Accounting Theory Essay
Accounting plays a fundamental role in controlling and directing an organisation. Accounting directs and controls organisations by encouraging appropriate decision making and by requiring disclosure about important areas of corporate governance1. Managers’ motivation to carry out financial disclosure is dependent on corporate governance and strategies. One measurement method for financial disclosures is the fair value accounting2. Fair value accounting can be termed as the method used to measure and estimate the potential market price of assets and liabilities. The use of fair value accounting has increased over the years reducing the use of traditional book keeping methods. Fair value accounting is said to make the accounting information and data more relevant3. However, there has been some concern about the reliability of this accounting system. This paper will discuss the viability of the statement: “If all financial statement preparers worldwide used fair value accounting as the only measurement method for financial disclosures then managers would have no incentive to manipulate accounting numbers or engage in earnings management.”
Fair value accounting system is immensely used today. Almost 100 countries across the world use fair value accounting extensively4. For instance, Accepted Accounting Principles in countries like the United States continue to utilize fair value concept. Fair value endeavours to capture the quality of a value in order to fulfil the standards of the conceptual framework. The fair value accounting system assumes that the transactions that are involved in selling an asset or transferring a liability occur in the principle market or in the absence of principle market5. Fair value accounting is used to measure financial disclosures. Measurement is the process by which monetary amounts are determined through calculations, estimation or apportionment. If different measurement systems are used in accounting calculation, no practical meaning can come out of the aggregate entailing cost, fair and value. However, fair value accounting is used to minimize this problem6. The conceptual framework does not necessarily establish the measurement bases to be used. Historic cost measurement accounting system is considered the dominant method. As mentioned earlier, historic cost system has been replaced by fair value accounting.
An example of accounting theory that predicts accounting practice to be used is agency theory. Agency theory is a framework that is used to evaluate the relationship between parties offering accounting information and parties using the accounting information7. According to the theory, the demand for voluntary disclosure is as a result of stewardship and decision-making purposes. As a result of the imbalances between information suppliers and information users, risk exists and may be misallocated between the involved parties. In an event where the market mechanism is not sufficient, accounting regulation may be necessary to reduce inequitable results8. Agency theory illustrate that accounting information may be utilized to unite the interests of information supplier and information user. Accounting information may reduce agency problem and therefore information disclosure is important. In order to unite the interests of parties, management earnings may be necessary.
Any accounting method used should offer incentive to managers to engage in earnings management. Earning management is important as it measures entity performance and is strongly connected to share value9. Earning management is the use of judgment and perception to alter financial reports in order to mislead stakeholders about the economic condition of an organisation or to influence the contractual results that rely on accounting numbers. Earning are managed in order to benefit the company by meeting shareholder needs and expectations and to meet the short-term goals that often result to maximize managerial salaries and remunerations10. Earnings management may be effective if used responsibly and thus full disclosure assist to regulate bad earnings management. Earnings can also be managed by manipulating accounting numbers to yield a growing profit stream and increase remuneration.
Fair value accounting differs significantly from historic cost accounting. For instance, the value of non-monetary assets is considered selling prices and changes occurring in these assets encompass unrealised gains11. In addition, changes in the power of money can potentially affect financial capital as well as profits. Fair value accounting is associated with a number of advantages. For instance, it offers useful information and thus market prices tend to be better predictor of financial risk. It also offers consistent information and selling price is said to be more relevant to decision making. However, critics argue that the concept of profit is not as meaningful and the actual performance of an entity may not be determined by fair value accounting12. In many organisations, different measurement bases are used together to different extents and in differing combinations. This results to mixed measurement model. Use of a mixed measurement model results to higher degree of flexibility and choice and this reduces additivity challenge. Therefore, utilization of fair value accounting as the only means of measurement for financial disclosure do not offer managers incentives to engage in earnings management13. One criterion for selecting a measurement approach involves management motivations and objectives.
Fair value accounting is said to reduce the incentive for managers to engage in earnings management. Fair value accounting has the ability to alleviate the utilization of the accounting-motivated transaction structures that assist in taking advantage of the opportunities for earnings management14. When historical cost accounting is used, in an event where the economy is down, managers can influence reported income by selling assets. However, this cannot be attained when fair value accounting is used since the underlying asset is conveyed at fair value while the result can be seen in the income statement. This tends to reduce the likelihood of income smoothing15. Overall, the use of fair value alone as a measurement bases reduces the likelihood of managing earnings because the amount as well as the timing of the unestablished gains and losses are not considered to be under management control. However, there may be some probabilities of management earnings under fair value by transferring assets between groupings16. For instance financial assets may be transferred from held-to-maturity to trading which will create some potential for management earnings. Nevertheless, a transfer from held-to-maturity is not in line with hold securities to maturity. As a result, some provisions tend to limit such possibility. Where market values are absent, there is possibility to manage unrealized gains and losses17.
In conclusion, fair value accounting is the method used to measure and estimate the potential market price of assets and liabilities. It is important for any accounting method used to offer incentive to managers to engage in earnings management. However, fair value accounting system alone limits the incentives of managers to manage earnings. When historical cost accounting is used, managers can influence reported income by selling assets. Generally, common accounting method alone is not enough to offer the benefits of accounting practices such as the ability to manage earnings. Therefore, companies should strive to introduce a mixed measurement model (historical cost and fair value) in order to yield benefits of a financial practice. Mixed measurement model results to higher degree of flexibility and choice.
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Danbolt, J., and W. Rees. “An Experiment in Fair Value Accounting: UK Investment Vehicles.” European Accounting Review, 17, no. 2 (2008):271-303.
Laux, C. and Leuz, C.The Crisis of Fair Value Accounting: Making Sense of the Recent Debate, The University of Chicago, Booth School of Business, Working Paper No. 33, (2009).
Ryan, S.G. Fair Value Accounting: Understanding the Issues Raised by the Credit Crunch, Council of Institutional Investors, White Paper, 2008.
Suda, K., and A. Shuto. Earnings management to meet earnings benchmarks: Evidence from Japan. Focus on Finance and Accounting Research. Nova Science Pub Inc. (2006).
Xie, B., W. Davidson III, and P. J. DaDalt. “Earnings management and corporate governance: the role of the board and the audit committee.” Journal of Corporate Finance, 9, no. 3 (2003): 295–316.
Zeff, S. A.. “Some obstacles to global financial reporting comparability and convergence at a high level of quality.” The British Accounting Review, 39, no. 4 (2007): 290-302.
Zeff, S. A. “Some obstacles to global financial reporting comparability and convergence at a high level of quality,” The British Accounting Review 39, no. 4 (2007):300.
Ryan, S.G. Fair Value Accounting: Understanding the Issues Raised by the Credit Crunch, Council of Institutional Investors, White Paper. 2008.
Danbolt, J., and W. Rees. “An Experiment in Fair Value Accounting: UK Investment Vehicles,” European Accounting Review 17, no. 2 (2008): 275.
Xie, B., W. Davidson III, and P. J. DaDalt. “Earnings management and corporate governance: the role of the board and the audit committee,” Journal of Corporate Finance 9, no. 3 (2003): 300.
Laux, C. and Leuz, C. The Crisis of Fair Value Accounting: Making Sense of the Recent Debate, The University of Chicago, Booth School of Business, Working Paper No. 33 (2009): 23.
Suda, K., and A. Shuto, Earnings management to meet earnings benchmarks: Evidence from Japan, Focus on Finance and Accounting Research, Nova Science Pub Inc. (2006): 75.
Burgstahler, D.C., L. Hail, and C. Leuz.. “The Importance of Reporting Incentives: Earnings Management in European Private and Public Firms,” The Accounting Review 81, no. 5 (2006): 1000.