Predicting Accounting Choices - Example

Predicting Accounting Choices Name Institution Predicting Accounting Choices Summary Accounting is based on empirically tested information whose reliability depends on the applicability in the past on the same line. For instance, if a certain accounting method could have been applied by a given company to solve a particular phenomenon successfully, it would be possible to employ the same method to solve a similar problem in future (Ball, 2013). Therefore, the predictability of the accounting methods is achieved by making observations on the past scenarios and comparing them with the current situation. The assumption is that by conducting several observations on a particular phenomenon one is able to better the ability to tell what will happen in the future once faced by a similar issue. This paper will focus on how accounting is used to positive or negative financial predictions so as to be able to make the best choices of the accounting policies. Introduction Application of accounting policies in the corporate world is a very vital and essential exercise that can’t be ignored at any cost. The success of any business will be determined by the kind of policies that are employed by the firm managers on various levels of the corporate governance in the company. This is because accounting enhances proper financial control and planning for the same. When the accounting standards had not been established worldwide most of the firms would employ policies that would help them maintain a good track of their financial activities and through which they would make predictions about the future. This paper will discuss the importance of accounting policies in firms and how they help in making proper predictions or positive predictions about the future. Moreover the paper will also elaborate some of the theories that explain the predictability of accounting system that is employed in the corporate world today. Several international accounting frameworks that are arbitrarily agreed upon all over the world will also be used for the furtherance of this study. Positive accounting theory This is a theory that tries to make ‘positive’ or good forecasting on the best accounting policies to be employed in the future by a firm so as to solve a certain issue (Gordon, Greiner, Kohlbeck, Lin & Skaife, 2013). The theory attempts to bring into the light some of the accounting choices that managers can make in order to achieve their goals given that there are some new accounting systems that have been put in place. Application of the positive accounting theories enables managers to respond properly to any proposed new accounting standard in the market. The term positive in this theory is used to mean that the main aim of the managers is to make accounting choice that will yield a gain to the company. The main objective of the accounting system is to help managers understand and be able to make forecasts on the best choice of managerial accounting policies. Therefore, positive accounting theory is a tool that helps the managers undertakes the process of choosing the best accounting practice effectively. Companies and organizations strive to organize themselves in the most efficient manner so as to capitalise on their prospects to survival. In order to achieve this there have to be accounting practices that enhances a positive predictability as this theory suggests The theory unwinds that firms consists of a nexus of contracts that are determined by such factors as institutional and legal environment within which the firm operates, degree of competition as well as the technological factors at any given time. As a nexus of contracts the firm managers try as much as possible to minimize the number of contracts in the firm so as to maintain the cost that is associated with them as low as possible. Most of these contracts consist of the information that firms may require in order to make the best decisions. Accounting policy choices are normally done so as to reduce the costs that are associated with the contracting processes. This is because contracting processes are normally supported by a certain accounting system. Moreover, accounting involves costs depending on the complexity of the process. The management team of various firms also needs flexibility in the accounting policies in order to be in a position to adopt any eventuality in the future. Flexibility to choose from a set of accounting policies When there are many accounting policies upon which the firm managers can choose from presents them with the ability to grab any available opportunity along their way. For instance the application of different ways of accounting for the depreciation of assets enables the managers to choose the system that suits their business. In accounting managers are viewed to be rational; they are effort adverse, self-interested and risk adverse, therefore, they make the choice of the accounting policies depending on the advantages that are connected to the policy chosen. (Prodhan, 2013) In making the choice for the accounting policies, one has to be opportunistic in that the choice should meet the company’s or the organization’s self-best interests irrespective of whether the policy maximizes profit or not. However, the policy ought to take into consideration the objectives of the corporate governance; reduced contracting costs. The advantage of information in the accounting processes is that managers are able to get an array of accounting policies thus solving the problem of inflexibility. Hypothesis of predictions with the accounting policies According to positive accounting theory predictions in the accounting policies can be organized into three main hypotheses; Bonus plan hypothesis According to this hypothesis accounting policies are chosen with the earnings in mind. The manager chose the accounting policy that will enable them to move the earnings to the current period as far as remuneration is concerned. The motivation is that by maximizing the company’s net income the managers believe they will be able to maximize their utilities as well through the incentives and bonuses. This hypothesis views that the employees compensation is determined by the ability to employ an accounting policy that is able to reduce the contracting costs thus improving the company’s earnings. Debt covenant hypothesis Managers will select a policy that will enable them take the earnings through compromising of the debts into the current period and reduce the possibility of any kind of technical default. This is because managers are able to shift the firm’s earnings from the future periods into the current time by lowering the possibilities of technical defaults on the debts. Political cost hypothesis This hypothesis suggests that accounting policies should be chosen with an aim to move the earnings to a future period. This can be done by reducing the political costs on the firm hence minimize the use of accounting policies. The less the accounting policies the simpler it is to deviate the currently reported earnings to future periods. It should be noted that by improving the firm’s profitability consumers attention is also won hence an increase in the taxes that the government charges from what the firm sells as well as other costs related to political regulations. The three hypotheses summarises the positive accounting theory as well as its ability to make predictions on the best type of accounting policy to be employed. They also make the theory empirical and verifiable. Empirical research on the positive accounting theory suggests that some of the hypotheses may not necessarily adhere to what the theory maintains but there is a possibility of some being violated. For example it has been discovered that where the managers operate with the bonus incentive plan they usually take up policies that encourage accruals so as to improve their expected bonuses. For the debt hypothesis it has been noted that the debtors insist on carrying out income-improving accounting policies before defaulting the debts. Moreover, in order to be more attractive to the consumers firms have also been seen to manipulate their net income so as to entice the investors. (Ball, Kothari & Nikolaev, 2013) The survival of a firm The ability of a firm to survive given that there are competitors as well as an array of accounting policies will be determined by the choice of the accounting method taken. A firm will check on the cost effectiveness of the accounting method before engaging on its utilization. Where there are competitors in the market those firms that organize themselves and employ accounting methods that minimize the contracting costs they are able to survive in the market. Conclusion Accounting provides a framework for predicting accounting choices as described in the following agreed rules of accounting system in the world; AASB (Australian Accounting Standards Board), IASB (International Accounting Standards Board),FASB (US-based Financial Accounting Standards Board, ICAA (Institute of Chartered Accountants in Australia) and CPAA (Certified Practising Accountants Australia). This is because as it has been discussed in this paper accounting policy choices are not just done but there has to be a given procedure to do so. For that reason a framework has to be developed upon which every manager has to adhere to in order to make the best decision as far as accounting policies are concerned. Positive accounting theory is used in making the best choice of the accounting policy for future predictions. References Ball, R. (2013). Accounting informs investors and earnings management is rife: Two questionable beliefs. Accounting Horizons, 27(4), 847-853. Ball, R., Kothari, S. P., & Nikolaev, V. V. (2013). Econometrics of the Basu asymmetric timeliness coefficient and accounting conservatism. Journal of Accounting Research, 51(5), 1071-1097. Gordon, E. A., Greiner, A., Kohlbeck, M. J., Lin, S., & Skaife, H. (2013). Challenges and opportunities in cross-country accounting research. Accounting Horizons, 27(1), 141-154. Prodhan, B. (2013). Multinational Accounting: Segment Disclosure and Risk (Vol. 59). Routledge. Read More