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Accounting Theory

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1. Introduction
Accounting practices have been argued to reflect information quality of the firm in the market. Recently, there has been renewed interest in the relation between information asymmetry and conservative financial reporting practices. Many theorists have critiqued this aspect of information asymmetry, which has garnered significant interest in the accounting arena in the world today. This paper is set out to analyze the literature on conservative financial reporting, dissecting Akerlof’s article surrounding information asymmetry. Following this, possible motivations by firms to undertake these accounting measures will be meted out, coupled with an examination of the empirical evidence in reflection of the measurement of conservatism, with a final conclusion pertaining the relationship of information quality and financial reporting choices being ascertained.

2. Conservative Financial Reporting
Conservatism is the differential verifiability required for the recognition of accounting gains versus losses that generates an understatement of net assets. (Basu, 1997) There has been evidence strongly suggesting that U.S companies had used conservative financial reporting practices since the last five decades. (Watts, 2003) It is argued that conservatism of financial reporting arises because of information asymmetry between firm managers and shareholders. While information asymmetry refers to a situation where one party has more or superior information compared to another, (Akerlof, 1970) theoretical researchers have found that managers do not have the same incentive as shareholders or investors, and can use their information advantages to transfer the wealth from shareholders to themselves. (Watts, 2003) Following that, managers tend to report good aspects of the financial statements so as to gain extra compensation that is frequently dependent on the financial outcome, which will result in information asymmetry problems. (Demski, 2004) Furthermore, regardless of whether the manager benefits or not, the manipulations generates an agency cost, which is referred as the cost due to conflicts between different goals of shareholders and managers. (LaFonds, 2006) As a result, researchers argue that the higher degree of information asymmetry, the higher demand for conservatism in financial reporting, which contributes to reducing agency problems.
In Akerlof’s article ‘The Market for “Lemons”: Quality Uncertainty and The Market Mechanism’, he posited certain instances where misinformation may arise due to the significant information asymmetry that exists in the market. He states that quality and uncertainty issues happen in the market, and because of that, individual sellers behave in a way that is variant from the norm of the market, driving good quality goods out and squeezing the market. (Akerlof, 1970, p.488) However, states by Akerlof, government intervention could make all parties better off. Akerlof then uses the model with automobiles to give out an example. Poor quality goods push good ones out and uncertainty issues arise. The writer also examines this example with Gresham’s Law, where information is assumed to be symmetric, and stated that, “[s]o the analogy is instructive, but not complete.”(Akerlof, 1970, p.490)
Further, Akerlof expounds the model of information asymmetry using statistic models and distinguish that from symmetric information. Information asymmetry assumes at least one party in a transaction has adequate information while the other does not. (Baruch, 2000) The latter part of the article discusses more examples of information asymmetry and its applications. Akerlof demonstrates how adverse selection model works in insurance industry and why insurance companies do not want to give insurance to elder people. Medicare may payoff on a cost benefit basis, and insurance companies cannot afford such many “lemons”. Information asymmetry also arises in employment. Minorities are not likely to be hired, as employers want to minimize uncertainty and maximize profit. Employers do not know how to judge good job qualification among them. They avoid the risk by refusing to hire minorities.
Akerlof also tests information asymmetry issues in the aspects of dishonesty generating additional ‘costs’. Dishonesty issues are greater in under-developed countries. Furthermore, the author discusses the importance of entrepreneurship as well. Taking India as an example, trust problems happen in the credit markets. Rich people dare to invest, and loans charge high interest on people unfamiliar. “If it is someone I don’t know well, then I think twice about it unless I can find out all about him,” as stated by a shopkeeper in Barbara Ward’s (1960) account. Finally, Akerlof draws the conclusion that difficulty of judging between good and bad quality remains and explains many economic problems.
As seen from the above account, Akerlof does indicate the level of disparity that exists in the market regarding the information asymmetry. Despite these, firms have still indicated a pursuance of these conservative accounting reporting measures for their respective incentives that can be acquired. These arguments will be discussed further in motivations for firms to adopt conservative financial reporting.

3. Motivations for adopting conservative financial reporting While financial reporting practices are argued to reflect information quality, which is pragmatically defined as the fitness for use of the information provided, it becomes controversial whether firms have an incentive to adopt conservatism in financial reporting. (Various authors, 2010) Notwithstanding the fact that arguments exist where conservative financial reporting has some limitations, companies and strong boards still have the motivation to undertake the conservative financial reporting practices. Three main motivations will be highlighted; (i) the reduction in agency costs and the monitoring of managerial manners, (ii) increasing the firm’s sustainability, and (iii) increasing the firms’ reputation. 3.1 Reduce agency costs and monitor managerial manners In this sub-section, the study highlights that firms and boards will demand conservatism because conservatism can help directors in reducing agency costs arising from asymmetric information between managers and other parties to the firm, such as deadweight losses. (Watts, 2006) Aforementioned, managers may prefer a more aggressive financial reporting choice as they can benefit from shifting wealth towards themselves based on advanced private information acquired. For example, managers can manipulate stock prices of the firm by manipulating accounting numbers, which will result in deadweight losses and, thus, reduce equity value. (Ahmed & Duellman, 2006) However, theorists argue that conservatism in accounting and financial reporting reduce manager’s ability to withhold the information by higher verifiable standards of recognition of revenues yet immediate realize of expenses. On the other hand, even the managers cannot succeed in taking advantage of the private information agency costs still arising due to their intentions. (Bushman, 2005) Therefore, it gives the firm and the board of directors the incentive to adopt conservatism in financial reporting so as to prevent the generation of agency cost as well as monitoring the managerial manners. 3.2 Increase firm’s sustainability Agency costs and firm value certainly are not the only things that shareholders and directors focus on; increasingly it has been more focused on the sustainability of the firm. Conservatism is argued to increase a firm’s sustainability by ways of increasing earning quality and reducing the risks associated with information asymmetry. The identical case related to this matter will be the tragedy happened to Enron in the U.S a decade ago. By financing through special purpose equities (SPEs), Enron’s credit fraud was not identified upon financial reports. However, this information asymmetry problem finally brought Enron to bankruptcy. Conservatism, nonetheless, is considered to prevent the downside risk associating off-balance sheet financing by reducing the information asymmetry between managers and outsiders. Other than that, conservative financial reporting is regarded to lead the firm towards high quality earnings in terms of persistent, controllable and bankable income. (Zhang, 1999) Moreover, by undertaking conservative accounting practice the firm will report a lower tax burden in the long timeliness that results in a more promising future of the firm. This sustainability aspect, coupled together with the firm’s pursuance of adopting a conservative financial reporting strategy, will definitely seek to provide the firm with a pivotal edge amongst its competitors. 3.3 Increasing the reputation of the firm Conservative financial reporting further postulates the way in which a firm is able to garner significant reputation within its market and industry as a whole. The reputation of a firm, in this aspect, will be directly dependent on the factor in which the firm will improve its efficiency level. By adopting conservative financial reporting procedures, the firms will seek to improve the information disparity that presently exists within its domain. (Ball, 2005) By eradicating this barrier by a certain extent, the firms’ employees would be able to improve its efficiency level by reducing additional costs that would be otherwise incurred. This, in effect, will result in a chain reaction that will see the firm in garnering significant market share that it otherwise would not have been able to obtain. This is solely because by offering greater productivity levels, the firm will be perceived to be ‘developing’ at an exponential rate, form which investors’ interests will be piqued. These firms will be viewed as firms with a greater growth potential due to the increasing efficiency that its workers are portraying. In totality, this will result in an increase in reputation for the firm in the market, especially by the influx of investors that will be hoping to obtain a part of this new ‘arising’ company. Having mentioned this, it is still important to note that the firms will not be considered to be solely in an advantageous position. This may be due to the probability that by obtaining the greater efficiency levels, the firms may have to incur potential short-terms costs that may be deemed to be excessive for the smaller firms in question in the market. (Armstrong & Guay, 2009) These costs will be in the form of additional training that the workers will be undertaking. For these smaller firms, with these additional short-term costs, their deficits may be a slight deterrent to short term investors, who may not find it viable to invest in such companies. Therefore, it can be seen that before any incentive based implementation is undertaken, the size of a firm, and its potential market influence, has to be taken into consideration as instead of garnering the potential benefits at present, these firms may in effect be ‘shortening’ its life span in the market. 4.Empirical methods pertaining to the measurement of conservatism Many theorists have attempted to ascertain the value that conservatism denotes. These attempts, starting off with Basu in 1997, have sparked a considerable interest in the area of conservative financial reporting. As such, many spin-offs of the traditional regression model have been developed, but for the purpose of this essay, only three will be highlighted; (i) market/book value ratio, (ii) accrual methodology, and (iii) the C-Score method. 4.1 Market/book value ratio method The market/book value ratio is a value that is depicted by obtaining the value of the equity per the book value of the company at the end of the financial year. The higher the level of the value that is obtained, the greater the level of conservatism surrounding the company for that particular period. (Basu, 1997) Though this measurement technique may be considered to be simplistic in its form, it has potential repercussions that may surround the firm in its development agenda for these conservative ways. Many theorists, though, have corroborated this measurement technique in the past few years and have accredited this concept to be of sound value. Despite garnering such positives from empiricists in the field of accounting, another major aspect of contemplating conservatism from this view is the fact that the firm’s growth potential and opportunity can also be plausibly ascertained. This is due to the fact that the more conservative in nature the firm is, the greater its growth potential. Theorists have succumbed to this conclusion based on their empirical data, which has been widely circulated around the field of accounting. However, critics of this methodology have claimed that, the increase in growth potential may be due to the temporary decrease (in the short run) in growth that the firms will potentially face. Thus, in actuality, thought conservative accounting may be deemed to generate a more positive outlook, it may have its drawbacks. Then again, these are theorems that have been articulated within the realm of accounting and may only hold true on paper, due to its simplistic nature. 4.2The Accrual Methodology The accrual method that is another measurement of conservatism is one where the non-operating accruals that have been dictated by the lagged assets are postulated, by multiplying their coefficient by the value of -1. The true nature of the firm’s conservatism is deemed to around the value of 1, with any value being taken to be greater than that, to be perceived as the firm following the more conservative financial reporting measures. (Givoly & Hayn, 2000) Pertaining to accruals, since they tend to reveres in future periods, the calculation and derivation of the values may be perceived to be rather problematic for analysts. Thus, since conservatism persistently leads to negative accruals, certain researchers have opted to generate and use the mean accruals as a substitute for conservatism (Ahmed et al. 2000). This particular method may pose certain limitation to the extent where the garnering and definition of certain accruals based on the time-based period are considered to be ambiguous, due the fact that the accruals tend to reverse in future periods. With no apparent standard baseline for researchers to adhere to, the development and structuring of differing values may pose a significant problem. 4.3 The C-Score Method The final method, that has been becoming increasingly popular amongst these researchers, is the C-Score method. This method, derived from the initial Basu model, mainly includes additional variables such as leverages and firm sizes, which were previously not included. Another main basis of this method, is the instance in which the timelines regarding the relation of the ‘good news and bad news’ to be relayed is taken into question. (Khan & Watts, 2009) The C-Score method can be deduced to be as below;
C-score Size=λ1+λ2 Sizei +λ3M /B +λ4Leverage
As it can be seen from the formula, the size of the firm and its leverages play a significant part with regards to the development of the C-Score. The higher the score, the higher the level of conservatism is deemed to be present within the firm. In addition to this, the analysts have posited the notion that this empirical research method may be considered one of the most efficient and ‘true’ natures of calculating the value of conservatism within a firm, since it takes into account the entire financial situation of the firm and do not pose that much of bias pertaining to any single situation. However, conversely, the main drawback that critics have petitioned regarding this method is the sole fact that this method is highly reliant on the stock prices, due to the fact that the relations of ‘good news and bad news’ plays such an integral role in the formula. Despite this fact, as a whole, this methodology has been accredited with much promise within the field of accounting as a great yardstick and baseline for future researchers to follow, so as to better understand the concept of conservatism, that is becoming increasingly prevalent in the field of accounting today.
In summary, these three main empirical methods have been widely used in accounting in the past few decades. Despite each posing its respective benefits, the consensus of the accountants is important in ascertaining a common baseline from which better comparisons will be viable, and for this matter, it can be said that the C-Score method would probably be the most suitable since it is the latest variation of the traditional Basu regression model.

5. Relationship between conservative financial reporting and information quality
In the field of accounting, the quality of information being present has been deemed to be a pivotal factor concerning the outcome of the firms’ goals; in particular this is seen to be important when assessing the firms’ influence in the market. When ascertaining a potential relationship between conservative financial reporting and information quality, it is imperative to note that no direct relationship exists between these two variables. Thus the only causal link that can be seen will be due to an additional variable that coexists with these two variables, and that is the earnings quality. Academics have stated that greater conservative financial reporting leads to an increase in earnings quality. (Brief, 2002) In the same vein, an increase in earnings quality is directly dependent on an increase in information quality. Therefore, it can be articulated that an increase in conservative financial reporting will result, or be resulted in certain cases, in an increase in information quality. Though these considerations are merely theorized in theory, its practical notions have yet to be ascertained, which proclaim its limitation on the matter.

6. Conclusion
In conclusion, it can be observed, through the various empirical methods posited above, the manners in which conservative financial reporting can be applied practically in the field of accounting. Though these applications themselves possess certain limitations, it is imperative to note that no such theorem exists, which no negatives offering a spillover effect into their market. For a firm to adhere to such policies, it is important to note the size of the firms and, furthermore, the leverages, in certain instances when applying the C-Score methodology that most theorists have accepted to be the most viable measure. All in all, conservative financial reporting has entered a new phase in the domain of accounting, with more new theorems to be on the rise in the near future, with this evolution taking precedence over its predecessors.

Bibliography * Ahmed, A.S., Morton, R.M. and T.F. Schaefer, 2000, Accounting Conservatism and the Valuation of Accounting Numbers: Evidence of the Feltham-Ohlson (1996) Model, Journal of Accounting, Auditing & Finance, Vol.15 (3), pp.271-292. * Ahmed, A.S., and S. Duellman, 2006, Accounting conservatism and board of director characteristics: An empiricalanalysis, Journal of Accounting and Economics Vol.43, Issues 2-3, July 2007, pp.411-437 * Akerlof , G.A., 1970, The market for “Lemons”: Quality Uncertainty and the Market Mechanism. The Quarterly Journal of Economics, Vol.84, No. 3 (1970), Oxford University Press. UK * Ball, R. and L. Shivakumar, 2005. Earnings Quality in U.K. Private Firms. Journal of Accounting and Economics. * Basu, S., 1997, The conservatism principle and the asymmetric timeliness of earnings. Journal of Accounting and Economics 24 (December). University of Rochester, New York. * Brief, R.P., 2002, Conservative Accounting and Earnings Quality (October 30, 2002). Working Paper * Bushman, R.M. and J.D. Piotroski, 2005, Financial Reporting Incentives for Conservative Accounting: The Influence of Legal and Political Institutions. Journal of Accounting and Economics, Vol.42, Issues 1-2, October 2006, pp.107-148 * Demski, S., 2004, Asymmetric Monitoring: Good versus Bad News Verification, chmalenbach, Business Review, Vol. 56, 2004 * Givoly D. and C. Hayn, 2000, Measuring Reporting Conservatism, Journal of Accounting and Economics, Vol.29 (3), pp.287-320. * Gordon, M.B and E. Bartov, 1996. Alternative Accounting Methods, Information Asymmetry and Liquidity: Theory and Evidence. The Accounting Review, Vol. 71, No. 3, 1996. * Guay, W. and R. Verrecchia, 2006. Discussion of an economic framework for conservative accounting and Bushman and Piotroski, Journal of Accounting and Economics. * Khan, M. & Watts, R.L. 2009. Estimation and empirical properties of a firm-year measure of accounting conservatism. Journal of Accounting and Economics. Vol. 48 * Watts, R., 2003a. Conservatism in accounting part i: Explanations and implications. Accounting Horizons. Vol.17 (3), 207-221. * Watts, R., 2003b, Conservatism in accounting part ii: Evidence and research opportunities. Accounting Horizons. Vol.17 (4). * Watts, R.L. and R. LaFond, 2006, The Information Role of Conservative Financial Statements. MIT Press, Cambridge. * Zhang, X.J., 1999, Conservative accounting and equity valuation, Journal of Accounting and Economics, Vol.29, Issue 1, February 2000, pp.125-149

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...From Sheet of Accounting Theory Difficulties in Segment Reporting * Base of Segmentation: in case of complex business, it’s difficult to select a base for organization as well as difficult to compare. * Allocation of Common Costs: Common costs are likely to be allocated, bringing segment information into question * Pricing Inter-segment Transaction: No specific method for inter-segment pricing, different method use for cost, cost plus market price and negotiable price. * Costs of Segment Disclosure: Increased competition may result segmental disclosures where profitable segment may attract competitors, & loss making segment arise the take over situation. Foreign companies are not required to provide segmental reports. * Management Conservatism: Management determination of segments implies that what is useful to management is useful to investors. FASB’s 5 possible objective for interim reporting: 1. To estimate annual earnings 2. To make projections 3. To identify turning points 4. To evaluate Management Performance 5. To supplement the annual Report. Problems in Interim Reporting * Accounting Problems: * Inventory Problems: There are three types of problems; * Determination of Inventory quantities * Valuation of inventories * Adjustment of valuation * Matching principle: Business operations are not similar throughout the year. Resources are acquired & output may be sold & there are......

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Positive Accounting Theory

...The Positive Theory of Accounting Outline In the text, Scott defines Positive accounting theory (PAT) as: “concerned with predicting such actions as the choices of accounting policies by firms and how firms will respond to proposed new accounting standards.” (263) PAT uses theory to predict the choices that management will make regarding their choice of accounting policies. This theory is introduced as a way to merge efficient securities markets with economic consequences. PAT takes the view that firms will conduct themselves in the way that maximizes their own best interests. Managers do not always do what is best for shareholders, but what will be the most beneficial to their organization. The choices that an organization makes are dependent on what industry they are in, and the factors within that industry An organization can be portrayed by the contracts it enters into. A firm’s contracts with employees, suppliers, lenders, and shareholders are central to its operations. The organization is inclined to keep these contract costs as low as possible. PAT emphasizes that an organization’s choice of accounting policies is motivated by keeping contract costs down. PAT does not propose that organizations completely identify what accounting policies they will use. Such specification is costly to commit to, and does not give management the opportunity to respond to unforeseen circumstances. Managers have flexibility to choose from a set of accounting policies,......

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Accounting Theory Is Useful

...usefulness of accounting theory is evident at various levels within the accounting profession and society in general including, standard setters, accounting professionals and users of accounting information. This essay will address two key areas, firstly, a personal reflection on this course and why studying theory is essential for practicing accountants. The second part is a critical evaluation of the conceptual framework and why it is an essential part of accounting literature. Areas evaluated include the purpose and benefits of a conceptual framework, a brief history of it in Australia, principle based versus rules based standards and some criticisms of it are discussed. Personal reflection I must admit, when scrolling through the list of courses I have left to complete my degree Accounting Theory did not jump out as one I was eager to enrol in. This is in no small part due to my lack of appreciation of how knowledge of the development of theory can give context and power to understanding changes. Whereas before I was more about practice and ‘getting it done’, it has become apparent that theory generally is an intrinsic element in advancing our understanding of our environment, culminating in improvements in practice. It is not a means of simply explaining or predicting behaviour, nor is it there only to serve as a framework for further inquiry (although these are important benefits of theory). Theory has a much more significant and elegant role to play in accounting......

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