Accounting Theory & Practice Final - Weeks 1-5

Role of Accounting Information in Contracts

(1) - Owner (principal) delegates the job to a manger (agent) to do the job on his/her behalf, both are utility maximizers - Agent is more informed (information asymmetry) - Agency problem arises if agent's interest contradicts with principal's interest (ex: chooses an accounting method that fits his/her benefit - agency costs) - Principal tries to extract more information and also wants the agent to put more efforts to the business - To achieve his objectives (to maximize), the principal needs to devise a contract such as a numeration package, an audit, monitoring contract, etc. - Only an 'optimum' contract leads to maximum utility for both parties (principal cannot exploit its employee, whilst the agent provides more truthful and voluntary information, and cares the firms as if his/her own since his/her utility is maximized too) - PAT theorist argue that regulation that force firms to use particular method and their auditing imposes unwarranted costs (2) - Similar to market based theories information is costly whilst supply is voluntary - Investors price information into the amounts they are prepared to pay the manager to obtain the useful information - If information demand by investors is not satisfied, markets may collapse (lemon problem, 'no information' is deemed bad news causing the trade to stop) - without information, good and bad firms are under/over priced; the good managers hence choose signaling (signaling entails costs; only good firm can consistently bear such cost; ex: dividends) - No government mandate needed for information supply because F/S are voluntary and used for signalling - Evidence: market-based renumeration schemes encourage managers to disclosure more information, therefore more and more contracts are tied to stock market performance (markets reflect all information including firm fundamentals; indeed research shows that stock returns show high correlation with firm-specific characteristics)

EM: Incentives for Opportunistic Behavior

(1) Managers like bonuses: An incentive for high earnings and high stock prices; big bath to income smoothing (2) Managers do not like volatility in earnings or share price (3) Managers do not want to violate debt covenants - Covenant Slack: a measure of the level of a firm's proximity to debt covenant violation; greater the slack, lower likelihood a borrower would violate a covenant (4) Managers prefer small profits to small losses (5) Managers do not want to miss analyst forecasts

(1) EM: Most Common Methods: Manipulating Revenues

(1) Manipulating Revenues: - Bristol-Myers Squib (MBS) sold over $1 billion worth excess inventory to wholesalers during 1999-2001, "Channel Stuffing" - to meet ambitions growth targets - to meet analyst expectations - Settled with SEC in US with fine $150 million

(2) EM: Most Common Methods: Boosting income with one-off gains

(Real earnings management) - Selling assets that are undervalued in B/S, such as shares of other companies, and recording a capital - Repurchasing debt whose market value is below book value - Spending less (or none) research and development (R&D) expenditures

Alternative Accounting Theories: Legitimacy Theory

- A firm's value system is congruent with that of society, but it aims to change/manipulate society's perceptions to conform its practices - Financial reports help achieve this objective

(3) EM: Most Common Methods: Shifting current expenditures to the future

- AOL capitalized marketing costs over three years 1993-1995 - In 1996, this asset stood at $314m, representing 33% of total assets and 61% equity - Had these costs been properly expensed as incurred, 1996 reported pre-tax income of $62m would have been a loss $175m

Accruals Ratio as measure of Earnings Quality

- Accruals are non cash component of earnings (other than cash, every line item in balance sheet is result of subjective choices surrounding recognition and valuation rules) - 'Accruals Ratio' is highly used ratio to measure earnings quality (not unique measure, but indication) - Calcuate with two methods: (1) Balance Sheet based Accruals Ratio (2) Cash lows based Accruals Ratio

(2) Accruals Ratios for EQ: Cash Flow Based AR

- Aggregate Accruals CF = NI - (CFO + CFI) -Accruals ratio CF = Agg Accr / [(NOA(t) +NOA(t-1))/2] - NI is net income, CFO cash flow from operations, CFI cash flow from investing

Accounting Regulation

- Before regulation, accountants used to practice what they deemed proper (different practices), and the view of 'invisible hand' was prevalent - 1933: Great Depression, SEC in US required mandatory disclosure for public firms - 1970: UK Accounting Standards (Steering) Committee, 1973: US FASB established, and standards followed

Capitalising vs Expensing

- Capitalising: to recognize the expenditure as an asset in B/S - Expensing: to recognize an expenditure it in the income statement - The accounting choices related to long-lived assets affect the timing of expense recognition, which in turn affects profitability trends. the choices may impact cash flows through taxes - Capitalising leads to higher profitability ratios (ROE and net PM) in the first year, and lower profitability ratios in subsequent years

Tax carry forward and carry back

- Company has loss for tax purposes (if company is liable for Corporation Tax and makes loss from trading), firm can elect to do one of two things TAX CARRY FORWARD - Set off the tax-loss against profits in future years (US: set off next 20 years, UK no time limit) TAX CARRY BACK - Set off tax loss against profits in prior years (US companies: 2 years back, UK: 1 year back)

Mainstream Approaches: Behavioral research and decision making

- Considered as positive research, seeks to explain behavior of individual and how they react to information - Different accounting methods influence decisions of users; they can be misled (because individuals tend to make mistakes and leads to market inefficiency) - individuals employ simplifying heuristics (judgmental shortcuts) when making decisions - representativeness, anchoring and adjustment, availability - Increasing amount of information will improve quality of decisions

TBL: Regulatory Developments

- Corporate social responsibility (CSR) index, UK - Environmental Protection Agency (EPA), US - Global Reporting Initiative (GRI), 1997 - International standards for CSR, IAASB, 2005 - The Transparency in Supply Chains Act, US 2010 - The Global Warming Solutions Act, US 2012 - USGAAP, IAS37: environmental disposal obligations

Earnings Management

- EM is mainly, but not always opportunistic (may be informative and efficient) - Accounting numbers, if properly measured / reported, should capture the underlying business reality - But, accounting numbers can be manipulated/distorted - Need to take into account incentives that are present for (opportunistic) earnings management

Mainstream Accounting Theories: Market Based Theories

- Economic reality is objective, unique, measurable - Markets reflect economic reality (share price is a proxy for 'true value' reflecting the consensus of all investors) - Alternative accounting methods can exist; there is no need for unique accounting method (allows discretion so manager can use information as signal) - Accounting information useful only if it helps market make better economic decisions - Investors take part in trading rationally, and make investment decisions to maximize utility - Aims less regulation: reliance on 'invisible hand' (regulation allows some discretion in accounting practice - firm value will be set by market)

Mainstream Accounting Theory: Normative (classical)

- Economic reality is objective, unique, measurable - Reflected by applying appropriate accounting method - Unique way to prepare financial statements capturing 'true' and 'fair' picture of an entity - Guides accounting regulation (IFRS, USGAAP): roles of standards, frameworks, or regulation is to provide guidance on what should be reported and how - Example: Stewardship, decision usefulness - Seeks to correct practice, and aims to ensure consistent use of it (regulation is in the form of standards, laws- penalties for infringement)

Mainstream Approaches: Positive Accounting Theory (PAT)

- Economic reality is unique, objective, measurable - cannot be defined by unique accounting methods or by markets - Economic reality determined by written / unwritten contracts between parties - Contracting parties seek profit maximization (agency theory view) and market is informationally efficient - Financial reports seen as form of contract, and are used to design contracts (salary package, loan agreement) - Self interest is the reason of accounting method choice (managers may overstate earnings and understate expenses if they perceive benefit from doing so) - (Santions)/Rewards for providing (un)/truthful information (regulation exists to prevent agents abusing contracts with principals) - with financial information we can devise a unique (optimum) contract that can capture economic reality, which is utility maximization of contracting parties

Why in a stock market... Firm announces earnings(loss) but price goes down(up)?

- Expected earnings are higher than reported earnings - Expected loss is higher than reported loss - Prices are formed by future expectations and hence they move by earnings surprises (actual - expected earnings) - Value Change = actual value - expected value - Pt = E [NIt+1]/r for firm value growth

Environmental aspect of Financial Reporting

- Firms should be more careful about the environment in which they operate - Earth's sources are definite - We consume non-renewable sources quicker than we produce new products to substitute them - We consume renewable sources quicker than we renew them

Social Aspect of Financial Reporting

- Firms should be responsible to wider society (perspective of stakeholder Theory - Freeman, 1984) - Financial reports favor some, lead to biased reporting

Deferred Taxes

- For temporary differences - Accounting profit calculated under IFRS/GAAP aims to reflect underlying economic reality - Taxable profit is calculated using tax rules / tax law - Difference between tax expense (accounting profit) and tax payable (taxable profit, owed to gov) - Deferred tax: asset or liability based on matching principle - Deferred tax asset: carrying amount < tax base - Deferred tax liability: tax base < carrying amount METHODS: - Deferral method: tax rate based on timing difference - Liability: tax rate when tax becomes payable; used when tax rates change in future

PAT and EMH

- Genesis of PAT is EMH - EMH: based on assumption that capital markets react in an efficient and unbiased manner to publicly available information - Capital market uses different data sources, if managers make less truthful disclosure then the market will question the integrity of managers (long run, manager cannot manipulate share price by changing accounting methods in opportunistic manner)

Accounting Harmonisation (international Reporting); Factors affecting

- Globalization of markets has created a need for development of accounting standards based on single worldwide set of financial reporting - 1973: International Accounting Steering Committee (IASC) - 1975: 59 standards (38 in use) issued with am to develop global standards - IFRS: mandatory over 140 countries; US applies own standards but convergence efforts FACTORS AFFECTING: - Business environment - Economic development - Laws and legal system - Cultures, level of education, religion - Development of accounting profession - Political environment, purpose of report (tax)

Alternative Accounting Theories: Types

- Grounded on Political Economy theory (works of Marx = class interests/struggle, structural conflict, inequality) - Accounting reports and disclosures are a means of maintaining the favored position of those who control scarce (economic) resources - Legitamcy Theory - Stakeholder Theory - Institutional Theory

Conceptual Framework (Under IFRS)

- If standard setters claim that unique standards can capture economic reality of a firm, then accounting information should exhibit some qualities fro defined users (shareholder, debt holders) - Conceptual framework: defines those qualities, users, sets objectives of financial report, and standards, and provides main definitions (such as asset, liability, gain, cost, expense) - We focus on IFRS conceptual framework, but the US GAAP is very similar

(4) EM: Most Common Methods: Presenting Assets Above Market Value

- Keeping inventory at cost when net realized value (NRV) is lower - Reluctant to impair assets (doubtful receivables) - Capitalising expenses rather than recording expense - Reclassifying assets and financial liabilites

(1) PAT Hypothesis: Bonus Plan

- Managers of firms with bonus plans are more likely to choose accounting procedures that shift reported earnings from future periods to current period, I.e. manage earnings upwards - Assuming markets are not fooled, renumeration packages can be tied to share price performance rather than accounting numbers - If manager adds value to firm, share price increases: manager gets bonus - If manager manipulates: price goes down, manager gets nothing, even fired; manager gives up manipulating earnings in long run

(5) EM: Most Common Methods: Failing to record liabilities

- Manipulating actuarial assumptions to reduce the pension liability - Use of operating leases (instead of finance lease) - Devising schemes to keep liabilities off balance sheet - Using special purpose entities (SPEs) like Enron

Agency costs

- Monitoring Costs: cost of monitoring agent's behavior (auditing) - Bonding costs: cost involved in agents bonding their behavior to expectations of principals (preparing F/S) - Residual loss: (I) Agent's imperfect decisions, (ii) too costly to remove all opportunistic behavior

Accounting Standards vs Tax Rules

- Not identical because objectives of standard-setters and taxmen differ - Standard setter: financial statements reflect underlying economics of a business and allow managerial discretion (manager may see straight line depreciation best for business, government imposes another method) - Tax rules: product of political and social objectives - Difference either permanent (affects accounting profit permanently) or temporary (reverses in time, treatment different)

PAT Criticism

- Not improving accounting practices - Not possible to write complete contracts - Does not incorporate notions of loyalty or morality, individual actions is driven by self-interest - Auditing cannot completely restrict opportunism

Accounting Standards

- Origin found in Anglo-Saxon accounting practices: accounting has been evolved in socio-economic environment that focuses on free movements of goods and capital - Main purpose: to facilitate efficient working of the capital markets by providing faithful (stewardship) and relevant (decision useful) information - UK Standards are principle based allowing discretion, while US are more rules based but both allow some discretion over which method can be used (inventory, depreciation, etc)

Positive Accounting vs Normative Theory

- PAT: predicts which firms/manager will and which will not use a particular method, but says nothing as to which method a firm should use - Normative: prescribes how a particular practice ought to be (prescriptions might depart from existing practice) - PAT: focuses on relationships between individuals and how accounting is used to assist in the function of these relationships (contracts) - Normative: focuses on accounting information (qualitative characteristics)

Behavioral research: Pareto Efficiency (PE)

- PE: state of allocation of (economic) resources, in which reallocation is impossible to make an individual better off without making at least another individual worse off (it is used in economic efficiency and income distribution studies) - auction theory, game theoretical models) - In an economy with 'I' individuals, 'c' commodities, and 'x' C-dimential allocations, an individual's Pareto efficient 'u' (utility) allocation is: Maxu(x), subject to: U(x)> uj - An allocation mechanism is behaviorally efficient in a particular context if it yields behaviorally efficient outcomes (ex: mutual benefits of stock trading to buying and selling parties are maximum) - Upon reaching Pareto-efficient allocation, there can be no remaining mutually beneficial transactions to exploit - Aftermarkets experiments help us measure how far short of allocative efficiency outcomes fall

Market Based Theory: Efficient Market Hypothesis (EMH)

- Prices rapidly incorporate/reflect all relevant information - Weak form: prices reflect past information - Semi Strong form: prices reflect all publicly available information - Strong form: prices reflect all private and public information - If accounting information does not impact share price, it is deemed not to have any information value

Behavioral research: Problems

- Research on similar issues show conflicting results (tests cannot be replicated, even in the replicated tests, the same person can exhibit different behavior) - Tests are mainly conducted under laboratory conditions (but reality differs in real world) - Field experiments cannot be generalized (ex: card payment behavior of Yorkshire farmers, mortgage payment behavior of single mothers in London) - 90% of field experiments have been single-subject studies, examining risk aversion, time preference, likelihood of loan repayment, willingness to trust, other aspects of individual consumer/investor behavior - Tests are more like decision theory experiments: few involve anything approaching market situations or any issues of allocation or even interactive behavior (ex: game theoretic behavior) - Individual actions may not lead to most efficient results (according to judgement), but this does not mean that individuals act irrationally - Rationality simply means that individuals act for their best interest according to their best knowledge, with lack of information, action may seem irrational to us - Even though behavioral research provides incomplete and conflicting results, it greatly helps us explore how to unravel: (1) the (unobserved) motivations of individuals (2) their preferences (3) their constraints, limits (4) their possible actions against events

Normative Theories: Stewardship and Decision Usefulness

- Stewardship: the role of management in a firm is the stewardship (entirely acting in the interest) of the resources of the owners - Decision Usefulness: financial reports should provide support to efficient resource allocation decisions, I.e., the accounting information should be relevant, which has predictive value, confirmatory value and is material

Tax

- Tax: compulsory contribution to state revenues; every person and legal entity not exempted from the tax has to pay from their earnings/income - Tax levied on employees are withheld by employers and paid to the state on employers' behalf - UK Tax rates for individuals: 0% to 45% depending on individual earnings

(2) PAT Hypothesis: Debt Hypothesis

- The closer a firm is to violation of accounting-based debt covenants, the more likely the firm manager is to select accounting procedures that shift reported earnings from future periods to the current period, I.e., manage earnings upwards - Any violation of debt covenants may lead to technical default (via covenants, firms are forced to pay less dividends, not to take on high levels of debt, or not to invest in some projects - To attract debt holders, or debt at lower cost, managers may adopt conservative accounting methods

(3) PAT Hypothesis: Political cost hypothesis

- The greater the political costs faced by a firm, the more likely the manager is to choose accounting procedures that defer reported earnings from current to future periods, I.e. manage earnings downward - A large firm with large profits increases the possibility that people may think the firm is exploiting public - "size" is a proxy variable for political attention - reduced profits are said to lower political scrutiny (e.g., consider banks - what happens when they announce high profits, or a large firm pays less tax)

(1) Accruals Ratios for EQ: Balance Sheet based AR

- Total Accruals (TACC) = NOA(t) - NOA(t-1) or change in NOA - Net Operating Assets (NOA) = [(Total assets - Cash) - (Total Liabilities - Total Debt)] - Cash = Cash + Cash equivalents + ST Investments - Accruals Ratio = TACC/[(NOA(t) +NOA(t-1))/2] - Higher the ratio, lower earnings quality

Behavioral inefficiencies in decision making

-Investors may not always form efficient portfolios - Investors may use past performance as an indicator of future performance in stock purchase decisions, and are influenced by historical high/low trading stock - Individual investors exhibit loss-averse behavior (ex: losses are twice as powerful) - Some investors may trade too aggressively - Investors may behave parallel to each other (herding) - Solution: provide more information and training

Accounting Theories: can be based on

1. Scientific/physical laws (gravity theory), which are particular phenomena always occurs if certain conditions are present 2. Social Phenomena (such as institutional theory)

Fair Value Accounting

AKA Mark to Market - Market value of an asset if active or liquid market - With no active market: use accepted valuation model or exit value (price that would be received to sell an asset or paid to transfer a liability) - research finds support for decision usefulness - Problems: risk of considerable volatility, market value may be overstated / understated, pro-cyclicality

Accrual

Accounting transactions recorded when they occur. Helps measure firm's performance

Statement of Financial Position (B/S)

Assets, Liabilities, Equity - Cost

Historical Cost Accounting

Assets/liabilities measured and reported at their acquisition values assuming money holds a constant purchasing power - In reality, there are changes in consumers' preferences, technology, general price level (inflation), fluctuations in exchange rates, etc.; overstate profit in times of rising prices, with distribution of profits leading to erosions in operating capacity WHY IS IT USED? (1)Relevant for decision making: owners are concerned about managers have done with funds entrusted to them, 'net income' rather than 'net worth' of a firm is a more relevant measure for management's success - income = ending equity - beginning equity (2)Historical Cost is less subjective to manipulation, based on acquisition value, objectively verifiable

Example of behavior in credit lending

Bank bank managers (or loan officers, relationship managers) are given targets to sell loans, mortgages, credit cards, etc., to businesses/people in their neighborhood - Market efforts intensify before quarter and year ends (during which many crucial errors are observed) - In times, branch managers have to report their everyday activities to marketing units in the headquarters (online reports, e-mails or calls) - They are under pressure to meet targets - Bank managers go out and find clients to sell loans, make visits to businesses, get acquainted with them, but they are not experts in analyzing firms or people's financial situation - After having lunch, exchanging visits, etc., with the clients they start feeling obliged to grant them loans or start thinking that their clients are financially robust to pay back loans - in reality many customers are either not able to pay back the required amounts or not creditworthy or may overestimate their needs, their pay back capabilities, etc. - Inefficiencies: businesses/people go bankrupt (payment schedule is not suitable), managers/loan officers loose their job (default rates high) - Solution:s (1) set branch limits for each loan the; give managers less authority to lend, and make experts investigate the cases above some limits (2) train branch managers, loan officers, etc (3) write robust credit policies (everyone knows what condition they use heir authority) (4) use software to prevent abuse (don't allow approval if a loan amount is over the defined limit, or (5) use software producing robust credit scores and rating

Critical Accounting Theory: Criticism

Critical theorists propose dialogue between parties, aim to eradicate ignorance and call for change to social structures (these are positive calls), but often fail to offer viable methods about - How / what we should submit as financial report? - Whom we should approach for financing? - How we should train an accountant / manager? - How much tax a corporation should pay? - When a person/firm earn more than others?

Deferred Tax Asset/Liability

DTA: Book Tax < Tax Payable DTL: Book Tax > Tax Payable

Accounting System: Managerial

Detailed plans and continuous performance reports - Internal Decision Makers (managers throughout the organization)

Accounting Theories: Alternative Approaches

Economic Reality is subjective, and socially constructed (analysts accountants/investors are subjective constructors of firm value) - Research is Interpretive, Critical, Social Constructivist - There is no such thing as objective firm value; it is: - dependent on beliefs, experiences, etc. (then, inform society, interpret, understand and explain it) - socially imposed by elites on their benefit (then, alert society, criticism and explain) - misleading (then, reconstruct the reality, unearth the hidden meanings, and redesign it)

Double Entry Bookkeeping

Every financial transaction has equal and opposite effects in two different acocunts

Accounting regulation: arguments for and against

FOR: - Development of normative accounting theories (accounting information reflects economic reality, unique accounting practice should be sought) - Market for information is imperfect; managers tend to manipulate accounting numbers, hence investors need protection from fraudulent/misleading information - Practices should be made uniform and comparable - Firms should be controlled to prevent exploitation AGAINST: - Regulation involves politics, imposes additional costs (ex. audit), causes oversupply of information-knowing they do not pay, public overstates information need - Standardizing accounting methods does not address different organizational characteristics and cannot keep pace with changing business, accounting environment - Managers manipulating accounting numbers (or hide information from the public) will eventually be punished/sanctioned; such firms will face price declines - Accountants are more informed; they will find a way to manipulate numbers if they wish to

Qualitative Characteristics of Financial Information

FUNDAMENTAL - Relevance (predictive, confirmatory, material): related to decision usefulness role of information - normative theory - Faithful representation (complete, unbiased/neutral, free from error): related to stewardship role of information; Accounting information should include all the information necessary to understand the phenomenon depicted ENHANCING - Comparability - Verifiability - Timelines - Understandability

Historical Cost vs Fair Value

HISTORICAL COST: stewardship (most reliable information) FV: decision usefulness role (most value relevant information) - IASB and USGAAP more in favor of fair value accounting; majority of accounting framework now adopt decision usefulness as the main basis for standard setting, but elements of 'economic reality' still exist

Accounting Theories: importance

Help us explain / prescribe, understand, evaluate, and predict accounting practices. Without a theoretical understanding, we are not able to assess accounting practices and their underlying motives.

Behavioral inefficiencies in decision making: Three types of common heuristics

Kahneman & Tversky (1979): three types of common heuristics (individuals employ simplifying heuristics or judgmental shortcuts when making decisions): - Representativeness: an individual is assessed by its representative group - Anchoring and adjustment: individuals make an initial judgement, then only partially adjust their view with additional information - Availability: individuals act according to recollections that easily come to their mind- actual occurrence rate of an event is ignored

Accounting Theories: Mainstream Approaches

Mainstream: economic reality is objective, unique, measurable, independent, and out there for us to find - Normative (classical theories) - Market based theories - Positive Accounting Theories - Behavioral and contingency theories

Invisible Hand

Market forces help automatically reach equilibrium in a market according to supply/demand. No outside intervention such as government is necessary. Adam Smith Theory of Market Sentiments: regulatory intervention is in the public interest

Critical Accounting Theory

Marxist critique to accounting practices (note: though that not all critical research informed by Marx) - Capital owner accumulates wealth by exploitation - Workers feel alienated both from society and from the products they produce as their lives are controlled by external parties rather than by their own free choices - Existing accounting practices are in the hands of corporations, hence only help/support exploitation - Governments deal with the symptoms rather than the underlying disease, that is capitalism

Cash Flow Statement

Operating, Investing, Financial Activities

Three main hypotheses of PAT

PAT assumes managers act opportunistically when selecting methods: - Bonus plan - Debt - Political Cost

PAT: Opportunism vs Efficiency

PAT theorists form assumptions and hypotheses on two opposing arguments: OPPORTUNISTIC: contributes to agency cost (hypotheses of PAT) - ex post (opportunistic actions after the fact - self-interest - Overstate earnings and understate expenses EFFICIENT choices reduce agency costs (smoothing earnings may be useful and informative about future cash flows) - Efficient contracting mechanism minimize agency costs - ex ante (through optimum contracts, manager will select accounting methods efficiently reflecting underlying firm performance or economic reality) - Efficient decisions reflect economic reality (choosing FIFO/LIFO/WAC for higher net income)

Accounting System: Financial

Periodic financial statements and related disclosures - Useful to external decision makers (investors, creditors, suppliers, customers)

Alternative Accounting Theories: Institutional Theory

Provides a complementary perspective to Stakeholder and Legitimacy Theory - Explains how legitimacy mechanisms become institutionalized - Financial reports are subjective and selective; there are differences between actual organizational practices and publicly announced practices - Evident in differences between the disclosure of a firm and its real performance

Computing ROE

ROE = NI / Avg Shareholder Equity Ending Shareholder equity = beginning + NI + OCI - Payout to shareholder

Statement of Financial Performance (I/S)

Revenue, COS, Expenses, Net Income

EM: Earnings Quality

Share price (P) at time t = sum ( expected earnings next year / (1+r)next year) - Accounting standard setters' ultimate objective is to make earnings more predictable (normative). Earnings quality is measured as predictive ability of current earnings to future earnings - In reality, we cannot reach perfect predictability, earnings are subject to measurement errors embedded in accruals - Intrinsic value of cash is more than trade receivables (there is always a possibility that receivables may not be fully recovered) - Hence, earnings quality becomes key in forecasting

Alternative Accounting Theories: Stakeholder Theory

Stakeholder is an identifiable group or individual affecting-or being affected by a firm's actions - Financial reports ignore all stakeholders' need of information (they serve privileged groups such as investors and debt holders)

(6) EM: Most Common Methods: Creating overstated reserves to be used to boost income in the future (cookie jar, big bath)

Sunbeam recognized large restructuring charges in 1996 - It reversed the providing to boost falling income, providing a misleading turnaround picture

TBL: Business Reality

TBL does not contradict to maximized returns concept - Although TBL reporting entails costs; e.g., training, implementation, abiding by the guidelines, new taxes, additional facilities, giving up some products, etc. - Firms with TBL reports performed better during the crisis (public and market continue to choose them) - Public is now more aware of diminishing resources, ask fairer wages, cleaner water/air, fair trade, better health benefits, environment, etc.

Corporation Tax or Corporate Income Tax (CIT)

UK: 19% US: 35% last year (now 20%) - Japan: 30% - Companies move operations to countries with lower (Ireland 12.5%) - IAS 12 Income Taxes (relevant accounting standard) - Profits (income, earnings, gains) are taxed - Dividends taxed in hand of shareholder (profits already taxed within firm, logic: entity and individual are different taxpayer - whoever someone earns something, it is subject to tax if not exempted) - Some expenses are not deductible from tax - Measurement of profits for tax authority (taxable profit) and accounting profit can be different

Triple Bottom Line (TBL) reporting

Ulitmate worth of a firm should be defined not only by economical but also social and environmental terms - Provides a framework for measuring and reporting the performance of a company using the three lines: (1) Social - People: labor practices, community impacts, human rights, product responsibility (2) Environmental - Planet: air quality, water quality, energy usage, waste produced (3) Economic - Profit: sales, profits, ROI, Taxes paid, monetary flows, jobs created