science that does not

exist separately from the accountants. The
accountants play an important role in the
creation of measuring and communicating
reality. In fact, accounting may be dominated
by particular methods or assumptions, which
leads to generalisation of empirical research.
The practicing accountants at the micro level,
who need to resolve problems in specific
situations will be ignored.
4.4
THE STRUCTURE OF THE CONCEPTUAL

FRAMEWORK
Figure 4.6 shows the basic building blocks for the IASB Framework as well as the
proposed MASB Framework.
Figure 4.6: Building blocks for the IASB Framework

54
Let us now examine each of these building blocks in detail.
4.4.1
Objective of Financial Statements
The IASB framework states that the main objective of financial reporting is to
communicate financial information to users. To achieve this objective, the
information selected must be:
(a)
Useful in making economic decisions;
(b)
Useful in assessing the prospects of cash flow; and
(c)
Related to the firms resources, that is the claims to those resources and also
the changes in them.
To assist the accountants to choose which of the information is to be reported, a

set of principle qualitative characteristics which make information useful has
been developed (this will be explained in detail in subsection 4.4.2).
It is also important to recognise the users of financial statements. Figure 4.7
shows the users identified by the IASB Framework:
Figure 4.7: Users of financial statements
55
Let us now look at the different needs of these users as shown in Table 4.2.
Table 4.2: Different Needs of Users
Users
Their Needs for Information
Investors
They need information to assist them to determine

whether they should buy, sell or hold their investments.
Specifically, shareholders are keen to have information
that would help them to assess the ability of the firm to
pay dividends.
Employees
They are interested in information on the stability and

profitability of the firm (that is, their employer). They are
also keen on information on the ability of the firm to
provide remuneration, retirement benefits, career
advancement and so on.
Lenders
They are interested in information that will help them

determine whether their loans (principal plus interest)
will be paid when due.
Suppliers and other Trade

Creditors
They are interested in information that enables them to

assess whether they would be paid the amount owing to
them when due. Their interest towards the firm is of
shorter term as compared to the lenders.
Customers
They are interested in information pertaining to the

continuance of the firm, especially if they have long- term
involvement with, or are dependent on the firm.
Government
agencies
Public
and
its
They are interested in information regarding the activities

of the firm. They also need information in order to
regulate the firms activities, determine taxation policies
and as the basis for national income and similar statistics.
The public is interested in information on the trends, the
range of activities and the recent developments in the
business operation of the firm.
56
4.4.2
Qualitative Characteristics
Figure 4.8 shows the IASB Frameworks list of qualitative characteristics of

accounting information that contributes to its usefulness.
Figure 4.8: Qualitative characteristics of accounting information
Let us examine each of these qualitative characteristics in detail.

(a)
Relevance
Figure 4.9 shows the four aspects of relevance.
Figure 4.9: The important aspects of relevance
57
The IASB Framework views information as relevant if it can help the users
in the following manner:
(i)
(ii)
Assist the users to form predictions on the outcome of past, present or

future events (Predictive Value); and/or
Help the users to confirm or correct their past evaluations (Feedback
Value).
By doing so, the users will be able to assess the rendering of accountability
by the preparers.
In addition, Timeliness of the information is also an important element of
relevance, because it is of no use to the users if the information is not
available when it is needed.
Another important aspect of relevance is the concept of Materiality. An
item is considered as material if its inclusion or omission would influence
or change the judgement of a rational user. Thus, if an item is material, it
would be relevant for it to be reported in the financial statements.
ACTIVITY 4.2
Can you think of an example whereby the concept of materiality is of
utmost importance?
(b)
Understandability
Understandability is defined as that quality of financial information that
exists when users of that information are able to comprehend its meaning.
In other words, information that is not understood is not useful as it
conveys no message.
Therefore, in the process of preparing the financial statements, the
preparers must consider the users ability to understand the financial
information as well as to examine the way in which the information is
presented. Usually, it is assumed that users have a reasonable knowledge of
the firms operations and the environment it operates in, and are diligent
and willing to study the information.
58
(c)
Reliability
The concept of reliability refers to the quality of financial information that
exists, which can be relied upon to represent faithfully and without bias or
undue error, the transaction or event.
Figure 4.10 shows the key characteristics of reliability.
Figure 4.10: Key characteristics of reliability
59
The key characteristics of reliability are explained in Table 4.3.

Table 4.3: Key Characteristics of Reliability
Key Characteristics of
Reliability
Faithful Representation
(d)
Explanations
Financial statements must report the actual transactions
and events that affect the firm. There are two other
concepts that help to achieve faithful representation:
Substance over form Transactions or events

should not be recorded merely in their legal form.
They must have substance and must reflect
economic reality.
Prudence This means that under the condition of

uncertainty, accountants must take caution in the
exercise of judgements when making estimations.
Verifiability
Verifiable data is said to exist, when knowledgeable

and independent individuals develop essentially
similar measures or conclusions from examining the
same evidence, data or records. In other words,
verifiability focuses on whether a particular
measurement basis is correctly applied, rather than on
whether it is appropriate.
Completeness
Financial information must be presented in

completeness within the boundaries of materiality and
cost. Reliability of the information is affected by
incomplete information, because an omission can cause
information to be false or misleading.
Neutrality
Financial statements must be neutral. In other words,

financial information must not be presented in such a
manner as to influence the users judgement and
decision-making process.
Comparability
Comparability is a concept whereby the users of the financial statements
are able to identify real similarities and differences in economic phenomena
of a firm at one time and over time, or between firms at one time and over
time. Thus, it is important that information be measured and presented in
the same manner for the firms to achieve comparability. In other words,
comparability can only be achieved when there is consistency in
measurement and display of information by the firm, from period to period
and by different firms.
60
ACTIVITY 4.3
Does consistency mean that a firm cannot change from one method of
accounting to another? Justify your answer.
4.4.3
Underlying Assumptions
Figure 4.11 presents the key assumptions underlying the preparation of financial
statements:
Figure 4.11: Underlying assumptions for the preparation of financial statements
Under the IASB Framework, the explanations for the three key assumptions
underlying the preparation of financial statements are:
(a)
Accrual Basis
The firms revenues and expenses are assumed to be reported on an accrual
basis. This means that revenues and expenses are recognised when they
occur (and not as cash or its equivalent when received or paid). Thus,
revenues and expenses are recorded in the accounting period and reported
in the financial statements of the related period.
(b)
Going Concern
It is assumed that a firm is a going concern and will continue in operation
for the foreseeable future.
(c)
Periodicity
The periodicity assumption implies that the economic activities of a firm
can be divided into artificial time periods. Commonly, these periods are on
monthly, quarterly and yearly bases. Accountants need to determine the
relevant transactions to be reported for the specific accounting period.
4.4.4
61
Constraints
Although the financial information may be relevant, reliable and material,

sometimes due to certain constraints, the information may not be selected for
inclusion in the financial statements.
Figure 4.12 shows the constraints in the preparation of financial statements.
Figure 4.12: Constraints of financial statements
The explanations of the constraints are:

(a)
(b)
Timeliness
There are two aspects to this constraint:
(i)
Frequency of Financial Reporting

In order to fulfil the qualitative characteristics of relevance, the
financial information should be presented in a relatively short
reporting period. However, the reliability of information may also be
affected if the time interval is too short; this is because the number of
arbitrary inter-period allocations will have to be increased.
(ii)
Timing of the Financial Statements

Financial statements must be presented as soon as possible after the
end of the reporting period. The relevance of the information would
be reduced if there is a substantial delay before the publication.
Costs versus Benefits

Information is not a cost-free commodity, especially for the preparers and
providers of the accounting information. The cost of providing the
information must be weighed against the benefits derived from using the
information. Therefore, it is possible that the information may be relevant,
reliable, understandable and comparable, but if the cost of preparing the
information is greater than the benefit derived from using it, then it
probably should not be part of the financial statements.
62
4.4.5
The Elements of Financial Statements

(Definition, Recognition and Measurement)
The elements of the financial statements are as shown in Table 4.4.

Table 4.4: Key Characteristics of Reliability
Elements
Definition
Assets
Assets are probable future economic benefits obtained or controlled by a

particular entity as a result of past transactions or events.
Liabilities
Liabilities are probable future sacrifices of economic benefits, arising from

present obligations of a particular entity to transfer assets, or provide
services to other entities in the future as a result of past transactions or
events.
Equity
Equity or net asset is the residual interest in the assets of an entity that
remains after deducting its liabilities. In a business enterprise, the equity
is also called the ownership interest.
Revenues
Inflows or other enhancements of assets of an entity or settlements of its

liabilities (or a combination of both) from delivering or producing goods,
rendering services, or other activities that constitute the entitys ongoing
major or central operations.
Expenses
Expenses are outflows or other using-up of assets or incurrence of

liabilities (or combination of both) from delivering or producing goods,
rendering services or carrying out other activities that constitute the
entitys ongoing major or central operations.
It is important to bear in mind that there is a difference between definition and

recognition of an element as shown in Table 4.5.
Table 4.5: Difference between Definition and Recognition of an Element
The Definition of an Element
The Recognition of an Element
A
statement
that
identifies
the
characteristics that a transaction or event
must have.
An action or process of recording a

transaction or event in the accounting
records.
63
Thus, a transaction or event has to satisfy both the definition and recognition
criteria for it to be an element of the financial statements. This is summarised in
the Figure 4.13.
Figure 4.13: Decision tree for preparers of financial statements
In other words, a transaction or event will not be included in the financial

statements if it fails the recognition criteria, even though it meets the definition of
an element.
The elements of financial statements have a number of properties that can be
measured. Accountants have the responsibility of selecting the most suitable
property to be measured under the specific circumstance. The basis of selection
will, of course, be determined by the purpose of measurement. In other words,
accountants must measure properties of the elements that provide relevant and
reliable information appropriate for making and evaluating decisions on the
allocation of scarce resources. Some of the most commonly used measurement
methods are historical cost, current cost and exit price accounting.
64
4.5
STANDARD-SETTING PROCESS
Accounting standards are developed through an internationally approved

process which is called Due Process. The following are the importances of
standards where the process of setting them are explained.
4.5.1
Accounting Standard
and
the
Needs
for
Financial reporting of the companies satisfies the information needs of different

stakeholders. Because a heavy reliance is put by the stakeholders for their
decisions, the financial reports must have certain qualitative as well as
quantitative characteristics, such as reliability and relevance.
Setting international reporting standards (IASs) makes comparison of financial
reports more meaningful. In addition, IASs assist financial reports to be reliable
and relevant enough to support decision making of users.
4.5.2
Issues in Standard Setting
The FASB defines standards by a comprehensive and independent process which

is monitored by Financial Accounting Foundations Board of Trustees.
The operating procedure is governed by the set of rules called The Rules of
Procedures.
The guidelines of the rules are summarised as follows, which include:
(a)
The organisation in which the FASB operates;
(b)
The FASB mission, how the mission is accomplished and related principles
that guide the Boards standards-setting activities;
(c)
The operating procedures of the FASB, including the responsibilities of the

Chairman, the composition of the FASB technical staff, the role of advisory
groups, the Emerging Issues Task Force and public forums in our due
process;
(d)
FASB various forms of communications, including the form and content of

Accounting Standards Updates, Exposure Drafts, and Concepts Statements;
(e)
Protocols for meetings of the FASB and voting requirements; and
(f)
65
Rules governing public announcements and the kinds of information made

broadly available to the public.
Before setting standards, FASB performs a plain-language Cost-Benefit Analysis

in order to evaluate the standard. To do this analysis, FASB gathers relevant
information regarding the costs of standard implementation and the benefits may
arise from that.
Although the nature of research activities depends on the project, the following
are common steps in the standard-setting process:
(a)
The Board identifies financial reporting issues based on requests or

recommendations from stakeholders or through other means;
(b)
The FASB decides whether to add a project to the technical agenda based
on a staff-prepared analysis of the issues;
(c)
The Board deliberates at one or more public meetings the various reporting
issues identified and analysed by the staff;
(d)
The Board issues an Exposure Draft to solicit broad stakeholder input (in
some projects, the Board may issue a Discussion Paper to obtain input in
the early stages of a project);
(e)
The Board holds a public roundtable meeting on the Exposure Draft, if

necessary;
(f)
The staff analyses comment letters, public roundtable discussions and all
other information obtained through due process activities. The Board
redeliberates the proposed provisions, carefully considering the
stakeholder input received, at one or more public meetings; and
(g)
The Board issues an Accounting Standards Update describing amendments

to the Accounting Standards Codification.
Figure 4.14 summarises the aforementioned standard-setting process.
66
Figure 4.14: Standard-setting process
4.5.3
Due Process of Standard-Setting in Malaysia
MFRSs due process is performed simultaneously with that of IFRSs because of

the same effective date for new and/or amended standards.
The five stages are followed for Due Process of standard-setting in Malaysia:
Stage1: MASB seeks public
pronouncements
comment
Stage2: Deliberation at
pronouncements
Working
the
on
IASB's
Group
level
draft
on
of
technical
IASB's
draft
Stage 3: Deliberation at the MASB (the Board)

Stage 4: Issuance of Standard by IASB
Stage 5: Issuance of Standard by MASB
Stage 1: MASB seeks public comment on IASB's draft of technical
pronouncements
In IASBs draft Discussion Paper, Exposure Draft and Request for Views, MASB
invites local constituents to comment on its website. The invited parties are the
relevant authorities, professional bodies, accounting firms, industry-related
associations and public listed companies.
67
The deadline of commenting is one month before IASBs comment deadline. The
reason is so that MASB has enough time to analyse the comments before
forwarding them to IASB.
Stage 2: Deliberation
pronouncements
at
the
Working
Group
level
on
IASB's
draft
The draft pronouncements of the IASB Board are prepared through a Working
Group (WG) meeting. The public comments are referred to in the meeting as well
(see Stage 3).
Stage 3: Deliberation at the MASB (the Board)
WG's comments and recommendations are summarised then and sent to the
Board for deliberation and consideration. After the Board reviews all comments
received, a comment letter to the IASB will be prepared and submitted to IASB
accordingly.
Stage 4: Issuance of Standard by IASB
When IASB (IFRS) is issued, WG deliberates on the modifications, and then,
sends recommendations and implications of standard to MASB to be considered.
Stage 5: Issuance of standard by MASB
MASB Board performs the due deliberation which leads to MFRS preparation. A
copy of that will be sent to FRF before issuing the standards as a Malaysian
approved accounting standard
The steps discussed above are depicted in Figure 4.15.
68
Figure 4.15: Due Process of standard-setting in Malaysia
4.5.4
Overview of FRS and the Adoption of FRS in

Malaysia
With the progress due to globalisation, it seemed necessary to have harmonised

financial reporting standards. Malaysia welcomed the accounting standards
global harmonisation because of a number of benefits it brings.
Some of the IFRS adoption advantages are:
(a)
Improved comparability of financial statements;
(b)
More advanced and complex reporting;
(c)
Reduction of political influence;
(d)
Greater access to capital markets;
(e)
Wider opportunities for both foreign and institutional investors in terms of

investment and credit decisions; and
(f)
Improved transparency, accountability as well as reducing costs (Chand &

White, 2007).
Several Malaysian governmental agencies were established to adopt the

globalised accounting standard. In order to protect the governments interest in
69
this aspect, a two-tier framework which consists of The Financial Reporting

Foundation (FRF), and the Malaysian Accounting Standard Board (MASB) under
the Financial Reporting Act 1997, was established.
For FRF, a total of 19 members were appointed by the Ministry of Finance (MOF)
and their aim is to monitor the MASBs performance, financial and funding
arrangements. FRF also functions as an initial source of opinions for the MASB
on proposed standards and pronouncements. It must be noted that FRF is not
directly responsible for setting the accounting standard.
In terms of MASB, it makes sure that the Malaysian accounting standards are
derived from the International Accounting Standards (IAS). To date, a total of 24
accounting standards of IASs were adopted and approved.
The harmonisation of IFRS began many years ago, within 2004 to 2005. The
MASB discussed the implications and effects of IFRS adoption. Prior to this
period, MASB instructed all Malaysian listed companies to adopt 21 Financial
Reporting Standards (FRS). It was decided that January 1, 2006 was the effective
date for the harmonisation of Malaysian financial reporting with the globally
approved accounting standards. By January 1, 2012 both FRF and MASB agreed
to fully adopt all IFRS. The MASB corresponded with the IFRS numbering,
however, adding a prefix of 1 which denotes an Islamic financial reporting
standard. The following section will focus on the challenges experienced by
Malaysia in the adoption process of IFRS
Challenges in adoption of IFRS
Malaysian companies were challenged by a few aspects of financial reporting.
The first issue faced for IFRS adoption was the high degree of complexity. A case
for this point is accounting for goodwill. More accounting techniques and
disclosures are required by the accounting standard for goodwill. In addition, the
local political and economic factors limited the comprehensive IFRS adoption in
different countries.
However, some challenges of IFRS adoption was shared among different
countries, like Malaysia.
Lack of enough expertise and a forced timeline for the convergence toward IFRS
in 2012 was the most common challenge. Another issue was fair value
accounting. It is still not clear how to implement fair value of financial
instruments, IFRS 9 in particular. Moreover, the earnings will not be stable by fair
value accounting implementation. As a result, it is necessary for the financial
reporters to inform the stakeholders about the impact of using IFRS on profit.
70
The conceptual framework (CF) is a structured theory of accounting.
The conceptual framework was intended to provide a coherent and

prescriptive guide to practice.
Reasons of the conceptual framework:

The framework will provide guidance to standard-setters in the
development of future standards;
It will promote more harmonised reporting and reduce the number of

alternative treatments;
It will help preparers, auditors and users of financial statements as well as

increase the decision usefulness of the financial information; and
It can limit the potential for political interference in standard-setting.
Problems with the conceptual framework:
Unspecified rules and conventions;
Does not resolve contemporary disclosure issues;
Vague definitions;
Do not address measurement issues;
Risk of mechanical decision making; and
The framework may become an end in itself.
In response to the corporate collapses (such as Enron, WorldCom and Global

Crossing) in the US, the FASB was set up in 1973 to develop the conceptual
framework. Based on FASBs conceptual statements, the IASB Framework
was issued in 2001.
The IASB framework has been used as a basis for the MASBs proposed
conceptual framework.
71
The structure for the IASB conceptual framework:
States the scope and objective of financial reporting;
Identifies and defines qualitative characteristics of financial information; and
Develops principles and rules of recognition and measurement;
Qualitative characteristics for the financial statements include:
Relevance (feedback value, predictive value, timeliness and materiality);
Understandability;
Reliability (representational faithfulness, verifiability, completeness and

neutrality); and
Comparability (consistency).
The three key assumptions for the financial statements are:
Accrual basis;
Going concern; and
Periodicity.
The two key constraints for the financial statements are:
Timeliness; and
Costs versus benefits.
The elements of financial statements are:
Asset;
Liability;
Equity;
Revenue; and
Expense.
There is a distinction between the definition and recognition criteria for the
elements. A transaction that meets the definition of an element, but fails in
the recognition criteria will not be included in the financial statements.
72
Accountants must measure properties of the elements that provide relevant

and reliable information, appropriate for making and evaluating decisions on
the allocation of scarce resources.
Accounting standard-setting involves a long process and many parties. As a

result, it is important to make sure the proper procedures are conducted and
feedback from all parties is gathered.
Comparability
Prudence
Completeness
Relevance
Conceptual framework
Reliability
Consistency
Representational faithfulness
Feedback value
Substance over form
Materiality
Timeliness
Neutrality
Understandability
Predictive value
Verifiability
1.
The IASB Framework is an example of

(a)
Empirical research.
(b)
Positive accounting theory.
(c)
Normative accounting theory.
(d)
Descriptive accounting theory.
2.
3.
4.
73
Which of the following underlying principles is the IASB framework based

on?
(a)
Accrual basis and materiality.
(b)
Substance over form and comparability.
(c)
Relevance and reliability.
(d)
Accrual basis and going concern.
What are the primary qualities necessary in selecting information for

inclusion in financial reports?
(a)
Prudence and understandability.
(b)
Relevance and reliability.
(c)
Comparability and reliability.
(d)
All of the above.
Which of the following users of financial statements are recognised by the

IASB Framework?
I
Lenders
II
Managers
III
Government
IV
Public
(a)
I and II only
(b)
I, II and III only
(c)
I, III and IV only
(d)
I, II, III and IV
74
5.
Which of the following qualitative characteristics of financial statements is

recognised in the IASB Framework?
6.
Relevance
II
Reliability
III
Understandability
IV
Comparability
(a)
I and II only
(b)
II and IV only
(c)
I, II and IV only
(d)
I, II, III and IV
The body responsible for developing the conceptual framework for

Malaysia is
(a)
IASB.
(b)
MIA.
(c)
FASB.
(d)
MASB.
1.
Describe the structure of a conceptual framework of accounting.
2.
What is the objective of a conceptual framework?
3.
State and explain whether the following statement is true or false:
Even if a liability meets the IASB framework definition, it still should not
be recognised if the firm cannot measure reliably the future sacrifice to be
made.
4.
5.
75
What is meant by the following terms in relation to the conceptual

framework?
(a)
Qualitative characteristics for financial statements.
(b)
Elements of financial statements.
(c)
Assumptions.
(d)
Constraints.
What type of information do you think is useful for shareholders, creditors

and public?
Topic Earnings
Measurement
and Creative
Accounting
LEARNING OUTCOMES
1. Define earning management;
2. Discuss some of the earning management techniques;
3. Explain the advantages and disadvantages of earning management;
4. Explain creative accounting; and
5. Discuss some of the practical cases for earning management, its
consequences and effects in Malaysia.
INTRODUCTION
This chapter discusses earning management and its implications and
consequences. Earning management is concerned with the managers intention to
manipulate the financial information of the company to make the companys
overview seem favourable. As a result, the financial information of the company
lacks necessary qualitative factors. Some of the techniques to conduct the earning
management are discussed. This chapter ends with some cases regarding earning
management. Through the cases, the empirical situations in which the earning
has been manipulated in order to mislead the financial information users are
referred to as well. Next, the chapter provides some examples of local and
foreign cases that relate to creative accounting. In creative accounting,
TOPIC 5 EARNINGS MEASUREMENT AND CREATIVE ACCOUNTING
77
accountants manipulate the accounting numbers by using their accounting

knowledge and roles.
5.1
OVERVIEW OF EARNINGS MANAGEMENT
Earning management is defined as the manipulation of financial and

accounting information so that the organisations performance becomes
favourable for stakeholders. Earning management brings the quality of
financial reporting into question and reliability of financial information is
at risk.
Earning management has become so widespread on the grounds that it has a lot
of personal benefits for managers to alter not only the organisations profitability
but also their own performance. Although earning management rate is on the
rise, individual investors are not able to discover it due to the current
complicated accounting rules.
To fight earning management efforts, the Security and Exchange Commission
(SEC) has underscored the necessity of elevating transparency in financial
reporting. This can be done by standard-setters through changing or improving
the processes of financial reporting so as to increase the quality, relevance and
reliability of accounting information. Another way SEC has chosen to combat
earning management is to convict managers who have committed fraudulent
behaviours in manipulating enterprise earnings.
5.2
PATTERNS OF EARNING MANAGEMENT
The following are some of the techniques to commit this unethical earning
manipulation:
(a)
"Cookie-jar" Reserves
According to GAAP, accounting for accruals includes a range of
estimations. Managers can pick a number from this range. If manager
chooses the highest number in the range for a typical expense and, when
the actual costs are incurred, the balance of this cost is transferred in the
subsequent period(s). This manager has deliberately made a cookie jar
reserve. This reserve helps the following period profit to be higher if the
real costs incurred within previous periods are lower than estimated costs
in that period.
78
Estimations examples include sales returns, warranty costs and pension

costs.
(b)
Big Bath
Companies are involved in some changes in their processes or structures to
keep their competition power. These modifications are costly which are
reported by an estimated number. Since managers report these costs, the
opportunities exist for real cost manipulation. This technique is called Big
Bath.
(c)
Big Bet on the Future

When an acquisition occurs, the corporation acquiring the other is said to
have made a big bet on the future.
In case of merger and acquisition occurrence, the acquirer is able to do the
following activities:
(i)
Reduce current earning by writing the research and development

processes costs involved in acquired company. In short, when the
costs are actually incurred in the future, they will not have to be
reported and thus future earnings will improve; and
(ii)
Increase the profit of the acquirer by integrating profits of acquired

company in financial reports. By acquiring another company, the
parent company buys a guaranteed improvement in current or future
earnings.
There are many other techniques for earning management, even though as stated
above, it is difficult for individual investors to figure them out.
5.3
EVIDENCE OF EARNING MANAGEMENT

FOR BONUS PURPOSES
The most well-known research on the bonus-related earning management has

been done by Healy (1985). Healy examined managers choices of accounting
policies in his paper entitled The Effect of Bonus Schemes on Accounting
Decisions. The bonus scheme he targeted had a linear relationship between the
net income and managers bonuses. However, the bonus starts with a minimum
amount of net income called bogey. The maximum bonus a manager could earn
was titled as cap where beyond a certain amount of net income, manager would
not receive any more bonuses. It was hypothesised that managers take advantage
of this bonus range to maximise their bonus under this compensation plan. This
hypothesis is driven on the grounds of the fact that managers are not motivated
79
to increase income when income is below the bogey or above the cap, because
there is no potential to gain a higher bonus.
As the empirical research revealed, the average accrual of firms with the net
income between bogey and cap had been increased for 94 companies within a
period of 50 years. Consequently, the net profit had been increased which led to
higher managers bonuses. On the contrary, firms with the net income either
below the bogey or above the cap had negative average accruals due to lack of
bonus opportunity for managers.
In addition, the findings of Healys study indicated that whenever changes in
accounting policies (such as amortisation calculation) affected the net profit,
firms conducted after bonus schemes which were introduced to managers.
5.4
MOTIVATIONS FOR EARNINGS

MANAGEMENT
Several motivation aspects are involved in earning management, which include:

(a)
Income Smoothing
Managers attempt to use their reporting discretion to intentionally dampen
the fluctuations of their firms earnings realisations.
(b)
Meeting Market Analysts Forecast

Companies engage in earnings management to meeting or beating the
analysts forecasts because the investors will make decisions based on the
analysts forecasts.
(c)
Stock Market Incentives

Companies engage in earnings management to encourage better reporting
which will lead to higher investment by investors.
(d)
Personal Incentives
The CEO of the company tries to manage earnings to show better
performance under their management. This is to fulfil the CEOs personal
interest.
(e)
Internal Motives
Earnings management occurred within a company. For example, financial
reports were altered to meet performance standards.
80
(f)
Management Compensation Contract Motivation

Managers manage the earnings in order to meet the bonus plan. It is
believed that managers are motivated to use earnings management to
improve their compensation or rewards.
(g)
Lending Contract Motivations

The companies which have huge amount of debts have an incentive to
manage earnings so that they do not breach their debt covenants.
(h)
Regulatory Motivations
Companies operating under closed monitoring for compliance with
regulations linked to accounting figures and ratios tend to manage
earnings. Such regulations may give managers incentives to use earnings
management.
5.5
THE ADVANTAGES AND DISADVANTAGES

OF EARNING MANAGEMENT
According to the agency theory, each person is motivated to increase self-interest.

Since managers are the principles agents in firms, conflicts of interest may arise
between them. The reason is the fact that managers are motivated to manipulate
net income so as to earn higher bonuses. To gain this incentive, managers may
take advantage of their freedom to choose the accounting method which creates
higher net income. This can be seen from two sides.
On one hand, earning management is bad because of the threat it imposes on
financial reports reliability. Earning management results in inside information
being revealed to the public which seriously damages the image of the company.
On the other hand, earning management provides managers the flexibility
lacking in the contracts with strict terms. If manager is controlled for the selfinterest risk, earning management comes in handy for smoothing the imposed
contract condition. In addition, blocked communication in terms of management
experience and competence is lifted by the earning management. Therefore,
investors and the board of directors will be informed about the expertise level of
the manager.
SELF-CHECK 5.1
Briefly outline the four motivation of earning menagement.
5.6
81
CREATIVE ACCOUNTING
Creative accounting can be defined as a process whereby accountants or accounts

preparers use their knowledge of accounting rules to manipulate the figures
reported in the accounts of a business. Since the accounting process involves
discretionary judgement to deal with conflicts between various approaches in
preparing financial statement, the process provides room for manipulation,
deceit and misrepresentation. These activities are known as creative accounting.
According to Amat, Blake and Dowd, 1999, creative accounting is defined as:
The accounting process consisting of dealing with many matters of
judgement, and of resolving conflicts between competing approaches to the
presentation of the results of financial events and transactionsthis
flexibility provides opportunities for manipulation, deceit and
misrepresentation. These activities practised by the less scrupulous
elements of the accounting profession have come to be known as creative
accounting.
Creative accounting has been attracting a lot of attention in recent times due to
the many corporate scandals. For example, Enrons management hid debts and
inflated profits using off-balance sheet techniques; HIH employed creative
accounting techniques and obtained unqualified audit reports to hide its
insolvent position; WorldCom was under investigation for its US$7 billion
accounting misrepresentations.
There are two main reasons why a firm uses creative accounting. They are:
(a)
To prevent shareholders from withdrawing capital; and
(b)
To show good stewardship and performance.
In other words, companies use creative accounting to show favourable returns on

their investors money.
However, it is important to note that creative accounting in itself is not
necessarily all bad. On the positive side, creative accounting helps to smoothen
up income patterns of large corporations, so as to avoid scrutiny and attention
from authorities and lobby groups with political agendas. Also, companies that
deal with volatile markets such as the oil companies might use creative
accounting to flatten erratic results so as to prevent alarming their investors. In
addition, companies that need financial support might use accounting policies to
achieve good debt ratios and high profitability margins.
82
However, from the negative perspective, creative accounting can mislead

investors by untruthfully reporting financial information of the firm in a
favourable light. This manipulative practice is often called cooking the books
Figure 5.1: Accountants may mislead investors by cooking the books
Another contributing factor as to why companies use creative accounting has

been the vagueness and flexibility of appropriate accounting treatment in the
accounting standards and legislations. Companies are allowed to decide the
accounting method that best suits their organisational needs. In other words, a
company has an option of deciding on accounting methods that gives their
preferred image (Amat et al. 1999).
The following demonstrates some local and foreign cases of creative accounting.
ACTIVITY 5.1
Creative accounting should be controlled by a stringent audit process.
Comment on this statement. Can you think of any other means of
control?
5.6.1
83
Local and Foreign Cases of Creative Accounting
Creative accounting is a common practice in the accounting profession. Here are

some cases of creative accounting:
Local Case:
Transmile Group Berhad
Transmile Group Berhad (Transmile), established in 1993, was principally
involved in the provision of airfreight, aircraft engineering and maintenance
services. The company was listed on the Bursa Malaysia in 1997. Transmile
shareholding as at 28 April 2006 was shared among local and foreign investors.
Some of the important investors were Pos Malaysia Berhad (17.3 per cent), JP
Morgan Chase Bank (USA) (4.4 per cent), Employee Provident Fund (3.9 per
cent), GAP Ltd (3.9 per cent), Goldman Sachs International (3.4 per cent) and Gan
(2.5 per cent). Transmile had flights from Peninsular Malaysia and East Malaysia,
to countries like China, Thailand and India.
By increasing its network, Transmile revenues and profit increased as well.
However, the accounting scandal in 2007 revealed the real story. When the
company did not submit its audited financial statements by its deadline for the
fiscal year of 2006 to Bursa Malaysia, its external auditor, on 4 May 2007, offered
an adverse opinion over the annual accounts due to the lack of supporting
documents. After another party conducted more sophisticated auditing, it was
revealed that the revenues and profits had been materially overstated from 2004
to 2006. The fact was that the company incurred loss instead of profit within all
these years.
Consequently, the shares declined from RM14 to RM8 due to the public
announcement of the scandal in May 2007. The market capitalisation
substantially suffered from this price off.
Figure 5.2 shows the Transmile Group Berhad stock price within the first 10 days
of May 2007.
84
Figure 5.2: Transmile Group Berhad stock price

Source: thestar.com
Megan Media Holdings Bhd

Megan Media was a company dealing with optical media storage. In April 2007,
two main subsidiaries failed to provide trade facilities. The creditor bank
initiated investigation on the wholly-owned subsidiary called Memory Tech
Sdn Bhd.
The first report showed notable irregularities in the Memory Techs financial
statements, fictitious trade creditors and debtors, undisclosed related party
transactions and a bogus deposit payment of RM211 million for production lines.
The Security Commission commenced the scrutiny on the whole group. As was
expected, the investigations on Megan Media uncovered losses which were
shown as profit instead. Since the company defaulted in submitting its
regularisation plan to the authorities according to the PN17 timeframe, it was
delisted in April 2008.
SCAN Associates Bhd
SCAN, the information and communications technology security solutions
provider, started to be under investigation from January 2009, when CEO Datuk
Aminuddin Baki Esa was removed and a police report was filed.
85
The reason for this was announce as misappropriation of funds. The earning
was manipulated and RM1.7 million was paid to a supplier who never made
any delivery.
The total financial effect was RM5.86 million which would be adjusted in the
previous year accounts.
SCAN also reported to police about its CEOs intention to mislead the board of
directors by manipulating RM6.8 million of its revenue in 2005 and 2007.
Although the CEO was the major shareholder, the board removed him in an
extraordinary general meeting in March 2009.
DIS Technology Holdings Bhd (DIST)
DIST, as an information technology and consumer electronics manufacturer,
announced on March 2008 that due to employee fraud, some of its recent
quarterly reports may have been misstated. As claimed, Starlight Marketing Ltd,
a major customer from Hong Kong reported this to DIST.
The significance of this fraud became apparent when it was considered that the
total sales to Starlight in 2008 and 2009 were about RM131 million, but RM82
million of that had not been paid yet.
After conducting investigative auditing in March, it was uncovered that there
was no personnel involved in this fraud. Consequently, it became a GN3
company in April of that year and trading in its shares had been suspended since
May 10.
The company faced major challenges in its operations due to its suppliers
disapproval to credit sell, lowered confidence in its products, failure to pay EPF
contribution and income tax and the banks withdrawal of its credit facilities.
Closing remark:
All the cases reported above demonstrate creative accounting incidents. Based
on agency theory and positive accounting theory, creative accounting exists in
relation to both managers and shareholders and from the loose accounting
standards that allow managers and accountants to practice their discretionary
judgement. In conclusion, creative accounting offers a formidable challenge to
the accounting profession.
86
Earning management is a process of manipulation of financial and

accounting information so that the organisations performance becomes
favourable for stakeholders.
Pattern of earning management include cookie-jar reserves, Big Bath and

big bet on the future.
Motivations for earning management include income smoothing, meeting

market analysts forecast, stock market incentives, personal incentives,
internal motives, management compensation contract motivation, lending
contract motivations and regulatory motivations.
Creative accounting can be defined as a process whereby accountants or

accounts preparers use their knowledge of accounting rules to manipulate the
figures reported in the accounts of a business.
Big Bath
Earning management
Big bet on the future
Fraud
Cookie-jar reserves
Misstatement
Creative accounting
Scandal
Discuss what actions can companies take in order to prevent the above
mentioned financial failures.
What are the other two methods of earning management?
Topic
Recognition
of Issues
Associated
with Asset
and Liability
LEARNING OUTCOMES
1. Define assets and liabilities;
2. Identify the recognition criteria for assets and liabilities;
3. Explain the importance of the recognition criteria for assets and
liabilities;
4. Discuss the impact of the recognition criteria on assets and liabilities;
and
5. Apply the concepts of value in the measurement of assets and
liabilities.
INTRODUCTION
What is an asset? What is a liability? The Oxford dictionary defines asset as a
thing, especially property owned by a person, company, etc. that has value and
can be used or sold to pay debts. Liability is defined as a debt; a financial
obligation.
88
TOPIC 6 RECOGNITION OF ISSUES ASSOCIATED WITH ASSET AND LIABILITY
So, can we say that a firms building is an asset? Most of us would say that it is an
asset.
Figure 6.1: Is a firms building an asset?
Let us ponder on Figure 6.1. Now, assume that the building was infested with
rats and was in such a bad condition that rendered it to be unusable for a long
period of time. Would you still hold the view that the building is an asset?
What if the workers who worked near the building suffered from health
problems due to the unhygienic environment and were suing the firm? Does the
firm have a liability, even though the case has not been decided?
These are the issues that will be covered in this topic.
6.1
WHAT ARE ASSETS?
An asset is any item of economic value which an individual or corporation owns

or controls, that could be converted to cash. Let us discuss this in detail.
6.1.1
Types of Assets
Visualise yourself as an accountant trying to list down all the assets that your
company owns. Bear in mind that the assets may come in different forms!
Usually, assets can be classified in a number of ways (refer to Table 6.1)
89
Table 6.1: Classification of Assets

1.
The Tangibility of the Assets
Tangible (Has Physical Substance)
Intangible (No Physical Substance)
Examples:
Example:
Property, plant and equipment
Patents, trademarks and brand names

2.
The Nature of the Assets
Monetary
Non-monetary
Examples:
Examples:
Cash and accounts receivable
Inventory and property, plant and equipment

3.
The Source of the Assets
Acquired externally
Generated internally
Assets are recognised at the cost of

acquisition.
Assets are recognised at their cost of

manufacturing or construction.
4.
The Longevity of the Asset
Consumed or used within a short period
Retained for a longer period
Examples: Current assets
Examples: Non-current assets

5.
The Liquidity of the Assets
Can be converted into cash at short notice
Cannot be converted into cash at short

notice
Example: Cash
Example: Plant and equipment
Are you already confused with all these classifications of assets?

Dont worry. There is an easier of way of understanding what an asset really is.
Check out the Malaysian Accounting Standard Boards Portal at
http://www.masb.org.my/ for the latest issuance, amendments and
announcements on the accounting standards.
90
6.1.2
Definition
Based on the Malaysian Accounting Standard Boards (MASBs) Framework for

the Preparation and Presentation of Financial Statement, an asset is defined in
paragraph 49(a) as:
A resource controlled by the entity as a result of past events and from
which future economic benefits are expected to flow to the entity.
Do pay close attention to the key words in bold.

Now, let us try to analyse each of these key words:
(a)
Future Economic Benefits

The future economic benefits in an asset refer to the assets potential to
contribute, directly or indirectly, to the flow of cash and cash equivalent to
the firm.
The future economic benefits may flow to the firm in the following ways:
(i)
an asset may be used solely or in combination with other assets in the

production of goods and services to be sold by the firm; and
(ii)
an asset may be exchanged for other assets.
An asset may be used to settle a liability; and
An asset may be distributed to the owners of the entity.
For profit-seeking organisations, the future economic benefits are used to

provide goods and services for exchange with the objective of generating
net cash inflows. The net cash inflows may include reduction in cash
outflows.
For non-profit organisations, the assets are used to provide services to the
beneficiaries. As generation of net cash inflows is not always the objective
of these organisations, these assets can benefit the organisations by enabling
them to meet their objectives of providing needed services to the
beneficiaries.
In summary, an asset is something that exists now and has the capability of
rendering service or benefit currently or in the future.
(b)
91
Controlled by the Entity

To be qualified as an asset, the economic benefit must be controlled by the
entity.
Ijiri (1967) states that:
Accounting is not concerned with economic resources in general, but only

those which are under the control of a given entity.
The capacity of an entity to control benefits is usually the results of legal
rights. In other words, ownership is often concurrent with control.
However, having legal rights is not the most important characteristic. An
asset may still satisfy the definition of an asset if the entity controls the
benefits which are expected to flow from the property, even though the
entity does not have legal ownership to the asset.
Example:
A transport company purchases a lorry for RM200,000. It pays RM50,000
now and agrees to pay the balance in instalment over the next two years. Is
the lorry an asset of the company?
In the above example, the transport company does not have the legal ownership
for the lorry until it has fully settled the payment. However, it owns the legal
rights to use the lorry. In other words, it has the right to obtain the service of the
lorry and it has control over the lorry. Thus, the lorry can be considered as an
asset of the company in the accounting sense.
Another example of asset is a property on lease. A company can consider the
leased property as its asset if it controls the benefits which are expected to flow
from the property.
ACTIVITY 6.1
Give another two examples of assets whereby the user has control but no
legal right over the assets.
92
(c)
Past Event
The asset of a firm must result from past transaction or other events. In
other words, transactions or events expected to occur in the future do not
give rise to assets.
Example:
ABC Company acquired a printing machine early this year. Therefore, the
machine is an asset. ABC is budgeted to purchase a second printing
machine later this month. In this case, the second machine is not an asset as
the transaction has not yet taken place.
6.1.3
Recognition Criteria
Have you ever wondered why human resource is not recorded as an asset in the
balance sheet?
Well, employees certainly provide future economic benefits to the company, the
company pays their wages therefore has control over them and they are the
result of a past event (the recruitment of the employees).
However, human resource is not generally recorded as an asset. This is because it
fails the recognition criteria.
An asset is recognised when:
(a)
It is probable that the future economic benefits will flow to the entity; and
(b)
The asset has a cost or value that can be measured reliably.
Probable means that it is more likely rather than less likely that future benefits
will arise.
Measured reliably means the asset must be capable of being measured reliably
before it can be recognised. If the assets value cannot be determined without
being arbitrary or subjective, then the asset is not recorded.
Going back to the earlier example on human resource, it is obvious that the
employees contribution to the company cannot be measured reliably, as the
employees may fall sick, go on emergency leave, be affected by personal
problems, suffer from depression and other factors, which are very much beyond
the control of the company.
93
IMPORTANT!
In summary, even though the probability of realising the future economic
benefits is not important to defining an asset under MASB framework, it is
critical in deciding whether to record an asset.
SELF-CHECK 6.1
1.
What are the types of assets?
2. Explain the key words that make up the definition of asset.
Now that we know what assets are and when to record them, let us look at
another important element in the balance sheet liability.
6.2
WHAT IS LIABILITY?
These are a companys legal debts or obligations which arise during the business
operations. Liabilities are settled over time through the transfer of economic
benefits such as money, goods and services.
Let us examine this in detail.
6.2.1
Types of Liabilities
As with assets, liabilities can be classified in a number of ways (refer to Table 6.2).
Table 6.2: Classification of Liabilities
1.
The Nature of the Liabilities
Monetary
Non-monetary
Examples:
Examples:
Accounts payables amounts are fixed

regardless of changes in the purchasing
power of the ringgit.
Long service leaves amounts owing are

not fixed.
2.
The Longevity of the Liabilities
Settlement within a short period
Settlement in a longer period
Examples: Current liabilities
Examples: Non-current liabilities

94
6.2.2
Definition
Based on the MASBs Framework for the Preparation and Presentation of

Financial Statement, a liability is defined in paragraph 49(b) as:
A present obligation of an entity arising from past events, the settlement
of which is expected to result in an outflow from the entity of resources
embodying economic benefits.
Again, just like the definition for assets, do pay close attention to the key words
in bold.
Now, let us us try to analyse each of these key words:
(a)
Present Obligation
An obligation is a duty or responsibility to act or perform in a certain way.
A decision by the management to acquire assets in the future does not, of
itself, give rise to a present obligation.
An obligation arises only when the asset is delivered or the company enters
into an irrevocable agreement to acquire the asset.
Now, let us look at how present obligation can be settled. Settlement of
present obligation may occur in many ways (refer to Figure 6.2):
Figure 6.2: Ways of settling present obligation

95
Do you know the parties who may have claims on the company? They are
the creditors and the owners of the company. Do bear in mind that between
the claim from creditor and claim from owner, only the claim from creditor is
a liability, because the creditor has prior claim on an asset in case of
liquidation. Also, the creditors claim is almost more specific in terms of the
amount and the timing of the payment, as compared to the owners claim.
In addition, the creditors claim is an obligation of the company. The
owners equity claim is basically a residual interest or claim, and not an
obligation of the company to transfer assets.
So far, we have discussed the various ways in which a company can settle
its present obligations, and the fact that only claim from creditors are
liabilities. Let us now examine the different kinds of obligations that a
company may have.
Generally, liabilities stem from legally enforceable obligations, as a result of
binding contracts or statutory requirements.
Liabilities can also arise from equitable or constructive obligations. An
equitable obligation arises from a moral or social obligation to transfer
assets. For example, ABC Chemical Company has polluted the river. Even
though it has no legal obligation to pay for the clean up work, it has an
equitable obligation to rectify the problem.
A constructive obligation is created, inferred, or construed from the facts
in a particular situation. For example, a company has the practice of giving
out refunds for damaged goods even when there is no legal obligation for
such refund. Another example of constructive obligation is when a
company has a policy of paying out special bonuses to its senior managers
during festive seasons even though there is no legal obligation to do so.
It is important to note that the present obligations can only be settled
through the transfer of assets.
Heres a challenging question for you:
ABC Company borrows RM100,000 from XYZ Bank and promises to repay
the loan by giving 10,000 of its own ordinary shares. Is it a liability?
The answer is NO. This is because ABC is not making a transfer or sacrifice
of asset. Shares in the company are not shares of the company. In reality,
this is unlikely to happen because no bank will be willing to assume this
kind of equity risk.
96
(b)
Past Events
Liabilities must result from past transactions or other past events. This is to
ensure only present liabilities are recorded and not the future ones.
Examples:
Accounts payable arises from the purchase of goods and the usage of
services;
An obligation to repay the bank for the receipt of bank loans; and
Future rebates based on annual purchases by customers.
SELF-CHECK 6.2
1. What are the types of liability?
2. Explain briefly the two key words that make up the definition
of liability.
ACTIVITY 6.2
Can you think of three items of liability in the balance sheet?
6.2.3
Recognition Criteria
As presented earlier in our discussion of assets, after the liability has been
defined, it is necessary for us to look at the criteria for recognising the particular
liabilities.
Similar to the criteria for assets, a liability is recognised in the balance sheet
when, and only when:
It is probable that the future sacrifice of service potential or future economic

benefits will be required; and
The amount of the liability can be measured reliably.
Most liabilities are determined on the basis of legal claims against the company
that it is obliged to meet.
97
The determination of the economic substance of the event is also important.

Economic substance has to do with the relevance of accounting information.
It is a common practice for accountants to be more willing to record liabilities
than assets. This is called the conservatism principle.
If the measurement is subjective and arbitrary, then it cannot be recorded as a
liability as unreliable information can be misleading.
6.3
MEASUREMENT
The definition of accounting measurement is the calculation of economic or

financial activities in terms of money, hours or other units. The measurement is
use to compare and evaluate accounting data.
6.3.1
Why Measurement Matters?
The measurement of assets and liabilities is important because it affects decisions

made by the users of financial statements. In other words, measurement affects
the users assessment of the financial performance and position of the company.
For example, measurements can affect investment and lending decisions. Most
lending contracts contain debt covenants that specify the maximum level of
leverage that a firm can have.
Another example would be the management compensation plans that specify
that management is to be rewarded for meeting profit targets. In this case,
measurement affects the levels of profit-based bonuses paid to the managers.
Managers might try to reduce expenditure on, let us say, research and
development, maintenance or advertising to boost current period reporting
profits. Alternatively, managers might delay the purchase of assets in order to
retain liquid resources to meet debts.
What do you think will happen if the liabilities are grossly understated and
assets are grossly overstated? As individuals like investors and lenders rely on
the reported measurements when making decisions, obviously they will suffer
losses especially if the company fails or is less economically profitable than
expected. Investors may even take legal action against the company on the basis
of such losses.
98
ACTIVITY 6.3
What do you think will be the effect of overstatement of liabilities and
understatement of assets?
6.3.2
What Do We Measure?
Generally, we measure the value characteristic of each asset and liability for
accounting purposes.
There are several monetary values that can be used to value the characteristics of
assets and liabilities, such as historical cost, current cost and exit price level. We
will discuss these measurement bases in Topic 8 of this module.
Now, let us try to answer this question:
Question:
Which measurement base, in terms of measuring the value of assets and
liabilities, would provide the most relevant and reliable accounting information
to managers, investors and creditors?
Basically, the firms choice of measurement base will depend on whether the
measurement is in terms of:
(a)
Cost; or
(b)
Value.
Let us analyse these two terms in more detail:

(a)
Cost
The cost of acquisition of an asset is the fair value of whatever is given in
exchange for the asset plus any cost incidental to the acquisition.
Fair value is defined to be the amount for which an asset could be
exchanged in an arms length transaction between a willing buyer and a
knowledgeable, willing seller.
It is important to note that cost should be determined according to all
circumstances involved in the transactions.
99
Thus, if the firm thinks that cost should provide the most reliable and
relevant accounting information to the users, then the measurement bases
to use would be historical cost and current cost accounting.
Historical cost refers to the cost at the time the asset is incurred. However, it
is rarely a truly objective measurement since it can be measured according
to a variety of assumptions.
For example, in the case of valuation of inventory, several assumptions can
being used, such as first-in-first-out, last-in-first-out and weighted average
cost.
Current cost refers to the amount that would be paid now to acquire the
best asset available to undertake the function of the asset owned. In other
words, it focuses on the cost of a currently available asset that is expected to
replace the existing asset, adjusted for the value of any operating
advantages or disadvantages of the assets owned.
(b)
Value
Value refers to the preference that people have for some items over others
because of the perceived benefits to themselves. In other words, value is not
intrinsic to the specific asset or liability, but relates to the consumers
willingness to give up something to obtain it.
True economic value is the most useful value to the users of financial
statements. However, it is a subjective concept as it relates to the preference
or desirability people have for one item as opposed to others.
In other words, the true economic value is difficult to ascertain because
there are many variables that affect the peoples preference and the value
they place on the particular assets and liabilities. Some are more important
than others, but we do not know the proper weights to assign to them.
Therefore, to make it easier to determine the value, the variables are
compiled into a number of smaller, more manageable sets depending on the
objectives of the firm. The measurement methods commonly used are exit
price and net realisable value.
Exit price refers to the amount received from selling an asset either to a
market for new commodity or to a second-hand market.
Net realisable value is defined as the expected selling price less expected
costs of disposition.
100 TOPIC 6 RECOGNITION OF ISSUES ASSOCIATED WITH ASSET AND LIABILITY
Let us now make a comparison between cost and value.

Cost represents a sacrifice.
Value has to do with future benefits.
However, it is interesting to note that
Cost and Value relate to each other.
Cost is incurred in expectation of receiving something valuable in the future.
As such, cost is value, that is the value of opportunity foregone!
But,
Is cost always equals to value?
From the objective point of view, the incurrence of cost does not necessarily
create future value that will equal to cost. This is because cost is an indicative
value at the time of exchange. Over a period of time, if there is evidence that the
value is less than cost, or greater than cost, an adjustment should be made in the
accounts to reflect the value.
SELF-CHECK 6.3
1. Can you recall the importance of measurement in assets and
liabilities?
2. The measurement base of a firm depends on cost and value.
Explain briefly the two terms.
TOPIC 6 RECOGNITION OF ISSUES ASSOCIATED WITH ASSET AND LIABILITY 101
Asset is defined as a resource controlled by the entity as a result of past

events and from which future economic benefits are expected to flow to the
entity.
The three essential components in defining an asset is:
future economic benefits;
controlled by reporting entity does not rely on legal enforceability;

and
past transactions or events planned or budgeted transactions are

excluded.
Assets can only be recognised when:
probably future economic benefits will eventuate probability is critical

in deciding when to recognise an asset; and
the value of asset can be reliably measured.
Liability is defined as a present obligation of the entity arising from past

events, the settlement of which is expected to result in an outflow from the
entity of resources embodying economic benefits.
The two essential components in defining a liability are:
Present obligation more than legal enforceability; and
Past events.
Liability can only be recognised when:
Probable future sacrifice of service potential or future economic benefits

will be acquired; and
The value of liability can be reliably measured.
Measurement affects the assessments of financial performance and position.
In order to determine the best measurement base to value the characteristics

of assets and liabilities, the firm needs to ascertain its objectives, and from
this, infer the kind of monetary value that will best inform users about the
firm.
The measurement base will depend on whether the measurement is in terms

of cost or value.
The cost of acquiring an asset is the fair value of whatever that is given in
exchange for the asset plus any costs incidental to the acquisition.
Measurement bases to be used are historical cost and current cost.
Value refers to preference people have for some items over others because of
perceived benefits to themselves. It relates to the consumers willingness to
give up something to obtain it. Measurement bases to be used are exit price
and net realisable value.
Cost refers to sacrifice, value refers to future benefits. However, cost is

incurred in expectation of receiving something valuable in the future.
Therefore, cost is also value, that is the value of opportunity forgone.
Asset
Present obligations
Controlled by reporting entity
Probable future economic benefits
Cost
Reliably measured
Future economic benefits
True economic value
Liability
Value
Past transactions or events
1.
What attributes must an item have in order for it to be defined as an asset?

Why?
2.
How do we know when to record an asset in the balance sheet?
3.
If a liability is a present obligation, does that mean that a legally enforceable

claim must exist before a liability exists? Explain. Conversely, if a legally
enforceable claim exists, does that mean that a liability must exist? Explain.
TOPIC 6 RECOGNITION OF ISSUES ASSOCIATED WITH ASSET AND LIABILITY 103
4.
5.
Requiring the same recognition criteria of probable for all the elements of
financial statements, the MASB framework aims to make redundant which
of the following?
(a)
Matching principle.
(b)
Going concern principle.
(c)
Realisation principle.
(d)
Conservatism.
Specify whether this statement is true or false. Explain your answer.

Even if a liability meets the MASB framework definition, it still should not
be recognised if the firm cannot measure reliably the future sacrifice to be
made.
6.
Are cost and value different concepts? How do they interrelate?
7.
Why is the measurement of assets and liabilities an important issue from

the behavioural, contracting and capital market perspective?
1.
Toy World operates a chain of toy shops. The business has been operating
for five years. The chief accountant has come to you for advice about two
financial reporting issues raised at a meeting of the board of directors. For
each issue, write a brief response to the chief accountants proposal. Your
advice should include reference to the definition of the elements of financial
statements in the MASB framework.
(a)
The company has placed an order with a toy manufacturer in China

to build a specialised piece of equipment at a cost of RM800,000. The
company has paid a deposit of 10 per cent which will be forfeited in
the event of cancellation. The board of directors say there is no
intention of cancelling the contract. The chief accountant is proposing
to recognise the full amount as an asset on payment of the deposit.
(b)
In the five years that Toy World Berhad has been operating, they have
only had to pay one claim to a customer who was injured as a result
of slipping and falling on a wet floor. The claim was settled by Toy
World for RM50,000. On the basis of that experience, the chief
accountant has proposed charging RM10,000 each year as a provision
that would grow to cover any future claims that may arise.
2.
Manis Manis Berhad spent RM6,000,000 on the television advertising of its

new range of sleepwear during the year. Market research indicates that the
advertising has definitely boosted sales. Is the advertising an asset? If so,
should it be recognised?
3.
What is the concept underpinning fair value? Why does a simple concept
become difficult?
4.
Mesra Berhad is attempting to bring its account in line with the Malaysian
accounting standards. Advice the accountant of Mesra Berhad whether a
liability exists in each of the following cases and, if so, what the liability is:
(a)
An order for raw materials has been placed with the firms regular
supplier.
(b)
There is a signed contract for the construction by Bina Berhad of a

major item of plant for Mesra Berhad.
(c)
The firm has unsecured notes of RM1,000,000 outstanding. Interest is

payable every six months in June and December. It is now August.
Topic
Recognition
of Issues
Associated
with Profit,
Revenue
and Expense
LEARNING OUTCOMES
1. Define profit, revenue and expense;
2. Identify the recognition criteria for profit, revenue and expense; and
3. Examine the impact of uncertainty on profit determination.
INTRODUCTION
We have examined definitions and the recognition criteria of assets and liabilities
in Topic 6. Let us now discuss three other key elements in financial statements in
this topic profit, revenue and expense.
Profit, generally means how much richer a person or entity has become in a given
period. Reported revenue shows the firms past operation and is used to predict
future performance. Reported expense shows the firms financial position and
performance in its engagement of a range of revenue-generating activities.
106 TOPIC 7 RECOGNITION OF ISSUES ASSOCIATED WITH PROFIT,

REVENUE AND EXPENSE
However, for decades, economists and accountants have been debating on the
appropriate basis for profit measurement (refer to Figure 7.1).
Figure 7.1: Debates on appropriate basis for profit measurement have been ongoing
Source: http://www.nydailynews.com
The measurements of revenue and expense are not always straightforward

processes due to the many different business models that exist. It is extremely
crucial for a firm to adopt an appropriate measurement technique as it will affect
the perceived value of the firm.
This topic will examine some of these issues in relation to profit, revenue and
expense.
7.1
WHAT IS PROFIT?
Profit is an income distributed to the owner in the profitable market production

process (business). Profit is a measure of profitability which is the owners major
interest in income formation process of market production (Profit (accounting)Wikipedia, the free encyclopedia).
Let us see other definitions.
TOPIC 7 RECOGNITION OF ISSUES ASSOCIATED WITH PROFIT, 107

REVENUE AND EXPENSE
7.1.1
Definition of Profit
Based on MASBs Framework for the Preparation and Presentation of Financial

Statement, profit is referred to in paragraph 104 as:
The residual amount that remains after expenses (including capital
maintenance adjustments, where appropriate) has been deducted from
income. Any amount over and above that required to maintain the capital
at the beginning of the period is profit
Let us analyse the aforementioned definition.

Take a look at the first part of the definition again
The residual amount that remains after expenses (including capital maintenance
adjustments, where appropriate) have been deducted from income
You will notice that the term income is used in the definition instead of
revenue. This is because income encompasses both revenues and gains
Figure 7.2: Defining profit

REVENUE AND EXPENSE
Revenues pertain to the ordinary activities of the ongoing major or central

operations, such as sales, fees, interest, dividends, royalties and rents.
Gains are increases in net assets from peripheral or incidental transaction and
from other events that may be beyond the control of the firm. Examples, disposal
of non-current assets and unrealised gains on holding assets.
In summary, the first part of the definition shows that:
Income Expense = Profit
This formula clearly reflects the accountants view of profit, which is a
measurement of the performance of the entity and management.
Let us now examine the second part of the definition of profit.

Any amount over and above that required to maintain the capital at the
beginning of the period is profit.
Profit, alternatively, is also linked to the concept of capital maintenance, whereby
only the inflows of assets in excess of amounts needed to maintain capital are
regarded as profit.
In summary, the second part of the definition shows that:
Inflow in assets > Amount to maintain capital = Profit; or
Net assets (Ending) Net assets (Beginning) = Profit
This formula clearly reflects the economists view of profit, which is the
change in wealth.
Let us look at an example of the calculation of profit:

ABC Company invested RM10,000 cash to start a business. In the beginning of Year 1,
ABC purchased stock for RM5000. Later that year, the stock was sold for RM8000. The
owner of ABC did not take any dividend during that year.
Calculate the profit as at end of Year 1.

REVENUE AND EXPENSE
Extract of Balance Sheet as at Beginning of Year 1

Cash
RM10,000
Owners Equity
RM10,000
RM10,000
RM10,000
Extract of Balance Sheet as at End of Year 1

Cash
RM13,000
[RM10,000+(RM8,000-RM5,000)]
Owners Equity
Net profit
RM13,000
RM10,000
RM3,000
RM13,000
Calculation of profit based on accounting view:

Sales Cost of goods sold = Profit
RM8,000 RM5,000 = RM3,000
Calculation of profit based on economist view:
Owners equity (ending) Owners equity (beginning) = Profit
RM13,000 10,000 = RM3,000
7.1.2
Accounting View Versus Economic View of Profit
Accountants and economists generally agree on the definition of profit.

However, both take a very different perspective in terms of recognising profit.
Let us see what are the views of profit between accountants and economists in
Table 7.1.
Table 7.1: Differing Views of Profit
Accounting View
Economic View
Any changes in value must be transaction-based.

Profit is generated because of the operations of the
entity, and these operations are revealed by the
transactions undertaken by the firm.
Recognises any increase in value

as part of the profit.
Realisation principle Any claims of increase in the

value of the net assets must be supported by
objective evidence, such as receipts and legal claims.
Consider market
sufficient evidence.
prices
are

REVENUE AND EXPENSE
Matching principle Expenses must be measured in

terms of historical cost, so that they could be
matched with the revenues.
Unrealised gains are recognised in

income statements.
SELF-CHECK 7.1
1.
What is the definition of profit?
2. Compare and contrast the different views of profit.
ACTIVITY 7.1
Profit is a better indicator of the economic performance of a company
than cash flows. Comment.
7.2
NATURE OF REVENUE
A transaction that is revenue in nature deals with short term items such as
income and expenses. Now, let us see in detail the definition of revenue.
7.2.1
Definition of Revenue
According to Financial Reporting Standards (FRS) 118 paragraph 7, revenue is

defined as:
A gross inflow of economic benefits during the period arising in the
course of the ordinary activities of an entity when those inflows result in
increases in equity, other than increases relating to contributory from
equity participants.
Inflow of economic benefits means:

(a)
An increase in assets or decrease in liabilities; and
(b)
An increase in equity.
In other words, the definition states that revenues are increases in the total
value of assets (or a decrease in the value of liabilities) and capital other than

REVENUE AND EXPENSE
additional investment by owners. Companies undertake certain activities to

generate revenues.
It is interesting to examine the operational view of revenues by Bedford (1965).
Bedford says that revenues arise only from those activities that are part of the
general business operations. Therefore, activities such as gifts and contributions
and government bonds transactions are not considered as revenue-generating
business activities.
Bedford also listed down specifically the general business operations:
(a)
Acquisition of money resources;
(b)
Acquisition of services;
(c)
Use of services;
(d)
Disposition of services; and
(e)
Distribution of money resources.
It is important to note that, in practice, to objectively identify and measure the

amount of revenues will require a set of rules. These rules are referred to as the
recognition principles.
Let us now examine the recognition principles for revenue.
7.2.2
Recognition of Revenue
Generally, accountants will only record revenues when there is sufficient

objective evidence to support the change in value.
ACTIVITY 7.2
At what point during the earning process, with sufficient evidence, can
revenue be recorded as earned?
As previously discussed in Topic 6, the recognition criteria for assets and

liabilities are, firstly, probable inflow of future economic benefits and, secondly,
the reliability of measurement. Assets and liabilities will only be reported when
they satisfy these criteria.

REVENUE AND EXPENSE
Similarly, the recognition criteria for revenue are based on the desire for both
relevant and reliable accounting information. Specifically, the three criteria are
shown in Figure 7.3.
Figure 7.3: Recognition criteria for revenue

Let us now analyse these recognition criteria in detail:
(a)
Measurability of Asset Value

In order for the revenue to be calculated objectively, the inflow of asset
value must be objectively determined.
In other words, measurability relates to the objective ability to assign
value to the sale; and objective broadly means unbiased.
Measurability of assets values is closely linked to their collectability, that is,
whether collectability of the cash is reasonably assured. Generally,
collectability is based on judgment derived from previous experience of the
firm. Specifically, collectability is about resolving the uncertainty associated
with the realisation of revenue. Commonly, the longer the collection period,
the more uncertain it is that cash will be collected.
ACTIVITY 7.3
Must the asset received be liquid (such as cash and receivables) before
revenue can be recognised? How about a firm that sells its product in
exchange for a non-current asset (such as plant and equipment)? Can
the revenue earned be recorded?

REVENUE AND EXPENSE
(b)
Existence of a Transaction
To understand what is meant by existence of a transaction, let us now
discuss the three questions as presented in Table 7.2.
Table 7.2: Questions and Answers in Understanding Existence of a Transaction
Questions
Answers
Must a firm be a participant in the

transaction before revenue can be
recognised?
The firm does not need to be a party to the

transaction for revenue to be recognised.
Generally, a market transaction is
sufficient.
Why is a firm allowed to recognise the

revenue even though there is no
transaction in which the firm is involved?
The accounting profession believes that

objective evidence is the main criteria for
recognition, not the transaction itself. Thus,
as long as sufficient objective evidence
exists before the moment of sale, the sale of
the output is guaranteed. Example,
inventories such as rice, wheat and barley
can be valued at current market price.
Is market value sufficient in terms of

objective evidence?
The market value is sufficient objective

evidence provided that:
the asset can be readily converted to
market value at any time; and
it is a guaranteed sale.
(c)
Substantial Completion of Earning Process

Must a firm complete its operations before revenue can be recognised?
Generally, revenue is generated or earned when the firm has performed
most of the activities.
It is important to note that, in most cases, signing of contract does not create
revenue as there is no performance by the seller at that point.
Sales point is generally considered as the most appropriate time to
recognise revenue.
According to Coombes and Martin (1982), revenue can be recognised at several

points in the operating cycle, depending on the industry the firm is in. A firms
operating cycle is presented in Figure 7.4.

REVENUE AND EXPENSE
Figure 7.4: A firms operating circle

Source: Adapted from Coombes & Martin (1982)
Now, looking at the operating cycle, let us try to answer this simple question:
At what point of the operating cycle should revenue be recorded as earned?
Coombes and Martin (1982) say that revenue is recognised at several points in
the earning cycle, for example:
Point 5 (Progressively throughout production) has been the point of earned

revenue recognition in the building industry for long-term construction
contracts;
Point 6 (Completion of production) has been the point of earned revenue

recognition for gold-mining companies and also wheat farmers. This is only
applicable when production is the critical event and the subsequent sale is

REVENUE AND EXPENSE
merely a routine transaction. In other words, the demand for the output must
be assured;
Point 7 has been applied where it is the responsibility of the purchasers to

collect the goods;
For most cases, Point 8 (delivery of goods to customers) has been the point
whereby the revenue is recognised as earned. This has been applicable to, for
example, soft drinks manufacturers, furniture manufacturers etc; and
Point 9 (Receipt of cash) has been the earned revenue point for professional
practices and for instalment credit sales.
IMPORTANT NOTE!
In the process of deciding whether the revenue should be recorded as earned, your
primary consideration should be the economic substance of the transaction or event,
and not its legal form. In other words, for the revenue to be recognised as earned by the
vendor, the vendor must pass over his or her control over the future economic benefits of
the goods to the buyer.
SELF-CHECK 7.2
1. What is revenue?
2. How is revenue recognised? Explain briefly.
ACTIVITY 7.4
Do you agree that revenue should be recognised in the period in
which service is rendered? Justify your answer.

REVENUE AND EXPENSE
7.3
NATURE OF EXPENSE
Generally, we can define expenses as the cost required for something or the
money that we spend on something. Let us discuss the definition of expenses in
accounting.
7.3.1
Definition of Expense
According to the MASBs Framework for the Preparation and Presentation of

Financial Statements, expense is defined in paragraph 70(b) as:
decreases in economic benefits during the accounting period in the form of
outflows or depletions of assets or incurrence of liabilities that result in
decreases in equity, other than those relating to distributions to equity
participants.
Do pay special attention to the words in bold.

Outflow or depletion of assets or incurrence of liability
Expenses are costs arising in the course of the ordinary activities, for example,
cost of sales, wages and depreciation. Normally, they are either outflows or
depletion of assets such as cash and cash equivalent, inventory, stocks, property,
plant and equipment.
7.3.2
Recognition Criteria and Matching
Similar to revenue, for an expense to be recorded in the financial statement, it

must meet the recognition criteria, which are firstly, probable that future
economic benefit will flow, and secondly, its cost or value must be measurable.
However, there is another principle that the accountants need to be concerned
with. It is the matching concept.
The matching concept provides guidance to the accountants in determining
whether a cost should be expensed and matched against revenue for the period
(and thus presented in the income statement); and which costs remain unexpired,
and to be recorded as assets in the balance sheet.

REVENUE AND EXPENSE
In fact, for many accountants, relating expenses to revenues for a given period is
their main responsibility. However, proper matching of expenses to revenue is a
difficult task in practice because it needs a great deal of judgment from the
accountants.
For example, the recognition of certain expenses and revenues might have to be
done on a discretionary basis, some expenses might be off-balance sheet, and
sometimes less objective evidence might be required for recognition of expense.
ACTIVITY 7.5
Can you think of an example of expense that is off-balance sheet?
In order to overcome these matching problems, three methods of matching are

commonly used. They are:
(a)
Cause and effect method;
(b)
Systematic and rational allocation of costs method; and
(c)
Immediate recognition method.
It is important to note that the first method (cause and effect) is the ideal
method to be used. The second and third methods (systematic and rational
allocation of cost and immediate recognition) are alternatives when the first
method does not apply.
Now, let us examine these three methods in detail.
(a)
Cause and Effect Method and Its Criticism

This is the ideal way of matching expenses with revenues.
This method is based on the cost attach concept, that states that goods
and services that are used up (in other words, expenses incurred) have
helped in the creation of revenue for that period.
In other words,
All costs attached to units of output = Accomplishment of the firm

REVENUE AND EXPENSE
For example:
(i)
The efforts of the sales executives in helping the firm to generate sales
revenue for the current period is represented by the commission paid
or payable to them;
(ii)
Revenue from the sales of products by the firm is usually related to

the cost of the products sold; and
(iii) Employees are usually assumed to help to create the current revenue
through the services they rendered.
ACTIVITY 7.6
Can you give another example that uses the cause and effect method
of expense recognition?
However, it may be difficult to apply this method in practice.

This is because the assumption is made that costs assigned to a given
period as expenses must have helped to generate the revenue for that
period. Therefore, accountants do not directly associate costs with revenue,
but match costs to the intervals of time (refer to Figure 7.5).
Figure 7.5: Accountants match costs to the intervals of time (as a cause and effect method)

REVENUE AND EXPENSE
Here is an example on why the rule of cause and effect can be difficult to
prove.
Say ABC Company earned a total revenues of RM200,000 and incurred a
total expenses of RM120,000 for the period. Of the total expenses, RM30,000
(or one-quarter of RM120,000) was for salaries and wages.
So, if the cause and effect method is applied, then we are assuming that the
services rendered by the employees and workers of ABC Company
generated one-quarter of the total revenues, or RM50,000. Can this be
objectively proven to be true? Certainly not!
(b)
Systematic and Allocation of Cost Method and Its Criticism

This method is used only when the cause and effect method cannot be
applied.
The purpose of this method is to recognise expenses in the accounting
periods in which the economic benefits associated with these items are
consumed or expired.
In other words, a pattern of economic benefits over a number of periods
must be assumed at the beginning of the period. The matching process
begins by relating expenses to segments of time and to correlate with the
revenue for that period (refer to Figure 7.6).
Good examples of this method would be depreciation expenses and
amortisation expenses.

REVENUE AND EXPENSE
Figure 7.6: Matching process begins by relating expenses to segments of time and to
correlate with the revenue for that period
However, this method is fraught with estimation and assumptions. Let us

take the example of the office equipment. Depreciation of the equipment
means the decrease or decline of its service potential.
However, how do we know in advance what kind of benefits or services
rendered by this equipment will be for each future period? How do we
determine objectively the time horizon and the residual value?
As you are aware, there are several different procedures for depreciation,
namely the straight-line, units-of-production, sum-of-the-years-digits and
diminishing-balance. Ideally, accountants would select a procedure that
more or less coincides with the pattern of benefits provided by the assets to
future periods of time.
However, this is not the case in practice, due to the inherent difficulties in
applying the cost allocation method. In fact, in the course of preparing the
financial statements, many accountants may ignore matching all together
when it suits them.

REVENUE AND EXPENSE
(c)
Immediate Recognition
This method basically covers all other possibilities that are not covered by
the first two methods. Examples of the recording of expenses using the
immediate recognition are advertising, training, and research as well as
development expenses.
Let us look at the case of advertising expense:
Generally the effect of advertising has long-lasting benefits, but they are
often difficult to determine. For instance, a soon-to-be mother may
purchase a certain brand of baby diapers because she has been influenced
by an advertisement she saw two years ago. Therefore, the cost of
advertising is recognised immediately as an expense as the benefits cannot
be determined in a credible manner.
In other words, immediate recognition method charges the costs as
expenses in the period in which they are paid or payable. This rule is
operational if no future benefits are discernible for a purchased goods or
service. However, can we say for sure that advertising and research as well
as development expenditure do not result in future benefits, and thus
should always be expensed immediately? Certainly not!
SELF-CHECK 7.3
1.
What is expense?
2. How do we recognise expense?

methods of matching.
Describe at least two
ACTIVITY 7.7
What do you think would be the best solution to resolve the ambiguity
of the matching procedure in the preparation of financial statements?
How about an allocation-free financial statement using the current exit
price? Do you think such a practice would be acceptable in the
financial community?

REVENUE AND EXPENSE
Profit is a return on capital not a return of capital.
Profit determination and asset/liability valuation are two sides of the same
coin.
Income Expense = Profit

This formula clearly reflects the accountants view of profit, which is a
measurement of the performance of the entity and management.
Inflow in assets > Amount to maintain capital = Profit; or

Net assets (Ending) Net assets (Beginning) = Profit
This formula clearly reflects the economists view of profit, which is the
change in wealth.
Accountants view profit as transaction-based, and that the realisation

principle and the matching principle must be met. Economists view profit as
increase in value, the market price as objective evidence and that unrealised
gain should be recognised in the income statement.
Critical recognition points for profit elements often lack rigour.
Revenues give rise to increases in net assets and have stringent recognition
criteria.
Expenses are monetary events which relate to a decrease in net assets of the
firm but are often recognised by convention rather than application of
principles.
Matching principles used to facilitate recognition involve considerable

judgment.
The three methods of matching are:

-
Associating cause and effect method;
Systematic and rational allocation method; and
Immediate recognition method.

REVENUE AND EXPENSE
Cause and effect method
Profit
Existence of a transaction
Revenue
Expense
Substantial completion of the earning

process
Immediate recognition method
Systematic and rational allocation method
Matching principle
Measurability of asset value
1.
What is the definition and concepts of profit that have been adopted and
proposed?
2.
Why is the concept of profit under debate?
3.
Under historical cost accounting model, which of the following financial

statements is the most important?
(a)
Balance sheet
(b)
Income statement
(c)
Cash flow statement
(d)
They are all equally important
4.
What is revenue?
5.
What are the criteria used in the revenue recognition process?
6.
What is expense?
7.
What are the recognition criteria and the matching concept as they are
applied to expenses in the accrual accounting system?

REVENUE AND EXPENSE
1.
Revenue was recognised when the events below occurred (accrual system).
State whether it was proper or improper according to accepted recognition
principles.
(a)
An order is received from the customer for 200 boxes of chocolates. It

is approved by the credit department.
(b)
A roof repairer did some work a year ago, but waited until now to
record the revenue because it took that long to collect the bill.
(c)
A contract is signed by a customer who agrees to have the firm build

a house for him according to his specifications. It is estimated that
construction will take eight months. The customer will pay in full
when the house is completed.
(d)
A lorry is delivered to a customer and a conditional sale contract is

signed by the customer. Title is to remain with the seller until the
customer makes full payment in six months.
(e)
A vacuum cleaner is delivered to a customer. The customer made a

down payment and is expected to make monthly payments for the
next 24 months. The credit rating of the customer is good. The full
sales value was recorded as revenue.
2.
Name the three basic methods of matching. Give an example of each. How
do they align with the expense recognition criteria?
3.
Why does the calculation of profit become so problematic in our world of

uncertainty? List the factors that influences the assumptions made to
calculate profit for the defined period.
Topic Reliability and
Relevance
Issues
LEARNING OUTCOMES
1. Define the meaning and mechanism of relevance and reliability;
2. Discuss how the trade-off between reliability and relevance is
justifiable;
3. Explain the challenges posed to qualities of accounting information;
4. State the caveats through relevance and reliability consideration;
5. Explain aspects related to historical cost accounting; and
6. Examine the nature of current cost accounting and exit price
accounting.
INTRODUCTION
Accounting information should be provided in a way that assures users of the
qualitative characteristics to support decision making. The Financial Accounting
Standard Board (FASB) aims to provide high quality information which benefits
users such as creditors and investors. Relevance and reliability are two kinds of
financial accounting information with qualitative characteristics. This topic
discusses how these concepts are defined and include their challenges and
cautious considerations.
126 TOPIC 8 REALIBILITY AND RELEVANCE ISSUES
8.1
RELIABILITY AND RELEVANCE
The targeted qualitative factors necessary for financial information are stated
clearly in FASB Concepts Statement No. 2, Qualitative Characteristics of
Accounting Information. Reliability and relevance (validity) of financial
information are the two main important qualities. Relevance refers to the
accounting information which is predictive, provides feedback and is presented
in a timely manner. These characteristics are crucially important, because the
decision-making process is highly affected by them. Reliability, however,
necessitates financial and accounting information to be verifiable, faithful and
neutral. Although there has been a trade-off in the uses of these two qualities,
FASB Concepts Statement 2 offered its view on this point as follows:
Although there seems to be considerable support for the view that reliability
should be the dominant quality in the information conveyed in financial
statements, even at the expense of relevance, while the opposite is true of
information conveyed outside the financial statements, that view has in it the
seeds of danger. Like most potentially harmful generalisations, it does contain a
germ of truth: almost everyone agrees that the criteria for formally recognising
elements in financial statements call for a minimum level or threshold of
reliability of measurement, that should be higher than is usually considered
necessary for disclosing information outside financial statements. But the
remainder of the proposition does not follow. If it were carried to its logical
conclusion ... the end would be that most really useful information provided by
financial reporting would be conveyed outside the financial statements, while
the audited financial statements would increasingly convey highly reliable but
largely irrelevant, and thus useless, information. [paragraph 44]
8.2
QUALITATIVE CHARACTERISTICS OF
ACCOUNTING INFORMATION
It is a fact that financial information must contain qualitative characteristics to be

beneficial to users, such as, investors, debtors and creditors. Figure 8.1 indicates
qualitative characteristics given in the form of a hierarchy of their conceptual
importance. The focus is on decision usefulness or the potential to be useful in
decision making.
Understandability means that users must understand the information within the
context of the decision being made. It is a user-specific quality, because they are
different in their capabilities to comprehend different information. The primary
financial reporting objective here is to provide comprehensible information to the
TOPIC 8 REALIBILITY AND RELEVANCE ISSUES
127
ones, who have reasonable understanding of business and economic activities,

and the ones who desire to consider the information.
It is important to know that information should make a difference in decision
making in order to be useful.
Figure 8.1 identifies two secondary qualitative characteristics. These characteristics
are important for effective decisions. These characteristics are comparability and
consistency. Comparability is the potential in helping users to see similar and
different cases between events and conditions. We compare information across
companies to make their resource allocation decisions. There is a concept
regarding the consistency of accounting practices over time that permits valid
comparisons between different periods. The predictive and feedback value of
information is increased if users can compare the performance of a company over
time (Spiceland, 2011).
Figure 8.1: Hierarchy of desirable characteristics of accounting information
Next, the two primary qualities, namely, reliability and relevance required for
financial information are explained.
Relevance in accounting refers to the information that significantly affects,

changes or creates decisions and predictions of the users. Therefore, a piece of
relevant accounting information acts as a moderating or mediating variable to
come to the final decision. A key relevance issue is the time of offering. The
sooner the accounting information is revealed, the more relevance it carries.
Reliability, however, discusses the confidence level of the quality of accounting
measures. Specifically, reliable information must logically lack any error and bias
in presentation, which assures users when they intend to use it.
ACTIVITY 8.1
In your opinion, which criteria is more important to investors, relevance
or reliability? Justify your opinion.
8.3
DEFINITION AND MECHANISM OF

RELEVANCE AND RELIABILITY
The primary decision-specific qualities for making useful accounting information

are relevance and reliability and these are critical. If information is not relevant to
the decision to be made, it will be useless. In contrast, relevant information is not
important if it cannot be relied on. It is interesting to consider the two
characteristics with their desirable components. The two secondary qualities,
comparability and consistency, are also considered.
To be useful for decision making, accounting information should be both
relevant and reliable.
8.3.1
Relevance
To make different decisions, information must have predictive and/or feedback

values. In general, useful information has both of those qualities. For instance,
when net income and the relevant components provide investor expectations on
its future cash-generating ability, then net income has feedback value. This
confirmation can also be useful in predicting future cash-generating ability in
revising the expectations.
129
This predictive ability is the main concept in earnings quality. It indicates the
ability of earnings to predict a companys future income. This is a concept to
explore the impact on earnings quality matters. In separating a companys
transitory earnings from its permanent earnings, a meaningful prediction of
future earnings could be obtained.
Timeliness is also an important element. Information is considered timely if it is
available to users in decision making. The need for timely information requires
companies to provide information to external users on a periodic basis.
Information is considered timely if it is available to users, before making a
decision.
8.3.2
Reliability
Reliability indicates verifiable, faithful and neutral information. Verifiability

indicates satisfaction among different measurers. For example, the historical cost
of a piece of land in a transaction or purchasing the land is verifiable, though the
market value of the land is much more difficult to verify. The historical cost of
the land is objective but the lands market value is subjective, being influenced by
the measurers past experience and prejudices. A measurement that is subjective
is difficult to verify, so it makes it more difficult for users to rely on.
Representational faithfulness is the agreement between a criteria and the
phenomenon it represents.
For many people, the term reserve that was used for double accounts indicates a
sum of money that is set aside for future bad debts. This term did not show
representational faithfulness. The description reserve now has been changed to
allowance for uncollectible accounts or allowance for doubtful accounts.
To clarify the mechanism of relevance and reliability, consider the case of a
company which bought a machine at a price of RM50,000 ten years ago.
However, the current market price for this machine is RM30,000. To comply with
auditing procedures, the accountant of this company prefers to record the
original price of this asset (RM50,000) in financial statements. In this occasion,
reliability is more observed in financial reporting. But parties like investors and
creditors of the company are willing to have a fair value of the companys assets,
because the current market price of assets such as machinery provides them with
more relevant information for their investment or credit decision.
ACTIVITY 8.2
Discuss in class how reliable accounting information affects suppliers
decision-making process.
8.4
TRADE OFF: RELEVANCE AND

RELIABILITY
Reliability assumes neutral information between the affected parties. However,

neutrality is related to the formation of accounting standards. Changes in
accounting standards could have adverse economic results on some companies,
their investors, creditors and other interest groups. Accounting standards give
regards to social and specific objectives, and no particular groups or individuals
should have priority over others.
The Financial Accounting Standard Board (FASB) encounters difficulties in
balancing neutrality with economic results. A new accounting standard may
prioritise some companies over others, but the FASB is to assure the financial
community that this was due to the standard, and not because of the objective to
establish the standard. Donald Kirk (a member of the first group to serve on the
FASB) emphasised the importance of neutrality in the standard-setting process as
follows:
If financial reporting is to be credible, there must be public confidence that

the standard-setting system is credible, that selection of board members is
based on merit and not the influence of special interests, and that standards
are developed neutrally with the objective of relevant and reliable
information, not purposeful manipulation.
Donald Kirk
Relevance and reliability have clashing qualities. For instance, provided forecast
of net income by the management of a company could have a high degree of
relevance to investors trying to predict future cash flows.
This is to say that a forecast includes subjectivity in predicting future events.
A trade-off is usually required between various degrees of relevance and
reliability.
131
Although some researchers discuss victimising relevance or reliability to arrive at

the other, both of these qualities are important for the usefulness of accounting
information. Users cannot neglect one to achieve the other, solely because of the
independent nature of relevance and reliability towards each other; however, a
trade-off is required in applying them.
For example, when fair values of assets are stated in financial reporting and
assets valuation, although these figures are more relevant, it cannot be inferred
that the information is without reliability. Assets such as shares have continuous
updated values upon demand, whereas land and machineries market prices must
be derived from surveys by the professional practitioners. Therefore, for some
assets with subjective market prices, the recorded values are relevant, because of
fresh evaluations, and reliable, because of verifiability.
ACTIVITY 8.3
Discuss the relevance and reliability of the balance sheet figures of
a sample firm with your peers. Are assets priced according to their
current market prices?
8.5
CHALLENGES ON RELIABILITY AND

RELEVANCE
Despite the necessity of financial statements to be reliable and relevant, attaining

these characteristics is somewhat difficult. One of the challenges is the fact that
many historical accounting measures are evaluated by estimations. The main
drawback of estimating values, mostly on mathematical basis, is non-compliance
of the calculations with reality. For instance, the historical value of an asset
according to net book value after deducting depreciation may be equal to almost
zero, whereas the updated market price might be at least RM2000. These
differences can substantially cause reliability and relevance to be obstacles to
accounting information.
In addition, even though it is possible that chartered asset-value experts consider
the above-mentioned shortcoming, the quantity of the assets needing reevaluation may be too many for them to be neither reasonable nor practical to
analyse. This is especially true for big corporations with a number of assets
valued many years ago. Moreover, it is demanding for multinational
corporations to present a fair and true view of their financial status, because of
added exchange rate fluctuations to fair value measurements. Overall,
establishing relevance and reliability in accounting figures are more to be

comparative in nature than absolute in value.
The other challenge in observing reliability and relevance for accountants is the
use of accrual methods. Although these methods are mathematically-based, they
do not necessarily illustrate the real picture. That is why the potential of wrong
presentation of assets in financial statements rises. To clarify, let us have a look
on how Robert R. Sterling stated this fact:
Accountants who continue to seek more precision are to be admired and
encouraged. However, those who seek absolute precision might be instructed by
considering what has been learned in the so-called exact sciences. Einstein ...
drew a sharp and clear distinction between the certainty of calculation and the
uncertainty of representations of phenomena: As far as the laws of mathematics
refer to reality, they are not certain; and as far as they are certain, they do not
refer to reality. The same is true for accounting: as far as the mathematical
methods used in accounting refer to reality, they are not certain; as far as they are
certain, they do not refer to reality
Calculating depreciation is a good illustration of the above mentioned point.
While depreciation calculation method may seem precise for the accountant, the
real depreciation amount differs in most cases. As a result, depreciation is
defined in Accounting Terminology Bulletin No. 1, Review and Rsum as:
Depreciation accounting is a system of accounting which aims to distribute the
cost or other basic value of tangible capital assets, less salvage (if any), over the
estimated useful life of the unit (which may be a group of assets) in a systematic
and rational manner. It is a process of allocation, not of valuation. [paragraph 56]
... a cost or other basic value is allocated to accounting periods by a rational and
systematic method and ... this method does not attempt to determine the sum
allocated to an accounting period solely by relation to occurrences within that
period which affects either the length of life or the monetary value of the
property. Definitions are unacceptable which imply that depreciation for the year
is a measurement, expressed in monetary terms, of the physical deterioration
within the year, or of the decline in monetary value within the year, or, indeed, of
anything that actually occurs within the year. [paragraph 54]
Therefore, financial accounting lacks absolute faithfulness and precision, which
makes users encounter challenges when they want to evaluate relevance and
reliability of information.
133
ACTIVITY 8.4
Which qualitative characteristic should be paramount for auditors?
Why? Discuss.
8.6
FAIR VALUE MEASUREMENTS AND ITS

CAVEATS
Relevance and reliability issues in accounting should be considered cautiously.

First, noting the source of valuation methodology in the market is important for
practitioners. If the sources of measuring assets or debts values in the market is
from financial reports, accounting information, relevance and reliability plays a
key role in this regard. The second caveat is the valuation model from the lenses
of investors.
Because market-based valuation models are performed by companies, the
possibility of price disagreement between investors and corporations is likely to
happen. Finally, assets and stock prices are scrutinised by other stakeholders,
such as, customers, suppliers, creditors and employees. That is why relevance
and reliability of the public accounting figures of companies are strongly advised
to be audited for the interests of these parties, as well as, investors.
To facilitate comparison of assets values in the US, companies are required to state
the hierarchical fair value level of all financial instruments reported in financial
statements. This classification is defined in U.S. GAAP Codification Topic 820,
Fair Value Measurements and Disclosures (ASC 820) (refer to Figure 8.2).
Figure 8.2: Fair Value Hierarchy under ASC 820

For the assets in Level 1, quoted prices are available in the market. Examples are
exchange traded investments, futures and actively traded debts.
Net book values of the assets in Level 2 are different from their current prices:
however, this difference is observable when measurement is made. A typical
example of this type of assets is credit swaps.
Assets that have almost no observable prices at the time of measurement are
classified in Level 3. These assets can be in the form of derivatives, auction rate
municipal securities, asset backed securities, mortgage-backed securities and
direct investments (refer to Figure 8.3).
Figure 8.3: ASC 820 Fair Value Hierarchy Examples
ACTIVITY 8.5
Classify the assets recorded in the balance sheet of a company and
classify each asset level based on the ASC 820.
8.7
135
HISTORICAL COST ACCOUNTING
Historical costing (HC) has been the accepted measuring system in published
financial statements throughout financial history. Generally, HCs valuation
system is perceived to be more objectively determinable and better understood
than are competing valuation systems.
8.7.1
(a)
Principal Assumptions of Historical

Cost Accounting
Flow of Costs
The accountants task is to trace the movement of costs attached to the
goods and services as they flow through the business.
The accountants must decide which costs have expired and therefore are to
be matched against revenues in the profit and loss statement, and which
costs remain unexpired and are to be placed on the balance sheet
statement as assets.
(b)
Stewardship
The stewardship objective of historical cost accounting emphasises the
contractual relationship between a firm and those who provide resources
to it (separation of ownership and control).
The stewardship function requires that those entrusted with the firms
assets and operating activities, normally management, are accountable for
the application of assets to operations and the subsequent impact on the net
value of assets from these operations.
Financial statements are key communication mechanisms designed to report on

the stewardship functions of management.
8.7.2
Reasons for Dominance of Historical

Cost Accounting
The reasons for the dominance of historical cost accounting are as listed in Table 8.1.
Table 8.1: The Reasons for the Dominance of Historical Cost Accounting
Reasons
Explanations
Relevant
in
making
economic decisions
Managers need data on past transactions to make

decisions concerning future commitments. This is because
past prices serve as a basis for forecast.
Verifiable
Historical cost is based on actual, not merely possible,

transactions.
Useful
Historical cost data are based on many years of trials and

errors spent to develop those data useful for modern
industrial and managerial accounting practices.
Understandable
The best understood concept of profit is the excess of

selling price over historical cost. Profit is accepted as a
measure of success.
Objective
Historical cost is supposedly less subject to manipulation

than other alternative measurement system such as
current cost or selling price.
There
is
insufficient
evidence
to
justify
rejection of historical
cost accounting
Most research studies indicate that current cost data does

not provide any more information than historical cost
data.
8.7.3
Criticisms of Historical Cost Accounting
The following discusses in detail the criticisms levelled against historical cost
accounting.
(a)
Objectivity of Accounting is Too Narrow

The view that the objective of historical cost accounting is to provide
information on the stewardship function of management has been criticised
as being a rather narrow interpretation.
Critics of historical cost say that decision-usefulness approach calls for a
forward-looking position rather than preoccupation with the past.
Investors are interested to know about the original amounts invested
137
directly or indirectly by the equity holders, as well as the increases and

decreases in value of their investment as represented by the net assets of the
company.
The recording, measurement and reporting of information using the
historical cost system is also opened for manipulation. For example,
acquisition cost of an asset is regarded as the outlay needed to bring asset
to its existing condition and location (refer to Figure 8.4). This acquisition
cost includes the cost of purchase, the cost of conversion and even rehandling cost and excessive spoilage costs. Sometimes these costs are so
abnormal that they have to be treated as current period costs charges
instead of as a portion of the asset costs. Thus, judgement is necessary in
ascertaining the acquisition cost and the practice is inconsistent.
Figure 8.4: The acquisition cost of an asset
So, the calculation of depreciation of non-current assets involves subjective

assessments in determining the useful life of the assets and its estimated
residual value.
(b)
Information for Decision Making

Historical cost is insufficient for the evaluation of business decisions. When
assets are acquired, their historical cost is useful because it refers to current
events. However, once the period of acquisition passes, it is no longer
current and therefore no longer relevant.
(c)
Basis of Historical Cost

The historical cost has the going concern assumption, that is, the life of the
firm is indefinite. Inventory can be expected to be sold and non-current
assets to be fully used in the business. Therefore, historical cost of the assets
is the appropriate amount to be matched with revenues.
However, critics say that it is the use of the non-current assets, not their
possible sale or purchase, that is relevant.
(d)
Matching
No established concept exists to ascertain proper matching.
Matching is essentially a process calling for random decisions to be made,
rather than consistent analysis. There is no way to select one method over
another except arbitrarily.
Sprouse (1973) argues that traditional accounting complicates the
evaluation of the financial position (balance sheet) of the company when
the statement of financial position (balance sheet) is considered mainly as a
dumping ground for balances that someone has decided should not be
included in the statement of financial performance (profit and loss
statement).
In other words, one of the consequences of the conventional matching
concept is that it relegates the balance sheet to a secondary position. The
balance sheet becomes merely a summary of balances after applying the
rules to determine profits, that is, an unamortised cost.
(e)
Notion of Investor Needs

Many investors are more concerned with the psychology of the market and
its effect in the short term on share prices. Conventional accounting takes
for granted these aspects of the investors needs.
Conventional accounting practices also emphasise current rates of return
rather than long-term profitability. This encourages creative accounting.
There is an incentive to produce financial information that contains
misleading data such as overstated revenues and assets or understated
expenses and liabilities.
8.7.4
Historical Cost Under Attack
Historical cost accounting uses the nominal dollar scale in its measurement of the
elements of financial statements. The nominal dollar scale assumes that dollars of
different time periods are all the same.
However, this scale is too simplistic. Historical cost accountings failure to
recognise changes in asset and liability values due to the passage of time has led
to the consideration of alternative measurement systems.
139
Shanahan (1992) argues that balance sheets contain outdated cost prices or
valuations that does not represent current market value and, thus, can hardly be
said to be true and fair. An asset cost several years ago does not help investors
assess whether a company is a worthwhile investment.
Some experts argue that measuring assets at their net market value and
measuring liabilities at their present value provides more relevant information to
users about the firms resources than does the historical cost basis of
measurement.
However, in general, the business community still prefers historical costs. Do
you know why?
ACTIVITY 8.6
Do you think the complexity of alternative measurement to historical
cost approach has become an excuse for keeping the historical cost
system? Explain your answer.
8.8
CURRENT COST ACCOUNTING
Current cost accounting is an approach that values assets at their fair market
value rather than the historical cost. Let us see this in detail.
8.8.1
The Nature of Current Cost Accounting
CCA is also called the replacement cost model. The basic concept underlying this
model is that the firm is a going concern and is continuously replacing its assets.
It is assumed that the cost of consuming the assets in the profit generation
process is equivalent to the cost of their replacement. In other words, the current
cost is based on the entity concept of maintaining intact the ability of the firm to
continue to deliver the same amount of goods and services the firms operating
capacity.
Assets are valued at current market buying prices.
However, market values are often unavailable for unique fixed assets such as
land, building and heavy equipment specially designed for a particular firm, and
also for used fixed assets that are not unique (even though second-hand market
may exist for these assets).
Therefore, in the absence of market price, Current Cost Accounting can be

estimated by appraisal or specific index adjustment.
8.8.2
Valuation Principles under Current Cost

Accounting
The valuation principles under Current Cost Accounting are as shown in Table 8.2:
Table 8.2: The Valuation Principles under Current Cost Accounting
Items
Non-monetary items
Monetary items and loan

capital
Non-monetary
assets
bought and sold on the
same market
Explanations
The current cost values are based with reference to:
The current buying prices;
Specific indices where market prices are unavailable; or
The service potential of an identical or like item for

superseded or specialised assets.
Monetary items are claims to a fixed number of dollars.
In nominal terms, they do not change during price

inflation. Examples are trade creditors and trade debtors,
cash, prepayments as well as short-term bank overdrafts.
Monetary assets are shown at amount they were

originally brought to account.
Monetary liabilities are value of amount expected to be

paid.
Examples are shares and commodities such as gold and

silver.
These assets are bought and sold in the same markets and
do not directly add to the operating capability of the
entity.
These assets are held for income-generating purposes or

for resale at a capital gain. Their ability remains
unchanged in a period of general inflation.
8.8.3
141
The Criticisms of Current Cost Accounting
Advocates of historical cost accounting are critical of Current Cost Accounting

due to the reasons as shown in Figure 8.5:
Figure 8.5: The criticisms of current cost accounting
ACTIVITY 8.7
In contrast to Current Cost Accounting, assets are valued at the current
market selling prices for exit price accounting. Do you think these two
systems are complementary or a substitute for each other?
8.9
EXIT PRICE ACCOUNTING
Exit price accounting is the price at which an investor sells an investment or at

which a firm sells all its merchandise and leaves a market. Now, let us examine
this in detail.
8.9.1
The Nature of Exit Price Accounting
Exit Price Accounting system uses market value/selling price to measure the
firms financial position and financial performance.
Under EPA, assets are valued at the net realisable amounts that the firm would
expect to obtain for them if they are disposed of in the normal course of
operations. Liabilities would be similarly valued at the amounts it would take to
pay them off as of the statement date.
The income statement for the period would be equal to the change in the net
realisable value of the firms net assets occurring during the period, excluding
the effect of capital transactions.
8.9.2
In Support of Exit Price Accounting
The support for Exit Price Accounting are as follows:

(a)
Providing Useful Information

According to MacNeil (1970), accountants should report all profits and
losses and values as determined in competitive markets. Marketable assets
should be valued at market price (exit price), non-marketable reproducible
assets at replacement costs and occasional non-marketable, non-producible
assets at historical costs. Income should include all profits and losses,
whether realised or not.
(b)
Relevant and Reliable Information

Sterling (1970) says that the exit price is:
Relevant to all users;
Reliable; and
Empirically meaningful.
(c)
143
Adaptive Decision Making

Chambers (1975) sees the firm as an adaptive entity engaged in buying and
selling goods and services. The firm will continuously attempt to adjust to
the competitive business environment for the sake of survival.
In other words, the adaptive behaviour sees the firm as always being ready
to dispose off the asset if this action is in its best interest. The firm will keep
a fixed asset only if the present value (PV) of the future net cash flow from
the use of the asset is greater than the PV of the expected net cash from an
alternative investment.
The monetary value of assets and liabilities can be determined objectively
by referring to the market price, that is, selling price, not purchase price.
This is because purchase price (or current price) does not reveal the firms
capability to go into the market with cash for the purpose of adapting itself
to present condition.
(d)
Additivity Results in Meaningful Financial Statements

EPA believes that the valuation of all elements in balance sheets and profit
and loss accounts should be at their monetary equivalent (exit values)
because this system concentrates on measuring the financial capacity of the
business at the end of the accounting period.
(e)
Allocation Free
EPA does not rely upon cost allocation for asset valuation and profit
determination.
(f)
Reality Real World Reference

EPA involves references to the real world examples as well as present and
actual market prices. For example, depreciation is not defined in the
conventional way but it is a decline in the market price of a fixed asset.
(g)
Objectivity
EPA is more objective and comparable than historical cost accounting
because exit values revealed less dispersion (in terms of accounting
estimates in useful life and residual value) than book values.
(h)
A Measure of Risk
It is often argued that exit prices and changes in exit prices are an indication
of the financial risk of purchasing an asset. For example, if the exit value of
an asset differs significantly from its entry price, than the purchase of the
asset is a risky proposition.
8.9.3
Criticisms of Exit Price Accounting
Now, let us look at the criticisms of Exit Price Accounting.

(a)
Profit Concept
Exit price, which is the opportunity cost, does not provide the relevant data
to match against revenues to measure the performance of the firm.
Accounting must measure past events, those that actually happened, rather
than those that might happen. Similarly, the exit price also fails in regard to
comparability because it is based on what might happen.
Weston (1971) says that Exit Price Accounting provides relevant
information only if the company plans to liquidate its assets. If the plan is to
continue business, then the information is not relevant. He also argues that
Exit Price Accounting has more of a forward looking, decision-usefulness
objective rather than a stewardship objective.
(b)
Value in Use versus Value in Exchange

Exit price accounting ignores the concept of value in use. It only adopts the
value in exchange.
Value in exchange (market value) represents the firms capability to buy
things and pay debts at a given date. It is determined by the market, not the
owner of the firm. Thus, it is objective and easily understood by people.
Value in use is basically a calculated amount of a present expectation. It is
personal to the owner of the firm. Furthermore, it is subjective and not
interpretable or understandable by others without a full explanation of the
expectation.
Godfrey et al. (2006) cited that when an asset is held rather than sold out, it
must be with the reason that it is worth more to its owner than its exit price,
otherwise it would be sold. In other words, the assets are purchased for the
purpose of producing goods for revenue, rather than for selling assets.
Thus, the use of exit price leads to an absurdity and a flagrant failure to
measure up to the criterion of correspondence with the economic events
which are being recorded.
(c)
Additivity
It is difficult to evaluate a firms operating efficiency using the Exit Price
Accounting model. Anticipatory calculations cannot be added together
with current figures.
145
In addition, the cash equivalent of individual assets sold separately and the
same assets sold as a package may be quite different. Exit Price Accounting
does not recognise the possibility of selling assets as one package.
8.9.4
Current Cost versus Exit Price
Edward and Bell (1961) believed that current cost is the normal method of
valuation compared to exit price for the following reasons:
(a)
Exit prices lead to anomalous revaluation on acquisition due to costs like

transportation charges, installation and removal charges as well as
imperfect access to markets;
(b)
Exit prices imply short-term approaches to business operations as they

reflect disposition and liquidation values; and
(c)
Using exit prices for finished goods inventory leads to the anticipation of
operating profit before the point of sale. This is because the inventory is
valued in excess of current cost.
Edward and Bell also argue that some assets that are custom designed for a
company have value in use but little value in exchange. Thus, the management
would believe that their value in use is greater than their exit value.
ACTIVITY 8.8
What is holding gains or loss? What are the benefits of separating out the
holding gains (or loss) in profit determination? What are some of the
shortcomings of this separation?
Accounting information should be provided in a way that assures users of

the qualitative characteristics to support decision making.
Reliability and relevance (validity) of financial information are the two main
important qualities.
Relevance refers to the accounting information which is predictive, provides

feedback and is presented timely.
Reliability, however, necessitates financial and accounting information to be

verifiable, faithful and neutral.
While updated relevant accounting information is a keystone for decision

makers, true and fair nature of reliable accounting documents is an important
point of consideration for stakeholders.
It is underscored that relevance and reliability cannot co-exist. One must be

sacrificed to benefit the other; however, accounting information can contain
one of these qualities whilst having the other to a lesser degree.
Relevance and reliability are not absolute in nature. But these notions are
more relatively highlighted, and they are achieved based on comparisons due
to the challenges and caveats in the course of their usage.
One should consider cautiously the evaluation and record the fair value of
assets, relevance and reliability issues in accounting.
Historical cost's valuation system is more objectively determinable and better

understood than other measuring system.
Historical cost is under attack in recent time because it fails to recognise

changes in asset and liability values due to the passage of time.
Proponents of current cost accounting believe that it provides more useful

information. Current cost accounting uses current market buying price.
Current cost accounting's relevance is not supported by empirical studies.
Exit price financial statements are allocation free and relate better to the real
world.
Exit price is criticised for not measuring events that actually happened;
instead it simply measures events that might happen.
Accrual methods
Historical cost
Comparability
Neutral information
Consistency
Relevance
Current cost
Reliability
Exit price
Trade-off
Fair value hierarchy
Verifiables
147
Fair value measurement
1.
Who is responsible in organisations to assure the reliability and relevance

of the accounting information? What are the possible challenges posed to
this person?
2.
Each part of financial information is more relevant to a specific user.

Moreover, reliability is also undeniably demanded by them. How can
information feeding quality be elevated in financial statements of a
business?
1.
Assume you support exit price accounting. Give at least three reasons for
your support.
2.
How will the use of current cost accounting help investors make decisions
about whether to buy or sell shares in a particular company?
Topic Specifics Issues
9
LEARNING OUTCOMES
1. Define accounting standards;
2. Discuss the advantages and disadvantages of accounting standards;
3. Explain accounting standards effects on related parties;
4. State the economic consequences of mandating accounting standards;
5. Discuss the empirical evidences of accounting standards adoption;
and
6. Discuss the legal nexus of contract and agency theory.
INTRODUCTION
This topic discusses accounting standards, especially the International Financial
Reporting Standards (IFRS). In the following subtopics, development, benefits
and costs as well as economic consequences of accounting standards adoption
are explained. For clarification, the related economic consequences as well as
sample research cases are provided. Although IFRS is defined in the US, it is
adopted in Malaysia as well. In order to illustrate the importance of financial
standards, the news on the convergence of IFRS with Malaysian Financial
Reporting Standards (MFRS) in 2012 is presented here.
Companies in Malaysia will now have the unique opportunity to
significantly improve their balance sheets and retained earnings balances

when applying the new International Financial Reporting Standards
(IFRS) converged with the Malaysian Financial Reporting Standards
(MFRS) in the preparation of their financial statements in 2012.
TOPIC 9 SPECIFIC ISSUES
149
The application of MFRS would be effective for annual periods beginning

on or after January 1 this year.
This change from IFRS to MFRS provides companies in Malaysia a
unique opportunity to possibly improve their net assets financial
position. Companies should not miss this opportunity because it is
extremely rare for a country to change its financial reporting framework,
said Ernst & Young Malaysia technical partner, Stephen Oong.
The MFRS is identical to the IFRS as issued by the International
Accounting Standards Board. When Malaysian companies prepare their
financial statements for the first time under MFRS in 2012, such
companies would actually be changing their financial reporting
framework from the existing Financial Reporting Standards in Malaysia
(FRS) to MFRS.
In the process of changing from FRS to MFRS, a company is allowed to
use several options.
Such companies are permitted to effectively cherry-pick accounting
treatments, which might significantly improve a companys financial
position.
It is imperative that companies applying MFRS should put in place the
process and the resources to make the necessary assessment of the effects
on their financial statements with the various options that are made
available to them in 2012, said Oong.
Prior to the adoption of MFRS, companies in Malaysia would normally
measure its investment in subsidiaries, investment in associates or
investment in jointly controlled entities at cost.
9.1
INTERNATIONAL FINANCIAL REPORTING

STANDARDS
The pre-requisite to have better decisions regarding investment capital is

financial reporting.
In order to make better decisions on whether, when and where to allocate
investment capital, high-quality financial reporting is a pre-requisite. The
Financial Accounting Standards Board (FASB) has been working in that regard
150 TOPIC 9 SPECIFICS ISSUES
since 1973, by establishing standards for the accountants to ensure proper

decisions.
FASB standards (Nongovernmental Generally Accepted Accounting Principles or
USGAAP) are essential for an effective US economy. All the investors and other
users of financial reports need credible, transparent, comparable and unbiased
neutral financial information and fair presentation; FASB is not trying to affect
behaviours or to achieve a specific result.
Financial reporting requires the costs for preparations and benefits justify these
costs. The FASB tries to improve financial reporting in the most cost-effective
manner.
International Financial Reporting Standards (IFRS) aims to provide stakeholders
with a common tool of understandability regarding financial information around
the world. IFRS was created to increase reliability, relevance and comparability
of accounting measures, with specific benefits for multinational corporations
(MNCs). More and more countries are trying to adopt IFRS to elevate harmony in
accounting practices. When the International Accounting Standards Committee
(IASC) was replaced by the International Accounting Standards Board (IASB) in
2001, the term IFRS began to be used instead of International Accounting
Standards (IAS). In spite of IFRS benefits, the lack of its adoption in the US and
drawbacks stated in France are among its criticisms for implementation.
ACTIVITY 9.1
According to the news stated in the introduction, discuss whether
financial performances of two of the most prominent companies in
Malaysia, namely PETRONAS and Shell Malaysia, have really
improved or not.
9.2
ACCOUNTING STANDARDS INFLUENCES

ON RELATED PARTIES
Before discussing the effects of accounting standards on related parties, we will

discuss the way FASB evaluates the advantages and disadvantages of standards.
An independent standard-setting process is important in making quality
standards, since that depends on getting information and various views from all
inputs. The FASB sets accounting standards through open processes and takes
information from all stakeholders who represent a broad range of capital market
151
participants including investors, analysts, donors to non-profit organisations,

financial statement preparers, auditors, academics and other interested parties.
The FASBs procedures, called due process, are specifically designed in the
stages of a project, to generate feedback on costs and benefits of a proposed new
standard. The best ways for transactions and the most cost-effective ways to
implement any change are asked from the stakeholders. Technical decisions by
the Board are made in public meetings after careful consideration of the inputs.
Figure 9.1 illustrates the many elements in the Boards decision-making process.
Figure 9.1: Elements involved in the Boards decision-making process
Accounting standards have consequences on all stakeholders; however, the

impacts are favourable to some groups in some circumstances, while others are
not satisfied with the rules of standards.
A case in point is the continual struggle between investors and companies. While
the former always pinpoint the importance of having more precise information
on the business processes, the latter try to massage the numbers to present a
favourable picture of whatever goes on in the corporation.
Historically speaking, numerous approaches were available for business entities

to find a way for information manipulation. To settle this problem in the US, for
instance, the Financial Accounting Standards Board had no choice but to reduce
accounting measurement alternatives so that it can protect investors interests.
ACTIVITY 9.2
What are the effects on the performance of not-for-profit organisations
by adopting Accounting Standards? Discuss.
9.3
ECONOMIC CONSEQUENCES OF
STANDARDS
The economic consequences of a new financial reporting standard are different

from the analysis of costs and benefits in admitting a new standard. The role of
financial reporting is not to influence capital allocation decisions or the actions by
managements. The role of financial reporting is to promote decisions and
provide information for the investors. The FASBs aim in establishing accounting
standards is to show the best picture of a companys financial position and
performance. Better information is expected to change capital allocation
decisions, but the Board does not influence the outcome of those decisions (refer
to Figure 9.2).
Figure 9.2: Standards economic impact process
153
Economic effects of accounting standards can be seen in practice. To begin, the

investment perspective presented by financial statements is one of the major
economic consequences of accounting information. Investors attention is focused
due to the financial reporting of corporations.
It is a fact that all paradigms are considered acceptable because each of them see
the picture from its own perspective. Therefore, there is no absolute right or
wrong opinion. This is relatively true for economic consequences of financial
accounting standards. As the standards are adopted with differing
considerations, they all have their own economic impacts in the business entities.
The explained economic impacts of financial statements on investors are actually
working in the reverse way as well. Accounting clerks inside the organisations
do their best to present expected figures in their financial statements, so that both
managers and investors have positive insights on courses of actions in the
corporation. The only rational defence for using these tricks is the awareness of
the economic response by the investors. As was pointed out in Topic 6, relevance
of fair value measures plays an indispensable role in investors evaluations of the
business; the existence of economic consequences are clear.
ACTIVITY 9.3
Discuss the economic consequences of financial reporting standards in
Malaysia.
9.4
ADVANTAGES AND DISADVANTAGES OF

FINANCIAL ACCOUNTING STANDARDS
Defining standards has its own positive as well as negative influences on

companies, investors and other related stakeholders. These effects are explained
in the following subtopics.
9.4.1
Advantages
Financial accounting standards facilitate corporate governance practices and

create more efficient capital markets. Informed decision making based on proper
aspects of judgment is also affected by credible financial information. In other
words, presentation of relevant and reliable financial reports enhances its
influence on decisions, whilst it makes the reporting more applicable and
practical to direct the users mind. To boost the reliability and credibility of
financial information, coordination of standard setting authorities, auditors and

audit committees, accountants as well as related parties must be integrated.
Financial standards are useful in different aspects. First, uniformity of financial
information structures and presentation is a result of mandating financial
standards. Although the impression and attention of the presented figures to
every market player may be different from others, financial standards ease and
elevate communication in the market. Nowadays, financial analysts use
computer data bases and monitoring systems to evaluate the potential
investments, and to signal their forecasts, which cannot be uniform and credible
if financial accounting standards are lacking.
Secondly, as stated by the agency theory, managers are agents of shareholders in
corporations. Since managers play a key role in the amount of information
released to shareholders, financial accounting standards is an effective tool to
confine managers choices for manipulating information flow only for their best
interests. Finally, lenders are helped in their preparation of contracts with
borrowers according to the standards. Moreover, governments shape their
expectations from different business entities according to the information
presented by harmonised standards.
9.4.2
Disadvantages
Financial accounting standards implementation leads to expenses for parties

involved. These costs can be viewed at first step by noting who prepares financial
statements. Costs incurred by training, changing the accounting system processes
and revising contracts impose hindrances on standards adoption. New standards
require continuous monitoring and supervision which adds on to the initial costs.
Moreover, managers believe that financial accounting standards changes cost of
capital and the attractiveness of company to third parties, while they are
concerned about compliance challenges. Managers highlight these standards as
costs to organisations, because they are taken, on their behalf, to paths which
may not be required.
Auditors are the next party who must pay the price for new standards adoption.
In addition to the initial costs of adoption as well as the continuous costs of
human resources for extra work imposed by standards, the general terms stated
in standards are regarded as serious challenges to auditing. One of these is the
problem of differing interpretations on the clients sides. Each customer tries to
consider his understanding from standards, and asserts possible practical actions,
whereas the proper intent of standards is neglected by them. Another
consequence of generalisation in standards is the consequence of the customers
challenge. The amount of lawsuits against auditors seriously endangers the audit
155
firms litigation. That is why auditors keep confirming the necessity of detailed
information within financial accounting and reporting standards.
Financial statement users are the largest group who are affected by costs due to
standards. The costs of training and monitoring of standards are common in the
other groups. But, financial statement users may pay the indirect cost of
standards. Specifically, when standards are not able to provide credibility and
consistency in information, financial statement users have to invest in re-creation
and revision of information, so that they can reach their goals and purposes.
SELF-CHECK 9.1
Discuss ways of mitigating disadvantages of adopting financial
reporting standards.
9.5
RECENT EMPIRICAL RESEARCHES ON THE

ECONOMIC CONSEQUENCES OF IFRS
ADOPTION
Despite a lot of effort, not much contribution has been made towards
harmonising accounting standards. Besides, it is still a long way towards
mandating standards adoption. European adoption did not occur until recently
(2005). The short time period since the adaption is insufficient to arrive at the
necessary implications of IFRS economic influences on this continent. Although
some researchers have introduced some notions on economic consequences of
mandating accounting standards, the recent standard adoptions constrain one
from stating the advantages and disadvantages of the standards.
Some studies render it unnecessary for capital market or market participants (for
example, institutional investors) from voluntary IFRS adoption. An example is
the empirical researches on German firms, which revealed that IFRS or US GAAP
(Generally Accepted Accounting Principles) adoption caused lower bid-ask
spread, less turnover and more cost of capital in comparison to the firms without
accounting standards adoption in Germany in the years 2000 and 2006.
Another example is the Cuijpers and Buijink study, which did not create any
support for the betterment in cost of capital forecasting among European
corporations, either with or without IFRS accreditation in 2005; whereas two
years later even higher cost of capital was proved to be imbursed empirically by
the IFRS-adopted firms.
Even though Hung and Subramanyam declared that IAS (International

Accounting Standards) adoption did not increase the value of accounting
measures, Landsman and Lang kept confirming that IFRS adoption escalated
quality of corporations financial reporting.
Evidence illustrates that market participants contribute more analysis as well as
increased foreign direct investments after IFRS adoption.
It is clear that the aforementioned empirical studies show disagreements in their
results. The root of this relies on the firms freedom on the time and the way of
applying accounting standards.
Behaviour is not driven by accounting standards in particular ways. The
standards are looking for financial information for the users to make decisions
for capital. As in a recent case, the FASB is engaged in a project to improve
reports on leases.
The project was in response to feedback from investors and other users of
financial statements, on the lack of transparency relating to material lease
obligations not included on the balance sheet. Although some industries indicate
that increased transparency on lease obligations would provide less favourable
economic pictures of specific companies, the objective of the standard is to
provide a fair representation of the rights of a company. The purpose is to find
the proper representation of the economic phenomena. Investors consider new
information to be favourable or unfavourable. The Board will carefully consider
the feedback received on the proposed changes to lease accounting before a final
standard is issued.
ACTIVITY 9.4
What incentives do you think increases the adoption rate of accounting
standards? How can governments motivate IFRS adoptions?
9.6
PHILOSOPHY OF POSITIVE ACCOUNTING

THEORY
Let us begin this section by re-examining the statement made by Watts and
Zimmerman (1986):
The objectives of (positive) accounting theory is to explain and predict

accounting practicesExplanation means providing reasons for observed
157
practicesPrediction of accounting practices means that the theory

predicts unobserved phenomena.
Positive Accounting Theory seeks to explain observed accounting practices by
searching for the reasons events occur (refer to Figure 9.3).
Figure 9.3: Accounting theory explains and predicts accounting practices
For example, researchers may search for empirical evidence about the attributes
of firms that continue to use the same accounting practices from year to year and
compare them with the attributes of firms that continually change accounting
techniques.
Another example would be the research on the reaction of firms to a certain
proposed accounting standard. Positive theory research may look for evidence to
explain why firms would lobby for or against the proposed standards. This
evidence would eventually be used to predict the impact of accounting standards
before they are implemented.
Positive Accounting Theory is neither normative (prescribes what should occur)
nor descriptive (focuses on describing event).
Positive Accounting Theory also has an economic focus. The explanation is
presented in Figure 9.4.
Figure 9.4: Economic focus
ACTIVITY 9.5
What were the dissatisfactions with normative accounting theory
which led to the development of a positive theory of accounting?
It is important to bear in mind that there are certain assumptions about the
behaviour of individuals that one needs to make in carrying out the positive
theory research (refer to Figure 9.5).
159
Figure 9.5: Example of an assumption on manager
9.7
THE EFFICIENT MARKET HYPOTHESIS
Efficient Market Hypothesis believes that financial markets are "informationally

efficient." In other words, prices on traded assets such as stocks, bonds or
property, already reflect
all known information, and therefore are unbiased in the sense that they reflect
the collective beliefs of all investors about future prospects.
In fact, Efficient Market Hypothesis is drawn on microeconomic price theory,
which emphasises supply and demand, equilibrium analysis and competitive
market. This means that in a competitive capital market, in equilibrium, the
marginal cost of information equals the marginal revenue.
Efficient Market Hypothesis also states that it is not possible to consistently
outperform the market by using information that the market already knows,
except through luck. Thus, in an efficient capital market where information is
fully incorporated into share prices when it is released, it is impossible, on
average, to earn economic profits by trading on information.
Important Note:
Efficient capital market in the context of Efficient Market Hypothesis does
not mean that the financial information presented by a firm is correct or
properly interpreted by the decision makers. It also does not imply that
managers make the best decisions or that investors prediction of future
prices are the most accurate. Market efficiency in Efficient Market
Hypothesis simply means that share prices reflect an aggregate impact of
all relevant information in an unbiased and rapid manner.
9.8
CAPITAL MARKET RESEARCH
There are two types of capital market research based on the Efficient Market
Hypothesis that are particularly important to Positive Accounting Theory. They are:
(a)
Studies to determine the impact of accounting information on share returns;

and
(b)
Studies that consider the effects of changes in accounting policy on share

prices.
Let us now examine the study by Ball and Brown (1968) pertaining to the impact
of accounting profits announcements on share prices.
9.8.1
The Impact of Accounting Profits Announcement

on Share Prices
The seminal work by Ball and Brown (1968) has been the foundation stone of
positive accounting and finance literature.
Ball and Brown tested the usefulness of the historical cost profit figures to
investment decisions. Using the theory in Efficient Market Hypothesis, they
argued that if the information is useful in making investment decisions, share
prices would adjust to reflect that information.
In the study, Ball and Brown used data for 261 firms between the period of 1946
to 1966. They focused on the price impact of unexpected profit announcements.
They found that 85 per cent to 90 per cent of the information contained in the
earning announcements was anticipated by the investors.
161
Ball and Browns study had several implications:

(a)
There is evidence of information content at the time of earnings

announcement;
(b)
There is evidence of continuous release of information to the market and

thus accounting was not the only source of information; and
(c)
There is evidence that the market is reasonably consistent in anticipating

the information in accounting reports. Thus, it is not possible to trade on
accounting information to earn economic profit after the information was
released.
Let us now look at two other capital market research studies by Leftwich (1970)
and Kaplan and Roll (1972) on mechanistic or behavioural effect of accounting
information.
9.8.2
Mechanistic or Behavioural Effect
Let us discuss the mechanistic and behavioural effect.

(a)
Leftwich (1970)s Hypotheses

Leftwich developed two competing hypotheses based on the financial
situation in the early 1970s. These hypotheses examined the behaviour of
abnormal rates of return at and around the time of a change in accounting
policy.
(i)
The mechanistic hypothesis

Market reacted mechanistically to changes in accounting numbers,
regardless of whether they were cosmetic or whether they had cash
flow implication. This meant that cosmetic or creative accounting can
fool market participants.
(ii)
The no-effect hypothesis derived from the EFFICIENT MARKET

HYPOTHESIS
The market ignored accounting changes which had no cash flow
consequences. This meant that the creative accounting change was
understood by the market participants, and they would not be
deceived by the change. On the other hand, if an accounting policy
affected the cash flows, we would expect to see abnormal returns at
the date of announcement.
(b)
Kaplan and Rolls (1972) Study on Leftwichs Hypotheses

Kaplan and Roll (1972) extended the study on Leftwichs competing
hypotheses by examining accounting changes which were considered as
cosmetic and were expected to increase the profits in the period of
implementation. An example of the accounting change that was analysed
was the change in accounting for investment tax credit from deferral to
immediate recognition.
The result of Kaplan and Rolls study indicated that firms showed negative
abnormal returns at announcement date when their investment tax credit
were changed to immediate recognition, then rising to a peak about nine
weeks after announcement before reverting to around zero.
Kaplan and Rolls result clearly showed that the market was fooled for
some time.
9.9
WHAT IS A LEGAL NEXUS OF

CONTRACT?
Let us understand the definition of legal nexus of contract by example.
9.9.1
Defining Legal Nexus of Contracting Relationship
Fathers Day falls on this Sunday. You plan to celebrate this special day with
your father. Besides taking him out for a nice dinner, you plan to buy him an icecream cake.
You have two options on how you can get the ice-cream cake:
Option (i)
You can buy milk, cream and butter from dairy farmers, then separately contract
with a cane-grower for sugar cane, a refiner to produce the sugar, a poultry
farmer for eggs, a flour miller for self-raising flour, an electrical appliance
company to create a refrigerator to set the ice cream, an oven to bake the cake, an
electrician to wire the refrigerator and oven and so on; or
Option (ii)
You can simply purchase the ice-cream cake from a bakery or supermarket. The
bakery or supermarket would already have direct or indirect contract with all
those providers of resources used to produce the ice-cream cake.
163
Clearly, Option (i) is costly, impractical and time consuming, and you probably
will not get the ice-cream cake ready by Sunday. Option (ii), on the other hand, is
less costly, convenient and obviously more practical than Option (i).
Now, let us look at another example.
Instead of an ice-cream cake, you plan to purchase a plasma television for your
father so that he can watch his favourite sports programme with comfort.
Again, you have two options:
Option A
You can go to the individual electrical shops in the Klang Valley and negotiate
with the retailers; or
Option B
You can go to an electrical outlet such as Best Denki and Harvey Norman where
more choices are available and cost less. This is because these electrical outlets
have already established contracts directly or indirectly with the various
suppliers of plasma televisions.
Once again, Option A is costly, time consuming and exhausting, and you may
not be able to get the present ready for your father by this Sunday. Option B
appears to be more practical and easy, as you will have wider selection of brands
and will also save you the hassle of bargaining for prices.
The two examples described above show that a firm (the bakery or supermarket
in the first example, and the electrical outlet in the second example) represent a
legal nexus (or connection) of contractual relationships, that centralise and link
the contracts between you as a consumer and the various suppliers.
In other words, instead of having a situation whereby all individual suppliers
contracting with individual consumers of their product, contracts are created
within the firm between the suppliers and consumers of the products. These
contractual relationships reflect the contracting theory.
Examples of these contracts are:
(a)
Contracts for the supply of goods;
(b)
Contracts for the sale and delivery of goods and services;
(c)
Contracts documenting the employment terms of managers; and
(d)
Contracts documenting the employment terms of factory workers by

financial resource providers.
SELF-CHECK 9.2
Can you define legal nexus of contracting relationship?
ACTIVITY 9.6
Can you think of another example of a contractual relationship?
9.9.2
Contracting Theory and Coases Argument
Contracting theory sees the firm as a centralised organisation linking suppliers

and consumers of factors of production. In fact, that explains the very existence
of the firm. The firm exists because it costs less for individuals to transact
through a centralised organisation than to do so individually.
Coase (1937) articulated the rationale of the firm (refer to Figure 9.6). He explains
that using the free market to purchase inputs is costly as it involves transaction
costs such as the cost to locate, identify, bargain for inputs and negotiate as well
as conclude contracts.
In addition, other costs have to be taken into consideration such as the cost of
internal ownership, the cost of training, monitoring and policing. Thus, in order
to save cost and to have an efficient means of organising economic activity, firms
are formed.
165
Ronald Harry Coase, born December 29, 1910, was a British

economist and the Clifton R. Musser Professor Emeritus of
Economics at the University of Chicago Law School. He graduated
from the London School of Economics in 1931.
Coase earned his doctorate from the University of London in 1951.
He immigrated to the US that same year and started work at the
University of Buffalo. In 1958 he moved to the University of Virginia.
Coase settled at the University of Chicago in 1964 and became the
editor of the Journal of Law and Economics. He received the Nobel
Prize in Economics in 1991. By reaching the age of 96, he was the
oldest winner of the Nobel Prize in Economics ever.
Figure 9.6: Ronald Harry Coase

Source: http://en.wikipedia.org/wiki/Ronald_Coase
Although many contractual relationships exist within a firm, there are two types
of contracts that the positive accounting theory focuses on, mainly because of
their nature which often gives rise to conflict of interest between the contracting
parties. These two contracts are management contracts and debt contracts (refer
to Figure 9.7). Both of these contracts are agency contracts.
Figure 9.7: Types of contract
Before we examine both these contractual relationships, let us now try to

understand the agency theory.
9.10 AGENCY THEORY

Let see in detail the agency theory.
9.10.1 What is an Agency Relationship?

Jensen and Meckling (1976) describe that an agency relationship arises where
there is a contract under which one party (the principal) engages another party
(the agent) to perform some service on the principals behalf. Under the contract,
the principal delegates some decision-making authority to the agent. This can be
illustrated in Figure 9.8
Figure 9.8: Definition of agency relationship
However, the agency problem arises when the agent does not act in the best
interest of the principal. This is because the agent has the authority to make
decisions, and he or she can transfer wealth from the principal to the agent
provided the principal does not intervene.
For example, in an situation whereby the agent is the manager, he or she may use
the company car during office hours to settle personal matters, or increase the
size of his or her office at the expense of the principal (the shareholders in this
case), or boost reported profits when his or her own reward is tied to results.
In other words, the core belief of the agency theory is that all contracting parties
are constantly seeking to maximise their own benefits, and this creates the
agency problem, which in turn, gives rise to agency costs.
167
9.10.2 Defining Agency Cost

Agency cost is defined as the monetary equivalent of the reduction in welfare
experienced by the principal due to the divergence of the principals and the
agents interest.
Agency costs comprise of:
(a)
Monitoring costs;
(b)
Bonding costs; and
(c)
Residual costs.
Let us now examine these costs in detail (refer to Table 9.1).

Table 9.1: Details of Agency Costs
Agency Costs
Monitoring Costs
Definition
The costs of measuring, observing and controlling the agents

behaviour.
Characteristics
This is the first cost to be incurred by the principal.

The principal can divert the cost to be borne by the agent by
reducing his or her salary and benefits. In other words, the principal
(shareholders, in this case) pays the manager (agent) less as the cost
of monitoring increases.
Examples
Agency Costs
Mandatory auditing costs, costs to establish management

compensation plans, cost incurred in budget restrictions, appointment
of board of directors and cost in setting up operating rules.
Bonding Costs
Definition
The costs incurred by the agent as a result of aligning his or her

interests with the principal, that is, to show that he or she is not selfserving. Thus, in order to guarantee that he or she will behave in the
interest of the principal, the agent has to establish mechanisms and
comply with these mechanisms. The costs for doing so is called
bonding costs.
Characteristics
The bonding cost is born by the agent.

Bonding costs (and also monitoring costs) need not be in financial
terms.
Agent will generally incur bonding costs to the extent that these
costs reduce the monitoring costs they bear. In other words, there is
zero bonding cost once the marginal cost of bonding equals the
marginal reduction in monitoring costs.
Examples
The time and effort spent in voluntary interim financial reporting, the
revenues forgone by being prohibited from selling firm secrets to a
competitor, voluntarily appoint independent directors and audit
committee.
Agency Cost
Residual Loss
Definition
The loss associated with not being able to fully align the interests of
the principal with the agent. In other words, it is a loss whereby the
agents interest is not the same as the principals interest, even though
monitoring costs and bonding costs have been incurred.
Characteristics
A deadweight loss. It is either too trivial or too costly to monitor.

This loss occurs when the net value of the agents output (or
performance) is less than if the agents interests are completely
aligned to the principals.
Examples
Manager (agent) takes home office stationary, uses the office fax
machine for personal matters, putting in less working hours than
shareholders (principal) would prefer.
SELF-CHECK 9.3
What is an agency relationship? Give one example.
ACTIVITY 9.7
How can the managers (agent) accounting decision transfer wealth from
shareholders and lenders (principal)? Also, how can the shareholders
and lenders constrain the opportunistic reporting by the manager?
It is important to note that the monitoring and bonding mechanisms in the
agency theory is very much related to the stewardship role of accounting. For the
rest of this topic, we will be discussing two specific agency relationships. They
are the manager-shareholder agency relationship and the shareholder-debtholder
agency relationship.
169
9.11 MANAGER-SHAREHOLDER AGENCY

RELATIONSHIP
In the manager-shareholder agency relationship, the shareholder engages the
manager to perform service on the shareholders behalf (refer to Figure 9.9).
Figure 9.9: Agency relationship of manager-shareholder
However, the separation of ownership and control means that managers, as the
agents of the shareholders, can act in their own interest. Often, the managers
interest may be very different from the interest of the shareholders.
There are a number of reasons why shareholders and managers incentives
regarding the firms policies are different; and the agency costs of equity arise
due to these differences. These reasons are:
(a)
Risk aversion;
(b)
Dividend retention; and
(c)
Horizon problem.
Let us now examine these three reasons in detail.

(a)
Risk Aversion
This means that managers prefer less risk than do shareholders. Managers
have limited incentive to increase the value of the firm through investment
in risky projects
Reasons:
(i)
Shareholders have the capacity to diversify their investment portfolio

so that it can minimise their exposure to investment risk;
(ii)
Shareholders have limited liabilities based on their shareholding; and
(iii) Managers prefer to invest in less risky transactions because the

managers most valuable asset, that is, his or her human capital (such
as management expertise) is invested in that one firm. Thus, losing the
job or getting less pay has a significant effect on the managers wealth.
Also, this risk cannot be diversified because the managers are only
employed in one management position.
Conclusion:
Managers rationally prefer to minimise their own risk rather than maximise
the value of the firm.
Example:
The management of an established property development company has the
opportunity to invest in and operate a highly speculative housing
development project. If the project turns out to be a success, the return to
the shareholders could be more than 100 per cent in the foreseeable future.
However, if the project fails, the company will suffer great losses and the
shareholders funds might even be negative.
From the perspective of the shareholders, they would want the
management to invest in the project if there is high probability of returns.
This is because the shareholders have limited liability, and thus they will
only lose an amount up to the value of the unpaid amount owing on their
shares if the project fails.
On the other hand, the managers would be averse to the investment in the
project because if it fails, they may lose their job.
(b)
Dividend Retention
This occurs when managers prefer to pay out less of the companys earning
in dividends than shareholders prefer. In other words, managers have
reduced incentives to pay dividends or they have increased incentive to
take on optimal levels of debt.
Reasons:
(i)
Managers prefer to retain money in the business (instead of paying

out the companys profits as dividend) to pay for their own salaries
and benefits; and
(ii)
Managers want to retain the money in the business to increase the size
of the firm and the scope of their power.
171
Conclusion:
Managers may limit the firms best investment opportunity.
Example:
The firms investment earns a 5 per cent rate of return for the shareholders.
However, the shareholders can invest personally to earn returns of 30 per
cent. Naturally, shareholders want to be paid dividends so that they can
invest in higher earning investment, rather than to leave the money in the
firm to be invested at a lower return. However, the managers may want to
retain the funds to increase their empire. Thus, the shareholders may lose
25 per cent because of the dividend retention problem.
(c)
Horizon Problem
This arises because of the difference in the time horizon interests of the
shareholders and managers with respect to the firm. Managers generally
have short-term focus on the performance of the firm as compared to the
shareholders.
Reasons:
(i)
Shareholders are interested in the long-term cash flows of the

company whereas the managers are interested in the cash flows of the
firm only for as long as they intend to stay with the firm.
(ii)
It is common for managers who anticipate moving to another firm in

the near future to promote an appearance of the profitability for the
firm in the short term, at the expense of long-term profitability.
Conclusion:
Managers may over-consume perquisites (that is money or goods given or
regarded as a right in addition to ones pay such as the company car, firstclass air ticket, annual all-expense-paid-for overseas holiday and so on.)
since they are, in the short term, focused in terms of their employment in
the firm.
Example:
Managers tend to present short-term profitability through reduction of
expenses such as repairs and maintenance, training and development of
workers as well as research and development of new products. These shortterm gains will eventually be overwritten by the longer term costs such as
the cost of obsolete or damaged equipment, inefficient and low-morale
workers as well as outdated products.
Now that we know the reasons for difference in incentives of the shareholders
managers in terms of the company policies, do you think there are ways to
overcome these differences, and thus reduce the agency cost of equity?
Yes, of course there are ways that the shareholders can resolve these disparities.
In fact, the most effective and important mechanism for the shareholders to
control the managers behaviour is the management compensation schemes that
link to accounting performance measures. They will provide incentives to
managers to maximise the value of the firm.
For example:
(i)
To minimise the risk aversion problem, managers can be motivated to act in

the shareholders interest by paying them bonuses at a progressive rate as
reported earnings increase;
(ii)
To reduce dividend retention problem, shareholders can approve a bonus

plan whereby the upper limit of the bonus is partially dependent on the
firms dividend payout ratio; and
(iii) To reduce horizon problems, the managers remuneration can be tied to the
share price movement.
SELF-CHECK 9.4
Why do the shareholders and managers incentives regarding the
firms policies differ?
ACTIVITY 9.8
Discuss how shareholders can overcome opportunistic reporting by
the management.
9.11.1 What is Bonus Plan Hypothesis?

An important hypothesis that we should examine is the bonus plan hypothesis.
This hypothesis states that managers with compensation plans are more likely to
choose accounting methods that increase current reported profits, such as
accruals and future costs. In other words, managers adopt accounting methods to
173
maximise bonuses if the contracts reward managers after pre-specified level of

profits is reached.
Bonuses can be paid in cash and/or shares or share options.
Bonuses can be tied to accounting numbers such as net income, sales and return
on assets and can also be based on market based performance measure such as
share price.
9.12 SHAREHOLDERS/MANAGERS
DEBT-HOLDERS AGENCY RELATIONSHIP
Figure 9.10: Agency relationship of shareholders/managers and debt-holders
In the shareholders/managers debt-holders agency relationship (refer to Figure

9.10) certain assumptions need to be made:
(a)
Managers have interests that are totally aligned with the interests of the
shareholders;
(b)
Principal is the debt-holders or lenders;
(c)
Agents are the managers/shareholders;
(d)
Managers/shareholders have limited liability and managers may hold

shares; and
(e)
The firms value consists of the value of debts plus the value of equity; thus,
in order to increase the value of the firm, the agents can either increase the
value of equity or transfer wealth from debt-holders.
It is important to examine how managers accounting decisions can transfer

wealth from debt-holders to the shareholders.
Specifically, the agency costs of debt arise due to these four main methods of
transferring wealth from debt-holders to shareholders. They are:
(a)
Excessive dividend payments;
(b)
Asset substitution;
(c)
Underinvestment; and
(d)
Claim dilution.
Let us now examine these four methods in detail.

(a)
Excessive Dividend Payments

This arises when the management pays out a certain level of dividend from
the loan received from the debt-holders.
Issuing higher dividend reduces the asset base that is securing the debt. In
other words, excessive dividend payments reduce debt-holders security.
Thus, if the management borrows funds and then pays out all of the
borrowed amount as dividends, debt-holders will be left with nothing and
the shareholders who received the dividend will have additional
advantages of the limited liability of the firm.
(b)
Asset Substitution
As we have learned, shareholders have limited liabilities within the firm
and, thus, tend to invest money into high risk, high return and diversified
portfolios.
On the other hand, debt-holders are generally risk averse. They normally
lend funds to firms that do not invest in assets or projects with higher risks
than what is acceptable to them. This is because investment in high risk
projects may be detrimental to the debt-holders if losses occur, as they do
not share in the increased returns on high risk and high profit projects
(unlike the shareholders) but they do share the losses.
Thus, the firms tend to invest in higher risk projects due to the possibility of
getting higher returns, even though such action does not benefit the debtholders.
(c)
175
Underinvestment
This arises when the shareholders/managers do not undertake positive net
present value projects because to do so would increase the funds available
for the firm to repay the debt-holders first, but not to the shareholders.
For example, ABC Company has a negative shareholders funds of
RM200,000 and is facing bankruptcy. It has the option of investing in a
project that would give a positive net-present-value of RM100,000.
However, the shareholders would not get any return from this project, as
the entire RM100,000 would be used to pay off the debts of the company, so
that the net debt would be reduced to RM100,000.
In practice, most likely the shareholders/managers would have incentives
to only invest in projects that earns a positive net present value in excess of
RM200,000.
In short, the shareholders/managers have no incentive to invest in positive
net present value projects, whereas the debt-holders prefer the firm to
invest in all positive net present value projects as it would increase the
funds available to repay the debts.
(d)
Claim Dilution
This occurs when the firm issues debt of higher priority than the debt
already on issue. The reason for doing so is to increase the funds available
for the management to enhance the value of the firm, as well as to increase
the value of the shareholders interest. However, by doing so, the relative
security and value of the existing debts would be decreased.
In other words, the shareholders/managers have the incentives to issue
higher priority debts than the existing debts. As a result, the value of the
existing debts would be diluted and become riskier in the presence of
higher priority debts. This surely would not be what the existing debtholders want.
The most effective way to prevent the shareholders/managers from
transferring wealth from debt-holders to shareholders is for the debtholders to price protect via increased interest charges or reduced amounts
provided. Specifically, this can be done through debt contracts.
9.12.1
Purpose of a Debt Contract
The purpose of a debt contract is generally to restrict the shareholders/managers by:

(a)
Restraining dividend policy by preventing excessive dividend payments;
(b)
Restraining investment opportunities by reducing asset-substitution and

underinvestment;
(c)
Restricting leverage by controlling claim dilution; and
(d)
Improving bonding covenant through provision of financial statements.
9.12.2 What are Debt Covenants?

Debt covenants are terms and conditions written into debt contracts to restrict the
activities of the management, so that the interest of the debt-holders will be
protected.
Breach of a debt covenant will constitute technical default on the debt contract.
This will provide the debt-holders with rights to institute actions that have been
agreed upon such as seizure of collateral.
SELF-CHECK 9.5
The agency costs of debt arise due to four main methods of
transferring wealth from debt-holders to shareholders. What are the
methods?
ACTIVITY 9.9
Give examples of debt covenants that are written into a typical debt
contract.
The pre-requisite to have better decisions regarding investment capital is

financial reporting. In order to make better decisions on the details and
process of allocating investment capital, high-quality financial reporting is a
pre-requisite.
177
IFRS adoption increases the harmony of financial information and facilitates

accounting reports comparisons.
FASB evaluates the advantages and disadvantages of standards before

creating them.
The economic consequences of a new financial reporting standard are

different from the analysis of costs and benefits related to the admitting of a
new standard.
The role of financial reporting is to promote decisions and provide

information for the investors. The FASBs aim in establishing accounting
standards is to show the best picture of a companys financial position and
performance.
Since accounting standards are adopted voluntarily, the benefits and costs of
standards adoption should be evaluated by firms.
Empirical evidence shows mixing results of the accounting standards

adoptions. As in a recent case, the FASB is engaged in a project to improve
reports on leases.
By example, the legal nexus of contract is collections of contracts between

different parties such as shareholders, directors, employees, suppliers and
customers.
Accounting Standard Adoption
Financial information
Legal nexus of contract
Agency Theory
Financial reporting
Debt contract
IFRS
Economic consequences
Malaysia Financial Reporting

Standard (MFRS)
Financial Accounting Standard Board
Mention the advantages of mandating accounting standards for firms.
What is the reason that financial standards adoption creates mixing economic
results in practice?
Topic Social and
10
Environmental
Reporting
LEARNING OUTCOMES
1. Explain the meaning of social and environmental responsibility
reporting;
2. Discuss the nature of social and environmental responsibility reporting:
3. Describe the importance of corporate social responsibility;
4. Apply the theoretical models to the development of social and
environmental issues;
5. Identify the voluntary reporting guidelines and the corporate
environmental reporting in Malaysia;
6. Apply the triple bottom line reporting; and
7. Discuss the measurement
environmental reporting.
issues
pertaining
to
social
and
INTRODUCTION
Economic development in the Asian region has been most rapid and dynamic for
the past decade. However, do you know that the cost of such achievement has
been very high?
Evidence shows that past growth has generated high levels of pollution, resource
degradation and poverty. Thus, building a social agenda that embraces the
vulnerable group of society and to prevent further environmental decline are
important challenges for economies in this region.
180 TOPIC 10 SOCIAL AND ENVIRONMENTAL REPORTING
Increasingly, business entities are expected to consider social and environmental

issues in their decision making. As a result, accountants are pressured to include
these issues in their reporting.
10.1
SOCIAL AND ENVIRONMENTAL

REPORTING
What is social and environmental reporting? Corporate social and environmental

reporting is a voluntarily but important compliance, which necessitates
companies to consider interests of environment, employees, society and other
stakeholders who are affected by company activities either directly or indirectly.
Let us start with traditional financial reporting and alternative view reporting.
10.1.1
Traditional Financial Reporting versus

Alternative View Reporting
Let us discuss the differences between traditional financial reporting and

alternative view reporting.
(a)
Traditional Financial Reporting

As you are aware, conventional financial reporting focuses on the
information needs of the shareholders or owners of the company.
Milton Friedman (1970) (refer to Figure 10.1) made a famous statement:
The business of business is business.
Figure 10.1: Milton Friedman

Source: http://en.wikipedia.org/wiki/Milton_Friedman, accessed on 30 May 2007
TOPIC 10 SOCIAL AND ENVIRONMENTAL REPORTING 181
Friedman views an organisations sole responsibility is to maximise profits

for its shareholders. He also states that the organisation uses part of its
profits for taxation and other statutory payments, thus any further
obligations put on it by the society would be deemed as an illegal tax. In
other words, managers do not have moral obligations.
However, Friedmans view has been under fierce attack from various
stakeholders in recent times. Stakeholders have been increasingly
demanding information not only on financial performance, but also on
social and environmental performance.
ACTIVITY 10.1
Who do you think are the stakeholders? Give example of stakeholders
in a typical manufacturing company.
(b)
The Alternative View of Business

(i)
Managers should run the business for the benefit of all stakeholders;
(ii)
Firms must demonstrate transparency and accountability beyond the

domains of financial performance; and
(iii) Firms are responsible to provide information regarding their social

and environmental performance.
10.1.2
Defining Social and Environmental Reporting
Do you know how important social and environmental reporting is? If you think
that this kind of reporting is only to show how successful the firm is financially,
then you are wrong!
Social and environmental accounting reporting aims to disclose issues not
necessarily covered by the traditional accounting function, into a form that is
useful for decision making.
Social and environmental accounting and reporting comprises actions that have
an impact on the:
(a)
Employees;
(b)
Occupational health and safety of the workers;
(c)
Minority and equity issues;

(d)
Community;
(e)
Indigenous people;
(f)
Environment;
(g)
Energy use;
(h)
Products;
(i)
Charitable donations;
(j)
Political donations; and
(k)
Support sponsorships; etc.
**Do bear in mind this is not an exclusive list.

In other words, social and environmental reporting recognises the firms
interaction with the broader community and its stakeholders. It has to be
considerate of the demand placed upon it, and also the need to remain a viable,
sustainable entity.
Do you know the meaning of sustainable?
Sustainable entity means an entity that is constantly seeking to meet the
needs of the present generation without compromising the ability of
future generations to meet their own needs.
Examples:
Gamuda Land markets eco-friendly homes and neighbourhoods, Alam
Flora carries out community education for a clean environment and
Maxis Communication organises Internet camps around the country for
the underprivileged children.
Before we proceed further to discuss the theoretical models, it is important for us

to understand the meaning of corporate social responsibility.
10.1
WHAT IS CORPORATE SOCIAL

RESPONSIBILITY (CSR)?
Let us start with the definition of CSR.
10.2.1
Definition of CSR
This is the definition of CSR by the European Commission in its Green Paper
in 2001:
being socially responsible means not only fulfilling legal expectation,

but also going beyond compliance and investing more into human capital,
the environment and relations with stakeholders.
EU Green Paper (2001)
In other words, CSR refers to a set of policies and strategies that is said to occur
when companies voluntarily integrate social and environmental concerns in their
business operations and in their interaction with stakeholders. You can also view
CSR as making economic returns without jeopardising the environmental
stability and social development.
10.2.2
Factors Motivating CSR
You may ask, why would a company voluntarily set up a CSR agenda? Now, let
us look at some of the motivating factors from the Malaysian perspective:
(a)
Moral Obligation
It is morally right for companies and their management to act in a socially
responsible manner.
(b)
Legal Regulation and Management Accountability

Generally, the Malaysian government will intervene on environmental
issues aiming at those companies that are directly responsible for the
environmental degradation. Penalties such as fines and clean-up costs are
imposed on the offenders.
On the other hand, companies that comply with the social and
environmental responsibility will enjoy benefits such as tax deduction on
expense incurred for their environmental programme and good reputation.
(c)
Shareholders Activism
These days, shareholders are becoming more proactive in highlighting CSR.
SELF-CHECK 10.1
1. What is social and environmental reporting?
2. Elaborate on what corporate social responsibility is.
ACTIVITY 10.2
Can you think of three examples of CSR initiatives by Malaysian
companies? Discuss in class how these CSR initiatives impact the
companies.
Now that you know what CSR is, let us analyse this area further by examining a
few theoretical models.
10.3
THEORETICAL UNDERSTANDING OF
SOCIAL AND ENVIRONMENTAL ISSUES
Let us look at three theoretical models in social and environmental issues.

(a)
Social Contract Theory

This theory explains that there are boundaries of acceptable interaction
between participants within the society. These boundaries will determine
the practices that are acceptable or unacceptable in meeting the needs of the
society.
Thus, management, via its social contract with the various stakeholders,
aims to perform socially desirable actions in return for acceptance of its
company objectives.
In other words, management actions are guided by social expectations of
their performance.
For those companies who disregard the boundaries of socially desirable
behaviour, society will allow the formation of governments with power to
regulate and restrict the activities of these companies.
(b)
Legitimacy Theory
Now that you understand the social contract theory, let us move on to look
at another theory that is closely linked to the social contract theory
legitimacy theory.
This theory explains the reaction of management towards changes in
community expectations. Management is said to behave in a way to avoid
further explicit restrictions (such as government regulations) or implicit
restrictions (such as reputation effects) on their operations.
Therefore, corporate legitimacy not only involves matching performance
with expectations, it is also about the means by which management can
inform external parties about their performance in social and
environmental performance.
You may be interested to know that management may seek organisational
legitimacy through alternative means. In other words, management may
attempt to justify its current actions by communicating its commitment to
improve environmental management and performance. Management can
also try to change the stakeholders expectations that it considers
unreasonable.
(c)
Stakeholder Theory
Basically, stakeholder theory is a rebuttal of the notion that a business only
has social responsibilities to make profits on behalf of shareholders.
Changes in business environment and company law have given rights to all
those groups that have claims on the company, such as customers,
suppliers, employees, government authority and lobbyists.
Specifically, the stakeholder theory explains that the behaviour of an
organisation is governed by, firstly, the nature of its diverse stakeholders;
secondly, the norms defining right or wrong adopted by these stakeholders;
and thirdly, stakeholders relative influence on organisation decisions.
So, who exactly are the stakeholders?
Figure 10.2 shows the various stakeholders that might be affected by the
companys decisions:
Figure 10.2: Various stakeholders that might be affected by the companys decisions
Source: Adapted from Weiss, J. W. (2006)
Freeman (1984) defines stakeholder as:
any individual or group who can affect or is affected by the actions,

decisions, policies, practices, or goals of the organisation.
Figure 10.3: R. Edward Freeman

Source: http://en.wikipedia.org/wiki/R._Edward_Freeman. Retrieved on: 30 May 2007
Freeman (refer to Figure 10.3) argues that stakeholder management is central to

putting any conception of CSR into practice. Stakeholder management involves
allocating organisational resources taking into account the impact of the firms
actions on various stakeholder groups, with the objective of maximising the
firms ability to realise its intended strategies.
Freeman further explains that the stakeholders can be classified into primary and
secondary groups. Primary stakeholders (for example, shareholders and
creditors) include those groups with direct and well-established legal claims on
organisational resources. Secondary stakeholders (for example, employees and
the natural environment) refer to those parties whose claims on organisational
resources are less well established in law and/or are based on non-binding
criteria such as community loyalty and ethical obligation.
Thus, stakeholder management directs management to pursue outcomes that
optimise the results for all involved stakeholders rather than maximising the
results for one stakeholder group (that is, shareholders).
10.4 VOLUNTARY REPORTING

A companys decision to disclose social and environmental information is mainly
voluntary. This is because there are limited social and environmental reporting
regulations.
10.4.1 International Guidelines for Social and

Environmental Disclosure
Currently, perhaps the most prominent set of international guidelines for social
and environmental reporting are those issued by the Global Reporting Initiative
(GRI). GRI is generally accepted as the current best practice reporting. Many
corporations with more extensive reporting practices use GRI as a basis for
determining the scope of their disclosure.
10.4.2 Corporate Environmental Reporting (CER) in

Malaysia
Corporate environmental reporting (CER) is the process of communicating
externally the environmental effects of an organisations economic actions.
ACCA (2002) reported that CER in Malaysia is still in its infancy. It surveyed all
the companies listed on the Bursa Malaysias main board, and found that
between 1999 and 2001, the number of companies engaging in CER increased
from 5.3 per cent to only 7.7 per cent. All those reporting companies used their
annual report for communicating environmental information to their
stakeholders. About 95 per cent devoted less than a page to CER in their annual
reports.
There are a number of reasons as to why CER is in its infancy in Malaysia (refer
to Figure 10.4).
Figure 10.4: Reasons for Malaysian companies not reporting
To further reiterate the issue of the general reluctance amongst Malaysian

companies to disclose more than what they really need to, Tan, Zainal and
Cheong (1990) found that voluntary disclosure in Malaysia is an exception rather
than the norm.
Johnson (2003) says the lack of pressure from other stakeholders such as the nongovernment organisations and pressure groups may explain why few companies
take CER seriously. He further elaborates that CER requires the companies to be
transparent and open, characteristics that are not prevalent in Southeast Asian
cultures.
10.5 WHAT IS TRIPLE-BOTTOM-LINE (TBL)

REPORTING?
To understand what is triple-bottom-line (TBL) reporting, let us look at
Figure 10.5.
Figure 10.5: Triple-bottom-line (TBL)
Reporting TBLs objectives are:

(a)
To move away from the traditional method of reporting that focuses on

financial performance; and
(b)
To move away from the adoption of the annual report as the primary
means of communication.
TBL reporting includes the combination of financial information, quantified nonfinancial information and narrative descriptions.
Presently, there is no single uniformed approach generally adopted by all firms.

There are some difficulties in valuing social and environmental assets, especially
in those cases where there is no active market, hence no future economic benefits.
SELF-CHECK 10.2
1. Describe briefly the main theoretical models in social and
environmental issues.
2. Explain the issue of voluntary reporting in Malaysia.
ACTIVITY 10.3
Do you think attaching values to social and environmental assets are
difficult? Can you think of three problems in carrying out such
valuation?
10.6 MEASUREMENT ISSUE

When you go through the social and environmental disclosure made by firms,
you will notice, most of the time, that the disclosure tend to be qualitative instead
of financial. Do you know why?
In fact, this is exactly the problem with linking social and environmental impact
that has economic consequences to the entity.
Historical cost, traditionally, may give a precise financial measurement; however,
this method does not produce the current valuation of the asset. This
measurement problem is further compounded for social and environmental
assets that have no active market. Also, even the question of whether it is
necessary to quantify the social and environmental issues in financial terms is
debatable.
Now, let us look at the arguments for and against valuation of social and
environmental issues.
(a)
The Argument for Valuation

In most companies, the decision-making process is dominated by the
financial implication. Thus, social and environmental consequences that
are not financially quantified may be considered as immaterial and may

be marginalised, even though their implications might have direct effect
on the entity.
This argument can be understood by looking at the reason for valuing
nature. By valuing nature, we are in a better position to consider the
implications within our decision process, and it will also encourage
solutions to the existing and future social and environmental problems.
(b)
The Argument against Valuation

Nature has an intrinsic value. It is crucial to the survival of our planet Earth
and to the quality of life that current and future generations seek to enjoy.
Such enjoyment cannot be financially quantified. By valuing nature, we are
actually trying to turn it into a commodity that we can preserve or
consume. In other words, quantification of nature makes nature another
economic resource that can be traded, and thus open for exploitation and
degradation.
(c)
Alternative Means of Measurement

Examples of other types of measurements that can be looked at include:
(i)
Reputation scales of social acceptance;
(ii)
Number of staff involved in further training;
(iii) Apprenticeships;
(iv) Scholarships; and
(v)
Sponsorship of community programmes.
SELF-CHECK 10.3
Briefly describe the issues in measurement use for social and
environmental disclosure.
ACTIVITY 10.4
Can you think of other ways of measuring social and environmental
issues?
The conventional business entities are perceived to be responsible for their

financial performance and responsible towards the owners or shareholders.
Stakeholders, which include the community and political bodies, are

increasingly demanding information not only on financial performance but
also on social and environmental performance.
Social and environmental accounting is accounting for events other than

economic events. It is also accounting in terms other than those strictly
financial.
Corporate social responsibility (CSR) refers to a set of policies and strategies

that is said to occur when companies voluntarily integrate social and
environmental concerns in their business operations and in their interaction
with stakeholders.
Factors motivating CSR:

-
Moral obligation;
Legal regulations and management accountability; and
Shareholders activism.
The social contract theory explains the boundaries of acceptable interaction

between participants within the society.
The legitimacy theory explains that corporate management seeks to meet

societys expectation, so as to avoid explicit restriction (by the government)
and implicit (reputation) restriction on their operation.
Stakeholder theory explains that the behaviour of an organisation is governed

by, firstly, the nature of its diverse stakeholders; secondly, the norms defining
right or wrong adopted by these stakeholders; and thirdly, stakeholders
relative influence on organisation decisions.
Reasons as to why corporate environmental reporting is in its infancy in

Malaysia include cost of reporting, lack of government pressure to report,
lack of pressure from wider society, lack of perceived benefits, fear of how
users will react and a perception that the company does not have an
environmental impact.
Triple-bottom-line is reporting on the economic, environmental and social

performance of a company.
Most companies disclosures tend to be qualitative, not financial. This is

because it is difficult linking social and environmental impact that have
economic consequences to the company.
Corporate social responsibility
Social contract
Intrinsic value
Stakeholder theory
Legitimacy theory
Sustainability
Shareholders activism
Triple-bottom-line reporting
Social and environmental reporting
1.
Why does the traditional financial reporting differ from the alternative
views of reporting?
2.
What does Friedman (1970) mean when he said The business of business is
business?
3.
What is the objective of social and environment reporting?
4.
What is corporate social responsibility?
5.
Explain the three theories of social and environment reporting.
6.
What is triple-bottom-line reporting?
7.
What are the arguments for and against valuation of social and
environment issues?
1.
What are the issues that constrain the development of reporting regulations
for social and environmental issues?
2.
Jonathan Lash (President, World Resources Institute) made the following

statement.
From the board room to the shop floor to the marketplace, business
decisions are skewed when environmental costs are hidden. Common
accounting practices hide these costs in two ways: by burying them in nonenvironmental accounts and by failing to link costs to the activities that
spawn them. As a result, managers are forced to make crucial business
decisions what products to manufacture, what technologies to employ,
and what materials to use without command of all relevant facts.
Evaluate the above statement.
3.
Is triple-bottom-line reporting a threat or an opportunity for an

organisation?
4.
Do you think that economic, social and environmental reporting is, or

should be included within the conceptual framework?
5.
What are the various stakeholders categories identified in the conceptual

framework? Do these stakeholders require information other than economic
performance? If so, what type of information would be desirable and is the
annual report an appropriate means of disseminating such information?
6.
What do you think are the contributing factors for increased accountability
for social and environmental performance?
7.
(a)
Why is there an opposition to mandatory reporting of environmental

and social information if the accountants believe that current
reporting practices are inadequate?
(b)
Is there any alternative to mandatory reporting?
(c)
Would such alternative be effective?
Topic Other Current
11
Issues in
Financial
Reporting
LEARNING OUTCOMES
1. Explain online reporting with XBRL;
2. Discuss how performance reports are developed;
3. State the information type included in management commentary;
and
4. Explain the view of employees as intellectual capitals of the
organisation.
INTRODUCTION
In this topic, we will discuss the current facilitation of online financial reporting.
XBRL (eXtensible Business Reporting Language) is the programing language for
this purpose. Using XBRL has offered a number of advantages such as extracting
data and information efficiently as well as assisting financial statements analyses.
Performance measurement has also attracted a great deal of attention nowadays
because managers are paid according to their performance. Therefore, knowing
the sequences of preparation and usage of these reports are substantially
necessary.
Due to the inefficiency of financial statements to include the detailed required
information, management is advised to prepare a report called management
196 TOPIC 11 OTHER CURRENT ISSUES IN FINANCIAL REPORTING
commentary. This report comes in handy for financial information users such as
investors, when they are eager to have more comprehensive perspectives of
companies, and also when they intend to make important decisions accordingly.
Finally in this topic, we will have a look at the intellectual capital within
organisations. This kind of capital states that human resources are precious
sources of benefits for companies, and they must be highly valued as they are the
main source of creativity and innovation.
11.1
ONLINE REPORTING AND XBRL
Nowadays, everyone is benefiting from searching and sharing information via

the Internet. As a result of these facilities, businesses are facing a number of
advantages and disadvantages. Since the Internet technology is in digital format,
companies are able to use this technology to modify and make improvements in
their activities, such as financial reporting.
The major shortcoming of using financial statements was their text format.
Consequently, extracting the data and transferring them to the spreadsheet
format was a challenge, until XBRL (eXtensible Business Reporting Language)
was first released in 2005 in the US.
XBRL refers to a language which makes communication of businesses feasible
online. This language does not need any person because machines can read it.
Information sharing is possible by the use of the tags in XBRL, providing
dialogue among various technologies.
XBRL usage is adopted by different countries starting with the US, Australia,
Germany, Korea, London, New Zealand, Tokyo and many more. In addition to
the mandated financial reporting in the form of XBRL in China since 2005, the big
four accounting firms are the advocates of this language as well.
The popularity of XBRL format for online reporting is because of its benefits,
some of which are mentioned here:
(a)
XBRL is online and it is related to business processes. Besides, it is

universally approved;
(b)
Automation is increased by XBRL;
(c)
Accuracy and reliability of financial statements information is provided;
(d)
Decision qualities are elevated;
(e)
The speed of analysis is improved;

TOPIC 11 OTHER CURRENT ISSUES IN FINANCIAL REPORTING
197
(f)
Cost of analysis is reduced because of automation and less manual work

required;
(g)
IFRS harmonisation is assisted due to XBRL; and
(h)
Information delivery and sharing financial reporting measures is assisted.
11.2
PERFORMANCE REPORTING
Performance reports refer to the reports created by responsibility centres during

fixed periods of times to compare the actual and planned figures such as costs
incurred. Managers use performance reports to improve or modify the courses of
business actions due to the favourable or unfavourable variances revealed in
these reports. The following spreadsheet (refer to Table 11.1) is an example of
total expense performance report for February in Waikiki Sands Hotel.
Table 11.1: Performance Report for February Kitchen, Waikiki Sands Hotel
As illustrated, this hotel experienced a $5,000 unfavourable performance in its

total costs and the manager was required to take corrective actions to reduce the
costs.
Total performance reports are developed hierarchically, meaning that each
department performance report is integrated into the higher department
performance report in the organisation chart. Oahu Division performance
reports, (refer to Figure 11.1) for instance, includes Waikiki Sands Hotel
performance reports periodically.
Figure 11.1: Organisation chart for Aloha Hotels and Resorts Incorporation
The Aloha Hotels and Resort performance report for February (refer to Figure
11.2) is presented as follows. The figures shown in parenthesis are related to cost
centres such as Grounds and Maintenance Department, and the Housekeeping
whereas profit and investment centres measures are shown with positive
numbers. Each department is a sample of a profit centre, but major divisions like
Maui Division, and the Oahu Division are considered as investment divisions.
199
Figure 11.2: Aloha Hotels and Resort Performance Report on February
It is apparent from these figures that a performance report is established from the
lowest level in an organisational chart and then forwarded to the higher level. To
show this relationship, the arrows provide the direction of combining reports
together. For example, total expenses of Kitchen department moves to Food
and Beverages department and, in turn, total profits of Food and Beverages
department makes a line in its higher department profit, Waikiki Sands Hotel.
Interestingly, total expenses shown by the above spreadsheet is quoted in the last
line of the total performance report.
Overall, performance reports are useful tools for general managers and CEOs to
assess not only their subordinates performance, but also their own performance.
Consequently, managers can make better decisions accordingly to develop
forthcoming programmes and plans, whilst upgrading the total performance of
the organisation as a whole.
ACTIVITY 11.1
Discuss who are the users of performance reports.
11.3
MANAGEMENT COMMENTARY
No one can deny the fact that financial statements do not include all the
information required by the users. Hence, managers need to declare information
such as financial statements details and explanations, organisational overview,
main objectives of the organisation and strategies and approaches to make goals
come true. These are done through management commentary reports.
A commentary report performs through the IFRS practice statement; however,
this report is voluntarily prepared. For the corporations with IFRS compliance in
financial statements preparation, the practice statement should be applied to
present the management commentary.
A management commentary feeds financial statements users with:
(a)
Performance of the organisation and prospects of future plans; and
(b)
Complementary qualitative and quantitative information on financial

statements of the corporation.
The rules of information illustration in a management commentary are:

(a)
Information compliance with the reported financial statements;
(b)
Lack of biasness and/or repetitiveness in comments; and
(c)
Presentation of useful information for users decision making.
201
A management commentary report entails components which fulfil financial

users needs. A summary of this inter-relation is presented in Table 11.2 where
users needs are defined by the International Accounting Standards Board
(IASB).
Table 11.2: Inter-Relation between Financial Users Needs and Management Commentary
Report Elements
Element
User Needs
The nature of the business
The knowledge of the business in which

an entity is engaged and the external
environment in which it operates
Managements objectives and its strategies

for meeting those objectives
To assess the strategies adopted by the

entity and the likelihood that those
strategies will be successful in meeting
managements stated objectives
The entitys most significant resources,

risks and relationships
A basis for determining the resources

available to the entity as well as
obligations to transfer resources to others;
the ability of the entity to generate longterm, sustainable net inflows of resources;
and the risks to which those resourcegenerating activities are exposed, both in
the near term and in the long term
The results of operations and prospects
The ability to understand whether an

entity has delivered results in line with
expectations and, implicitly, how well
management has understood the entitys
market, executed its strategy and managed
the
entitys
resources,
risks
and
relationships
The critical performance measures and

indicators that management uses to
evaluate the entitys performance against
stated objectives
The ability to focus on the critical

performance measures and indicators that
management uses to assess and manage
the entitys performance against stated
objectives and strategies
ACTIVITY 11.2
Provide a management commentary report and discuss its elements
in class.
11.4
HUMAN RESOURCE AND INTELLECTUAL

CAPITAL
Intellectual capital is the result of mixing human resources working in an

organisation, and intellectual property belonging to that organisation.
Nowadays, companies are not just valued by the deduction of their assets from
the liabilities, because business intellectual properties play a key role in the value
of an organisation even in its market share prices.
As a kind of intellectual capital, human resources with proficiencies, knowledge
and valuable experiences would definitely contribute to an organisations value.
Therefore, the ways corporations put effort to retain their human capital, and
also take advantage of them for innovations and creativity, are substantially
indispensable. The reason for this claim is that human capital belongs to
employees, which businesses can easily lose if they leave.
The course of accounting which deals with human capital measurement is called
Human Resource Accounting (HRA). HRA categorises the costs related to
human resources as assets in the balance sheet instead of expenditures in the
profit and lost statement. This is done because employees are assets which
benefit the company.
Adoption of HRA practices is not far away from global acceptance due to the
recent advancements in financial reporting guidelines offered by IFRS. The more
accountants are required to comply with increasing formidable rules posed by
IFRS, the more the incidents of integrating new measurements will be, including
human resource evaluations in financial statements.
ACTIVITY 11.3
Discuss in groups whether human resource accounting training in
organisations leads to higher employee retention or not? If yes, how?
Corporate social responsibility (CSR) is an optional compliance with ethical

principles, and the scope of its monitoring includes activities which benefits
environment, employees, customers, society and all individuals surrounding
the company.
203
To measure the impacts of social activities of a company, the company must

be accounted for their social contributions. This is called social accounting.
CSR guidelines adoption provides firms with benefits in many aspects, such
as, risk management and brand recognition.
XBRL is a language readable by machines which is used for extracting and

analysing financial statements figures.
Performance reports help managers make better decisions.
Managers use performance reports to improve or modify the courses of

business actions due to the favourable or unfavourable variances revealed in
these reports.
Financial statement users can enjoy having more useful information included
in the management commentary.
A management commentary feeds financial statements users with:
Performance of the organisation and prospects of future plans; and
Complementary qualitative and quantitative information on financial

statements of the corporation.
With the recent advancements in financial reporting standards, especially

IFRS, human capital evaluation will be integrated into financial reporting.
Corporate social responsibility
Management commentary
eXtensible Business Reporting

Language (XBRL)
Online reporting
Human resource accounting
Performance reporting
Social accounting
Intellectual capital
What are the benefits of CSR adoption in different aspects of organisation

practices?
What factors have made online reporting with XBRL increasingly favourable?
Topic Islamic
12
Accounting
LEARNING OUTCOMES
1. Define the meaning of Islamic accounting;
2. State the objectives of Islamic accounting;
3. Explain the principles of Islamic accounting;
4. Classify Islamic accounting; and
5. Discuss the role of Accounting and Auditing Organisation for
Islamic Financial Institutions (AAOIFI)
INTRODUCTION
This topic offers an overview of the accounting practices in Islam and defines the
meaning of Islamic accounting. Since Malaysia is an Islamic country,
familiarisation with Islamic accounting practice is crucially important for learners.
The reason is that there are some differences in Islamic accounting rules and
regulations from those of current accounting practice. Therefore, those who intend
to deal with Muslims are required to be aware of the differences and similarities
between these two accounting methods. Financial institutions also have to follow
Islamic principles in their profession. Even Bank Negara Malaysia (Central Bank of
Malaysia) has included Islamic finance clarifications on its website:
Malaysia's long track record of building a successful domestic Islamic

financial industry of over 30 years gives the country a solid foundation
financial bedrock of stability that adds to the richness, diversity and
maturity of the financial system. Presently, Malaysia's Islamic banking
assets reached USD65.6 billion with an average growth rate of 1820 per
cent annually.
206 TOPIC 12 ISLAMIC ACCOUNTING
Today, Malaysia's Islamic finance continues to grow rapidly, supported

by a conducive environment that is renowned for continuous product
innovation, a diversity of financial institutions from across the world, a
broad range of innovative Islamic investment instruments, a
comprehensive financial infrastructure and adopting global regulatory
and legal best practices. Malaysia has also placed a strong emphasis on
human capital development alongside the development of the Islamic
financial industry to ensure the availability of Islamic finance talent. All
of these value propositions have transformed Malaysia into one of the
most developed Islamic banking markets in the world.
Rapid liberalisation in the Islamic finance industry, coupled with
facilitative business environment has encouraged foreign financial
institutions to make Malaysia their destination of choice to conduct
Islamic banking business. This has created a diverse and growing
community of local and international financial institutions.
Currently, Malaysia has a significant number of full-fledged Islamic
banks including several foreign owned entities; conventional institutions
who have established Islamic subsidiaries and also entities who are
conducting foreign currency business. All financial institutions are given
permission to conduct both ringgit and non-ringgit businesses.
Malaysia continues to progress and to build on the industry by inviting
foreign financial institutions to establish international Islamic banking
business in Malaysia to conduct foreign currency business.
This topic discusses the objectives and principles of Islamic accounting as well as
Islamic accounting core concepts.
12.1
MEANING OF ISLAMIC ACCOUNTING
Islamic accounting is the type of accounting which aims to assure religious

stakeholders that Islamic thoughts are observed in business processes.
Consequently, Muslim stakeholders are facilitated through Islamic accounting to
measure their contributions toward Islamic religious (called Syariah) principles.
Syariah precepts are the basis for performance of Islamic business institutions.
TOPIC 12 ISLAMIC ACCOUNTING
207
Hence, Islamic banks, financial institutions and their applications for serving
the community have been made to look for the most appropriate ways to give
the most proper information to users of financial statements of those
institutions. Conceptual frameworks for accounting have been attempted to be
established, but they seem to be very slow, and the conceptual framework of
Accounting and Auditing Organisation for Islamic Financial Institutions
(AAOIFI) has the same problems.
A conceptual framework is the basis and other notions derive from that; it is seen
to be required in establishing reporting standards in accounting. A conceptual
framework is used for settling and resolving accounting disputes that have arisen
during the standard-setting process on the conformity of specific standards to the
conceptual framework.
According to Karim (1990), Islamic banks have taken the initiative to self-regulate
their financial reporting. However, a uniform conceptual framework may be
difficult to achieve, since communities have different views.
Because accounting standards allow some alternatives to accounting practices,
according to Godfrey (2000), accounting practice is overly permissive. Thus, it is
essential to judge the type of desired or suitable accounting standards. A
conceptual framework is nothing more than providing the broad and general
objectives for financial reporting.
Now, let us discuss the objectives of accounting in Islamic methodology.
ACTIVITY 12.1
Why is Islamic accounting so important for Muslims? Discuss.
12.2
OBJECTIVES OF ACCOUNTING IN ISLAMIC

METHODOLOGY
The accounting objective is inseparable from accounting concepts and accounting

concepts, and all their derivatives are developed from the accounting objective.
According to Adnan and Graffikin (1997), AAOIFI could not avoid the influence of
capitalist or liberal thought developed in Western ideology. The objectives are to
provide information for investors and customers to make economic decisions, and
they do not cover how it may serve other users such as employees, society, etc.
Shahul (2000) states that Islamic financial institutions should provide some
information needed by the Islamic society. Khan (1994) argues that the
information requirements of an Islamic society are different from those of a
capitalist society.
It is stated in Islam, that the focus is on God and the community demands a
social accountability perspective, and not the personal accountability as in the
West. Adnan & Gaffikin (1997) indicate paying zakat should be the basic
objective of accounting information for Islamic institutions.
The aim of accounting information is clear in Islam (seeking Allahs pleasure and
not materialism). Anyhow, maximisation of profit (or wealth) is not the only aim
of living. Hence, the objective of decision usefulness focusing on shareholders
and creditors is not permissible in Islam. Since the centre of focus is on decision
usefulness for primary users of shareholders and investors, it results in the
objectives of AAOIFI being not in line with Islamic principles. The goals in
establishing Islamic banks are how to achieve success in the world (Karim, 1995).
The main objectives of Islamic accounting are as follows:
(a)
As stated in the Islam holy book (called Quran), it is necessary for Muslims
to conduct financial dealings in writing. This is because there must be a
record of the final balance of fund transfers as well as clarifying the
ownership status of assets;
(b)
Another objective of Islamic accounting as stated in the Quran is to prevent

any misunderstanding among Muslims whenever there is a contract or
dealing among them. When the transactions are written, there would be
less room for doubts to occur;
(c)
Since Islamic accounting requires the transactions to be in written form,

judgement among parties involved in the deal would be performed in a
better way;
(d)
By the use of Islamic accounting, Muslims will be aware of the ultimate

results of their business after measurements are conducted. Therefore, they
will be able to make better decisions;
(e)
According to Islamic finance rules, each follower must pay a fixed

proportion of his income for charitable activities. This amount is called
zakat and it is the extra money after deducting the necessary individuals
costs from the income. Islamic accounting assists Muslims to measure the
amount of zakat they have to pay; and
(f)
In case of partnership among Islam followers, accountability of each

partners profits or losses would be calculated.
209
ACTIVITY 12.2
Investigate the extent to which Islamic accounting has reached its
objectives in Malaysia.
12.3
FEATURES OF ACCOUNTING IN ISLAMIC

METHODOLOGY
The conceptual framework (CF) in Islamic accounting is developed through

two approaches, the first of which is based on Islamic principles, which is to be
then compared with contemporary accounting thought. Therefore, the objectives
of financial reporting are to use the postulates of accounting and definitions
of accounting principles from Syariah principles; this is referred to as the
constructive approach. This approach is to minimise the effects of secular
contemporary accounting on the objectives to be developed. It is necessarily
detached from certain features of reality, and one cannot know a priori how
influential this factor will turn out to be. It is moving from theory to practice.
The second approach is the pragmatic approach, which begins with
observations and measurements towards generalised conclusions. According to
Karim (1995), this approach provides the objectives of Western financial
accounting appropriate for Islamic business, and excludes any objectives
violating Syariah precepts.
Advocates of Islamic accounting highlight some specific characteristics which
distinguish Islamic accounting from other accounting practices. The following
summarises these features:
(a)
Islamic accounting is based on the concept that everything in this world

belongs to God and all the people will be accounted for their deeds towards
God after resurrection;
(b)
Morality is emphasised in Islamic accounting. Examples are advices on

being trustworthy and honest for Muslims;
(c)
The major sources of Islamic accounting are the Quran and Sunnah, which
are comprehensive and free of errors and biases;
(d)
The scope of considerations in Islamic accounting is focused on legal and

lawful transactions, whereas illegal or unlawful deals are strictly
prohibited;
(e)
Islamic accounting aims to provide strong motivations and incentives for

followers to observe mankind and behavioural principles in their conducts;
and
(f)
Islamic accounting has eyes not only on terrestrial matters, but also on
sacred and metaphysical aspects.
ACTIVITY 12.3
How can governments in Islamic countries motivate businesses to
integrate Islamic accounting standards in their accounting systems?
12.4
CLASSIFICATIONS OF ACCOUNTING IN
ISLAMIC METHODOLOGY
It is stated that some of the weaknesses in accounting are due to improper

definitions of accounting. GAAP (Generally Accepted Accounting Principles)
defines principle as conventions, rules or procedures and some accounting
principles may be misinterpreted in the categorisation of CF of accounting
(assumptions, qualitative characteristic and constraints or fundamentals).
According to Islamic perspective, there are different classifications of
terminology:
(a)
Asl (foundation, for instance the compliance of Syariah Islamiah);
(b)
Mabda (principle, such ashalalmuamalah, truth in the stewardship

reporting, zakat-focused reporting); and
(c)
Kaidah (rule).
These classifications are not interchangeable because each classification has its
fixed position. However, the problem is inconsistencies are shown with some
existing standards.
Accordingly, accounting in Islam is categorised according to two main notions:
(a)
Accountability
This concept discusses the fact that every individual must be accountable
towards himself and other society members. Moreover, accounting for this
world as well as the next world after resurrection, is compulsory in Islamic
accounting practice.
(b)
211
Financial Accounting
This notion deals with accounting issues such as profit, cost, revenue
and so forth. Examples of Islamic financial accounting systems are zakat
accounting, governmental accounting and corporation accounting.
SELF-CHECK 12.1
What are the two main notions for classification of Islamic accounting?
12.5
PRINCIPLES OF ACCOUNTING IN ISLAMIC

METHODOLOGY
In this part, the accounting concepts which serve as the base for Islamic
accounting are illustrated. These concepts are prepared by AAOIFI to facilitate
the implementation and harmonisation of Islamic rules in accounting.
12.5.1
Accounting Entity/Unit
It is stated in the SFA No. 2 (para 6568) that an Islamic bank is considered an
accounting unit that is apart from its owners or funders. Ahmad (1990) agrees
with the examination of the notion on the rules governing financial contracts
in Islam, expressed by Ibn alArabi. It consists of prohibition of interest and
legitimacy of trade, prohibition of unjustified enrichment, prohibition of
dubious circumstances and uncertainty in trade, and giving consideration to
intention, aims and welfare. According to Gambling and Karim (1991), some
jurists see no objection to the extension of this status quo to trading concerns, in
case of conformity of arrangements to the requirements of the Syariah.
As Khan (1994) states, the entity concept suffers from some incongruities. This
concept is closer to the Islamic framework since the business owner is not known.
Accordingly, the proprietary concept is close to the Islamic framework since
zakat has to be calculated on the property of individuals. It is sufficiently
convincing that this concept is acceptable from an Islamic point of view.
However, we support the views by Khan (1994) that the proprietary theory is
more Islamic as compared to entity theory.
12.5.2
Going Concern Concept
According to this concept, the business will continue to exist in the near future,
and by valuing the assets at the historical cost in the balance sheet, the benefits of
the assets will accrue in the near future. This concept assumes something other
than Allah to be equal to His characteristic. Abdel-Magid (1981) also opposes the
concept since the Islamic model does not recognise this concept. Ahmed (1994)
says that this hypothesis does not seem to contradict any of the Islamic
principles. If a person is known to exist, his existence is not denied until evidence
to the contrary is produced.
In our opinion, the going concern concept does not violate Islamic principles.
However, the conservatism concept is closely linked to other concepts, and
objectivity matching as well as realisation has resulted in many arguments.
12.5.3
Accounting Period Concept
It is expressed that the accounting period postulate does not contradict any
Islamic principle and is desirable since it helps in paying zakat. This concept was
known to Muslims before it emerged more recently as an accounting concept.
According to Muhammad (peace be upon him (pbuh), No zakat is to be on
wealth until a year passes, and so every Muslim is ordered to calculate his or
her wealth once a year for zakat.
12.5.4
Unit Measurement Concept
Changes in the purchasing power of money should be ignored in setting financial

rights and obligations. Adnan and Graffikin (1997) state that it is not dealt in with
sufficient reasons. The consequences of adopting this are very important in Islam,
since it sacrifices the values for honesty and fairness. According to Ahmed (1991)
money is unable to serve as a just and honest unit of account. It makes money an
inequitable standard and enables some people to be unfair to others. This
contradicts Islamic principle, as part of verse 29 of Surah An-Nisa, do not eat
up your property among yourself for vanities.
While some suggest the use of replacement or present value-to-value assets, there
are many suggestions given to solve this problem. However, this is not easy.
Ahmed (1994) states that if all these suggestions were to be implemented, it only
serves as a temporary solution and not a permanent solution to accounting
problems in inflationary or deflationary environments. It is argued that the
application of gold or silver used in the age of the Prophet Muhammad (pbuh), is
perhaps relatively resistant to inflationary effects.
213
We agree that money backed by gold price is more stable. Gold-based currency
can be applied, since it is less volatile. The differences in the gold price should be
charged to the reserve account. We do not agree that the concept of unit
measurement is Islamic. Nevertheless, continuous research must be conducted to
find better alternatives which fit more accurately to the Islamic perspectives.
Principles which govern Islamic accounting have some similarities with the
current accounting practice. The lists of these principles are:
(a)
Distinguish entities between the owners of business and the business itself;
(b)
Going concern for the enterprise;
(c)
Periodic nature of accounting reports;
(d)
Recording transactions instantly;
(e)
Objectivity;
(f)
Considering monetary values for transactions and records;
(g)
Relevancy of assets values in terms of their current market prices;
(h)
Matching revenues and expenses of each period of fiscal year;
(i)
Differentiate various kinds of profits according to their sources of origin,

such as, capital profit and subsidiaries profits; and
(j)
Mandating disclosure of financial information for the users.
ACTIVITY 12.4
Define the similarities of Islamic and current accounting concepts.
12.6
ACCOUNTING AND AUDITING

ORGANISATION FOR ISLAMIC FINANCIAL
INSTITUTIONS

(AAOIFI) was established by Islamic accounting advocates so that Islamic
principles on accounting can be integrated in Islamic financial institutions.
AAOIFI is located in Bahrain and has received a lot of support from many
countries including Australia, Indonesia, Malaysia, Pakistan, Saudi Arabia and
South Africa. However, Islamic accounting standards are developed in the
Kingdom of Bahrain and the Dubai International Financial Centre, Jordan,

Lebanon, Qatar, Sudan and Syria.
The commission (AAOIFI) provides significant assistance to the financial
institutions following AAOIFI standards and the main objectives of this nonprofit organisation are:
(a)
Provision of accounting principles in agreement with Syariah principles;
(b)
Holding seminars, conferences, training courses and so on to transfer

accounting thoughts to the users;
(c)
Establishing, notifying and interpreting auditing and accounting thoughts

standards, and principles for financial institutions with Islamic accounting
guidelines; and
(d)
Reviewing and modifying Islamic accounting standards.
ACTIVITY 12.5
How can AAOIFI motivate companies to observe key principles of
Islamic accounting?
Islamic accounting is a practice of accounting with standards in compliance

with Syariah guidelines.
Objectives of Islamic accounting are stated in Syariah and the main sources
for these objectives are the Quran and Sunnah.
The main objectives of Islamic accounting are:
Dealing financially in writing;
Preventing any misunderstanding among Muslims in contracts;
Becoming aware of the ultimate results of the business after doing

necessary measurements;
Paying a fixed proportion of his income for charitable activities called

zakat; and
Calculating each partners profits or losses in case of a partnership.

215
Features of Islamic accounting are observing moral accounting practice and

conducting ethical behaviours in accounting.
Islamic accounting shares some of its principles with current accounting

principles, such as, accounting entity or unit and going concern concepts.
Financial accounting and accountability are two main categorisations of

Islamic accounting.

(AAOIFI) is the official body which defines and spread Islamic accounting
standards and thoughts for Islamic financial institutes.
Accountability
Islamic accounting
Accounting and Auditing Organization

for Islamic Financial Institutions
(AAOIFI)
Kaidah
Mabda
Accounting entity
Morality
Accounting period concept
Quran and Sunnah
Asl
Shariah principles
Concern concept
Unit measurement concept
Financial accounting
Written format
Zakat
What are the main classifications of Islamic accounting?
Define the major objectives of Accounting and Auditing Organisation for Islamic
Financial Institutions (AAOIFI)?
Topic Comprehensive
13
Cases
LEARNING OUTCOMES
1. Discuss the ethics which may be threatened in some job offers;
2. Discuss the earning management that big companies may commit;
and
3. Discuss the key function of internal auditors in fraud prevention
and detection.
INTRODUCTION
In this topic, the practical issues which may arise in companies are explained. After
reading this topic and going through the comprehensive cases, it will become
obvious how even the big firms may become bankrupt due to lack of proper
accounting practice or ethics.
13.1
CASE 1: ETHICS IN ACCOUNTING
Consider the situation that you are offered the position of Financial Controller in
a family business. But, in fact, you work as the Finance Director. Due to defaults
for the payment to the crediting bank, the company issued 33 per cent of the
shares to a venture capitalist, but no Board seats.
The bank supports continues if the performance figures are attractive. You have
been promised a large bonus and 1 per cent share option if you massage the
figures. If you fail to do so, no bonus and share option will be given to you.
TOPIC 13 COMPREHENSIVE CASES
13.1.1
217
Key Fundamental Principles
Integrity Can you support the business without being involved in potentially
misleading information?
Objectivity - How can you avoid your financial interest influencing your
professional judgement?
Professional behaviour - How will you manage relationships with the affected
parties?
Before considering the possible actions, identify the following matters:
(a)
Relevant facts about the business policies, procedures and guidelines,

accounting standards, applicable laws and regulations;
(b)
Affected parties; and
(c)
Who should be involved in resolution?
13.1.2
Possible Actions
The following are the possible actions:

(a)
Prepare a list of short-term financial benefits based on forecasts for the

family. Explain the negative consequences of the short-term benefits on the
long-term business conditions. Motivate them to think twice before
conducting the manipulation.
(b)
Do not involve your name in manipulation. Consider whether the values of

the organisation are consistent with your own.
13.2
CASE 2: INTERNAL AUDITOR FUNCTION

IN FRAUD DETECTION
In March 2002, Cynthia Cooper, WorldComs internal auditor (and now famous
whistleblower), reported CFO Scott Sullivans misuse of an unneeded reserve for
doubtful debts to the external auditors and to Max Bobbit of the Audit
Committee. That same month, the SEC delivered a Request for Information
letter to WorldCom concerning the SECs investigation into WorldCom. This
gave Cynthia Cooper more leeway to go beyond the internal audit departments
operational audit and into the realm of a financial audit. In May 2002, John
218 TOPIC 13 COMPREHENSIVE CASES
Sidgemore, WorldComs new CEO, appointed Cooper to head a complete

investigation into WorldComs books.
On May 21, Glynn Smith of the internal audit team, received an e-mailfrom a
manager in Texasthat attached an article about a WorldCom employee in
Texas being fired for questioning WorldComs accounting for property plant and
equipment (PPE). The internal audit team was already suspicious about
approximately $2 billion of PPE expenditure that had never been authorised.
The e-mail galvanised the attention of the investigators. Ultimately, the
investigation revealed the misuse of excess reserves and the misallocation of $3.8
billion of line costs to PPE. WorldComs internal auditing team was untiring in
its quest to uncover the fraud.
13.3
CASE 3: SUCCESSFUL PEOPLE ARE NOT

A MYSTERY; THEY JUST USE THE RIGHT
CHEMISTRY
Adolph Dias, the financial controller of a multinational company in Dubai reached

the peak of his career in 1983. He was only 28 years old at that time and found that
his job lacked challenge. The innovator in him yearned for new horizons. In
his words when I feel I have reached the peak, I look for another one.
(a)
Restless Young Man

The young Adolph Dias always refused to stay in the comfort zone for too
long. In his first job as an employee of one of the largest chain of retail
stores in India, he quickly reached the senior-most position in the chosen
profession in the field of Chartered Accountancy. Adolph Dias exceeded all
expectations of the employers. But there was something lacking in his
career. He felt the challenge factor was missing. He moved to Dubai in
1978, in search of a new challenge, a new horizon. Within a few years, he
was elevated to the position of the Financial Controller of a large
multinational company.
(b)
Entrepreneurial Zeal
At the peak of his career, Adolph decided that he should start his own
company. True to the spirit of embracing challenges, he decided to venture
into something new. In the early 1980s the chemical industry was growing
and presented tremendous scope for innovation and development. In order
to get a grip of an unfamiliar field, Adolph decided to start as a supplier of
raw material to the process industry. His experience as a supplier gave him
first-hand information of the difficulties faced by entrepreneurs in the
chemical industry. He saw how important it was to use consumers
219
complaints as a guide for investing in research and development and

innovation to get the most benefit for his customers. Adolph was confident
that he could solve some of the problems faced by the chemical industry.
The entrepreneurial zeal in him goaded him to turn his dream into reality.
(c)
Creating a Culture for Innovation

In 1984 Adolph Dias, started his own company Gold Valley Chemical
Corporation (GVCC). The company produced raw materials for the paint
industry. He encouraged intrapreneurship at GVCC and with a six member
research team launching their first product Whitegold.
The product that his company developed Whitegold significantly
enhances the quality of titanium dioxide which is a major chemical used in
the paint industry. Adolph Dias stated,
Titanium dioxide is a very expensive raw material which no paint
manufacturer can virtually do without today.
Gold Valley Chemical Company decided to enhance the performance of
titanium dioxide so that the refractoriness of paint was increased.
According to Adolph,
There were two ways to do it: one was to change the refractive index of
the product and two, to do what we call the spacing of the product.
The company chose the latter one because it was easier to do and it used a
technology that the company could implement with a short period.
According to Adolph,
Titanium dioxide on its own gives a high level of whiteness and opacity,
but with Whitegold, it improves its own performance. So, together with
titanium dioxide, Whitegold performs in an unbeatable manner.
The GVCC website describes Whitegold thus:
Whitegold is a very pure, brilliant white, hybridised inorganic pigment
providing excellent Titanium Dioxide extension possibilities. Its excellent
opacity and unmatched brightness when used as an extender is just some of
the outstanding properties of this product.
(d)
Innovation and Technical Change

Adolphs fascination for, and obsession with the world of paints spurred
him to experiment and innovate. GVCC has a number of other innovative
products that have greatly benefited the paint industry. Sometimes, the
process of developing a new product at Gold Valley begins with finding a
technology to make a product that will better meet an existing customer
need (refer to Figure 13.1).
Figure 13.1: Entrepreneurial decision making at Gold Valley

Source: GVCC
Kwickoat is an innovative product. It is an instant paint in the sense that

what instant coffee did to coffee, Kwickoat does to paint. No more of the
laborious process of mixing the paint with the right amount of additives.
Just add water to the paint powder and voila, you are ready to paint the
town! Adolph calls it a do-it-yourself (DIY) product for the global market. It
is ideal for large-scale contractors who work with low-cost trade sales
paints. GVCC developed this technology because it knew from watching its
customers that there was a large unmet need and thus a potential in the
market for a paint that comes in powder form and is a DIY product. Adolph
explained that any person can buy the product from the shelf of any paint
shop and all that was needed to make paint was a glass of water, you stir it
in and you have paint ready to apply.
(e)
Accolades for Innovation

On the 23 July, 2008 Adolph Dias president of Gold Valley Chemical
Company based in the Emirates of Ajman in the United Arab Emirates won
the nanotechnology award which was established and awarded by the
National Aeronautics and Space Administration of the USA.
221
According to the nanotechnology awards committee, GVCC was selected

for the award, because it had developed a product that incorporates
nanotechnology in its design and operation, with significant current or
near-term commercial applications.
(f)
Tenacity and Obsession for Creative Thinking

There are some men who, when they have climbed a peak, look for another
one. They do not want to stagnate; they do not accept the status quo. The
entrepreneur in Adolph Dias has always been shadowed by another
persona: the creative artist. While entrepreneurship earns Adolph his bread
and butter, his artistic pursuits feed his inner being and soul.
(g)
Forays into the Literary World

Adolph Dias was the prolific writer of rhymed verses. Rhymes with reason,
he calls them. The pace of his writing is such that he could well be a
candidate for the Guinness Book of World Records for penning the largest
number of verses on a daily basis! Each morning, he would take out his
notebook and jot down his thoughts on sundry topics, mainly spirituality,
love and self-help, in rhymed verse, before he started his other business. So
prolific and faithful was Adolph to his passion that he completed a quarter
of million verses (complete manuscripts for over 2,500 books). Adolph
planned to publish the verses in a book form. The creative powerhouse
called Adolph Dias was constantly occupied in creating something new,
something innovative and something off the beaten path.
(h)
Conclusion
Adolph Dias was an innovator and entrepreneur (refer to Figure 13.2) who
used his resources and competencies to develop new or improved good to
respond to the needs of customers. Innovations can result in spectacular
success for an organisation. Words of wisdom (WOW) from one of
Adolphs books: Successful people are not a mystery; they just use the
right chemistry.
Figure 13.2: Characteristics of innovators/entrepreneurs
13.4
CASE 4: BIG BATH IN CHINA,

ACCOUNTING AND CORPORATE
GOVERNANCE
China launched its reform and open policy in the late 1970s. Since then, China
has been undergoing a transition from a centrally-planned economy towards a
market-based economy. The most obvious milestones in the development of
Chinas financial system are the establishment of stock markets in Shanghai and
Shenzhen in the 1990s (Child and Tse, 2001). After that, some state-owned
enterprises (SOEs) started to be transformed into public companies through
initial public offering (IPO). Prior to 1990, China had introduced some changes to
its accounting system with the purpose to attract foreign investment. Since 1990,
the stock exchange has emerged as a driving force to change accounting practice,
moving toward Western practice.
223
In the late 1990s, there began a separation of financial accounting from tax
accounting and to adopt accrual accounting for financial accounting. Thus,
companies were required to estimate the allowance for bad debt for its accounts
receivable. Although some SOEs were transformed into listed companies, their
governance remained basically unchanged because the government kept a lion
share of stocks and, thus, continued its control on corporate decisions. Unlike
that in the developed world, Chinas corporate governance institutions are weak
by any measure, and yet it has managed to achieve quite spectacular levels of
growth over the last quarter of a century (Mueller, 2006). China had introduced
changes, in a pragmatic way, to its governance institutions and accounting
practices. The situation could be demonstrated by the following case.
Company C was founded in 1950s to develop military radar systems. In 1980s, it
moved into the consumer electronics sector. Prior to the late 1970s, a TV set was a
luxury for a great majority of Chinese households. In the wake of economic
reforms launched in the late 1970s, TV sets and other electronic products started
to go into many Chinese households, creating an increasing market demand. The
entire 1980s saw a great shortage of colour TV and other electronic products in
the market. In 1985, Mr Chen became the chief executive officer (CEO) of
company C, marking the beginning of an impressive history in which company C
rose from a military industrial company in the relatively undeveloped western
hinterland to a star company in China. Its net assets increased from Rmb40m to
Rmb13.2b over the period from 1985 to June 2004 when Mr Chen retired. In 1997,
the company reached its peak in terms of performance, generating Rmb15.7b
sales with 25.9 percent gross margin and Rmb2.6b net income. The companys
colour TV became the number one brand in the country.
The colour TV industry in China had more than 130 manufacturers in the
beginning of 1996. Among all, very few of them had notable sales. Even foreign
brands were suffering in the Chinese TV market at that time. The prices were
lowered in the suburbs due to smuggling. To make matters worse for local
manufacturers, import tariffs were lowered for small-screen colour TVs from 60
to 50 per cent and from 65 to 50 per cent for large-screen colour TVs. Foreign
direct investment in China was daily increasing as a result of the attractive
market size. TV productions by all of the largest TV manufacturers were
launched in China.
Company Cs capacity was double than the second competitor for colour TV
production at that time. The company enjoyed effective relationships with key
component suppliers as it was the biggest manufacturer of many major TV
components, such as plastic injections parts, electronic components and remote
controls. As a highly vertically integrated company located in the Western
hinterland, the company enjoyed a cost advantage and earned the highest profit
margin among all domestic colour TV manufacturers. Its net profit margin was
around 20 per cent, far ahead of most of its domestic rivals. It enjoyed a high
level of brand awareness and a high quality image among domestic brands.
In 1994, Company C did an IPO on the Shanghai Stock Exchange. But, after the
IPO, the company remained a SOE in the sense that the government continued to
hold 53 per cent of its shares. In 1998, it contributed about 15 per cent of its
provincial GDP and about half of the gross industrial output of the city where it
was located. Across China the company employed more than 30,000 people. To
monitor the performance of SOEs, the government established some criteria
including the increase of assets and enhance of profitability. Although the criteria
were established, the practice of executive appointment had been largely at
administrative discretion, with decisions made behind closed doors: The
emergence of the notion of governance in China was accompanied by a
critique of the system of socialist planning and associated forms of government.
One of the hallmarks of socialist planning, and the system of government in
China in general, was the combination of rewards and punishments, quotas and
reliance on administrative commands. Commencing in the 1980s, critics of the
system argued that administrative intervention was overly heavy-handed
(Sigley, 2006).
Notwithstanding its strong position in the Chinese TV market, Company C was
faced with an increasingly competitive market in the mid 1990s. Industry
estimates in 1995 indicated that domestic manufacturing capacity was as high
has 35 million units, more than double domestic sales of colour TVs. Exports
were believed to absorb only four million units at the time, leaving a
considerable overhang of excessive capacity in China. By early 1996, Company C
was holding an inventory of around one million units with a total estimated
value exceeding Rmb2b.
On March 26, 1996 Company C took action and fired the first shot in a price war,
announcing price reductions for all its 1700-2900 colour TVs ranging from
Rmb100 to Rmb850. Some domestic rivals followed Company Cs suit while
others did not. As a result, the former group gained and the latter group lost
market share. Within several months after price war, Company Cs overall
market share had increased from 16.68 to 31.64 per cent, rising to 35 per cent in
1997. As expected, foreign brands stayed away from price war. Sony and
Panasonic, for example, both decided to take the high road, focusing on quality
and functionality.
Before the price war, imported and joint venture products accounted for 64 per
cent of the market and local manufacturers for only 36 per cent. After that, the
market share of domestic products significantly increased, accounting for a total
225
of around 60 per cent by the end of 1996. In 1997. eight out of the top ten best
selling brands in China were Chinese. Company C had become one of the best
selling colour TV brand companies in China, with market shares at 35 per cent.
Only two foreign brands, Panasonic and Philips, muscled into the top ten, each
with about five per cent of the market share. On May 21, 1997 the companys
share price reached Rmb66 per share.
The first ever large-scale price war drastically changed the landscape in the
industry in favour of Chinese companies. However, the industry as a whole
continued to be dogged by the excessive capacity. According to industry reports,
Company Cs inventory of colour TVs had risen to five million units in 1998
when it launched another major price war, cutting prices by another 10 per cent.
But this time the price cuts did little to increase its market share and instead
squeezed its profit margin considerably.
In order to improve the situation, the government made the decision to change
the CEO. On May 15, 2000 Mr Chen was asked to retire from his CEO position
and became chairman of the board. At the time Company Cs share price
dropped to Rmb12.5 per share. But it should be noted that in China the share
price might not be used as a reliable performance measure. Over the period from
2000 to 2005, China recorded a high-economic growth, but the Shanghai Stock
Exchange Index, the main stock market index in the country, declined from about
1,400 points at the beginning of 2000 to around 1,000 points in June 2005. It
reached its period peak in June 2001 at about 2,250 points. It has been noted that:
[. . .] to understand the economic behaviour of Chinese firms and the Chinese
stock market, one must first understand the role of government and its influence
on the firms economic activities. During the economic transition, local
governments serve multiple roles: providers of public service, agents of Chinas
central government to monitor listed firms and major shareholders of listed firm.
This complicated relationship gives rise to a unique phenomenon in the Chinese
stock market: local governments intimately dance with listed firms to the tune set
by the central government (Chen et al., 2008).
It was very unfortunate that the new CEO stayed in office for only about eight
months because he failed to meet the governments expectation either. As a
consequence, Mr Chen was called back to take the rein of company on February
10, 2001.
Soon after resuming the role as CEO, Mr Chen took a bold move by selling hard
in overseas markets. In November 2001, he signed a contract with Company X as
the sales agent in the US market. Initially, Company X was a small firm run by a
local Chinese. By making the best use of Company Cs low price of TV sets,
Company X later emerged as the fifth largest colour TV supplier in the US.
Although the sales of Company C for the years 2002 and 2003 was Rmb780m and
Rmb5.04b, respectively, the financial statements illustrated that increased sales
was accompanied by a high figures in accounts receivable and an increasing
inventory. At the end of May 2004, the companys share price dropped further to
Rmb7.06. After the exclusion of accounts receivable and inventories, Company C
reported a loss of Rmb3.7 bn for 2004. The share price closed at Rmb3.54 on
December 31, 2004.
Company C Financial Statement
Company Cs financial statements from 2001 to 2005 are provided in Table 13.1,
together with the footnotes on accounts receivable for 2002-2004.
Table 13.1: Company C Income Statement (Rmb Million) from 2001 to 2005
Footnotes on accounts receivable (A/R), 2002-2004

2004 Footnotes
At the end of 2004, the total A/R owed by Company X was Rmb3,839m, among
which Rmb295m were within one year; Rmb3,513m one to two years; and Rmb31m
two to three years. Company X was experiencing financial difficulties and was
having trouble.
In servicing its debt, considering the situation, Company C had filed a lawsuit to
a Los Angeles court and the case was under court investigation. Given that the
227
normal way for Company Cs A/R could not truly reflect the situation, the Board
decided to set aside Rmb2,597m as a bad debt allowance for Company X.
Without such a charge, the total allowance for bad debt would have been
Rmb360 m. Thus, the net impact on net income was Rmb2,237m (Table 13.2).
Table 13.2: 2004 Year-end A/R and Allowance for Bad Debt (Rmb Million)
The financial statements received clear audit reports throughout five years
(Tables 13.3 and 13.4).
Table 13.3: Balance Sheet (Rmb Million)
Table 13.4: Statement of Cash Flow (Rmb Million)
2003 footnote
A/R increased considerably over 2003 with the biggest increase related to
company X, whose A/R was Rmb4,447m, among which Rmb3,512m were within
one year and Rmb934m between one and two years. On December 31, 2003 the
company C had inventory of more than Rmb7bn after writing down
approximately Rmb300m (refer to Table 13.5).
2002 Footnotes
In 2002 company Cs A/R stood at Rmb4.22b, with that owed by Company X
accounting for Rmb3.83b. The company reported a 27 per cent decrease of A/R
relative to that in 1999 (refer to Table 13.6).
229
Discussion Questions
(a)
Discuss Company Cs performance from 2002 to 2004 based on its financial

statements. Elaborate your answer to the quality of reported earnings.
(b)
Since a majority of companies were controlled by the government in terms

of their shares and top decisions, what were the agency problems between
the principal (the government) and the agent (the CEO)?
(c)
The Company C abused the big bath strategy for its sales and revenue
manipulation. Discuss the accounting policy change in terms of Chinas
business environment in general and Company Cs circumstance in
particular?
13.5
CASE 5: FINANCIAL TURNAROUND OF

INDIAN RAILWAYS (B)
The years from 2004-2005 and 2007-2008 will always be cherished as a golden
period of growth and turn-around in Indian Railways (IR) history.
However, in the years 2008 to 2009, the impact of the implementation of the
recommendations of the 6th Central Pay Commission started to become apparent
on IR finances. During the years 2008-2009, IR carried 833.39 million tonnes of
goods traffic and 7.05 billion passengers reflecting an annual growth of five per
cent and 7.81 per cent, respectively, over the previous year. The traffic receipts
during the year also grew to INR 798.37 billion showing annual growth of 11.4
per cent. However, the operating expenses increased to INR 543.49 billion.
Further, provision of INR 70 billion for depreciation and INR 104.9 billion was
provided for pension expenditure. The total working expenses increased to INR
718.39 billion by 31.9 per cent over the previous year. As a result, the surplus was
reduced to INR 91.75 billion before dividend and to INR 44.57 billion after the
dividend payment of INR 47.17 billion (refer to Table 13.7, Table 13.8 and Figure
13.3). The operating ratio deteriorated to 90.46 per cent during 2008-2009 from its
second best of 75.9 per cent in the preceding year (the best ever operating ratio of
IR was 74.7 per cent in the years 1963-1964).
Table 13.7: Indian Railways Financial Statement
Figure 13.3: Operation Indian Railways Chart

231
Table 13.8: Earnings and Expenditure (INR Billion)
The years 20092010 were also equally challenging for the railways. Although IR
carried 887.79 million tonnes of goods and 7.38 billion passengers with annual
growth of 6.5 and 4.8 per cent, respectively, and earned traffic receipts of INR
871.04 billion showing annual growth of 9.1 percent, implementation of the 6th
Pay Commissions recommendations substantially increased operating
expenditure to INR 658.1 after provision for depreciation to INR 21.9 billion and
pension to INR 149.2 billion annual growth. The total working expenses
increased to INR 829.15 billion with 15.42 per cent growth over the previous year.
This heavily impacted the internal generation for plan investment which came
down to INR 55.44 billion before dividend and merely INR 7.5 million after
dividend payment. The operating ratio deteriorated to 95.3 per cent during 2009
to 2010 (refer to Table 13.7, Table 13.8 and Figure 13.3).
The testing times for the railways continued in 2010 to 2011 as well, due to the
impact of allowances and several post-budgetary factors. On the earnings side,
disruption of train movements due to public agitation resulted in a loss of about
INR 15 billion and another INR 20 billion due to the ban on the export of iron
imposed in certain states of the country. As a result, the loading was reduced to
924 million tonnes from a budgeted target of 944 million tonnes and actual
loading was still lower at 922 million tonnes. However, by prudent financial
management, the railways absorbed the brunt of increased staff costs, also the
operational shortfall, with a minor increase in freight rates leaving fare charges
untouched for the eight consecutive year and attained annual growth of 8.5 per
cent in earnings which rose to INR 945 billion (refer to Table 13.7, Table 13.8 and
Figure 13.3).
On the expenditure side, two hikes in the rates of HSD oil and increased
electricity tariff in some states, higher DA rates and excise duty rates as well as
the impact of unanticipated higher salary and allowances resulted in the
ordinary working expenditure of INR 681.39 billion. After providing INR 55.15
billion towards depreciation and INR 158.20 billion for pensions, respectively, the
total working expenses increased to INR 894.74 billion by 7.91 per cent over the
previous year. Accounting for full dividend liability of INR 49.41 billion, it
attained surplus of INR 14.05 billion. However, these resources fell short of the
planned requirement of capital expenditure for which IR had to seek a bridging
loan of INR 30 billion from general revenues in 2011 to 2012 which will be
liquidated in 2012 to 2013.
As could be seen, IR has not only overcome the challenge of global slowdown
but also the increased costs without resorting to fare increases in the larger
interest of the economy. It continued to grow despite, during the above period
both in quantum and monetary terms, being well above the average gross
domestic product growth of the economy. The position was aptly explained by
the then Union Rail Minister in the Budget Speech for 2010 to 2011:
Madam Speaker, I have no hesitation in informing this August House that Indian
Railways is passing through a very difficult phase. The year 2009 10 was challenging
for the railways. Implementation of the 6th Pay Commissions recommendations
increased the expenditure on staff and pension by an unprecedented 97 per cent. The
latest assessment of Pay Commissions impact reveals an additional expenditure of
Rs.73,000 crore (INR 730 billion) during the XI Plan period.
This has heavily impacted our internal generation for plan investment. However, by
prudent financial management, we have not only paid the full dividend for 2009 10,
but also achieved an operating ratio of 95.3 per cent. In fact, if we do not take pay
commission arrears into consideration, which rightfully are liabilities of previous
financial years, the operating ratio would have been 84 per cent even with payment
of higher salaries and pension. If the salaries and pension are also kept at the earlier
levels, the operating ratio comes down even further to 74.1 per cent.
The budget projections for 2011-2012 envisaged annual growth of 7.7 per cent
in freight loading to 993 million tonnes and a growth of 5.9 per cent in
passenger traffic to 8.27 billion passengers. The Gross Traffic Receipts were
estimated at INR 1,062.39 billion with annual growth of 12.2 per cent. Ordinary
working expenses (OWE) were assessed at INR 736.5 billion to cater for annual
increments in salaries, allowances, higher requirement for fuel and materials
233
for increased level of activity as well as lease payments after allocating INR 158
billion for pensions and INR 70 billion for depreciation. Thus, the total working
expenses were projected to INR 964.5 billion. The expected operating ratio was
91.1 per cent.
However, due to post budgetary factors, the revised projections for the year
reported in the budget projection for 2012 to 2013 indicates reduction of freight
loading to 970 million tonnes and passenger traffic to INR 8.3 billion.
Accordingly as per the revised estimates, IR is expected to earn INR 1,039 billion
and incur operating expenses of INR 986.1 billion inclusive of pensions INR 168
billion and depreciation INR 61.6 billion. The surplus before dividend is
estimated at INR 71.4 billion and that after dividend liability, of INR 56.52 billion,
at INR 14.9 billion and the operating ratio is expected to deteriorate to 95 per cent
(refer to Table 13.9).
Table 13.9: IR Budget Projection
Source: Explanatory Memorandum on the Railway Budget for 2012 to 2013
In the interim, two expert committees were set up, namely, the High Level
Railway Safety Committee headed by Dr Anil Kakodkar and the Expert Group
on modernisation and resource mobilisation headed by Mr Sam Pitroda. Both
committees submitted their reports in February 2012 and provided a blueprint
for safety and modernisation of IR. The plan in brief had the following
recommendations:
(a)
Modernise the key revenue generating assets such as track and bridges,
signalling, rolling stock and stations as well as terminals;
(b)
Look for opportunities related to public private partnerships, land and

airspace, dedicated freight corridors and high speed trains to meet with
funding requirements;
(c)
Review and assess capital projects sanctioned and work-in-progress,

prioritise works to ensure financial viability, social benefits and timely
completions;
(d)
Focus on key enablers like information and communication technology,

indigenous development and safety;
(e)
Strengthening of human resources;
(f)
Disinvestment in railway public sector undertakings;
(g)
Re-densification or commercialisation of surplus land in existing railway

colonies in different locations. A few pilot projects could be immediately
explored;
(h)
Commercial exploitation of railway schools and hospitals, without

displacing any of the priorities from the point of view of IR employees.
Management contracts (on the basis of revenue sharing) could be tried for
some of the larger hospitals or schools with a view to achieve significant up
gradation of standards; and
(i)
Levy modernisation surcharge from passengers or freight business on a per

PKM/NTKM basis and create a dedicated Reserve Fund to fund these
initiatives in a sustainable manner.
The recommendations of these experts committees have been accepted for

implementation and incorporated in the Rail Budget 2012 to 2013 as well, which
is also the first year of the 12th Five Year Plan (2012-2017) as is evident from the
budget speech of the Union Rail Minister:
Madam, I intend to align Indian Railways investment in the 12th Plan period
keeping in mind the recommendations of the two committees that I have set up. I
am happy to inform the Honourable Members that the 12th Plan investment
proposed by Railways at 7.35 lakh crore represents a quantum jump over the
investment during XI Plan of 1.92 lakh crore. The required resources for the plan
are proposed to be met by:
(i)
Gross Budgetary Support of Rs.2.5 lakh crore (INR 2500 billion);
(ii)
Government support for national projects of Rs.30,000 crore (INR 300

billion);
235
(iii) Ploughing back of dividend of Rs.20,000 crore (INR 200 billion);

(iv) Internal Resources of Rs.1,99,805 crore (INR 1998.05 billion);
(v)
Extra Budgetary Resources of Rs.2,18,775 crore (INR 2187.75 billion); and
(vi) Railway Safety Fund of Rs.16,842 crore (INR 168.42 billion).

Thus, the railways will soon emerge stronger, leaving behind the impact of the
Pay Commission and engage fully in the revival of its financial health. To achieve
this, IR has further sharpened its economy drive to cut down costs to extant
feasible and tap all avenues for generation and revenue from both traditional and
non-traditional sources. The steps taken by the railways to increase the revenues
are optimisation of operational efficiency and earnings through progressive
increases in axle loads as well as the carrying capacity of freight cars. In addition,
the railways have also taken a number of steps to attract additional traffic, which
inter-alia include implementation of a differential tariff regime for specifically
addressing situations arising out of skewed demand during different periods of
the year as well as across different regions of the country.
A slew of freight incentives schemes are also in place for attracting traffic,
particularly in the traditional empty flow direction and during the lean season.
As with regards to control over expenditure, there is constant endeavour on the
part of IR to avoid wasteful expenditure and control the growth of non-plan
expenditure. The steps taken include prioritisation of expenditure on works for
better use of available resources, improvement in inventory management,
optimising the fuel consumption, tight control over expenditure in areas such
as contractual payment, overtime allowance, purchase of material, etc.,
austerity and economy measures in areas such as hospitality, publicity,
advertisements, inaugural ceremonies, seminars and workshops as well as
contingent office expenses.
Budget estimates for 2012 to 2013 as presented in the Rail Budget by the Union
Rail Minister contemplates IR to carry 1,025 million tonnes of revenue earning
originating traffic, which is 55 million tonnes more than the revised estimate
target of 970 million tonnes during 2011 to 2012. The freight earnings target has
been kept at INR 893 billion, indicating a growth of 30.2 per cent over a revised
estimate of 2011 to 2012. The number of passengers is expected to increase by 5.4
per cent in the year with an increase in the number of trains and higher
occupancy. The passenger earnings have been kept at INR 361 billion, an increase
of INR 73 billion over the revised estimates of 2011 to 2012 by a minor increase in
passenger fares after a gap of nine years.
Gross traffic receipts are expected to rise to INR 1,326 billion, that is, an increase
of INR 286 billion over the revised estimates of 2011 2012. OWE are estimated at
INR 844, that is, 11.6 per cent higher than the current year to meet additional
liabilities along with provision of INR 185 billion to the pension fund and INR 95
billion for the depreciation reserve fund. The railways have budgeted to
discharge full dividend liability of INR 66.76 billion to the general exchequer for
the years 2012 to 2013, calculated on the basis of applicable rate for the current
year besides loan of INR 30 billion and still earn a surplus of INR 155.57 billion.
Although IR has rolled back the increase in passenger fares in certain classes,
which would impinge the projected passenger earnings to some extent, yet the
constant annual growth in traffic and earnings vouches for its financial strength
(refer to Table 13.10).
Table 13.10: Source Wise Plan Outlay (INR Billion)
Source: Year Book 2008-2009 to 2010-2011 Indian Railways
Therefore, the railways is not overly worried as it is a question of increased

working expenses as evident from the Union Rail Ministers budget speech for
2012-2013:
The best ever Operating Ratio of Indian Railways was 74.7 per cent in the year
1963-1964. In consultation with the Railway Board, I am targeting to improve the
Operating Ratio from 95 per cent to less than 80 per cent by the end of 12th Plan.
This landmark improvement in railway finances would enable building up of a
strong base to meet the challenges ahead and bring back the confidence of people
in Railways, thereby dispelling all apprehensions that Indian Railways is going
downhill. I expect to achieve an Operating Ratio of 84.9 per cent in 2012 to 2013
as compared to 95 per cent in the current year. If this trend continues, I have no
doubt that my Operating Ratio will improve upon even the best ever of 74.7 per
cent within the 12th Plan.
Notes
(a)
The 6th Central Pay Commission was set up by Union Cabinet of India on 5
October 2006 for revising the salaries of central governments employees;
237
(b)
Operating ratio is the money spent to earn INR 100 and is calculated by
dividing total revenue by total expenses;
(c)
Railway Budget speech 2011 to 2012; and
(d)
Budget Speech 2011 to 2012.
Refer to Table 13.11 and Figure 13.4 to see the data indicating the railway fund
balance and fluctuation or movement of total funds from 2004 until 2013.
Table 13.11: Railway Fun Balances (INR billion)
Figure 13.4: Railway total funds
Big Bath
Financial turnaround
Earning management
Internal auditor
Ethics
What are the key responsibilities of the internal auditor in fraud prevention?
How can firms evaluate their real performance based on their financial reports?
Answers
TOPIC 1: INTRODUCTION TO ACCOUNTING THEORY
Self-Test 1
1.
A theory is the logical reasoning underlying a statement of belief.
2.
The purposes of accounting theory are to explain current accounting

practices and to provide the basis for developments in such practices.
3.
Accountants are often required to impose some logical and quantitative

order on imprecise events or transactions so that they can present the
financial implications of these events or transactions. The accountants are
also required to deal with the existence of a vast number of conflicing
accounting theories. Accounting theories are often developed from different
perspectives which lead to many interpretations of accounting practices.
4.
The two approaches to formulation of theory are the deductive approach

and the inductive approach. Deductive means to derive at a conclusion by
reasoning. Inductive means to imitate, to bring on the act of reasoning from
a particular premise to a general conclusion.
5.
(b)
6.
The demise of the normative period is due to the following factors:
7.
(a)
Normative theories were based on subjective opinion, which varies

between individuals. Dissatisfaction arises because these theories do
not resolve the differences in opinion.
(b)
Normative theories cannot be empirically tested because it is

impossible to demonstrate empirically what ought to be. Thus, it is
unclear whether the theories have strong foundations.
The main problem with these theories is that, for positive theorists, wealth
maximisation becomes the answer to every question whatever the
observed practice, it could be construed as a means of maximising wealth.
This has attracted criticisms regarding the biased fashion in which the
positive theorists dismiss alternative viewpoints.
240 ANSWERS
Self-Test 2
1.
There are alternative interpretations in accounting theory. An overall

theory of accounting can be an instrument for recognising and measuring
income and capital. Essentially, it is a set of rules a blueprint for
constructing specific accounting systems for the recognition and
measurement of the income and capital of the particular entity. The results
of a specific accounting system of a particular firm provide an explanation
of what happened to the firm or serve as a basis for prediction of what may
happen, but the overall theory itself provides no explanation or prediction
of the economic events of any particular individual firm. This is in contrast
to a theory in the sciences where theory provides an explanation of a given
phenomenon and/or serves as a basis for prediction of what will occur in
every single instance.
An alternative interpretation given under positive theories of accounting is
that the place of explanation is to provide logical answers to the reasons
why accountants adopt certain accounting procedures. For example,
explanation offers reasons as to why accountants use an apparently
outdated historical cost system to measure assets and liabilities and
provides reasons for the political reactions of accountants to alternate
inflation accounting systems. Prediction provides an ex ante estimate of
the behaviour or reaction of accountants to the imposition of certain
accounting standards. In an ex post sense, prediction provides a
prediction of the unobserved behaviour of accountants that is, how
many accountants use LIFO versus FIFO; how many accountants use
conservative procedures, etc.
2.
The historical evolution of accounting provides clues and explanations for

most of the important events that have shaped the development of
accounting. This information increases the ability of students of accounting
to make judgements on a broader and more informed basis.
It also helps to put into context the current phase of change that accounting
is experiencing. Viewed in isolation, this phase of change could appear
anomalous but when the whole evolution of accounting is examined, it is
easier to see it as the next phase in the ongoing process.
Studying history is helpful in understanding the accounting problems and
why the institutional arrangements have evolved the way they have.
History also enables us to better assess existing practices because we can
compare what we have now with methods used in the past. In addition,
studying accounting history makes it possible to better understand our
present and to forecast or control our future. It enables a better
understanding and appreciation of the intellectual heritage of accounting
and its evolution as a social science.
ANSWERS 241
3.
The range of accounting theories are:

Accounting as an Historical Record
Accounting theory is concerned with providing a faithful record of
transactions of an entity. However, the issues pertaining to objectivity and
consistency are questionable. Transactions that increase profits might be
treated differently from transactions that decrease profits.
Accounting as a Language
This theory views accounting as a language through which management
can convey its financial performance, the utilisation of the resources
provided by various parties and also the details of past transactions that
had been entered into by the users.
Accounting as Intra-corporate Politics
This theory states that the accounting system is formed and used as a
resource in shaping company policies and in decision making, as a way to
enhance and further the aim of management.
Accounting Standard Setting as Politics/Political Process
This theory views accounting standards as a product of political process
whereby managers lobby for accounting standards to serve their own
interest and select accounting techniques that maximise their own utility.
Accounting as Mythology
This theory states that the accounting system is used to justify, rationalise
and legitimise decisions that are made.
Accounting as Magic
This theory asserts that accounting is a method of deceiving the users of
reports.
Accounting as Communication-decision Information
This theory states that accounting reports are prepared to suit the needs of
users and this in turn will impact the decision-making behaviour of
managers and investors.
Accounting as Economic Good
This theory believes that accounting is part of a wider information set
which includes macroeconomic, political, taxation and other specific
information that affects the performance of the firm.
Accounting as a Social Commodity
This theory asserts that accounting information can affect the welfare of
different groups in society.
242 ANSWERS
Accounting as Ideology and Exploitation

This theory views accounting as a means by which it is used to exploit and
extract wealth in support of elite interest groups at the expense of
employees and society at large.
Accounting as a Social Club
This theory believes that accounting principles, standards and societies
exist, firstly, to promote the group interests and aims of accountants;
secondly, to instil a professional culture and enhance a monopoly in
professional knowledge and; thirdly, to enhance the accountants public
image of professional competency.
4.
5.
It is useful to view accounting from different perspectives because it helps

us to understand:
(a)
The interpretive nature of the accounting process;
(b)
The influence of changing contexts on how accounting and

accountants are understood; and
(c)
The difficulty of trying to understand accounting from just one

perspective.
Some of the major contributions are:

(a)
The works of Chambers in developing a behavioural premise-based

theory of accounting supported by his and other writers
contributions to a view of accounting and the evaluation of economic
behaviour that required an emphasis on current replacement values;
(b)
The works of Mattesich and others that promoted an analytical

axiomatic theory of accounting that emphasised the mathematical and
economic foundations of accounting activity;
(c)
The emphasis of Edwards and Bell and others on a theory of business

income that focused on valuation of income generating assets in times
of fluctuating price levels; and
(d)
A concern to add academic rigour. Accounting had not been studied

extensively prior to this time except as an extension of applied
economics or to collect accounts of practice;
(e)
A growing complexity in business organisations that was associated

with an expanding level of business sophistication in which the
demand for information for management and performance evaluation
was expanding; and
(f)
A more dynamic and volatile economic environment.

ANSWERS 243
In addition, there were significant contributions with modified or even

opposing views identified and promulgated through professional body
reports, journal articles, books, etc.
There is also some indication of greater interest by professional bodies.
Even at this early stage, there were threats to professional independence
through greater legislation and the profession was attempting to protect its
right to govern its own activities. Associated with this was the emergence
of the recognition of university qualifications as the basis of professional
entry. So the environment was one in which the profession saw the need to
justify its existence as an academic discipline built on theory rather than
practice.
6.
Truth refers to a statement that has been confirmed through scientific

testing. If the statement is analytical, the testing is a logical one.
Mathematical statements are of this type. Their truth is determined by
proving that mathematical rules have been followed. This testing reveals
whether the analysis is valid rather than true. If an argument is valid and its
premises are true, then the conclusion is also true. If the statement is
empirical, then persuasive, objective empirical evidence exists to support it.
A decision must be made by the experts of the given field of study from
which the statement evolves concerning the persuasiveness of the evidence.
If by absolute we mean certain, then truth in science is not absolute,
because it is inferred knowledge based on a finite amount of evidence.
From a behavioural point of view, certainty is a matter of degree and
conviction. We behave as though a statement is absolutely true, because we
are personally convinced by the evidence. But this type of behaviour can
occur with the dogmatic and self-evident bases as well.
7.
You may come up with a range of syllogisms for discussion. Your answers
should be discussed in terms of their validity.
An example of one syllogism for a deductive theory:
Premise 1: All firms that are unable to pay a certain rate of dividends to
their shareholders should cut back on their unprofitable operations.
Premise 2: To cut back on their unprofitable operations, firms should
retrench the number of workers whose retrenchment will return the firm to
profit-making status.
Premise 3: ABC Co. is unable to pay a certain rate of dividends to its
shareholders.
Premise 4: ABCs operations in Kuala Selangor are unprofitable.
244 ANSWERS
Premise 5: If 1,000 workers from ABCs Kuala Selagor based-assembly plant

were retrenched, that would return the firm to profit-making status.
Conclusion: ABC should retrench 1000 workers from its Kuala Selangor-based
assembly plant.
TOPIC 2: HISTORICAL DEVELOPMENT OF ACCOUNTING

Self-Test 1
1.
(b)
2.
(c)
3.
(c)
4.
(b)
5.
Hofstedt and Kinard (1970) define behavioural accounting research as the

study of the behaviour of accountants or the non-accountants influenced by
accounting functions and reports. Behavioural accounting research
encompasses the judgement and decision making of accountants and
auditors; and the influence of the output on users judgements and
decisions making.
6.
The limitation of behavioural accounting research (BAR) is the lack of a

single underlying theory which helps in the unification of the diverse
research questions and findings of BAR. This is because human information
processing is too complex for the current research theories and methods.
Thus, till now, BAR researchers are still unable to develop a common
framework useful for generalisation for policy makers.
Self-Test 2
1.
The main difference between normative and positive theories is that

normative theories are prescriptive, whereas positive theories are
descriptive, explanatory or predictive. Normative theories prescribe how
people such as accountants should behave to achieve an outcome that is
judged to be right, moral, just or otherwise a good outcome. Positive
theories do not describe how people should behave to achieve a good
outcome. Instead, they describe how people do behave and why they
behave in certain manner, as well as predicting what they will do
regardless of what is right. Therefore, normative accounting research is
ANSWERS 245
more concerned with policy recommendations and with what should be

done in contrast to explaining why current practice is carried out in the
manner that it is (positive accounting research).
The fundamental differences between positive and normative accounting
theories are identified in the table below.
Normative Theory
Positive Theory
Prescriptive
Descriptive, explanatory or predictive
Value laden
Non-value laden
Does not involve empirical

methodology
Empirically-based
2.
Although many positive accounting researchers do not accept the value of

normative accounting research and vice versa, both positive and normative
theories can co-exist and complement each other. Positive accounting
theory can help provide an understanding of the role of accounting which,
in turn, can form the basis for developing normative theories to improve
the practice of accounting. For example, positive accounting research about
the value-relevance of financial instrument disclosures will reveal if such
disclosures are useful for users of financial statements in making decisions.
Then, the research can provide the basis for regulators to develop
accounting standards or to evaluate existing standards addressing
disclosure issues using normative theory in order to improve the whole
accounting system.
3.
Decision-usefulness approach is based on the assumption that the basic

objective of accounting is to aid the decision-making process of certain
users of accounting reports by providing useful and relevant accounting
data, that is, the usefulness of accounting data is a critical question under
this approach. The decision-usefulness approach is also an instrumentalist
approach. In a narrower sense, one direct test of an overall theory of
accounting would be to determine whether the output data of the
accounting systems, which are constructed on the basis of the overall
theory, are useful to users. The data of the accounting systems are utilised
by users in their prediction models, and the conclusions (predictions) are
then used in their decision models.
4.
A critical question in the decision-usefulness approach concerns the

usefulness of accounting data. This approach is based on classical economic
concepts of profit and wealth or economic concepts of rational decision
making. In essence, the decision-usefulness approach formulates normative
theories, because it follows some fundamental assumptions such as that
246 ANSWERS
accounting reports should provide useful and relevant information to users,

and that profit and value can be measured precisely.
5.
There are three decision making processes:

(a)
Brunswik Lens model;
(b)
Process tracing method; and
(c)
Probabilistic judgement.
TOPIC 3: PARADIGMS IN ACCOUNTING RESEARCH

Self-Test 1
Critical and interpretive paradigms view the research from different angles.
While the critical school of thought pays attention to the differences in societal
science research and tries to combat with them, interpretive research
methodology pinpoints the goal achievement whilst accepting the disparities.
But when mixed method is used in accounting research and paradigms are
investigated simultaneously, the common grounds would emerge in surveying
the research topic and this serves as a keystone to create homogeneity and
establish bridges between paradigms. For example, once critical paradigm
focuses on the discriminations in research, the roots of these phenomenon will be
extracted. These aspects definitely assist interpretive paradigm to effectively deal
with dissimilarities in society when targeting the desired goal, making purposes
come true more practically. Hence, co-existence of paradigms are motivated
which, in turn, leads to homogenous accounting research while having the
advantage of comprehensiveness.
Self-Test 2
Paradigms usage is not always helpful. The first reason is the fact that the return
rate of using an individual paradigm tends to decrease after some time. Then,
paradigm users are restricted to the scopes which are only covered by
paradigms. Consequently, creativity in terms of the research topics without a
related paradigm is imprisoned. Finally, these restrictions cause the previous
problems to remain unsettled. This leads to lack of courage among researchers to
address the issue, resulting in uncovered topics remaining unsolved.
ANSWERS 247
TOPIC 4: CONCEPTUAL FRAMEWORK AND

STANDARD-SETTING PROCESS
Self-Test 1
1.
(c)
2.
(d)
3.
(b)
4.
(c)
5.
(d)
6.
(d)
Self-Test 2
1.
A conceptual framework is a structured theory of accounting. At its highest

level, it states the scope and objective of financial reporting. It defines the
qualitative characteristcis of financial information at the next level. It also
identifies the basic elements of accounting reports. A conceptual framework
is also extended to provide recognition and measurement principles.
2.
The objectives of a conceptual framework is to, firstly, provide guidance to

standard setters in the development of future standards; secondly, to
promote more harmonised reporting and reduce the number of alternative
treatments; thirdly, to help preparers, auditors and users of financial
statements and increase the decision usefulness of the financial information;
and fourthly, to limit the potential for political interference in standardsetting.
3.
True. IASB framework specifies definition and recognition criteria for the
elements of financial statements. Even if an element satisfies the definition
criteria it should not be recognised in the financial statements, unless it
satisfies the recognition criteria of probable occurrence and reliable
measurement.
4.
(a)
The qualitative characteristics for financial statements are relevance,

understandability, reliability and comparability. Learners are
encouraged to explain and elaborate on these characteristics.
Reference is in sub-section 4.4.2.
248 ANSWERS
(b)
(c)
(d)
5.
The elements of financial statements are assets, liabilities, equity,

revenues and expenses. Learners are encouraged to explain and
elaborate on these elements. Reference is in sub-section 4.4.5.
The assumptions underlying the preparation of financial statements
are accrual basis, going concern and periodicity. Learners are
encouraged to explain and elaborate on these assumptions. Reference
is in sub-section 4.4.3.
The constraints of financial statements are timeliness and costs versus
benefits. Learners are encouraged to explain and elaborate on these
constraints. Reference is in sub-section 4.4.4.
Shareholders are interested in information that could assist them to

determine whether they should buy, sell or hold their investment.
Specifically, they are keen to know whether the firm has the ability to pay
dividends.
Creditors are interested in information that enable them to assess whether
they would be paid for the amount owing to them when due.
The public is interested in information about the trends, the range of
activities and the recent developments in the business operation of the firm.
TOPIC 5: EARNING MEASUREMENT AND CREATIVE

ACCOUNTING
Self-Test 1
The first thing to know in order to prevent a financial scandal from occuring is
knowing the facts that how these monetary disasters occur. The scandals are not
always commited by the defrauding managers or employees. One usual occasion
leading to this phenomenon is when a previously ethical employee makes a few
bad decisions. As this person intends to cover the track of his mistakes, the
misconduct becomes bigger and bigger. Therefore, the following approaches may
be implemented by companies to avoid financial frauds:
Reward Honesty: If honesty is rewarded, the employee will be motivated to

be honest even if any wrong doing is intentionally or unintentionally
committed. This can be done by integrating professional behaviour in
measuring employees performance and bonus evaluations.
Changing the Organisation Culture: It is a fact that being honest in an

dishonest environment is quite demanding. Therefore, when the room for
declaring the disagreements and whistleblowings are culturally delivered
ANSWERS 249
within any organisation, the honest and ethical employees will reveal a
number of practices which may be the fraud and/or error indications.
Having/Increasing Controls: The companies which are governed in an

effective and transparent way benefit from the internal audits and controls
performed over the possible misstatements opportunities. Consequently, for
instance, some companies assign a minimum of two employees for the main
procedures so as to monitor the critical processes conducted.
Self-Test 2
Flushing the Investment Portfolio:

Companies may buy other companies shares so as to either earn more profit
or establish strategic alliance. If they purchase less that 20 per cent of the
shares, they are considered as non-controlling investors.
Based on the accounting principles, they are not obliged to disclose the profit
earned from their investment in their net profit for the year. Instead, the
following classifications are available:
1. Trading Securities: Any capital gains or dividend earnings are declared in
the operating income.
2. Available for Sale Securities: When these securities are acquired, they are
reported in other comprehensive income at the bottom of the income
statement. However, the profit or loss made from the sale of this
securities are reported in the operating income.
Because of the offering of the above mentioned options, some of the earning
management opportunities are open to abuse in companies:
1.
Timing sales of securities which gained value: For companies that need
extra gains, the portfolios with added value are sold and reported in
operating profit.
2.
Timing sales of securities which lost value: In the occasions where

companies aim to reduce the operating profit of the year, they sell the
sequrities which have unrealised loss.
3.
Chaning of Holding Intent: Since the two classifications mentioned

have different accounting treatment in terms of one having unrealised
gain/loss, managers may classify trading securities to available-for-sale
or vice versa.
250 ANSWERS
4.
Write-down of impaired securities: In this technique, the securities with

a highly probable long-term loss are written down, regardless of the
their total portfolio performance.
Shrink the Ship:

When companies buy back their stock, no profit or loss is recognised on the
grounds that gains/loss are reported when the deal is with outsiders. As it is
clear, no gain or loss is involved in this situation, so how can companies
commit the earning management?
Let us take an example. When this years earning is RM500,000, and the
companies outstanding share is 100,000, the earning per share (EPS) is 5
(500,000/100,000).
If we consider the next year profit remains the same as the last year (RM
500,000), but the 10,000 of the outstanding shares are bought back, EPS will
be 5.56 {500,000/(100,000 10,000)}.
Although the net profit of the company had no growth the year after, the EPS
was improved.
TOPIC 6: RECOGNITION OF ISSUES ASSOCIATED WITH

ASSETS AND LIABILITY
Self-Test 1
1.
The three attributes that an item must have in order for it to be defined as
an asset are:
future economic benefits;
controlled by reporting entity does not rely on legal enforceability;

and
past transactions or events planned or budgeted transactions are

excluded.
(a)
Future Economic Benefits

The future economic benefits in an asset refer to the assets potential
to contribute, directly or indirectly, to the flow of cash and cash
equivalent to the firm.
(b)
Control by the Entity

To be qualified as an asset, the economic benefit must be controlled by
the entity. The capacity of an entity to control benefits is usually the
results of legal rights. However, having legal rights is not the most
ANSWERS 251
important characteristic. An asset may still satisfy the definition of an

asset if the entity controls the benefits which are expected to flow
from the property.
(c)
2.
Past Event
The asset of a firm must result from past transaction or other events.
In other words, transactions or events expected to occur in the future
do not give rise to assets.
We should record an asset in the balance sheet when it meet the recognition
criteria.
An asset is recognised when:
(a)
It is probable that the future economic benefits will flow to the entity;
and
(b)
the asset has a cost or value that can be measured reliably.
Probable means that it is more likely rather than less likely the future
benefits will arise.
Measured reliably means the asset must be capable of being measured
reliably before it can be recognised. If the assets value cannot be determined
without being arbitrary or subjective, then the asset is not recorded.
3.
A liability need not be legally enforceable. A liability may be equitable or

constructive as well. Most liabilities are legal liabilities, but company policy
of a moral obligation may give rise to a recorded liability as long as the
intent is to transfer assets or render a service to settle the obligation.
Examples are Christmas bonuses that may be accrued if not paid in
December, or vacation pay.
The past transaction or event is not as clear for non-legal liabilities as for
legal liabilities, and thus may be more difficult to recognise. For such
liabilities, the future sacrifice cannot be avoided without significant
penalty, such as decrease in employee morale. Interpreting the meaning of
significant penalty is a matter of opinion.
A legally enforceable claim need not exist for an asset to exist according to
the MASB framework. Control is the main criterion, not ownership.
On the other hand, if a legally enforceable claim against the entity exists, it
is clear that there is legal obligation, and it is presumably a liability.
4.
(d)
252 ANSWERS
5.
True. MASB framework specifies definition and recognition criteria for the
elements of financial statements. Even if an element satisfies the definition
criteria it should not be recognised in the financial statements unless it
satisfies the recognition criteria of probable occurrence and reliable
measurement.
6.
According to MASB framework, the cost of acquiring an asset is the fair

value of whatever is given in exchange for the asset plus any cost incidental
to the acquisition. Fair value is defined to be the amount for which an
asset could be exchanged in an arms length transaction between a willing
buyer and a knowledgeable, willing seller.
Value refers to the preference that people have for some items over others
because of the perceived benefits to themselves. In other words, value is not
intrinsic to the specific asset or liability, but relates to the consumers
willingness to give up something to obtain it.
Cost and value are perceived as different concepts because cost represents a
sacrifice, whilst value has to do with future benefits.
However, cost and value are interrelated to each other as well. Cost is
incurred in expectation of receiving something valuable in the future. Thus,
cost is actually the value of opportunity foregone.
Nevertheless, cost does not always equal to value. This is because the
incurrence of cost does not necessarily create future value that will equal to
cost, as cost is an indicative value at the time of exchange. Over a period of
time, if there is evidence that the value is less than cost, or greater than cost,
an adjustment should be made in the accounts to reflect the value.
7.
Financial reporting aims to provide useful information for decision making.

Assets and liabilities must be measured in a way that captures their value
to the firm in order for them to convey useful information. Investors,
lenders and analysts need useful information to make decisions about
investment and lending. For example, assets and liabilities form part of
users evaluation of a firms position and performance. Ratios incorporating
assets or liabilities values may help assess past performance or they may be
part of financing and remuneration contracts. Thus, the way we measure
the assets and liabilities will affect the balances reported in financial
statements, and can ultimately influence behaviour of capital market
participants when entering contracts.
ANSWERS 253
Self-Test 2
1
(a)
The definition for assets according to the MASB framework is:
Future economic benefits;
Control; and
Past transaction.
In this case, future economic benefits would be expected to flow to Toy

World for the equipment being built. Payment of 10 per cent deposit would
not constitute control. Control of the asset would not exist until it was
delivered to Toy World. Entering into the contract and paying the deposit
would constitute a past event.
The fact that this transaction does not satisfy all the definitions necessary
for an asset to exist because there is no control at this stage would mean
that the full amount of the equipment would not be recognised. The deposit
would be recognised as a current asset and the remainder of the asset
would not.
(b)
A provision is a liability of uncertain timing or amount. The definition

for liability according to the MASB framework requires a:
Present obligation; and
Past event.
In this case, even though a future sacrifice may occur and the
payment to the injured customer would constitute a past event, no
present obligation exists and so given that only one of the elements of
definition is met, the chief accountant cannot recognise a provision.
2.
The three essential features of an asset are: (i) probable future economic
benefits, (ii) control by the entity, and (iii) origin due to a past transaction or
event. Let us discuss each in reverse order.
Firstly, the advertising is definitely due to past event or transaction.

Manis Manis Berhad has already spent money for advertising.
Secondly, the firm has control over the content of the commercials and
obtains the benefits of the commercials.
Thirdly, in terms of whether advertising constitutes probable future

economic benefit, we need to determine whether the advertising has
future economic benefits beyond the current year. Since the product is
new, the product has become familiar to consumers through the
advertising campaign; therefore, do appear to have future benefits. The
254 ANSWERS
increase in sales revenue since the promotional campaign is evidence of

the effectiveness of the advertising. The cost, in this case, is to help
establish a market for the companys product.
The definition of an asset appears to be met. But that does not mean that
an asset should be recognised (recorded). The uncertainty of future
economic benefits and their measurement makes any estimate of future
benefits relatively arbitrary, and for this reason, as with research and
development costs and internally generated goodwill, firms will
expense advertising costs rather than capitalising an internally
generated asset. This approach is consistent with the MASB framework
adoption of the concept of prudence.
3.
Assets and liabilities should be carried in the balance sheet at fair value to
provide relevant information for decision making. Fair value can be
determined in exchange or by referring to the existing value of a
comparable item in the market place. Fair value becomes difficult when
there is no obvious market to value the item. In the case of financial
instruments, standards-setters require the use of mathematical models to
calculate the hypothetical market price.
4.
(a)
No liability. The pertinent event is not placing an order but receiving

title to the goods. When title passes, then a purchase has been made,
and account payable is recorded.
(b)
No liability. The contract is wholly executory. Until there is

performance, there is nothing to record.
(c)
Yes. Interest payable for two months. Accrued interest is to be

recorded. The event is the passing of time. The company is using the
money that was borrowed each day.
TOPIC 7: RECOGNITION OF ISSUES ASSOCIATED WITH

PROFIT, REVENUE AND EXPENSE
Self-Test 1
1.
Profit is the increase in the value of the capital of the firm between two
points in time, excluding investments and withdrawals by owners. Profit is
the return on capital, not a return of capital. In deriving profit, the
accounting procedure involves the spreading of the flows of receipts and
payments over a period of time in a certain way. In practice the profit
concept involves numerous decisions and judgements.
ANSWERS 255
2.
The concept of profit is under debate because of the difference in

perspective between the accountants and the economists. Accountants view
profit as transaction based, and that the realisation principle and the
matching principle must be met. Economists view profit as increase in
value, the market price as objective evidence and that unrealised gain
should be recognised in the income statement.
3.
(b)
4.
Revenue is defined by the standard setters as an inflow of economic

benefits. Revenue arises in the course of ordinary activities. Revenue is also
viewed as something that arises because of something done by the firm. All
firms activities form part of its earning process. Thus, a point for
recognising the revenue must be determined within this earning process.
5.
The revenue recognition criteria used to guide accountants as to when

revenue is realised are measurability of asset value, existence of a
transaction and substantial completion of the earning process.
6.
Expenses are a monetary event which relates to a decrease in the net assets
of the firm. This decrease in value will eventually give rise to an outflow of
cash. Expense must be associated with a physical activity of the firm, that is,
something that the firm does. In other words, in the earning process,
production and sales generate revenue and the usage of goods and services
in support of those functions causes expenses to occur. As guidance,
standard-setters have defined expenses in terms of decreases in economic
benefits arising from the outflow or depletion of assets or the incurrence of
liability.
7.
An expense is to be recognised in the financial statement when it is

probable that future economic benefits associated with the item will flow
from the entity, and the item has a cost that can be measured reliably. The
decrease in future economic benefits relates to a decrease in an asset or an
increase in a liability. Conventional accounting sees revenue as the
accomplishment resulting from the efforts expanded by the firm. Thus, for
any given period, matching expenses with revenue yield the net
accomplishment, or periodic profit.
Accountants use three matching methods, namely:
Associating cause and effect;
Systematic and rational allocation; and
Immediate recognition.
256 ANSWERS
However, applying these three methods is not a straightforward process

and involves a great deal of judgement. Accruals and deferrals are
connected to the matching process. The accountants must decide whether a
cost pertains to future revenues and therefore should be deferred; or
whether a cost is related to current revenues and therefore should be
accrued.
Self-Test 2
1.
2.
(a)
No. There is no sale.
(b)
No. Revenue should have been recorded a year ago when the repair
was done.
(c)
No. There is no performance yet. If the company has already begun to

construct the house, then it could record the full amount as revenue. If
there is performance, then a sale has been made.
(d)
Yes. The sale was made because the lorry was delivered. This is not an
instalment sale, since there will be no periodic payments. Despite the
fact that title has not been passed, the customer has full control over
the usage of the lorry. Thus, this is considered as simply a credit sale.
(e)
Yes. Although this is an instalment sale, the sales basis should be

used, because there is no evidence of great uncertainty in collecting
the payments.
The three basic principles of matching are:
Cause and effect: cost of goods sold, for example: sales commissions,
salaries and wages, certain selling costs;
Systematic and relational allocation: depreciation, amortisation,

depletion, insurance;
Immediate recognition: for example, utility, salaries and wages.
The MASB framework focuses on the recognition criteria more than on

matching. The two criteria for the recognition of expenses are:
It is probable that any future economic benefit associated with the

item will flow to or from the entity; and
The item has a cost or value that can be measured with reliability.
For an expense to be recognised in the financial statement, it must meet

both of the recognition criteria. These criteria imply that any matching of
expenses and revenue is limited by the extent to which the recognition
criteria are met. Therefore, under the MASB framework, expenses should
ANSWERS 257
be matched to the period in which the asset expire or liability increase

occurs rather than being matched against the revenues that they have
contributed to earning. The recognition criteria relate to the outflow of
service potential or future benefits having occurred, and the need for the
amount to be reliably measurable. The application of the matching concept
does not allow the recognition of items in the balance sheet which do not
meet the definition of assets and liabilities.
However, the matching concept underpins accrual accounting. Therefore,
the MASB framework recognises the matching concept which states
Expenses are recognised in the income statement on the basis of a direct
association between the costs incurred and the earning of specific items of
income. The matching process involves the simultaneous or combined
recognition of revenues and expenses that result directly and jointly from
the same transactions or other events. For example, the various components
of expense making up the cost of goods sold are recognised at the same
time as the income derived from the sale of the goods.
3.
The adoption of a system that breaks the life of a firm into defined
accounting periods, which normally bears no relationship to the life of
assets employed to operate a business, requires assumptions about the
benefits derived from such assets in any one accounting period. Often it is
difficult to estimate the contribution made by assets to revenues recognised
in any one accounting period. In order to calculate profits, assumptions
often need to be made about:
Whether revenue has been achieved because of activity within a

particular period;
The likelihood of future realisation of the revenues;
The allocation of expenses that extend beyond one accounting period,

or were incurred in developing assets to generate future revenues.
TOPIC 8: RELIABILITY AND RELEVANCE ISSUES

Self-Test 1
1.
Managers are in charge of fair, unbiased and updated information. They are
the entities that decide what information should be referred to in financial
statements of the business. Consequently, managers provide financial
statements whilst they give importance to interests of different parties and
stakeholders in their consideration. Here, the possibility of occurrence of
challenges arise. Trying to fulfil the expectations of different stakeholders
258 ANSWERS
may lead to conflict of interests among them. That is the reason managers
ought to give preference to a few of stakeholders like investors in terms of
their benefits and interests. Therefore, the relevance and reliability of
financial statements are in favour of the targeted groups. In addition, as
agency theory states that managers may tailor financial reporting in a way
which benefits their bonus and remuneration rather than the whole
business entity and its stakeholders. This behaviour is not ethical while
reliability and relevance of data are endangered.
2.
Notes and supplementary plans and schedules are appropriate tools to

clarify the details of how the business is running. The notes are tools by
which stakeholders such as creditors, customers, suppliers, employees and
so on are able to gain more relevant and reliable information when they
want to create any kind of relationship with the business.
Self-Test 2
1.
2.
In support of exit price accounting:
Exit prices are objective because they are market determined. If there is
not market ptice, then the item is stated zero.
Current (exit) values reveal the financial condition of the firm, its ability
to adapt to the environment that is, to go into the market to buy and
sell.
All the values in the financial statements are additive that is, they
refer to one characteristic: cash or current cash equivalent.
Current values are relevant to users for their decision models.
There is no problem concerning the allocation of costs.
Exit price accounting is based on events that actually happened

increases and decreases in values as determined in the market, as well
as items purchased, sold or paid. Values in the financial statements are
based on reality.
Research studies show that in many cases current (exit) values are more
objective than historical cost. In any event, current values are less
subjective than most people believe.
Investors should calculate rates of return based on the company's ability to

replace assets and continue operations. If this rate of return in less than the
cost of capital (required rate of return) then investors should invest in other
firms. Investors can also rate investments based on the rate of return of the
current buying cost of inputs. Investments should be made in descending
order based upon calculated return or expected return on current cost
ANSWERS 259
accounting. Using current cost accounting means that financial statements

between firms are now comparable.
TOPIC 9: SPECIFIC ISSUES

Self-Test 1
Advantages are as follows:
(a)
Facilitate corporate governance practices;
(b)
Create more efficient capital markets;
(c)
Improve decision making;
(d)
Increase uniformity of financial information structures;
(e)
Prevent managers from manipulating information flow; and
(f)
Assists lenders and government agencies in their interaction with

businesses according to the standards.
Self-Test 2
There are factors which challenge the similarity of empirical studies. These
factors include:
(a)
Voluntarily nature of standards adoption;
(b)
Differing characteristics of firms in various industries;
(c)
National law differences among different nations; and
(d)
Dissimilarity of market conditions and investors overview of standards

adoption.
TOPIC 10: SOCIAL AND ENVIRONMENTAL REPORTING

Self-Test 1
1.
The traditional financial reporting focuses on the information needs of the

shareholders or owners of the company. The alternative financial reporting
takes the view that managers run the business for the benefits of all
stakeholders. Thus, firms must demonstrate transparency and
accountability beyond the domains of financial performance, and are
260 ANSWERS
responsible to provide information

environmental performance.
regarding
their
social
and
2.
Friedman argues that an organisations sole responsibility is to maximise

profits for its shareholders. This is because the organisation has already
used part of its profits for taxation and other statutory payments, thus any
further obligations put on it by the society would be deemed as an illegal
tax.
3.
The objective of social and environmental accounting reporting is to

disclose issues not necessarily covered by the traditional accounting
function, into a form that is useful for decision making. Social and
environmental reporting recognises the firms interaction with the broader
community and its stakeholders. It has to be considerate of the demand
placed upon it, and also the need to remain a viable, sustainable entity.
4.
CSR refers to a set of policies and strategies that is said to occur when
companies voluntarily integrate social and environmental concerns in their
business operations and in their interaction with stakeholders.
Alternatively, CSR can be viewed as making economic returns without
jeopardising the environmental stability and social development.
5.
The three theories explaining social and environmental reporting are:

(a)
Social Contract Theory

This theory explains that there are boundaries of acceptable
interaction between participants within the society. These boundaries
will determine the practices that are acceptable or unacceptable in
meeting the needs of the society. Management, via its social contract
with the various stakeholders, aims to perform socially desirable
actions in return for acceptance of its company objectives.
(b)
Legitimacy Theory
This theory explains the reaction of management towards changes in
community expectations. Management is said to behave in a way to
avoid further explicit restrictions (such as government regulations) or
implicit restrictions (such as reputation effects) on their operations.
Management may seek organisational legitimacy through alternative
means. In other words, management may attempt to justify its current
actions by communicating its commitment to improve environmental
management and performance. Management can also try to change
the stakeholders expectations that it considers unreasonable.
ANSWERS 261
(c)
Stakeholder Theory
This theory explains that the behaviour of an organisation is governed
by, firstly, the nature of its diverse stakeholders; secondly, the norms
defining right or wrong adopted by these stakeholders; and thirdly,
stakeholders relative influence on organisation decisions. Freeman
(1984) defines stakeholder as: any individual or group who can
affect or is affected by the actions, decisions, policies, practices, or
goals of the organisation. Stakeholder management is important
because it involves allocating organisational resources, taking into
account the impact of the firms actions on various stakeholder
groups, with the objective of maximising the firms ability to realise
its intended strategies.
6.
Triple-bottom-line (TBL) is reporting on economic, environment and social

performance of an entity. TBLs objectives are to move away from the
traditional method of reporting that focuses on financial performance; and
to move away from the adoption of the annual report as the primary means
of communication. TBL reporting includes the combination of financial
information, quantified non-financial information and narrative
descriptions.
7.
The Argument for Valuation:

This argument can be understood by looking at the reason for valuing
nature. By valuing nature, we are in a better position to consider the
implications within our decision process, and it will also encourage
solutions to the existing and future social and environmental problems.
The Argument against Valuation:
Nature has an intrinsic value. It is crucial to the survival of our planet Earth
and to the quality of life that current and future generations seek to enjoy.
Such enjoyment cannot be financially quantified. By valuing nature, we are
actually trying to turn it into a commodity that we can preserve or
consume. In other words, quantification of nature makes nature another
economic resource that can be traded, and thus open for exploitation and
degradation.
Self-Test 2
1.
Issues constraining the development of reporting regulations for social and

environmental issues include:
What is relevant to potential users?;
262 ANSWERS
How should performance be measured (financial versus qualitative)

and what format (triple-bottom-line)?;
How regularly should reporting occur?; and
What is the appropriate reporting medium?
2.
Inappropriate cost allocation is an issue of concern regardless of what

generates the costs. Environmental issues, especially those that relate to byproducts and indirect impact, may cause management to further consider
the means by which they determine cost drivers. This is most important, for
example, when emissions are regulated, where there are restrictions on
waste disposal or when restrictions are influencing the availability of
supplies or the future acceptance of the product (for example, refrigeration
reliant upon CFCs).
3.
The context in which the TBL report is prepared needs to be examined.

Whereas the TBL may not be seen as a direct threat, it may be seen as
another fad where considerable effort is being exerted to gather data on
performance that is not then utilised for decision making. As such, if there
are no direct tangible outcomes from the process that improve overall
performance, then companies may encounter opposition internally to
implementation, and externally may face accusations of tokenism to social
and environmental issues. So threats predominantly focus on the company
exposing itself to these issues without substance in terms of a commitment
to improved performance. Opportunities may exist in focusing attention on
a broader range of firm performance criteria. For a company committed to
improvement on social and environmental performance, tangible outcomes
may be achieved through the development of a greater understanding of
the interrelationships of functions and impacts of the firm.
4.
Social and environmental reporting is the dissemination of information on

the interaction between the entity, society and the environment, including
information on performance and management. The traditional accounting
system is premised on money as the unit of measurement. Assigning
monetary amounts to social and environmental transactions or event is
problematic, given that for many of these transactions there is unlikely to be
a market enabling the transaction to be measured reliably. Hence, these
assets cannot be reliably measured using traditional techniques. It does
raise the question as to whether we should only be seeking to measure
economic benefits, when other real, but intangible, benefits flow from such
assets (that is retaining an asset for future generations). Traditional
accounting seems inappropriate as a means of measuring the worth of
these assets. The limit of the scope of the conceptual framework to
economic transactions does not prevent firms from reporting social and
ANSWERS 263
environmental performance separately to economic performance using

measures that do not necessarily involve the assignment of monetary
figures.
5.
The stakeholders identified in the conceptual framework fall into three

categories:
Suppliers of capital (for example, shareholders and lenders);
Recipients of goods and services (for example, customers); and
Parties performing a regulatory review or oversight function (for

example, statutory bodies).
Primarily, the stakeholders have an economic interest in the entity, and the
emphasis is on economic decision making and the provision of financial
data. Expanding the scope of stakeholders interested in a firms
performance, financial and non financial, would necessitate the provision of
information not currently required. This would include social and
environmental performances. Examples of social performance information
would include staff turnover, relative pay for female and male staff and
sponsorship of community programmes. Examples of environmental
performance would include penalties and fines for breach of environmental
laws, electricity and gas consumption, and consumables recycled. The most
appropriate medium for disseminating social and environmental
information would need to be evaluated. A number of Malaysian
companies have embraced reporting to diverse stakeholder groups and
provide environmental and social information via detailed reports in
addition to financial reports. For example, Telekom Malaysia has produced
a comprehensive social and environmental report to supplement the
financial performance conveyed in its financial reports.
6.
Contributing factors may include increased community attention and

government intervention. (Learners should be encouraged to discuss in
class the factors they feel could impact the manner in which the firms carry
out their operation and make disclosures).
7.
(a)
Mandatory reporting restricts the options avaliable to firms. It may

also impose additional costs to those firms that do not currently
voluntarily disclose information. There is still much debate as to what
information is appropriate for all companies to disclose.
(b)
Many parties have argued that a voluntary regime is adequate for the
reporting of social and environmental information. The basis of such
arguments are that the issues and functions of firms differ
significantly; hence regulatory requirements would constrain
264 ANSWERS
reporting, not allowing companies to provide appropriate

information, while currently providing enough information for
compliance purposes.
(c)
Evidence suggests that voluntary reporting has provided inadequate

information on the majority of companies. Whereas leading
disclosures of social and environmental information have been
provided as examples of how voluntary disclosure is successful (and
highlighting that for these companies disclosures goes beyond that
would be required through mandatory requirements), these are a
minority of reporting entities. For the majority of companies,
reporting is ad hoc and incomplete wih the information provided
typically biased toward the good news; in other words, few
companies are prepared to highlight negative aspects of their
performance within a social forum. Hence, if information is deemed
necessary, then mandatory requirements are essential to encourage
the reporting laggards and to provide consistency for conparative
purposes.
TOPIC 11: OTHER CURRENT ISSUES IN FINANCIAL

REPORTING
Self-Test 1
1.
CSR guidelines offer many advantages for organisations in terms of:
(a)
Human Resources
(b)
Because of increasing attention of new and current staff on CSR activities,

companies with CSR activities have better recruitment and also lower
employee turnover;
(c)
Risk Management
(d)
Risks in terms of company image and regulatory issues can be mitigated by

having CSR guidelines implementation;
(e)
Brand Recognition
(f)
A moral company aiming to contribute social activities would be

differentiated and well-known in todays competitive market;
(g)
Operation License
ANSWERS 265
(h)
With implementation of environmental and humane moral activities,

companies will have the power to respond to various watchdogs and
pressure groups in their society; and
(i)
Supplier Relations
(j)
It is clear that suppliers play a key role in production cost and product
quality of companies. Therefore, suppliers may receive CSR checklists to
assure companies about meeting their expectations.
Self-Test 2
(a)
XBRL is online and it is related to business processes. Besides, it is

universally approved;
(b)
Automation is increased by XBRL;
(c)
Accuracy and reliability of financial statements information is provided;
(d)
Decision qualities are elevated;
(e)
The speed of analysis is improved;
(f)
Cost of analysis is reduced because of automation and less manual work

required;
(g)
IFRS harmonisation is assisted owning to XBRL; and
(h)
Information delivery and sharing in terms of financial reporting measures

is assisted.
TOPIC 12: ISLAMIC ACCOUNTING

Self-Test 1
Accounting in Islam is categorised according two main notions:
1.
Accountability
This concept discusses the fact that every individual must be accountable
towards himself and other society members. Moreover, accounting for this
world as well as the next world after resurrection is compulsory in Islamic
accounting practice.
266 ANSWERS
2.
Financial Accounting
This notion deals with accounting issues such as profit, cost, revenue and so
forth. Examples of Islamic financial accounting systems are zakat
accounting, governmental accounting and corporations accounting.
Self-Test 2
AAOIFI provides significant assistance for the financial institutions following
AAOIFI standards and the main objectives of this not-for-profit organisation are:
(a)
Provision of accounting principles in agreement with Syariah principles;
(b)
Holding seminars, conferences, training courses, and so on to transfer

accounting thoughts to the users;
(c)
Establishing, notifying, and interpreting auditing and accounting thoughts

standards, and principles for financial institutions with Islamic accounting
guidelines; and
(d)
Reviewing and modifying Islamic accounting standards.
TOPIC 13: COMPREHENSIVE CASE

Self-Test 1
Although the main responsibility of fraud prevention is with the managers,
internal auditors play a key role in this regard by assuring the sound
implementation and monitoring of managers within the organisation. Creation of
an appropriate culture and announcing the top tone are the main tools which
internal auditors will use in fraud prevention.
The Committee of Sponsoring Organisations of the Treadway Commission
(COSO) developed a five-component framework which assist internal auditors in
fraud prevention.
Control environment: Setting ethics policy, developing whistle blowing

programmes, establishing hiring guidelines, supervision by audit committee.
Risk assessment: Assigning suitable experienced experts in risk assessment,

and performing regular risk assessment.
Control activities: Defining segregation of duties, and authorisation

processes.
Information and communication: Training fraud awareness and allerts,

requiring the employees approval regarding the corporate policies.
ANSWERS 267
Monitoring: Receiving independent experts evaluations and reports, and

receiving assistance from technology.
Self-Test 2
The performance evaluation of companies based on their financial statements can
be done through measuring the variety of ratios and comparing them with the
previous years rations, major competitors rations, or industry averages. These
ratios are classified in terms of Liquidity such as Current ratio, and Quick ration;
Solvency such as Debt-to-assets ratio; Debt-to-equity ratio; Profitability like Gross
profit margin; ROA and ROE; Efficiency including Inventory turnover; and
receivables turnover.
GLOSSARY
References
AAOIFI. (1998). Accounting and Auditing Standards for Islamic Financial
Institutions. Manama, Bahrain: Accounting and Auditing Organization for
Islamic Financial Institutions.
Abdul-Magid, M. F. (1981). Theory of Islamic banking: accounting implications.
The International Journal of Accounting Education and Research, 17 (1), 79102.
Adnan, M. A., & Gaffikin, M. (1997). The Shariah, Islamic banks and accounting
concepts and practices. Proceedings of International Conference 1:
Accounting, Commerce and Finance: The Islamic perspective. Sydney,
Australia: University of Western Sydney.
Akers, M, D., Giacomino, D. E., & Bellovary, J. L. (2014). Earnings management
and its implications: Educating the accounting profession. The CPA Journal :
The New York State Society of CPAs.
Albrecht, D. (2010, January 6). Economic Consequences and the Political Nature
of Accounting Standard Setting. The Summa.
Ball, R., & Brown, P. (1968). An empirical evaluation of accounting income
numbers. Journal of Accounting Research, 6 (2), 159-178.
Bamber, E. M. (1993). Opportunities in behavioural accounting research.
Behavioural research in accounting, 5, 1- 29.
Bedford, N. M. (1965). Income determination theory: An accounting network.
Addison-Wesley.
Beresford, D. R. (1991). Benefits, Costs and Consequences of Financial
Accounting Standards. Financial Accounting Standard Board.
Birnberg, J. G. & Shields, J. F. (1989). Three decades of behavioural accounting
research: a search for order. Behavioural research in Accounting, 1, 23-74.
BNM Malaysian Financial Sector. (n.d.). Retrieved from:
http://www.bnm.gov.my/index.php?ch=fs_mfs&pg=fs_mfs_bank
268
REFERENCES
269
Burrell, G., & Morgan, G. (1979). Sociological paradigms and organizational

analysis. London:Heinemann Educational Books Ltd.
Campbell, N. (1938). Symposium: Measurement and Its Importance for
Philosophy. Proceedings of the Aristoteliam Society, XVII, 121-142.
Coombes, R. J., & Martin, C. A. (1982). The definition and recognition of revenue
under historic cost accounting. Australian Accounting Research Foundation.
Cooper, D., Hopper, T., 2007. Critical theorising in management accounting
research. In: Chapman, C., Hopwood, A.G., Shields, M.D. (Eds.), Handbook
of Management Accounting Research, 1, 207245.
Crowther, D. (2000). Social and Environmental Accounting. London, England:
Financial Times Prentice Hall, p. 20
Devi S., Hooper, K. I. & Davey, H. (2004). Accounting theory and practice A
Malaysian perspective. Petaling Jaya: Pearson Malaysia Sdn Bhd.
Edwards, E., & Bell, P. (1961). The theory and measurement of business: Income.
Berkeley: CA University of California Press.
EU Green Papar. (2001). Promoting a European Framework for Corporate Social
Responsibility, Brussel, Commission of the European Communities.
Retrieved
from:
www.btplc.com/Societyandenvironment/Reports/
Greenpaperon CSR. pdf
Fortin, S. (2005). Relevant and reliable? CA Magazine, 138 (2), 45-48.
Friedman, M. (September 13, 1970). The social responsibility of business is to
increase its profits. New York Times, pp. 122-126.
Gambling,. T. & Karim, R. A. A. (1991). Business and. Accounting Ethics in
Islam. London, England: Mansell Publishing Limited.
Godfrey, J., Hodgson, A. & Holmes, C. (2000). Accounting theory. Australia: John
Wiley and Sons Australia Ltd.
Godfrey, J., Hodgson, A., Holmes, S., & Tarca, A. (2006) Accounting theory. (6th
ed.). Australia, Wiley & Sons Ltd.
Handbook Of The Code Of Ethics For Professional Accountants. (2010). New

York, NY: International Federation of Accountants.
270 REFERENCES
Healy, P. M. (1985). The Effect of Bonus Schemes on Accounting Decisions.

Journal of Accounting and Economics, 7 (1-3), 85-107.
Healy, Paul, M., & James, M. W. (1999). A review of the earnings management
literature and its implications for standard setting. Accounting Horizons
13 (4), 365383.
Hofstedt, T. & Kinard, J. (1970). A strategy for behavioural accounting research. :
Accounting Review, 45 (1), 38-54.
Hopper, T., & Powell, A. (1985). Making sense of research into the organizational
and social aspects of management accounting: A review of its underlying
assumptions. Journal of Management Studies, 22 (5), 429-465.
Hopwood, A.G., (2007). Whither accounting research? The Accounting Review
82 (5), 13651374.
Ijiri, Y. (1967). The foundation of accounting measurement. Englewood Cliffs, NJ:
Prentice Hall.
International Accounting Standards Board. (2010). Management Commentary.
IFRS Foundation Publications Department.
Johnson, L. T. (2005). Relevance and Reliability. FASB Report.
Kaplan, R., & Roll, R. (1972, April.). Investor evaluation of accounting
information: Some empirical evidence. Journal of Business, 45, 225-257.
Karim, R. A. A. (1990). Standard setting for the financial reporting religious
business organizations: The case of Islamic banks. Accounting and Business
Research, 20 (80), 299-305.
Khan, Muhammad Akram. (1994). Accounting Issues and concepts for Islamic
banks. Malaysia: Malaysian Accounting Standards Board (MASB).
Laughlin, R. (1995). Methodological Themes: Empirical Research in Accounting:
Alternative Approaches and a Case for Middle-Range Thinking.
Accounting, Auditing and Accountability Journal, 8 (1), 63-87.
Lukka, K. (2010). The roles and effects of paradigms in accounting research:
Management Accounting Research, 21(2), 110-115.
REFERENCES
271
Lukka, K., & Granlund, M., (2002). The fragmented communication structure
within the accounting academia: The Case of Activity-based Costing Research
Genres. Accounting, Organizations and Society, 27 (1/2), 165190.
Maines, L. A. (1995). Judgement and decision-making research in financial
accounting: a review and analysis. In Ashton, R.H. and Ashton, A.H. (Eds).
Judgement and decision-making research in accounting and auditing (pp. 76101). Cambridge: Cambridge University Press.
Malmi, T. (2010). Reflections on paradigms in action in accounting research:
Management Accounting Research, 21(2), 121-123.
Modell, S. (2010). Bridging the paradigm divide in management accounting
research: Management Accounting Research, 21(2), 124-129.
Ronald, W. H. (2010). Managerial Accounting: Creating Value in a Dynamic
Business Environment. New York, NY: McGraw-Hill.
Parker, L.D. & Roffrey, B.H. (1997). Methodological themes, back to the drawing
board: Revisiting grounded theory and the everyday accountants and
managers reality. Accounting, Auditing and Accountability Journal, 10 (2),
212-247.
Profit (accounting) - Wikipedia, the free encyclopedia. (n.d.). Retrieved from
https://en.wikipedia.org/wiki/Profit_(accounting)
Schipper, K. (1989). Commentary on Earnings Management:
Horizons, 3 (4), 91102.
Accounting
Shahul Hamed Mohamed Ibrahim. (2000). The need for Islamic acounting:
Perception of Malaysian Muslims acountants and academicians on the

objectives and characteristics of Islamic acounting. (Unpublished Phd thesis).
University of Dunde, UK.
Shanahan, J. (1992). Group of 100 opposed to market value accounting. New
Accountant, 25, p. 9.
Spiceland, J. D., & J. F. (2011). Intermediate
McGraw-Hill Irwin.
Accounting. Columbus, OH:
Sterling, R. (1970). On theory construction and verification. Accounting Review,

45 (3), 444-457.
272 REFERENCES
Watts, R., & Zimmerman, J. (1986). Positive accounting theory. Englewood Cliffs,
NJ: Prentice Hall.
Weston, F. (1971). Response to evidence for a market selling price accounting
system. In Sterling, R.(Ed.), Asset valuation and income determination.
Houston, TX: Scholars Book Co.
Zhenkun, W. (2007). The Benefits and Problems of Online Financial Reporting
with XBRL.BAA Annual Conference.
MODULE FEEDBACK
MAKLUM BALAS MODUL
If you have any comment or feedback, you are welcome to:

1.
E-mail your comment or feedback to modulefeedback@oum.edu.my
OR
2.
Fill in the Print Module online evaluation form available on myVLE.
Thank you.
Centre for Instructional Design and Technology
(Pusat Reka Bentuk Pengajaran dan Teknologi)
Tel No.:
03-27732578
Fax No.:
03-26978702

BBAT4103 Accounting Theory PDF

Încărcat de

Informații document

Titlu original

Drepturi de autor

Formate disponibile

Partajați acest document

Partajați sau inserați document

Opțiuni de partajare

Vi se pare util acest document?

Este necorespunzător acest conținut?

Drepturi de autor:

Formate disponibile

BBAT4103 Accounting Theory PDF

Încărcat de

Drepturi de autor:

Formate disponibile

BBAT4103

Copyright Open University Malaysia (OUM)

Prof Dato Dr Mansor Fadzil

Sabrina Chong Yee Ching

Assoc Prof Dr Wan Fadzilah Wan Yusoff

Centre for Instructional Design and Technology

Meteor Doc. Sdn. Bhd.

First Edition, August 2008

Copyright Open University Malaysia (OUM)

Introduction to Accounting Theory

Historical Development of Accounting

Copyright Open University Malaysia (OUM)

Paradigms in Accounting Research

Conceptual Framework and Standard Setting Process

Copyright Open University Malaysia (OUM)

Issues in Standard Setting

Earnings Measurement and Creative Accounting

Recognition of Issues Associated with Assets and Liability

Recognition of Issues Associated with Profit,

Copyright Open University Malaysia (OUM)

7.1.2 Accounting View Versus Economic View of Profit

Realibility and Relevance Issues

Copyright Open University Malaysia (OUM)

Social and Environmental Reporting

Copyright Open University Malaysia (OUM)

10.4 Voluntary Reporting

Other Current Issues in Financial Reporting

Copyright Open University Malaysia (OUM)

Copyright Open University Malaysia (OUM)

X COURSE ASSIGNMENT GUIDE

Copyright Open University Malaysia (OUM)

Copyright Open University Malaysia (OUM)

Copyright Open University Malaysia (OUM)

COURSE GUIDE DESCRIPTION

Copyright Open University Malaysia (OUM)

Table 1: Estimation of Time Accumulation of Study Hours

Briefly go through the course content and participate in initial discussion

Study the module

Attend 3 to 5 tutorial sessions

Assignment(s), Test(s) and Examination(s)

TOTAL STUDY HOURS

Discuss accounting theory, major theoretical accounting frameworks and

Evaluate the development of accounting;

Assess the various paradigms in accounting research;

Discuss the accounting profession based on the conceptual framework and

Examine the issues related to earning management and creative accounting;

Discuss the issues of measurement in accounting with regards to assets and

Analyse issues associated with profit, revenue and expense;

Evaluate the reliability and relevance issues in accounting;

Critically comment on the economic consequences of accounting standards;

Copyright Open University Malaysia (OUM)

Explain various current issues in financial reporting such as social and

Discuss the issues relating to online reporting and XBRL

Explore the issues relating to Islamic accounting; and

Critically analyse case studies with regards to accounting issues.

Copyright Open University Malaysia (OUM)

TEXT ARRANGEMENT GUIDE

Self-Check: This component of the module is inserted at strategic locations

Copyright Open University Malaysia (OUM)

Welcome To ICAEW.Com (2015). Retrieved from http://www.icaew.com

Copyright Open University Malaysia (OUM)

Let us consider these scenarios:

Why do apples fall from tree?