Topic 1: Accounting Theories
Topic 1: Accounting Theories • •
Theory: a coherent group of propositions or principles forming a general framework of reference for a field of inquiry Accounting theories explain and predict accounting practice (positive theories) or prescribe particular practice (normative theories) o Positive accounting theory (PAT) o System-oriented theories
Positive Accounting Theory • • • • •
•
•
• • •
Tries to explain (or predict based on previous experience) existing accounting practices Does not necessarily deal with what should occur according to accounting standards and the Conceptual Framework Most large businesses in the USA have separation between management and providers of equity and debt financing In other countries, there is separation between inside shareholders and outside equity and debt holders o E.g. many companies in Asia are controlled by family groups, but also have many outside shareholders Assumptions: o All persons try to maximise their own self-interest o Rational behaviour, such that each individual is trying to maximise their own self-interest o Semi-efficient markets – markets are responsive to accounting choices and these choices can influence prices (e.g. stock prices) o Price protection – markets accurately adjust prices to reflect the actions of managers Conflicts of interest arise between insiders and outside equity holders: o Difference in risk aversion o Shirking o Insiders tunnel firm’s funds to themselves via: ▪ Non-arms length transactions – fraud ▪ Insiders consume excessive perquisites o Horizon problem – insiders have short term focus and outsiders have long term focus o Over-retention of profits Conflicts of interest arise between insiders and creditors because insiders try to maximise value of equity rather than value of firm (debt + equity). E.g.: o Excessive dividend payments – leads to reduced cash to service debt o Claim dilution o Asset substitution – taking high-risk projects do not benefit creditors because they do not benefit from upside gain (creditors receive a fixed payment), yet they may suffer from the downside risk (i.e. if the project fail, creditors may receive nothing) o Underinvestment Excessive management perquisites and shirking can also be considered agency costs of debt if they lead to debt default In perfect markets, these agency conflicts would be costlessly eradicated Imperfect markets leads to residual agency problems, because we have: o Positive transaction costs 1
Information asymmetry (insiders know more than outsiders about the firm, e.g. agents who manages the principals resources know more about the firm than the capital owners) From these residual agency problems we get: o Demand for accounting and auditing o Incentives to choose accounting policies systematically among firms o
•
• •
•
•
Residual agency problems include agency costs of equity and agency costs of debt. These costs are shared between insiders and outsiders because the outsiders cannot estimate them accurately Agency Costs of Equity results from a trade off between: o Decline in value of firm due to manager’s shirking and other conflicts with outsiders; and o Monitoring and bonding costs incurred to reduce the manager’s shirking, etc. behaviour Agency Costs of Debt results from a trade off between: o Decline in value of debt due to manager’s attempts to shift wealth from debt-holders to equity-holders; and o Monitoring and bonding costs incurred to reduce that behaviour Thus, agency costs = costs of monitoring and bonding + residual loss due to manager’s adverse actions against capitalholders that monitoring and bonding cannot stop because the cost to do so is too great
Agency Costs of Equity – Monitoring and Bonding Mechanism • • • • • • •
Financial reporting Management compensation (bonus plans) Auditing (external and internal) Corporate governance – e.g. audit committees, independent directors, etc. Market for corporate control (takeovers) Managerial labour market Product markets
Agency Costs of Debt: Monitoring and Bonding Mechanism • • • •
Restrictive covenants on borrowing – e.g. borrowing firm may have to maintain debt/asset, coverage or debt/equity ratio, whereby violation leads to repayment in full Monitoring (via general and specific financial reports) Debt-holders have members on board of directors and remuneration committee Dividend restriction
Quasi Contracting Costs and Political Costs •
Refers to the possibility that the firm will have wealth transferred from it by governments or actions of special interest groups, e.g.: o Loss of special concessions o Increased taxes (mining super profits tax; carbon tax) o Government investigations (ASIC, ACCC) o Adverse publicity in the media
Role of Accounting in Monitoring and Bonding •
Contracts often contain accounting hurdles 2
Bridgeman Ltd signs a contract on 1 July 2014 to build a bridge for a customer at an
(a) Recognition of costs incurred on the bridge construction project: DR
agreed contract price of $20 million. At the date of signing the contract the estimated construction costs are:
Construction in progress 4,000,000 Cash/Trade Payables 4,000,000
CR
(b) Recognition of billing to customers: DR Accounts receivable 3,000,000 CR Construction in progress 3,000,000 (c) Receipt of cash from customer
Construction costs are the costs directly
DR
attributable to the construction, e.g. direct material, direct labour, manufacturing overhead.
Cash Accounts receivable
CR
2,000,000 2,000,000
(d) Recognition of revenue and expenses on the construction based on 25% * completion
All other attributable costs in general, e.g. insurance, design, standard preparation (admin costs) and R&D are not part of the contract costs
* ($4m actual costs incurred / $16m total expected costs) = 25% DR
Construction in progress 1,000,000
DR CR
Bridgeman Ltd incurs actual costs to build the bridge of $4 million by the end of 1st year but still expects that the total costs of construction will amount to $16 million. Bridgeman has invoiced the customer $3 million during the first year but has only
Construction Expense Construction Revenue
4,000,000 5,000,000
(gross profit increases construction in progress) (16m x 25%) (20m x 25%)
Do we have to recognise a contract liability? Look at the amount that we charged the customer by comparing AR with the Construction in progress. If AR > Construction in progress the company charged the customer more than what they have completed. Here, the constructor must recognise a contract liability:
received cash from the customer
DR Contract Asset CR Contract liability
amounting to $2 million by June 2015. Required: Provide journal entries for the
AR = $3,000,000 – $2,000,000 = $1,000,000
financial year 2015, assuming the above
Construction in progress = 4,000,000 – 3,000,000 + 1,000,000 = $2,000,000
cost estimates are reliable.
AR < Construction in progress (contractor didn’t overcharge the customer) there is no contract liability
Bridgeman Ltd incurs actual cost of $8m for
The percentage of completion of the contract at 30 June 2016 is calculated as
the second year of the project (the year to
follows:
30 June 2016). At the end of the
2nd
year
% Complete =
the management of Bridgeman expects
Actual costs so far $4m + $8m = = 57% Total expected costs $21m
that the total construction costs for the bridge will amount to $21 million instead of the initial assessment of $16m.
Gross Profit recognised in: •
1st year: Gross profit of
•
2nd
(20m − 16m) × 25% = 1,000,000
year: Expected loss
$ (1,000,000)
of $21m LESS
Required: Provide journal entries for the 2nd
contract price of
year (Hint: This means $1m loss is now expected from the construction of the bridge instead of the initial assessment of $4m profit)
(expected cost
$20m) Less Profit already recognised Loss recognised in
2nd
year
1,000,000 $ (2,000,000)
Construction expenses recognised in the 2nd year: (21m × 57%) − (16m × 25%) = 8m 3
(57% is an accumulative figure, so you need to deduct the expense in the first year) Construction Revenue = $6m (Loss = $2m, Construction Expenses = 8m, revenue = $6m) OR, calculate the entry in the CIP first, the ‘construction expenses’ account becomes the balancing item:
The Bridgeman Ltd journal entry to record the contract revenue and contract expenses for the year to 30 June 2016 is as follows: DR
Construction Expenses
8,000,000
CR
Construction Revenue
6,000,000
CR
Construction in progress
2,000,000
Alternatively, you can make the following journal entries to record the construction revenue and expenses for the year ended 30 June 2016 (same as textbook) 1.
DR
Construction expenses CR
1,000,000
Provision for Loss on construction contract 1,000,000
(A liability on an ‘onerous contract’ is recognised because the cost of settling the performance obligation ($21m) is expected to exceed the amount of the transaction price allocated to that performance obligation ($20m)) 2.
DR
Construction expenses CR
1,000,000
Construction in progress (contract asset)
1,000,000
(Reverse the profit recognised in 2015) 3.
DR
Construction Expenses CR
Construction Revenue
6,000,000 6,000,000
(Recognition of revenues for 2015 and recognition of expenses for the same amount, $6m is obtained as shown above)
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Theory: a coherent group of propositions or principles forming a general framework of reference for a field of inquiry Accounting theories explain and predict accounting practice (positive theories) or prescribe particular practice (normative theories) o Positive accounting theory (PAT) o System-oriented theories
Positive Accounting Theory • • • • •
•
•
• • •
Tries to explain (or predict based on previous experience) existing accounting practices Does not necessarily deal with what should occur according to accounting standards and the Conceptual Framework Most large businesses in the USA have separation between management and providers of equity and debt financing In other countries, there is separation between inside shareholders and outside equity and debt holders o E.g. many companies in Asia are controlled by family groups, but also have many outside shareholders Assumptions: o All persons try to maximise their own self-interest o Rational behaviour, such that each individual is trying to maximise their own self-interest o Semi-efficient markets – markets are responsive to accounting choices and these choices can influence prices (e.g. stock prices) o Price protection – markets accurately adjust prices to reflect the actions of managers Conflicts of interest arise between insiders and outside equity holders: o Difference in risk aversion o Shirking o Insiders tunnel firm’s funds to themselves via: ▪ Non-arms length transactions – fraud ▪ Insiders consume excessive perquisites o Horizon problem – insiders have short term focus and outsiders have long term focus o Over-retention of profits Conflicts of interest arise between insiders and creditors because insiders try to maximise value of equity rather than value of firm (debt + equity). E.g.: o Excessive dividend payments – leads to reduced cash to service debt o Claim dilution o Asset substitution – taking high-risk projects do not benefit creditors because they do not benefit from upside gain (creditors receive a fixed payment), yet they may suffer from the downside risk (i.e. if the project fail, creditors may receive nothing) o Underinvestment Excessive management perquisites and shirking can also be considered agency costs of debt if they lead to debt default In perfect markets, these agency conflicts would be costlessly eradicated Imperfect markets leads to residual agency problems, because we have: o Positive transaction costs 1
Information asymmetry (insiders know more than outsiders about the firm, e.g. agents who manages the principals resources know more about the firm than the capital owners) From these residual agency problems we get: o Demand for accounting and auditing o Incentives to choose accounting policies systematically among firms o
•
• •
•
•
Residual agency problems include agency costs of equity and agency costs of debt. These costs are shared between insiders and outsiders because the outsiders cannot estimate them accurately Agency Costs of Equity results from a trade off between: o Decline in value of firm due to manager’s shirking and other conflicts with outsiders; and o Monitoring and bonding costs incurred to reduce the manager’s shirking, etc. behaviour Agency Costs of Debt results from a trade off between: o Decline in value of debt due to manager’s attempts to shift wealth from debt-holders to equity-holders; and o Monitoring and bonding costs incurred to reduce that behaviour Thus, agency costs = costs of monitoring and bonding + residual loss due to manager’s adverse actions against capitalholders that monitoring and bonding cannot stop because the cost to do so is too great
Agency Costs of Equity – Monitoring and Bonding Mechanism • • • • • • •
Financial reporting Management compensation (bonus plans) Auditing (external and internal) Corporate governance – e.g. audit committees, independent directors, etc. Market for corporate control (takeovers) Managerial labour market Product markets
Agency Costs of Debt: Monitoring and Bonding Mechanism • • • •
Restrictive covenants on borrowing – e.g. borrowing firm may have to maintain debt/asset, coverage or debt/equity ratio, whereby violation leads to repayment in full Monitoring (via general and specific financial reports) Debt-holders have members on board of directors and remuneration committee Dividend restriction
Quasi Contracting Costs and Political Costs •
Refers to the possibility that the firm will have wealth transferred from it by governments or actions of special interest groups, e.g.: o Loss of special concessions o Increased taxes (mining super profits tax; carbon tax) o Government investigations (ASIC, ACCC) o Adverse publicity in the media
Role of Accounting in Monitoring and Bonding •
Contracts often contain accounting hurdles 2
Bridgeman Ltd signs a contract on 1 July 2014 to build a bridge for a customer at an
(a) Recognition of costs incurred on the bridge construction project: DR
agreed contract price of $20 million. At the date of signing the contract the estimated construction costs are:
Construction in progress 4,000,000 Cash/Trade Payables 4,000,000
CR
(b) Recognition of billing to customers: DR Accounts receivable 3,000,000 CR Construction in progress 3,000,000 (c) Receipt of cash from customer
Construction costs are the costs directly
DR
attributable to the construction, e.g. direct material, direct labour, manufacturing overhead.
Cash Accounts receivable
CR
2,000,000 2,000,000
(d) Recognition of revenue and expenses on the construction based on 25% * completion
All other attributable costs in general, e.g. insurance, design, standard preparation (admin costs) and R&D are not part of the contract costs
* ($4m actual costs incurred / $16m total expected costs) = 25% DR
Construction in progress 1,000,000
DR CR
Bridgeman Ltd incurs actual costs to build the bridge of $4 million by the end of 1st year but still expects that the total costs of construction will amount to $16 million. Bridgeman has invoiced the customer $3 million during the first year but has only
Construction Expense Construction Revenue
4,000,000 5,000,000
(gross profit increases construction in progress) (16m x 25%) (20m x 25%)
Do we have to recognise a contract liability? Look at the amount that we charged the customer by comparing AR with the Construction in progress. If AR > Construction in progress the company charged the customer more than what they have completed. Here, the constructor must recognise a contract liability:
received cash from the customer
DR Contract Asset CR Contract liability
amounting to $2 million by June 2015. Required: Provide journal entries for the
AR = $3,000,000 – $2,000,000 = $1,000,000
financial year 2015, assuming the above
Construction in progress = 4,000,000 – 3,000,000 + 1,000,000 = $2,000,000
cost estimates are reliable.
AR < Construction in progress (contractor didn’t overcharge the customer) there is no contract liability
Bridgeman Ltd incurs actual cost of $8m for
The percentage of completion of the contract at 30 June 2016 is calculated as
the second year of the project (the year to
follows:
30 June 2016). At the end of the
2nd
year
% Complete =
the management of Bridgeman expects
Actual costs so far $4m + $8m = = 57% Total expected costs $21m
that the total construction costs for the bridge will amount to $21 million instead of the initial assessment of $16m.
Gross Profit recognised in: •
1st year: Gross profit of
•
2nd
(20m − 16m) × 25% = 1,000,000
year: Expected loss
$ (1,000,000)
of $21m LESS
Required: Provide journal entries for the 2nd
contract price of
year (Hint: This means $1m loss is now expected from the construction of the bridge instead of the initial assessment of $4m profit)
(expected cost
$20m) Less Profit already recognised Loss recognised in
2nd
year
1,000,000 $ (2,000,000)
Construction expenses recognised in the 2nd year: (21m × 57%) − (16m × 25%) = 8m 3
(57% is an accumulative figure, so you need to deduct the expense in the first year) Construction Revenue = $6m (Loss = $2m, Construction Expenses = 8m, revenue = $6m) OR, calculate the entry in the CIP first, the ‘construction expenses’ account becomes the balancing item:
The Bridgeman Ltd journal entry to record the contract revenue and contract expenses for the year to 30 June 2016 is as follows: DR
Construction Expenses
8,000,000
CR
Construction Revenue
6,000,000
CR
Construction in progress
2,000,000
Alternatively, you can make the following journal entries to record the construction revenue and expenses for the year ended 30 June 2016 (same as textbook) 1.
DR
Construction expenses CR
1,000,000
Provision for Loss on construction contract 1,000,000
(A liability on an ‘onerous contract’ is recognised because the cost of settling the performance obligation ($21m) is expected to exceed the amount of the transaction price allocated to that performance obligation ($20m)) 2.
DR
Construction expenses CR
1,000,000
Construction in progress (contract asset)
1,000,000
(Reverse the profit recognised in 2015) 3.
DR
Construction Expenses CR
Construction Revenue
6,000,000 6,000,000
(Recognition of revenues for 2015 and recognition of expenses for the same amount, $6m is obtained as shown above)
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